Could Dubai be the spark for a correction?

In my last post I indicated that the US Dollar was poised to rally because of excessive bearish sentiment. Many market analysts had opined that the stage was set for a USD rally but any USD reversal needed a spark such as a geopolitical event.

We may have seen that spark. The world awoke this morning to the surprise news of the potential default by Dubai World.



As FT Alphaville puts it [emphasis mine]:

Dubai’s government stunned the debt markets on Wednesday by asking for a 6-month standstill on the debts of its flagship holding company Dubai World.

The shock move came just hours after the Government of Dubai raised $5bn via a bond issue, the proceeds of which traders had rather naively assumed would be used to pay back a loan issued by Nakheel, Dubai World’s property arm.

This may seem like a stupid and naïve question, but how can someone ask for a debt standstill just hours after raising a bond issue without some disclosure in the prospectus document?

Overnight the markets have moved from euphoria over the prospect of a V-shaped recovery to the despair over a potential sovereign default. Get ready for Extremistan.

Is the USD poised to rally?

As good market analysts know, when the public gets on board a story, chances are everyone is already in the trade and the trend is likely to reverse soon. So it is with interest that I got the following viral email entitled "What good is a Dollar?"

The answers: Make a penguin
A dragon:


Camera:


Butterfly:



Scorpion:


You get the idea. With investor bearishness on the US Dollar at an extreme reading, who is left to sell?

The USD is the funding currency for a lot of carry trades (buy the high yielding currency and sell the low yielding currency). Should the greenback rally, it would mean a lot of hedge funds and currency desks would have to immediately de-risk and the ensuing sell-off as market participants rush to safety won't be pretty.

Global cooling?

I woke up on Saturday to see the New York Times headline Hacked E-Mail Is New Fodder for Climate Dispute. The New York Times headline editor was restrained while others were far more outraged. As an example, Mish’s blog stated the story as:

It's now official. Much of the hype about global warming is nothing but a complete scam.

Thanks to hackers (or an insider) who broke into The University of East Anglia's Climatic Research Unit (CRU) and downloaded 156 megaybytes of data including extremely damaging emails, we now know that data supporting the global warming thesis was completely fabricated.

He went on to detail some of the incriminating emails in his blog post about the alleged conspiracy to fudge the data. You can also see the emails here.


Sunspots and global cooling
Before the news of this hacker break-in, there had already been skepticism about the global warming thesis. I had previously speculated on this topic in a post:

What I am writing here may be sacrilege to some people. The popular consensus about Global Warming is that the Earth is undergoing a warming period caused by the effects of industrialization. However, there is another view that global warming is caused by solar activity – sunspots and solar winds.

Currently, the forecast for the latest solar cycle is that it’s late. Such extended cycles have been associated with cooling periods such as the Little Ice Age experienced a few hundred years ago. Indeed, there have been reports that there is more ice in the Arctic (yes – it’s only one data point) and there has been some hand wringing among the scientists about the timing of the solar cycle.

Is this theory about solar activity correct? I have no idea. I do have allow for the possibility that it is a valid one and should the Earth enter a cooling period, this would be bullish for energy demand and result in higher energy prices.

There are links between solar activity, climate and commodity prices. In 1823, William Herschel reported finding a correlation between sunspot activity and wheat prices. In June 2009, NASA announced that a Dalton Minimum is possible, which implies that world could undergo a period of cooling.

I am not investing based on global cooling as my base case, but what happens if Mr. Market decides to price in the possibility of global cooling?

What do you think that would do to energy demand if the Earth were to undergo a period of global cooling?

What are the possible effects on food production and commodity prices?

Just thinking out loud...

The price of cheating death

I was at dinner with some friends and the conversation turned to the topic of undiscovered investment opportunities. One of my nominations for undiscovered investment theme was life extension technology. In October 2009, the respected medical journal Lancet published a study indicating that given the trend of progress in life extension strategies, people born in the year 2000 in today’s major industrialized countries will likely live to 100.

What does that mean for investors? Who are the winners and losers under such a scenario?


Biotech a winner?
The natural winner in life extension is the biotechnology industry. But not so fast! The real winners may not be available for investment.

Here is a case in point. Back in 1979-80, I correctly identified the microcomputer (they were called microcomputers back then as IBM didn’t introduce the PC until August 1981), would be the growth industry of the future. I told anyone who listened that the microcomputer would be as common as the office photocopier in five years. I was wrong, it was more common than the photocopier as there were multiple PCs in most offices.

Who were the major publicly listed players in the microcomputer then? They were Commodore, Tandy (Radio Shack) and Atari, which was a division of Warner Communications. Apple hadn’t gone public yet and hadn’t gotten into the business at the time. Microsoft was just a small private concern.

This story shows that it is possible to identify a long-term trend, but the winners may not be available to the ordinary investor for quite some time.

If we can’t invest in the more obvious primary winners of a trend like life extension, we can identify the winners and losers from second order effects of longevity.


Loser: Pension funds
There has been an implicit social contract in Social Security and other defined benefit pension plans. Contribute to it and we pay you when you retire, but you promise to die on time.

What if people stopped dying in accordance to the actuarial projections? Today, the leading edge of the post-World War II Baby Boom cohort are now beginning to face retirement. There have also been a tremendous amount of work being done on life extension strategies, which will likely to bear fruit in the next ten years or so. If these strategies begin to take effect for the Boomers as they enter retirement, then the extension of even a few years of expected lifespan would increase pension fund liabilities.

Already there have been a number of terrifying articles on the path of the U.S. budget and Social Security by Laurence Kotlikoff. Here is an example of Kotlikoff’s projections (and this was written in 2006 before the advent of the trillion dollar deficits):

To close our fiscal gap, we face a menu of pain: raise income taxes 70%, hike payroll taxes 109%, cut Social Security and Medicare a combined 41%, eliminate 79% of federal discretionary spending, or some combination.

In a later study, however, Kotlikoff revised his projections by stating that China can save the day but the results wouldn't still be pretty.

At the extreme, pension benefits may have to get modified. David Merkel at Aleph Blog wrote that retirement is a modern invention. If things get bad enough, we may have to un-invent the concept.


Winner: Life insurance companies
The reverse side of the pension plan liability coin is the life insurance business. If you are paying premiums based on an expected life expectancy of, say 78 years, and you die at 85, then you will have overpaid for insurance protection. The life insurance company wins, at least from a financial viewpoint. Multiple that by several million people and you get an idea of the gains the industry faces.


Winner: Equities and real estate
In America, the effects of the Baby Boom generation are well known. They grew up, dabbled in alternative lifestyles, went into the work force, bought houses and now they are now approaching retirement. Standard retirement planning prescriptions has been to heavily invest in equities when young and lower the equity allocation with age. The question is, with the huge number of Boomers, who are they going to sell their stocks and houses to? The next age cohorts, popularly dubbed Generation X and Y, don’t have the same sheer numbers as the Boomers.

If the Boomers live longer, then the selling pressure on their equity and residential real estate holdings will lessen.


Possible losers: Gen X and Y
If these life extension technologies arrive in time to affect the Baby Boomers and combined with pension pressures, will the Boomers be tempted, or forced to stay at the wheel and work longer than expected? If so, what happens to the cohorts behind them? Will the Gen X cohort and Gen Y behind them be frustrated by lack of advancement because the Boomers refuse to relinquish their mantle of leadership?

What about Europe? There is a smaller Baby Boom generation in Europe, but that cohort is about ten years behind the post-World War II baby boom effect well-known in North America, Australia and New Zealand. This European age cohort will have more time to take advantage of these technologies. What will happen to social and demographic pressures were that to happen?


Other winners and losers
The purpose of this post is to encourage debate and comments are welcome. Can you think of any other winners and losers?

I have tried to avoid the simple analysis of “leisure industries would be the winners” as people live longer and tried to think more about the longer term implications. I would welcome any comments on this long-dated theme, especially from actuaries.

This is a “big picture” investment thesis with a time horizon that is longer than the horizon of most investment managers, much like the controversial Peak Oil thesis (which gained greater attention last week from the controversy over IEA’s projections). As such, I expect that the theme wouldn’t get a lot of investment traction. Nevertheless, it’s important to keep your eye on the horizon as you invest.

Fundamental meets technical analysis

The mark of a good fundamental analyst is the ability to dig and look for data points that the rest of the market hasn’t really focused on. So it is with great interest that Jeff Matthews, who often has good fundamental insights, indicated that the economy may be improving or poised to improve because of extremely low inventory levels that he is seeing on a bottom-up basis. In addition, FedEx had reported improving volumes back in September, another sign of economic improvement.

Matthews concluded that this argues for buying transportation stocks and went on to speculate that this was one of the reasons why Buffett wanted to buy Burlington Northern:

But given the fact that he stands at the center of an economic supply chain that stretches from a candy maker in South San Francisco to a high-tech machine tooling supplier in Israel, we think it’s no wonder Warren Buffett decided the time was right to buy the rest of Burlington Northern.

There’s going to be a lot of—to be technical again—stuff that will need to be getting moved around in the next twelve months.

It’s the inventories, and Buffett isn’t stupid.

Where is the market consensus?
One of the failings of fundamental analysis, however, is that fundamental analysts may be correct in their analysis but they can get their timing wrong. So is Jeff Matthews early?

To get an idea of the market consensus, the chart below shows the ratio of the Dow Jones Transportation Average relative to the Dow Jones Industrials Average. As you can see from the chart, the Transports show no sign of life on a relative basis and could be argued that it is in a minor downtrend.

Is Jeff Matthews mistaken? early or what?

For Buffett to be so tactical with an investment the size of a Burlington Northern would be out of character for him. As for Matthews' call for a growth surprise, I prefer to wait for some confirmation that market perception has turned before hopping on board his train.

To each his own.

Possible Chinese re-valuation: Why now?

Ahead of Obama’s visit to China, the markets have been abuzz with a statement from the People's Bank of China that it will consider “changes in international capital flows and the trends of major currencies”. This is a departure from the broken record mantra of keeping its currency “basically stable at a reasonable and balanced level”. These statements have created speculation that China is ready to either revalue the RMB upwards or allow it to float.

Analysts have said for years that China will start to move when it is ready. So why now?

I can think of several reasons that, put together, might have prompted this change in attitude, as evidenced by several headlines that have crossed my desk:

• China is preparing the ground for the RMB as a regional currency, which lowers the demand for the US Dollar as a medium of exchange for world trade (hat tip Ron Liebis). There is the news that HSBC is facilitating trade using the RMB as a medium of exchange.
  
  
• China wants to continue to inflate, at least in the short term. When you read through the rhetoric, China is to continue its loose monetary policy despite its high growth. Isn’t loose monetary policy under these conditions inflationary and would tend to devalue your own currency?
  
  
• Chinese culture is big on "face". Making this statement ahead of Obama's visit gives the president "face" and shows for US consumption that he is making progress with the Chinese on the currency issue. They are more or less ready to move in any case so making these statements now cost them nothing.

What is not a reason? Tim Geithner’s statement that “I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar.”

Watch the wheels within the wheels of Chinese policy.

Unemployment and stock prices

I normally have a live and let live attitude toward other people's market analysis. Once in a while, I come across research that seem so misguided that I feel compelled to speak up.

A blogger recently posted an intriguing bit of analysis on a discussion group that I subscribe to and it was entitled 10% Unemployment: A Remarkable Signal for Stocks. He shows the chart below and concluded that “[h]istorically the stock market has performed exceptionally well after unemployment has peaked.”




How do you know unemployment has peaked?
That’s interesting analysis, but how do you know that unemployment has peaked? The latest NFP figures don't seem to be pointing toward any peak in unemployment. By contrast, David Rosenberg of Gluskin Sheff believes that U.S. unemployment is going to see 12-13% before this is all over [emphasis mine]:

There are serious structural issues undermining the U.S. labour market as companies continue to adjust their order books, production schedules and staffing requirements to a semi-permanently impaired credit backdrop. The bottom line is that the level of credit per unit of GDP is going to be much, much lower in the future than has been the case in the last two decades. While we may be getting close to a bottom in terms of employment, the jobless rate is very likely going to be climbing much further in the future due to the secular dynamics within the labour market…

Think about it. We haven’t yet hit bottom on employment but that will happen at some point. Employment is not going to zero, of that we can assure you. But when we do start to see the economic clouds part in a more decisive fashion, what are employers likely to do first? Well, naturally they will begin to boost the workweek and just getting back to pre-recession levels would be the same as hiring more than two million people. Then there are the record number of people who got furloughed into part-time work and again, they total over nine million, and these folks are not counted as unemployed even if they are working considerably fewer days than they were before the credit crunch began.

So the business sector has a vast pool of resources to draw from before they start tapping into the ranks of the unemployed or the typical 100,000-125,000 new entrants into the labour force when the economy turns the corner. Hence the unemployment rate is going to very likely be making new highs long after the recession is over — perhaps even years.

Buyer beware
This is a lesson for individual investors of buyer beware. This analysis sounds like generic boosterism for the stock market. While I understand that investment advisors may have their own agenda in promoting a certain viewpoint, experienced advisors know that success comes from serving their clients’ long-term interests.

Investors and analysts need to learn to thimk!

Bookstaber goes to the SEC

I see that Richard Bookstaber is moving to the SEC. Good for him!

I hope that this is the start of some adult supervision by the regulatory authorities. Consider what Bookstaber had to say about the banking system in an older post on his blog:

The last thing a bank wants is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.

How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand and price. And, second, by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.

There is a lot of asymmetries in the i-bank business, according to Bookstaber:

Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.

If we were to look at the sorts of strategies employed by large investment firms and banks, my bet is we would see a bias toward short volatility, short gamma, short credit and short liquidity. All facilitated with innovative products – you can’t really do the first two without derivatives – and all leading to these sorts of return characteristics.

Government support = regulation
If banks want to pursue these asymmetric strategies and get the government to backstop them, then they have to accept some form of regulation. David Merkel at Aleph Blog, has just put up a good post on the nuts and bolts of how to approach banking regulation.


Otherwise bring back the partnership i-bank
The other alternative is to bring back the partnership investment bank and eliminate government support. Having most of your own net worth tied up in your business will focus the partners on the risk side of the business a lot more. Isn’t it funny that partnership based entities like legal and accounting firms generally don’t have the same problems as investment banking? The last time we had a big blowup (Arthur Anderson), we didn’t see accountants running to the government for a bailout.

What if the social fabric tears?

I have written before about what academics call anchoring, or expectations. My previous post was about the anchoring of inflationary expectations. This time, it’s about the social fabric of America, which is far more important.


The American Dream
The mythic story of America has been the American Dream. America has long held to be the Land of Opportunity, where people like Michael Dell could build an empire by selling computers out of his college dorm.


How much unravelling can the Dream take?
I posted previously that an OECD study showed that social mobility in the United States is actually lower than more “egalitarian” countries like Denmark and Norway. But those are only statistics and statistics don’t really impact the social psyche.

What is a greater concern to me is how the American Dream is unravelling in some parts of America in the wake of the Great Recession. A good example can be seen in a post at Naked Capitalism about the trials and tribulations of a family struggling with unemployment and credit card debt. Here are some messages from the family:

We haven’t eaten out in years, never pick up fast food, ever, don’t walk the malls, never received any public assistance, have a 2000 Tundra and a motorcycle to save on gas, make everything from scratch (even my own homemade laundry soap!)… frankly, I don’t know many folks around here that have saved for a stormy day. Saved? That’s a joke to most of us. We’ve gotten our phone disconnected and share a cell phone, we plan each and every trip to the store with a list of necessities, haven’t had a vacation in over 15 years, and up until my husband got a job last week, we were selling everything we could sell in the house on ebay. At least I am cleaning out the closets that haven’t been cleaned in years.

And:

We had lentils and cornbread last night…yum yum, and we’ll heat them up tonight as well. I did mention that my husband got his first paycheck last Friday. Sent from Heaven. We celebrated with brats and homemade kraut and hard rolls! Beats a t-bone any day in our book. Hubby is from Austria, so he can make some great kraut.

A Naked Capitalism reader responded [emphasis mine]:

I am astonished at how many readers you have who have no idea whatever how the financial bottom fourth or fifth of America lives. When I was a kid in western Kentucky I had a few classmates who lived in unpainted old clapboard houses out in the country, in some cases former slave quarters and so a century old. I remember one such house that even had a dirt floor. When I was little my mom’s parents lived in a tiny mountainside house in Appalachia that had no indoor plumbing. They hand pumped water from a well and heated it on a coal stove, and for a toilet across the dirt road there was an outhouse that hung out over and dumped onto the weeds on the descending slope. Stunk to high heaven, of course, and there were lots of bugs. At eight years of age, having to go in the middle of the night armed only with a flashlight was a character-building experience.

Things are a little better in the rural south now, but they sure aren’t good, now that the small farms are gone. In my adult life I’ve seen one relative living in a broken-down trailer with a caved-in roof and a goat tied up in the yard. And I’ve seen my cousin, with a small-college degree in math no less, getting by for a good while in the middle of nowhere, south Carolina on $9,000 a year from intermittent and part-time jobs. We can be all snooty about the poor not working hard enough, but I’ve also seen a sister quit a job pulling visibly diseased tissue off of Tyson chickens on a production line rather than get campylobacter one more time. We demand they live and act all middle class, but as a society we honestly don’t give them half a chance.

These guys who talk about saving hundreds of $thousands in small-town rural America are particularly irritating. How do you do that on $9K/year or $12K/year exactly? The US Census Bureau says in 2007 the bottom 20% of US households earned less than $19,178, so these are not trivial numbers of people. We never won our war on poverty really. We just forgot about it when the conservatives become obsessed with the hordes of welfare queens (and drag queens) that they imagined were filling our cities.

One of my big shocks when I started traveling more was to discover that compared to a lot of places a large part of the central and southern US (including parts of the upper Midwest) was actually what used to be called a third-world country, with way more poverty, illness, and borderline illiteracy than Europe et al. Re literacy I remember in Turkey seeing Chekov plays for sale at a truck stop in the middle of nowhere. My Turkish friends thought it odd that I’d find that odd. To them it was perfectly reasonable that a truck driver might want something interesting to read.

Does the social fabric tears? How do people anchor expectations?
As the Great Recession takes its toll on the bottom half of the US population, what happens if people anchor move from America the Land of Opportunity to Third World America the Land of “broken-down trailers with a caved-in roofs and a goat tied up in the yard”?

The mood of America could very well turn from being aspirationally driven to one where “I want my slice of the pie.” The former promotes growth while the latter leads to social turmoil and highly investor unfriendly. At its worst, it can result in socialist and communist tendencies if dominated by the Left, or skinhead-like tribalism if dominated by the Right (think KKK or even Hitler).

Where the middle class goes, so goes social stability. If there are significant tears in the social fabric, then does the world start anchoring on America the Superpower to America as another country, just like Brazil is another country?

Before you dismiss this as leftish claptrap, consider this Randall Forsyth commentary in that bastion of socialism Barrons about the captain and galley slaves who are at risk of getting thrown overboard. (And if this mentality is getting into the pages of Barrons, what does this say about the rest of the country?)

Watch this space. While I don’t believe that a descent into chaos is inevitable, it is definitely a risk and would create incredible social, political and financial upheaval not only in the United States, but the rest of the world.

Those risks are now just starting to show up in the currency and commodity markets.

Are the bulls exhausted?

What more do the stock market bulls want? The latest statement is dovish as you can possibly ask from the Fed [emphasis mine]:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

Despite the tone of the FOMC statement, the stock market rolled over in the last hour of trading. The leaders of this rally, such as small caps, are now leading the charge to the downside relative to the S&P 500:



Similarly, the banks, as measured by BKX, is showing a similar pattern:

You can tell the tone of a market in the way it reacts to news. This reaction tells me that the bulls are exhausted and the path of least resistance is down.

Get ready for Extremistan

Nicholas Nassim Taleb, the author of The Black Swan, has been talking about the states of Mediocristan and Extremistan. The two concepts has been described as follows:

"Mediocristan" and "Extremistan" are two world domains. In the former, extremes exist but are inconsequential, in the latter, extremes are not expected, but play a massive role. In the former, the ordinary plays a massive role. In the latter, one's wealth can change massively in a second.

What makes the pre-conditions for Extremistan? John Robb, who blogs at Global Guerilla, describes the conditions for extreme events.

• More winner take all competitions. As in: a small number of individuals or companies win everything. More inequality and less social justice are inevitable.
• Actions by individuals and small groups generate increasingly extreme results (this is akin to the superempowerment thesis for global guerrillas readers). As in: "eventually, one man might be able to declare war on the world and win."
• Systemic events, both negative and positive, will occur at a high frequency, faster and with more extreme outcomes than ever before (this is also a common feature of unstable, high performance systems that lack a correspondingly high performance control system -- as in, you don't need to predict far in advance if you can correct fast enough).

These conditions sound much like the circumstances described by Simon Johnson, former chief economist at the IMF, in his Atlantic article. Johnson describes a society where there are class differences and when crisis hits, the elite gets bailed out and the middle and lower classes take the brunt of the adjustment. In the end, the rich get richer.


What about China?
Can China save the world? In the current financial crisis, China is held out as the last refuge of hope. Its economy is growing while other major industrialized countries are mired in no or slow growth. It has massive reserves, which could serve to forestall the worst effects of deflationary adjustments.

Mike Pettis, who blogs at China Financial Markets, believes that Chinese growth is not sustainable in the medium term. If and when Chinese growth is perceived to be rolling over, then the markets could fall hard [emphasis mine]:

I spend a lot of time talking to large hedge funds and institutional investors – with at least three or four one-on-one meetings a week – on China and market conditions. It worries me that recently I have heard investors say many times, generally very sophisticated investors, that we are clearly in a bubble and the best strategy is to ride it out as long as we can. This has almost become one of the mantras of sophisticated investors – the less sophisticated, I guess, assuming that the crisis is safely behind us.

It worries me because of course we can’t all collectively ride the bubble and bail out before everyone else does. I wonder if this means that an awful lot of the big funds can be expected to rush to the doors at the same time when things turn bleak. If so, of course, that means we are likely to see both the upside and the downside market risks increase. Several of my fund management friends have insisted the problem has to do with the nature of hedge fund compensation. Most of the hedge funds were hurt pretty badly in the financial crisis, but a very large number of them were very pleasantly surprised by how quickly they’ve been able to make back a substantial share of their losses.

In China, we also find elements of Extremistan.


What can investors do?
This all adds up to an Age of Instability. Jim Welsh, writes in his newsletter:

History suggests that these extended periods of instability (1929-1949, 1966-1982), do not reward investors who buy and hold, or the institutions that disdain cash. As a kid growing up in the Midwest, during July and August, I always wore a t-shirt and shorts and wore a crew cut. In January and February, my hair was longer and I never went outside in shorts and a t-shirt. (Well maybe once on a dare.) If my parents had known, they would have rhetorically asked me if I was stupid. So here’s a worthwhile question. Why do investment professionals advise their clients to simply buy and hold, whether we are in a period of stability or instability?

This brings me back to a theme that I have talked about before. There are no models for all seasons. Buy and hold may not be appropriate in the Age of Extremistan.

In an era of instability, you need to use models that capture and profit from the instability. An example is the inflation-deflation timer, which would be well-suited for an environment where market expectations oscillate between the Arctic deep freeze of deflation and the equatorial heat of runaway inflation.


The Inflation-Deflation Timer for Canadians
Incidentally, I have also updated the Inflation-deflation timer for Canadian Dollar investors. The analysis resulted in a model whose back-tested returns beat all other asset classes by 10% or more during the test period. As the chart below shows, the Inflation-Deflation Timer slightly outperformed a 60% stock/40% bond portfolio in “normal” times and stood out during crisis periods. Downside risk was slightly better than the 60/40 balanced fund.




What’s more the Inflation-deflation timer appeared to be a highly diversifying asset to a 60/40 balanced portfolio. A minimum risk portfolio would indicate a 45% allocation to an Inflation-deflation timer strategy.


You can find the full details of the Canadian model here.

Watching central banks for direction

As the markets wait this week for statements from the FOMC and other central banks around the world, here is what I am watching for in the central bank announcements.


How worried is the Fed about inflation?
Central bankers don’t speak off the cuff. Paul Volcker was once joked that when he went out to dinner, he felt compelled to say “I’ll have the steak but that doesn’t mean I don’t like the lobster.”

It is therefore interesting that several Fed governors have started talking up the dangers of inflation. I wrote in a previous post that Don Kohn made a speech indicating that they were concerned about the “anchoring” of inflationary expectations. If inflationary expectations rise, then it would take a lot of tightening (e.g. Volcker’s painful and tight policies of the early 1980’s) to get them back down again.

If the Fed is becoming worried about anchoring, then expect a more hawkish statement.


How do you define inflation?
In my post What kind of inflation I pointed out that inflation would like show up in commodity prices. (Isn't it funny that that the countries that have raised rates so far, i.e. Australia and Norway, are mainly resource based economies?)

If you were to measure inflation by core CPI, it is likely to be subdued. Indeed, other core measures such as trimmed mean PCE has been trending down. Commodity price inflation may show up a bit more in headline CPI, but rises in headline CPI is likely to be restrained by the deflationary effects of all the excess slack present in the economy.

How worried is the Fed about inflation? And what how do you define inflation?


What happens to the USD carry trade?
What do the other central bankers do this week? Will the Fed’s comments be in sync with the announcement from the ECB or BoE? The tone of policy coordinarion (or lack thereof) could have huge effects on the US Dollar and FX markets.

As Art Cashin pointed out, the USD has been the funding currency of choice in the carry trade. The downdraft seen in the markets last week has been the result of a rally in the greenback, which led to a general de-risking of portfolios and trading books.

After the dust from the central bank statements settles and if the USD continues to rise, then we may be witnessing a sea change in expectations and market tone. In such a case, we can expect further downside in the equity and commodity markets.

Is this the long awaited correction?

As the S&P 500 began to weaken last week, there has been a cacophony of voices declaring that this is THE CORRECTION. The questions in a lot of investors’ minds are:

• Are we starting a major correction?
• If so, how far down are we going?

Personally, I believe that the market’s fundamentals were too overstretched for this to be a minor pullback and I concur with the assessment that the bears are taking control of the tape. The tone of the instant euphoria over yesterday's one-day rally of 2% is a contrary bearish signal that this market has further downside in the weeks ahead.


How far down?
Downside targets for the S&P 500 vary wildly. Among technicians, the 920-950 level is often cited as a target, a 10-15% correction. That target level would roughly be the 200-day moving average should the market decline to those levels in the next two or three months.

More bearish types like David Waggoner at Minyanville has suggested that a multi-year top could be in and the “next intermediate level pivot down is around 882”.

Fundamentally oriented investors appear to be more bearish than technicians. Jeremy Grantham’s latest quarterly letter stated that GMO’s fair value on the S&P 500 is 860. Grantham believes that a correction, when it comes, would be at least 15% and would likely overshoot their fair value estimate – which makes downside risk considerable from current levels. David Rosenberg believes that the market is 20% overvalued. By contrast, the market appears even more overvalued if we were to use Tobin Q as a valuation standard.


What to watch for
Trying to guess the downside target here is a mug’s game. I have no idea whether this is a minor pullback or a major correction that could see us test the 666 old lows. I believe that the bears are in control, but here is what I am watching for to see how far the market could decline.

• What is the appetite for risk? Don’t forget that the market’s rally from the March lows has been a risk trade all the way up. It’s hasn’t been just stocks that have been rising, but all risky assets. I would therefore watch all risk measures, such as quality spreads in the bond market. More importantly, I would watch the US Dollar. Art Cashin recently suggested that the USD has been the funding currency for currency carry trades and a big reversal in the greenback could cause over-leveraged hedge funds and trading desks to de-risk in a hurry. If reversals in the Dollar are subdued, then corrective action in the stock market could be subdued as well.
  
• What about sentiment? In my post A fragile and frothy market I pointed out that institutions and hedge funds were in a crowded long, but individual investors had been skeptical of the market rally. Watching indicators like the AAII sentiment surveys would be an important sign in the weeks ahead of whether individuals buy on weakness, which would be bullish short term but bearish medium term, or stay cautious, which may portend a more limited correction. If individual investors are convinced that the economy is truly turning around (and never mind the snark) and buy, then it could truly be a sign that we may have seen a multi-year top for the S&P 500.

The elusive search for a quant alpha

My post Why I am not a bottom-up equity quant generated a fair amount of feedback, both on the comments section and by email. I have had a number of interesting exchanges, particularly on where I believe a quantitative alpha can be found.

To briefly summarize my point in my previous post, the barriers to entry of bottom-up equity quantitative analysis has dropped dramatically over the last couple of decades. As a result, the competitive advantage of using multi-factor bottom-up quantitative stock selection techniques has eroded considerably. We are all using the same databases and the same tools. Is it wonder why we wind up in the same crowded trade and bottom-up stock selection alpha is becoming such an arms race that no one can win?


Back to first principles: Modeling human behavior
To find the ever elusive alpha, it is important to go back to first principles and ask: Why does quantitative analysis work?

Unless you can convincingly answer that question, you will not find an enduring alpha.

The roots of quantitative analysis came out of the anomalies research literature written by finance academics starting in the 1970s. Remember the low P/E anomaly? The P/B anomaly? Small cap and neglect effect? That research was followed by inquiries into earnings expectations and surprise, etc. Investment managers took many of those insights and implemented them in a systematic way in their portfolios. Thus quantitative analysis was born.

What many quants never understood or forgot why buying low P/B stocks gave you better returns. Stocks with cheap valuations, as measured by low P/B, usually have something wrong with them fundamentally – a “yuck” factor. Buying them required an investor to hold his nose from smelling the “yuck” in the portfolio. Quantitative analysis gave you the discipline to buy those stocks.

It was true in those early days and it is true now. The value of quantitative techniques is the systematic application of a principle that exploited human behavior.

Many quants have forgotten the human behavior modeling part of building models.


Still an alpha in modeling human behavior
I can suggest a couple of ways to build quantitative alpha. Both of them require work and real change in the genetic disposition of how quants are trained and think.

The first is the geeky solution.

Today, most bottom-up multi-factor models use common factors like P/E, P/B, EV/EBITDA, etc. While that is a useful technique for valuing stocks from 30,000 feet up, why not use the powerful of the computer to get much closer to the ground?

We know that industry analysts analyze their companies differently. A retail analyst will focus on metrics like same store sales (often released monthly), sales per foot (what are the drivers to sales per foot?), etc. An energy analyst, by contrast, might focus on finding costs, lifting costs, refining margins, etc.

We have the technology. Why not build specialized industry expert systems to analyze stocks by industry? Why use common metrics like P/E or Price to Sales across all industries (what is Price to Sales for a bank?), when they may not be relevant to that industry?

Expert systems lie in the Artificial Intelligence realm, but AI research has come a long way and it is time that quants applied this kind of technology to investing. Does this require real work? Yes. Does this involve a major investment in technology and development? Yes, but where do you think competitive advantage comes from?

Think of this approach as a way of using the systematic discipline of quantitative analysis to model fundamental investor behavior.


Be more heuristic
Another way is to become more empirical and heuristic in using quantitative techniques. The approach that I outlined in my previous post of moving toward top-down analysis is an example of this.

Avner Mandelman also wrote a great column on using heuristic techniques to marry the power of quantitative analysis to the insight of fundamental investors. That’s also a great solution.

To each his own.


Changing the firm
Make no mistake. Changing this way requires real work and changing the very culture and genetic disposition of quantitative analysts. Quants will have to become much more market savvy. For example, I have spoke to finance academics and interviewed junior quantitative analyst candidates who only have no idea of how to execute a trade and have a foggy idea that, yes, there is a bid-ask spread.

Years ago, I had a job interview with a very large asset management firm with assets in the hundreds of billions. Quants were compartmentalized in sub-functions. One group is responsible for stock selection alpha, another for sector alpha. Portfolio construction is the purview of a wholly different group, which is sometimes geographically removed from others. Portfolio implementation and trading is done by another. Well, you get the idea. Firms like this tended to be populated by quants with very impressive academic credentials. The core belief of these kinds of firms tended to be that if we could get smarter PhDs, we can build the next generation earning surprise model (or whatever model), and get a better alpha.

That kind of compartmentalization encourages a degree of over-specialization that creates a form of dysfunction in the firm. People are not encouraged to see the big picture. You are certainly not required to be market savvy. The way you get to the top of these behemoths is to be better technically and play the right political games, just as the way you get to the top of an investment bank is to be the better revenue producer without an understading of the bigger issues.

Firms built like that are destined become dinosaurs. They will mine lower and lower grade ore until they wake up one day and realize that the ore body is all gone.

Quantitative investment firms need to change if they are to pursue the next generation of alpha. But to change, they have to work harder and differently. It requires cultural change.

Cosider the case of Jeremy Grantham as an example of cultural change. Grantham co-founded GMO when he left Batterymarch, a former employer of mine, and both managers are known to be highly quantitative. Both have moved beyond their pure quant roots. Grantham's latest quarterly letter touches on a variety of topics:

• Valuations are still stretched (S&P 500 fair value is 860), but corrections are likely to be subdued. He wrote six months ago that "regardless of the fundamentals, there would be a sharp rally" because the market had, in effect, overshot. Nevertheless, near-zero interest rates and other forms are stimulus are likely to put a floor on this market.
• He believes that an emerging markets bubble is forming. Value managers would tend to get out and buy something else that's cheaper, but not Grantham: "For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon. Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early."

These selected musings don't sound like the dogmatic assertions of a single-paced quantitative modeler (we believe in X, whether X is quality companies, low P/E, P/B, etc.) but possessing of situational awareness.

In conclusion, quant is not dead. I have demonstrated that it is possible to build quant models that does not put you into a crowded trade. You have to change the way you think and work harder.

What kind of "inflation"?

The inflation or deflation debate remains highly bifurcated, with many prominent investors and economists on both sides.


Nobel laureates among the deflationists
In the deflationists’ corner, we have Nobel laureates Joseph Stiglitz, Paul Krugman (who has argued vehemently for the deflation case) and prominent bond manager Bill Gross. To paraphrase their case, the deflationists believe that the combination of too much debt, massive wealth destruction, a weak American consumer and high unemployment, which restrains labor’s bargaining power, makes a case for a re-run of the Japanese Lost Decade experience highly likely. In the face of these deflationary pressures, the classic macroeconomic solutions of fiscal and monetary stimulus are not going to be very effective.


A more nuanced view of inflation
Given those views, the classic inflationist argument that all this government spending and money printing is going to result in inflation seems to be a little hollow.

However, there is a different school of inflationist thought that is more nuanced than the classic view. One prominent member of this school is Warren Buffett, who is worried about the eventual effects of the fiscal deficit on the US Dollar:

An increase in federal debt can be financed in three ways: borrowing from foreigners, borrowing from our own citizens or, through a roundabout process, printing money. Let’s look at the prospects for each individually — and in combination.

The current account deficit — dollars that we force-feed to the rest of the world and that must then be invested — will be $400 billion or so this year. Assume, in a relatively benign scenario, that all of this is directed by the recipients — China leads the list — to purchases of United States debt. Never mind that this all-Treasuries allocation is no sure thing: some countries may decide that purchasing American stocks, real estate or entire companies makes more sense than soaking up dollar-denominated bonds. Rumblings to that effect have recently increased.

Then take the second element of the scenario — borrowing from our own citizens. Assume that Americans save $500 billion, far above what they’ve saved recently but perhaps consistent with the changing national mood. Finally, assume that these citizens opt to put all their savings into United States Treasuries (partly through intermediaries like banks).

Even with these heroic assumptions, the Treasury will be obliged to find another $900 billion to finance the remainder of the $1.8 trillion of debt it is issuing. Washington’s printing presses will need to work overtime.

He concludes with [emphasis mine]:

Once recovery is gained, however, Congress must end the rise in the debt-to-G.D.P. ratio and keep our growth in obligations in line with our growth in resources.

Unchecked carbon emissions will likely cause icebergs to melt. Unchecked greenback emissions will certainly cause the purchasing power of currency to melt. The dollar’s destiny lies with Congress.

Simon Johnson, former chief economist at the IMF, echoes this view on the risks to the currency. Historian Niall Ferguson also believes that the US Dollar is dying a slow death.


What do you mean by “inflation”?
If Buffett et al is correct, then the deflationists could technically be correct in that the US and global economies remain weak, and inflation doesn’t really show up very much in the official statistics watched by central bankers. Moreover, competitive quantitative easing by world central banks may not, in the short run, show up in the currency markets at all and the downside in the US Dollar may be limited.

Where inflationary pressures show up is in commodity markets.

Would that be inflation?

Well, it depends on what you mean by inflation. If you measure it using core CPI, then the answer is definitely no. It may show up a bit more in headline CPI. Even during the commodity price run-up in the 2001-7 era, analysts like David Rosenberg argued that there was no inflation – just look at the falling price of cars, plasma TVs and electronics, etc.

I don’t mean to get Clintonesque here (i.e. it depends on what you mean by “is”), but Rosenberg was both right and wrong. It just depended on what you mean by inflation.


Re-examine your long term portfolio plans?
If Buffett and company is right on their “inflation” outlook, then investors need to re-examine their investment policy and long term portfolio plans.

A portfolio that relies on commodity and commodity-linked equities would be an effective inflation hedge under such a scenario. However, portfolios that rely on fixed income based solutions, such as inflation-indexed bonds like TIPS or even yield steepener trades, may be less effective as these kinds of inflationary signals may not show up as well in those markets.

In the meantime, the Inflation-Deflation Timer, which is a tactical model based on the measurement of inflationary expectations, remains at an “inflation” reading.

Poltical stability & middle class: an update

After my recent post political stability and the middle class, some distubing items have appeared:

• The debtors' revolt continues. A story in the New York Times reports that the courts are taking a dim view of lenders who try to foreclose without proper documentation. If this trend continues, chaos will ensue.
• There is more backlash against Wall Street. Speaking about bankers' bonuses, the vice-chairman at Goldman Sachs stated that the public must "tolerate the inequality as a way to achieve greater prosperity for all" - an unfortunate remark picked up by The Guardian. Meanwhile, a headline in the alternative press reads After the Billionaires Plundered Alabama Town, Troops Were Called in ... Illegally.

Watch out for the pitchforks. Down that road is turmoil, political disintegration, and chaos.

Simon Johnson is proving to be prescient. These stories sound like the sorts of things that might happen in an emerging market country in financial trouble. Is there any wonder why there is downward pressure on the US Dollar?

A fragile and frothy market

As the S&P 500 tests resistance at the 1100-1120 zone, which is the 50% Fibonacci retracement level, it is useful to think about market tone.

How the market reacts to news is often a useful guide to future direction. When the bulls were in full control of the market action, a downgrade by a single analyst on WFC wouldn’t have taken the market down dramatically in the last hour. When the bulls were in full control, news that the Chinese economy had grown by 8.9% would have been an excuse for further advances and not pullbacks. Moreover, the widespread skepticism over China’s official statistics would have been swept under the rug.


Technical divergences everywhere
Today there are technical divergences everywhere. I won’t go into every single one but the most glaring is the faltering leadership of small cap stocks, which led the rally that began in March 2009. As the chart below shows, the ratio of the Russell 2000 (small caps) to the S&P 500 (large caps) has broken its relative uptrend line, indicating that small cap leadership is rolling over.



Is the “risk trade” over-owned and over-loved?
Sentiment readings are getting more constructive for the bears. There is no doubt that the risk trade is coming back. The news that John Meriwether is staring his third hedge fund after blowing up two others in spectacular fashion could be the top tick for the market. Moreover, EPFR reports that investors are going out on the risk trade by buying emerging market funds: “the $4 billion of net inflows into Emerging Market Equity Funds in the week ending October 14 was the largest weekly total since December 2007.”

Mary Ann Bartels of BofA/Merrill Lynch reports that large speculators (read: hedge funds) are starting to sell their crowded long position in NASDAQ 100 futures, the high-beta vehicle of choice among the fast money crowd. As well, the AAII poll of individual investors is at an elevated bullish level, though not quite a crowded long reading.



On the other hand, Mark Hulbert wrote that newsletter writers are still skeptical of this stock market rally, which is contrarian bullish.


Watch how sentiment develops
On top of that, you have a market that is overvalued by Tobin Q standards and seriously intermediate term overbought. The inability of the market bulls to shrug off bad news and to advance in the face of good news, as well as faltering small cap leadership are signs indicative of an imminent pullback.

Given the still somewhat mixed sentiment picture, the key to future market direction would be how sentiment readings change should the market correct. Would investors be so convinced of a V-shaped recovery (see examples of stories here, here and here) that they would buy on dips and send sentiment readings into over-owned territory, which would be bearish? Or will they turn cautious, which may ironically limit the downside of any corrective action.

Political stability and the middle class

I wrote about the possible social backlash of the financial crisis back in April. Given the uproar over the size of the Goldman Sachs bonus pools, it’s time to revisit the topic and the picture isn’t pretty.

Simon Johnson, former chief economist at the IMF, recently reiterated his views on the effects of the financial crisis on US income inequality by saying, in effect, that America is becoming a banana republic:

The US increasingly displays characteristics that we have seen many times in middle-income “emerging markets” – new dimensions of vast inequality, forms of financial instability that benefit the best connected, and consistently easy credit for the privileged.

In an interview with the Washington Post, Elizabeth Warren, Chair of the Congressional Oversight Committee, stated her views of how the evolution of US society has affected the middle class:

When we compare middle-class families today with their parents a generation ago we have basically flat earnings-a fully employed male today earns on average about $800 less, adjusted for inflation- than a fully employed male earned a generation ago. The only way that houses could increase or families could increase their household income was to put a second earner into the workforce, and, of course that’s now flattened out because there aren’t any more people to put into the workforce. So you’ve got, effectively, flat income in this time period with rising core expenses; housing; health insurance; child care; transportation, now that it takes two cars to get everywhere, two jobs to support; and taxes, because you’ve got two people in the workforce and we have a somewhat progressive taxation system. So that families are spending a lot more on what you describe as the basic nut.

These folks have to work twice as hard just to tread water. But it isn’t just about the lack of income gains and flat real earnings over several decades, Warren went on to discuss the effects of credit, health care, college costs, the housing crisis and shifts in income distribution on the middle class and their expectations. She concluded that [emphasis mine]:

In the 1950s and the 1960s, coming out of World War II, we said as a government, as a people, what can we do to support the middle class. You know that’s what FHA was to help people get into homes, right? VA, GI loans on education, we looked at policies, like whether or not they strengthen and support the middle class.

Somewhere, that began to change in the late 1970s, early 1980s, and the middle class instead became like a resource to be pulled from, and you know, they became the turkey at the Thanksgiving dinner. Who could who could carve off a piece? Who can get this little piece? Who could make a profit from this piece and that piece or squeeze down on the wages? And the middle class has gotten shakier and shakier, hollowed out.

The consequences of that are far more than economic. The middle class is what makes us who we are. It affects the poor. A strong and vital middle class is a middle class that can offer a helping hand to the poor. A strong and vital middle class is a middle class that has room, is creating new jobs to basically to suck the poor up out of poverty and into middle class positions. The middle class is what gives us political stability. It’s what gives us an America that’s all bought into the whole process that what we do is not just about a handful of folks at the top who profit from it. We all profit from it, and that’s why we work, and that’s why we vote, and that’s why we accept that the outcome of elections. And that’s why we’re safe to walk our streets, because we have a middle class for which this ultimately works, this country.

If the middle class crumbles, what happens to political stability?


Windfall profits tax only the beginning?
There have been proposals about a windfall profits tax for investment bankers, which may only the beginning. Niall Ferguson has detailed other popular backlashes against bankers in history and the results were ugly.

US Rep. Marcy Kaptur (D-OH) has gone as far as to suggest that we are undergoing a financial coup d’etat. Barry Ritholz has supporting data for her position and has indicated that bankers run Congress and their lobbying efforts has been their best single investment in history.


Quell the mobs
Hopefully the adults can step in and quell the mobs. We could be witnessing the disintegration of the capitalist system. Watch for signs such as a debtors’ revolt (as per Naked Capitalism) and Michael Moore and his fringe beliefs becoming more mainstream.

That’s when things get really ugly.

A quant's view of The Fourth Turning

I finally got around to reading the interview with Neil Howe, the co-author of The Fourth Turning. In the book, he outlines his approach to generational research:

We think that generations move history along and prevent society from suffering too long under the excesses of any particular generation. People often assume that every new generation will be a linear extension of the last one. You know, that after Generation X comes Generation Y. They might further expect Generation Y to be like Gen X on steroids – even more willing to take risk and with even more edginess in the culture. Yet the Millennial Generation that followed Gen X is not like that at all. In fact, no generation is like the generation that immediately precedes it.

Instead, every generation turns the corner and to some extent compensates for the excesses and mistakes of the midlife generation that is in charge when they come of age. This is necessary, because if generations kept on going in the same direction as their predecessors, civilization would have gone off a cliff thousands of years ago.

So this is a necessary process, a process that is particularly important in modern nontraditional societies, where generations are free to transform institutions according to their own styles and proclivities.

In our research we have found that, in modern societies, four basic types of generations tend to recur in the same order.

He then outlines the four generational archetypes and believes that America is undergoing a generational shift. To demonstrate his point, he goes back into American history and shows examples such as the generational shift between the leadership of Abraham Lincoln and Ulysses S. Grant. He goes on to postulate what that may mean for American society and, by extension, the investment implications of that shift.


Torturing the data until it talks?
Among quants there is a saying that goes “don’t torture the data until it talks”, which is another way of saying don’t over-fit the data. While Howe & Strauss’ analysis is very intriguing, I find many disturbing signs of data fitting that make me uncomfortable.

To my mind, here are some questions that need to be answered in order to validate the analytical approach and methodology.


Where are the women?
The research authored by Howe & Strauss goes back in American history and shows a number of examples of generational shifts. The archetypes cited are invariably male. While that may have been valid in the past, women have taken a greater leadership role in American society and their influence is growing. Mark Perry at Carpe Diem shows in the accompanying chart that there is a distinct male-female gap in post-secondary education, which should result in shifts in gender leadership over time:




NBER’s research also cites the same kind of gap across OCED countries and not just in the United States, excerpt here [emphasis mine]:

The decline in the male-to-female ratios of undergraduates in the past 35 years is real, and not primarily due to changes in the ethnic mix of the college-aged population or to the types of post-secondary institutions they attend, the authors assert. The female share of college students has expanded in all 17 member-nations of the Organization for Economic Cooperation and Development in recent decades, so much so that women now outnumber men in college in almost all rich nations.

My question is: How does the rising influence of female influence of events affect these cultural archetypes?


Other demographics
This approach to generational research is valid if the dynamics of the underlying population is relatively stable. However, demographic studies indicate that the United States is about to undergo a demographic shift away from a white population to a more Spanish speaking mix. What does that do the assumptions of the study?

While we are on the topic, what about the immigrant experience? True, the mythic status of America has been the land of immigrants, how does immigration and the emerging leadership of the immigrant class affect the generational shift thesis? There is a recent article in Canada’s Globe and Mail entitled If are a new Canadian you go to university. The article cites a study that details the degree of post-secondary education by different immigrant groups by ethnicity.

If there is all this ethnic demographic shift and shifts in education going on, by gender and by new immigrants, how strong is the generational shift thesis?


Is the analysis portable to other countries and cultures?
In the book, the authors call this a study of Anglo-American history and culture. If we were to focus on the first word Anglo, does that template of generational research to Britain? What about other English speaking former British colonies with predominantly Anglo rooted cultures such as Canada, Australia and New Zealand? If not, what is it that makes the American experience so unique that this form of analysis cannot be transported to other countries and cultures?

Quants call this approach out of sample testing. Can this template of generational research be applied to other cultures? What about other cultures with long histories? Some that come to mind include China, India, Japan, Russia, France, Italy and Greece.


Howe & Strauss vs. Ferguson
By contrast, economic historian Niall Ferguson's analysis of current events appear to be more robust and compelling. Ferguson reaches back into history, across countries and cultures to find similarities to today. He finds parallels in the current Sino-American relationship with the Anglo-German relationship before the World War I. He has also indicated that America's precarious financial position is similar to the position of the Ottomans at the dusk of its empire.

The conclusions of Howe & Strauss' analysis is intriguing as it represents a tempting lens into the future. However, until the questions that I raised can be answered, it just looks a lot like an attempt to over-fit the data.

Why I am not a bottom-up equity quant

I spent close to two decades of my career building bottom-up equity quantitative models to pick stocks, in Canadian, US and international markets. I was asked why I don’t do that anymore.

My flippant answer was:“Been there, done that.”

My longer answer was that the competitive advantage of doing bottom-up quantitative analysis is being eroded to such an extent that alphas are rapidly diminishing.

Let me explain. Back in the 1970s and 1980s, the task of performing equity quantitative analysis required a large commitment by an investment organization. Sure, there were databases around, but the task of integrating them was a non-trivial task that required investment in staff and infrastructure.

Here are some sample issues. How do you marry an earnings estimate database (e.g. IBES) with a fundamental database (e.g. Compustat) when:

• The series have different periodicities (annual & quarterly for the fundamental and daily/weekly/monthly for earnings estimates)?
• The identifier for earnings estimates is for the security (stock specific) but the fundamental database is identified by company (as multiple share classes are not uncommon for non-US companies)?

Add to that the issues of adding data for new listings, deletions, name changes, etc. The investment organization quickly finds itself not in the investment business, but the database maintenance business.


Falling barriers to entry
Fast forward a couple of decades, the apperance of system integrators like Factset Research Systems have revolutionized the business and dramatically lowered the barriers to entry to bottom-up equity quantitative analysis. Today, you can build an equity quantitative research capability by subscribing to these services.


Opera singers don't belt, quants control for factor risk
Moreover, a generation of quants has been conditioned by the likes of Barra to decompose risk as industry plus a Fama-French like common factors such as Market Capitalization and Style (Value/Growth).

The implications of this analysis framework is that just as opera singers are genetically imprinted not to belt when they sing, bottom-up equity analysts are conditioned to believe that you shouldn’t try to forecast the returns to these risk factors. Instead, the appropriate way to forecast alpha is to forecast alpha based on residual risk, or stock pick after controlling for, at the very least, industry and sector risk.

The combination of lower entry barriers and groupthink has led equity quants into a crowded trade. They all uses some form of multi-factor stock selection model, but the data comes from the same databases. The factors all appear to be uncorrelated but we saw what happened in August 2007.


The low lying fruit is gone
Even when you succeed, it’s a really tough business.

I recently attended a seminar put on by a risk model vendor and a respected equity quant manager. The equity manager put up an analysis showing various ways of integrating their forecast alphas with the risk models that they use. The most optimal technique for a long only portfolio, with a 2-2.5% forecast tracking error, resulted in an annual alpha of about 1.5% a year.

1.5% sounds pretty good.

However, you have to consider that this is a forecast alpha from a model portfolio with no turnover costs. Once you throw in trading costs, the shortfall between the turnover of the forecast alpha and the actual portfolio, which could vary greatly, and even the fact that good managers with tight investment processes experience portfolio dispersion (difference in returns between accounts with similar mandates) of 2% or more, 1.5% doesn’t sound that good.

As I said before, it’s getting to be a really tough business.

So far my solution has been to do something that is truly queasy and nauseating to many equity quants. I have been using top-down investing and factor rotational approaches to quantitative investing. The approach disturbs quants because it's less disciplined, less risk controlled (according to the way they are trained) and appears to be so, well, empircally oriented.

My approach is not the only answer but bottom-up equity quants need to find new sources of alpha.