A Value Opportunity in the Oil Patch?

Further to my recent post on energy stocks resuming a relative uptrend, conditions remain largely unchanged since that observation and there remains a healthy dose of skepticism on energy. Oil prices and energy equities have been in a long multi-year uptrend, aided and abetted by a softening US Dollar. If you believe that the long-term secular trend for this sector is still up, then there are some laggards that you could look at, such as real estate plays in the Oil Patch.

Divergence = Opportunity?
The accompanying chart shows the indexed US$ values of the XLE (Energy Select SPDR ETF) and a couple of smaller cap Canadian property developers, Melcor Developments (MRD.TO) and Gendis Land Development (GDC.TO), both listed in Toronto. These are developers who are mainly focused in Alberta, the heart of the Canadian Oil Patch. While the XLE has been on a steady uptrend for the past year, the Canadian developers have been on a roller coaster ride. Over time, there is still good physical demand for property from wage and employment gains in that part of the country and property prices should move in line with the region’s underlying economy.

The Canadian residential property market has gone through a cycle somewhat similar to the US, albeit more muted. Lending standards did not get as wild as they did south of the border. The most aggressive lending products were zero-down mortgages and the worst of the US excesses such as no-doc and negative amortization loans did not migrate to Canada.

Key risks: These are smaller capitalization stocks and their prices could be volatile. In addition, the group does face a headwind from Canadian lenders starting to tighten up on lending standards which would restrain demand.

Energy stocks ready for another upleg?

LT Uptrend + Breakout + Neutral Sentiment = Bullish

Energy stocks may be ready for another upleg for three reasons.

Long term uptrend: the first chart shows the relative ratio of XLE (Energy Select SPDR ETF) to SPY (S&P 500 SPDR ETF). As you can see the Energy sector has been in a long term relative uptrend against the market, as defined by the S&P 500. As oil prices approached $100 and pulled back, so did the Energy relative to the market.

Relative strength breakout: the sector broke out to an all-time relative high against the S&P 500 in mid-December.



Neutral mutual fund sentiment: Using the technique shown in the sidebar (titled Reverse Engineering a Manager's Macro Exposure) I imputed the average Energy sector exposure of 22 US large cap blend equity mutual funds. These 22 funds can be thought of as a composite of the S&P 500-like mandate funds from the largest mutual fund complexes. As you can see from the chart, mutual funds moved from a significant overweight to a neutral/underweight position in the Energy sector.

In future posts I will highlight other divergences and opportunities within the Energy space.

No Skill and No Opportunity = No Value-Added.

Richard Grinold once showed that:

He meant that a manager’s value-added (Information Ratio) was a function of his selection skill (Information Coefficient) and the number opportunities (N) he had. In other words, no skill = no value-add and no opportunity = no value-added.

During the holiday season the markets are thin and small trades can create a lot of price movements. In this environment I have no skill and little opportunity to add value. Blogging will therefore be very light and I will back in the New Year.

Happy Holidays and Happy 2008!

More on surviving as a quant

Here is another post in the series of surviving and prospering as a quant. John Maudlin, writing in the 14 Dec 2007 edition of his newsletter Thoughts from the Frontline, commented about how the Fed seems to have mis-handled its FOMC statement. The US equity market lurched downwards after the FOMC statement came out at about 2:15pm ET and rallied furiously the next morning on the news of the coordinated central action. John commented that:

By and large, this Fed is a room full of academics that have never "run money," with the exception of Richard Fisher of Dallas who ran a hedge fund at one point in his career. We are in the middle innings of what will be seen by history as the single biggest credit crunch since the 1930's. With the exception of Fed governor Donald Kohn, they have never been in a crisis when they were in the driver's seat.

The Fed is full of people who are far smarter than I am, but there is a difference between book smart and market savvy and a good quant should be both.

Stat Arb + Economic Stress = Trouble?

As part of a continuing series on surviving as a quant , I would like to focus on how investors need to know the economic rationale behind a quant strategy.

The statistical arbitrage hedge fund strategy, or “stat arb”, is a case in point. Classic stat arb can be simplified as buying oversold stocks and shorting overbought stocks, along with some risk control layered on top of the stock selection process.

The economic rationale behind this type of strategy is that the stat arb practitioner is being paid to provide liquidity to the market. In normal times, this approach can be quite profitable but it can backfire badly during periods of economic stress. If you use a short-term investment strategy of buying oversold stocks and shorting overbought stocks during a recession, you will ride the big losers (e.g. Adelphia, Enron, etc.) all the down to the bottom.

The accompanying chart shows the investment results of an overbought/oversold model. It ranks US large cap stocks on a short-term overbought/oversold measure and buys the bottom 20% most oversold and shorts the top 20% most overbought stocks. I do not pretend for the moment that this is an actual stat arb strategy as it has no risk control. However, it does serve as a proxy for the performance for these types of strategies as I have discussed elsewhere. This model had a drawdown of over 20% in 2001, as many stat arb strategies did at the time, and has been having some difficulty currently.

The signs of economic stress in are everywhere, particularly in the US. Investors should be wary of too much exposure to stat arb strategies under these economic conditions.

An interesting Oil and NatGas divergence

Natural gas hasn’t followed the rally of crude oil. Even as crude oil approached $100 natural gas languished in the $7-8 range, compared to the highs of $14-16 seen in late 2005. The accompanying change shows the ratio of the price of natural gas to crude oil futures. I have used the 12-month strip as the reference prices (1/12th the front month + 1/12th the 2nd month + … + 1/12th the 12 month future) as natural gas prices can be seasonal. The chart shows that natural gas prices are probing new lows against oil prices.

A look at the Commitment of Traders data from the CFTC shows a very different kind of story. Commercial traders, who are usually thought of as the “smart money”, are excessively long natural gas and giving a bullish signal. On the other hand, the signal from the COT data for crude oil can be best described as neutral.

As a former trader I can attest that all these fundamental and sentiment signals don’t matter until they matter. Others have traded successfully on COT data but I have found them problematical as a timing tool. These conditions have persisted for several weeks. Just because these conditions are at extremes doesn’t mean that they can’t get stretched further.

In future posts I will examine other interesting divergences in the energy and energy related markets.

Financials or Tech: Which would you prefer?

S&P 500 Financial Index vs. S&P 500
No Capitulation in Financials
The above chart shows the relative performance of the S&P 500 Financials vs. the S&P 500. Given the well-publicized subprime problems, the sector is not surprisingly oversold.

Using the technique shown in the sidebar (titled Reversing Engineering a Manager's Macro Exposure) I imputed the average financial sector exposure of 22 US large cap blend equity mutual funds. These 22 funds can be thought of as a composite of the S&P 500-like mandate funds from the largest mutual fund complexes. As you can see from the chart, mutual funds have been overweight the sector and appear to be increasing their weight.



Large cap blend mutual fund managers, as a group, are finding value in Financials and there is no sign of panic over the subprime meltdown in their behavior.

S&P 500 Technology Index vs. S&P 500

Tech looks constructive
By contrast, this chart shows that the relative returns of the S&P 500 Technology Index vs. the S&P 500. The Tech sector rebounded in the Summer of 2006 and has been in a relative uptrend since the the Summer of 2007. The sector has pulled back but the relative uptrend remains intact.

The same mutual fund analysis shows that the average US large cap equity blend mutual fund is roughly market weight the sector. From a sentiment analysis viewpoint, this gives the Tech sector room to resume its leadership trend that it began a few months ago.

Surviving and prospering as a quant

I have learned working over the years that the key to surviving and prospering as a quantitative investor is having the combination of quantitative skills with market knowledge and experience. It’s critical to understand the context and limitations of your models. Here is a quick quant quiz:

What is less risky (this not a trick question)?
1 To jump out of an airplane at 30,000 feet without a parachute
2 To stay in the plane while someone else jumps out (yes, there is a pilot flying the plane)

The correct quant answer is 1. Jumping out of the airplane is less risky because the standard deviation of the outcome is zero.

This illustrates the importance of reality checks for models. Mrs. Humble Student of the Markets, who is a pilot, calls it “raising your head up from the instrument panel and looking out the cockpit window once in a while”. Bob Park of FINCAD, a vendor of derivatives software, calls it “domain knowledge”.

Quantitative systems work beautifully most of the time. When they fail they can fail spectacularly, particularly if the failure is due to faulty assumptions. The greatest quantitative failure in the last fifty years was neither the recent sub-prime meltdown nor the Long Term Capital Management collapse.

The greatest quant failure occurred in the 1960s and it was caused by Robert McNamara and the “whiz kids” in their conduct of the Vietnam War. They incorrectly framed the problem and focused on the wrong metrics. The results scarred an entire generation and altered American foreign policy ever since. As an example, you can find an analysis of differing analysis of a battle of the Vietnam war here at Fabius Maximus' blog.

Is Bill Miller becoming a (gasp) Value manager?

Bill Miller’s Legg Mason Value Trust (LMVTX) has had a great long-term track record that would be the envy of most managers. Unfortunately the fund lagged the S&P 500 in 2006 and it looks like it will lag again in 2007, barring a last minute recovery.

Using the techniques shown in the sidebar titled Reverse engineering a manager's macro exposures, I estimated his style (Value/Growth) exposures. Despite the “value” label in LMVTX, Miller has long been thought of as tilting towards the Growth style (remember his big holdings in AOL in the fund?) However the fund has tilted more towards the Value style and has tended to outperform when Value outperforms Growth and underperformed when Growth outperforms Value.

Using the same form of analysis, his other macro exposures are:

- Long market beta
- Short oil and USD
- Long emerging markets vs. the US market

In future posts I will use the same technique to examine what other investors (hedge funds, mutual funds, etc.) are doing in the market.

What exactly are hedge funds hedging?

Real alpha is hard to find
Can someone remind me why investors pay 2% and 20% fees?

This chart shows the weekly returns of the HFRX Global Hedge Fund Index and the S&P 500. The HFRX Index is an investable index of hedge funds and returns are reported daily, net of fees.

Yes - you can choose other flavors of hedge fund indices but the results are going to be roughly the same. The correlation of most diversified hedge fund indices to the S&P 500 is 0.8 and up.

Bridgewater Associates did a study in 2004, updated in 2006, called Hedge Funds Selling Beta as Alpha showing that you can replicate the return patterns of many strategies with simple instruments. Some sample quotes:

emerging market hedge funds are over 80% correlated to a simple 50/50 mix of emerging market equities and bonds...

and

M&A arb funds...do no better than simply buying the top 10 announced targets and selling the top 10 acquirers.

A few years ago CALPERS noted that hedge funds fees were too high - a comment that the press seized on. They went on to say, however, something to the effect that they were not averse to paying for alpha, a comment that the press did not trumpet at the time.

Real alpha is hard to find. There are a lot of crowded trades and strategies out there. The real trick for a hedge fund investor is to find a differentiated alpha.