Tuesday, April 29, 2008

Still waiting for a market bottom

As the S&P 500 seems to have formed a double bottom in January and March, the question in many investors' minds must be "Have we seen the bottom?" My review of some of my market indicators indicate that it’s probably a little early to flash the all-clear signal for US equities.

In particular, the problem areas of the market, namely the investment banks, housing and employment, continue to struggle, suggesting that the worst may not be over for this bear market. Here are some of the indicators that I am watching:

Insiders are bullish
Mark Hulbert reports that insiders have been buying their own stock at levels that are comparable to other market bottoms. Insider signals tend to have a very long time horizon but their actions does have bullish implications.

Investment bank valuations - more downside?
Since much of the recent stresses that have shown up in the investment banks and brokers, I go back to my rule of thumb that I would like to see a price to book ratio of 1 for the investment banks. The P/B of 1x was a good signal of a market bottom in the 1974-5 and 1981-2 bear markets.

While Lehman (LEH) did reach a P/B of 1x for one day at the time of the Bear Stearns panic, other investment banks and brokers such as Morgan Stanley (MS), Merrill Lynch (MER) and Raymond James (RJF), which is an interesting bellwether as it has no significant prop trading operations, are trading at valuations of 1.5 to 1.8 times book. Goldman Sachs (GS) is trading at valuations that are even higher than that.

I could be wrong here but my guess is that there needs to be more pain in the brokerage stocks before the market bottoms.

Smart funds defensive while overall sentiment is bullish
A check in with my group of smart funds shows that their posture remains defensive. The accompanying chart shows the market beta of the “smart funds” compared to the “consensus funds”. Smart funds have a market beta, or implied market exposure, that is lower than the market while consensus funds are at or positive market exposure. Moreover, the recent Barron’s Big Money Poll shows 50% of their respondents to be bullish or very bullish, compared to 13% as bearish. This is a contrarian bearish reading.

Problem areas of the economy not stabilizing yet
This economic downturn was the result of overbuilt housing fueled by overly aggressive real estate lending. The chart below shows the S&P 500 Homebuilders relative to the S&P 500. The homebuilders remain in a relative downtrend and show no signs of stabilization, which is not a good sign for the health of the overall market.

Addendum: When you get stories like KB Home's Broad Says Home Prices May Drop Another 20%, it doesn't exactly inspire confidence that housing has bottomed.

Similarly, we have seen employment statistics starting to weaken, as is the case in any recession. Rather than looking at the payroll numbers, which are backward looking, I prefer to look at market discounting real-time statistics. My proxy is the price action of S&P Supercomposite Human Resources and Employment Services, consisting mainly of temp and employment agencies. The chart below of these stocks relative to the S&P 500 indicate that, like the Homebuilders, the Temp Agencies remain in a relative downtrend with no convincing signs of stabilization.

How far or how long before a bottom?
If my assessment is correct then the next question would be “how long or how far down before we see a bottom in the market?” William Hester at Hussman Funds, in his recent article Recessions and the Duration of Bad News, suggests that if this was an “average” recession we will likely see much more bad news in employment, housing, earnings, etc. If this was an “average” recession the chart he shows suggests that we are currently seeing a bear market rally but a more convincing market bottom is a few months off (see the last two charts in the article).

Is this an average recession? I have no idea. All I can do is keeping watching my indicators for signs of a market bottom.

Friday, April 25, 2008

A reprieve for hedge funds but challenges remain

We all know the story. The hedge fund industry grew from a handful of funds on a relatively small asset base in the early 1990s to over $2 trillion in assets today. What really spawned the explosive growth were hedge funds’ positive returns which were uncorrelated to the equity market in the post-2000 Tech Bubble bear market.

Since then, the chart below of the HFRX Global Hedge Fund Index and the S&P 500 shows that hedge funds returns have become highly correlated to the S&P 500. In the current equity market downturn, hedge fund returns has fallen with the S&P 500 but the level of correlation has decreased in the last few months.

Challenges remain for the hedge fund industry
Despite the near term recovery, several challenges remain for the hedge fund industry. Firstly, no doubt many hedge fund investors feel chastened by their experience and caution will be the watchword going forward. In addition, various studies have shown that hedge fund returns can be replicated using factor betas. Larger sponsors that I have spoken with echo the sentiments of Russell Read, chief investment officer of the $225 billion California Public Employees Retirement System: “We can get average market risk very cheaply. We hate paying a performance fee for something we can get very cheaply.”

The industry is getting more institutional
These problems are well known and many commentators have given their views on how the hedge fund business is likely to evolve so let me throw me my two cents worth.

  • The industry needs to move away from a strict absolute return based focus and need to better understand clients and customize solutions
  • Fee compression pressure will intensify as a result

Understanding the client
For most of their history, hedge fund managers have marketed themselves as absolute return vehicles, with low correlations to other asset classes. As returns came down, they clung to the low correlation idea but that line is wearing a little thin these days.

Low correlation, in of itself, has limited value. Supposing that I told you that I had access to a fair roulette game, i.e. the house didn’t have an edge. Returns would be uncorrelated to virtually any asset class that you could think of. Would you fund me on a 2% and 20% fee structure?

I believe that the key to surviving and prospering as an alternative asset manager is to learn to listen more to clients and understand how sponsors put together portfolios. You represent a piece of a jigsaw puzzle to them and know what the benefits you offer.

This William Mercer study for the State of Arizona is typical of the new thinking. Mercer suggests, among other things, that sponsor portfolios should be optimized to alpha exposure. Expected alpha, alpha volatility and alpha correlation all matter in how you pick managers. This is part of the move toward the “portable alpha” concept where a sponsor moves towards a liability driven investing framework. He builds a passive portfolio based on that benchmark and then overlays a “portable alpha” on top of the passive portfolio.

Fee compression pressures to rise
If the concepts in the Mercer study become accepted and widespread then fee compression pressures are likely to rise. Reading between the lines the terms of “expected alpha”, “alpha volatility” and especially “alpha correlation” sound suspiciously like the hedge fund factor betas concept that Bridgewater Associates and others have documented in their studies. The obvious conclusion is you shouldn’t be paying the same level of fees for beta as alpha.

Further fee pressures could come from portable alpha implementation. A sponsor can gain access to a portable alpha in two ways. The high cost route would be to buy it from a hedge fund or a hedge fund of funds. The cheaper way would be to synthetically create an alpha stream by hiring a traditional long-only manager and shorting the manager’s benchmark against the long portfolio. As an example, the sponsor could hire a small cap equity manager and then simultaneously short the Russell 2000 using derivatives. The hedge fund solution would cost 2% and 20% or more. The synthetic alpha solution would run around 0.5% and 1.0% for a reasonably large sponsor.

If you were a pension fund or endowment fund, what you choose?

Tuesday, April 22, 2008

The limits to China’s growth

I have a seven year old daughter. Despite her Chinese heritage I am not in a huge rush to enroll her in the Chinese Mandarin classes as many of the other parents have enrolled her peers. There are two reasons for this. First, Chinese is a difficult language (no alphabet, all characters must be learned by rote memorization) that is learned best in an immersion environment. Second, I believe that by the time she is ready to move into the working world China will no longer be ascendant the way it is now. The Chinese language courses that parents are rushing to put their children into now will turn out to be as useful as the Japanese courses in the late 1980s (anyone remember Theory Z?)

A bearish call with a very long term horizon
Before you start flaming me, note that I am talking about a very long term time horizon. While I believe that China will grow at very high rates in the next five to ten years, there are two main long-term problems with China which will limit her growth path:
  • China is a nation of small business entrepreneurs but the small business model is not scalable
  • Chinese age demographics are getting more unfavorable

First, some good news and bad news about China’s growth: From personal observation I have found the Chinese tend to be very entrepreneurial. This effect is demonstrated by the business dominance of the overseas Chinese in much of Southeast Asia, which has created friction in the past in countries such as Malaysia, Indonesia and the Philippines. This entrepreneurial spirit has created a nation of small businesses and an enormous dynamism which is fueling much the growth in China.

However, Chinese business culture has not fully developed a professional manager class (with some limited exception in Hong Kong and Singapore). The business model of much of these small businesses consists of a single person at the top with managers and workers below, most of whom have little or no authority. Small businesses are not scalable into large businesses if there are no professional managers. Such a culture can create a nation of shopkeepers but not a nation of industrialists. This will create barriers to further growth at some point in the future.

Demographics another headwind
China has undergone over a generation of the one-child policy, which has served to restrict her population growth. The law of unintended consequences raised its head along the way.

The population is aging rapidly. The accompanying chart shows that the UN projects the proportion of China’s elderly population, which is defined as those over age 65, will rise from 6.8% of the population in 2000 to an astounding 22.9% in 2050. China’s dependency ratio (ratio of non-working to working population) will rise from 10 per 100 workers in 2000 (19 for US in 2000) to 37 in 2050 (vs. 32 for US). The demographic bonus of a rising young, productive, working population will have been spent in the next 20-30 years.

Source: US GAO, The Future Sustainability of Social Insurance Programs

A nation of little emperors
Beyond the mere numbers of age demographics, the cultural effects of the one-child male-preferred policy may further inhibit the growth dynamism of China’s economy. The family pyramid has become inverted, with parents and grandparents doting on the single child. This has created a nation of spoiled “little emperors” many of whom have grown up with a sense of entitlement and may not have the same work ethic as older generations. Many of these “little emperors” are now in their 20s. Can we really expect the same entrepreneurial drive from this age cohort as from older cohorts? Culturally, this will further inhibit China’s growth potential in the future.

Too early to short China
I began this post by referring to my seven year old daughter. It is with that time horizon in mind that I refer to China’s longer term challenges. In the meantime, China remains a powerhouse of economic growth for the next 5-10 years. Shorting it now would be like standing in front of a speeding freight train.

Wednesday, April 16, 2008

Storm clouds starting to lift for commodities

I am on record as a long term bull on commodities. The near term risks that I see for this trade are:
  • Cyclical: A US slowdown will spread to the rest of the world and reduce cyclical commodity demand
  • US$ rally: A countertrend rally in the US$ will create headwinds for commodities

Cyclical risks are abating
A look at some real-time indicators for the world economy shows signs of stabilization and recovery. Dr. Copper, which is an indicator of world cyclical demand, is at or near new highs. The Baltic Dry Index, a shipping cost benchmark, fell from all-time highs in 3Q 2007 and has stabilized (see the chart here, click on the BDI & Copper link to see the two together).

While I continue to be concerned about a counter-trend rally in the US Dollar as the US economy shows signs of recovery later this year, the cyclical risk in the commodity trade is greatly lessened.

As an investor, I would be inclined to raise from an underweight to a neutral position in the commodity sensitive plays in my portfolio.

Monday, April 14, 2008

More on the secular pilot shortage

My recent post entitled a secular warning for the airlines elicited a lot of comments from the pilot community. The comments fall mainly into the category of “if there is a pilot shortage why am I so badly paid/poorly treated?”

Don't confuse secular with cyclical effects
My answers consist of several parts. First, don’t confuse the secular effect with the cyclical effect. With airlines from Aloha to Frontier going into Chapter 11, a possible Delta-Northwest merger in the works and the US economy in recession, there should be a surplus of pilots in the short term – that’s the cyclical effect. The longer term secular effect is found at the age demographics of most flying clubs that I have visited – there are few members in their 20s and 30s. Members below the age of 50 seem to be the “young pups”.

Some airlines have begun to address this problem by doing their own training, which takes a long time to pay off, or moving to the multi-crew pilot concept in which someone gets qualified as a member of a cockpit crew instead of a pilot. Under this scheme, it is possible to qualify as a member of a cockpit crew without being qualified as a private pilot. This solution seems to be just a case of the blind leading the blind.

Pilots reap what they sow
The history of poor pay for pilots is related to the number of people who love flying. There are many pilots who would still say that they have the greatest job in the world despite the mediocre pay scales, long hours away from home, etc. If you are willing to accept those conditions in exchange for the experience of flying for a living, who do you have to blame for that?

Still a lot of denial out there about the secular trend
Nevertheless, I continue to be disappointed by the reaction to this secular trend. A recent discussion of air travel in 10 years by a number of observers in the aviation industry was mostly a case of people talking their own “book”, an indication that the industry remain in denial over the looming pilot shortage.

Thursday, April 10, 2008

Smart funds still underweight financials

A reader recently wrote and asked if the smart funds had reacted to the Fed’s rescue efforts of Bear Stearns et al. A check in with the analysis of Smart Funds show that they remain more underweight Financials than they ever have in the last four years, though they have somewhat moderated their underweight. By contrast, consensus mutual funds have moved to a slight overweight in the sector.

Another shoe to drop?
This posture is suggestive that the Smart funds believe that there are more trouble ahead for banks. Barry Ritholtz at Big Picture recently posted on a RBC Capital Markets research report on 5 reasons why bank stocks have not bottomed. I would also add my comment that in extreme market conditions the brokers tend to trade at about book value. Today, most are trading at 1.6 to 1.7 times book. JPM and C moved to a price/book of 1 in the recent turmoil, but they are financial conglomerates and not pure brokers.

In addition, John Mauldin at Thoughts from the Frontline wrote in his weekly newsletter that:

In an opinion letter posted on the SEC website last weekend clarifying how banks are supposed to mark their assets to market prices is this little gem (emphasis [his]):

"Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability."

…There are two problems with this rule. First, it clearly creates a lack of ransparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company. Second, can a forced liquidation or distress sale be from a margin call? Obviousy [sic] the answer is yes. but as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then they find out that the investment bank is valuing them differently on their books than the price at which they were forced to sell, there will be some very upset managers and investors. Cue the lawyers.

In other words, this is going to be a mess.

Monday, April 7, 2008

Have we quants been brainwashed by Barra (II)?

Further to my first post have we quants been brainwashed by Barra, I received a response from Jen Bender of MSCI/Barra who indicated that “it's not use of the same risk models that causes increased correlation in times of meltdown/liquidity crunch.”

I did not wish to imply that it was the common use of the Barra or any other risk model that got equity quants into trouble in August 2007. What got quants into trouble in August 2007 was the mindset of the only active risk that should be taken is stock selection, or residual risk, and that we should control for industry risk and common factor risk such as size, style, etc.

Dan diBartolomeo of Northfield wrote (italics are mine):

…it is common practice to measure risk using the assumptions of uncorrelated residuals, while using stock selection strategies that can only work if equation (1) does not hold (no factor bets). Since active mangers will be concentrating their portfolios in those securities expected to act alike in providing superior returns, the average residual covariance will be positive…Hence, if we use a risk model which assumes uncorrelated residuals we will have a downward biased estimate of the risks not identified by the factors of our risk model.

He went on to say:

One should also be particularly careful with multi-factor selection strategies where some but not all of the selection factors are in common with the risk model. In such cases, the risk model will tend to neutralize exposure to the risk factors, which will lead to the selection of a security set which are weak on the selection factors which are in common with the risk model, while having extremely high exposure to the selection factors which are presumed independent of the risk model. As such, it is easy for a multi-factor selection strategy to become dependent on a single component, defeating the purpose of the multifactor construct.
(I am grateful to George Wolfe for pointing this out to me.)

If the “stock selection alpha is the only acceptable source of alpha” mindset is becoming a crowded trade, then it’s time to move outside of that box. Goldman Sachs published a research report entitled “A Stockpicker’s Reality: Part III, Sector strategies for maximizing returns to stockpicking” in 2002 where they “examine the degree to which risk management strategies can be used to increase returns. This question differs substantially from the normal application of risk control, which is focused on tracking error rather than returns.” Their conclusion was:

- Value-driven methods are most compatible with quantitative risk management of benchmark-driven portfolios.
- Growth-driven methods are far less compatible with strict quantitative risk limits and are more effective in relatively more concentrated, less risk-controlled portfolio construction applications where risk management is handled at the asset allocation level by diversifying across managers.

In other words, different strokes for different folks. (If you would like a copy of that Goldman Sachs research report please email me. )

Thursday, April 3, 2008

Sheep can make money too!

As a counterpoint to my post Channeling my inner contrarian I thought that I would write about being a sheep and the advantages of following the crowd.

A few years ago, I managed equity market neutral portfolios at a firm that was mainly known for commodity trading using trend following techniques, which are well described by Michael Covel in his book. During my tenure there I noticed that while the commodity positions were spread out among various futures contracts they often amounted to a few macro bets (i.e. on interest rates, on the US$, etc.) I came to the conclusion that these models were identifying macroeconomic trends that are persistent and exhibit serial correlation, which creates investment opportunities for patient long-term investors. For example, if the Fed is raising rates the odds are they will continue to raise rates until they signal a neutral or easing bias, i.e. there is a trend to interest rates, which is information that investors can use. The key risk in this class of models is knowing when to exit the trend, as short and long term reversals can be devastating to the bottom line.

With those principles in mind, here are some of the big macro trends that could be investment opportunities (and this shouldn’t be a surprise to most people):

  • The falling US Dollar
  • Worldwide inflation, especially in commodity prices
  • Growth in China

The falling US Dollar

The accompanying chart shows the US Dollar Index in a multi-year downtrend (this is where technical analysis is useful as it spots long term trends). The currency is reflective of investor concerns of the current account and fiscal deficits going out as far as the eye can see and no meaningful policies to reverse them. The recent Fed actions of rescuing the system from collapse have led to some to question the Central Bank’s inflation fighting credentials, which have resulted in additional Dollar weakness. In the short term, however, the US Dollar is near the bottom of its channel and seems to be poised for a counter-trend rally.

Worldwide inflation, especially commodity inflation
Inflation is everywhere and spreading. You just have to read stories like Stop the inflation in the US and Workers strike at Nike contract factory and demanding 20% raises in Vietnam, a low-wage country that had previously been a source of deflation.

Commodity inflation is not just restricted to headline commodities like gold and oil, but is very broad based can be seen in foodstuffs (which begs the question of whether Core CPI = CPI ex-food and energy is a good indicator of inflation). The accompanying chart shows the Continuous Commodity Index (CCI), which is a continuation of the old equal-weighted CRB Index before its re-constitution to a liquidity-weighted index in 2005. The CCI has been advancing in the major non-US currencies as well as US Dollars, indicating that the commodity advance is 1) broad based and 2) independent of US Dollar weakness.

Similarly, gold prices have also been showing a similar pattern to the other commodities. Gold appears to be regaining its former status as the alternative reserve currency. As I indicated before, the US Dollar is likely to rally in the short run and gold and other commodities would run into a headwind under such a scenario.

"Peak Oil" is an additional possible bullish dynamic for oil prices
Crude oil has a possible bullish dynamic of its own in addition to the rising trend in commodity prices: Peak Oil. Much has been written about peak oil by the likes of Matt Simmons, various contributors at the Oil Drum and by many others at APSO so I won't repeat them here. If the peak oil theory is correct and world oil production is indeed rolling over, then we are in for a period of very tough adjustments in not only energy usage but in the pattern of economic growth.

Growth in China
The China growth story is well known and likely to persist. However, direct investment in China is problematical because of an ill-formed culture of corporate governance. A recent article in the FT indicates that:

Board structures at Chinese companies can lead to “confusion, ambiguity and potentially ... undermine the board of directors”, according to a study [by Risk Metrics] of the corporate governance risks faced by investors in China.

Even Hong Kong has its problems:

Risk Metrics noted minority shareholders in the two jurisdictions [Mainland China and Hong Kong] do face some common risks. The state’s firm grip over China’s largest industrial and financial companies is mirrored in Hong Kong by the influence of tycoons and their families.

Instead of investing directly into China, I would suggest vehicles such as the Korean market (EWY: iShares MSCI South Korea) as a way of participating in Chinese growth. Countries such as Japan and Korea supply China with capital goods to facilitate growth in the Chinese economy. The accompanying chart shows the relative returns of the South Korean KOPSI Index in US Dollars relative to the S&P 500. The Korean market bottomed out relative to the S&P 500 in 1997 and has been in a relative uptrend since. A trend following investor would look at that chart and say “stay with the trend!

The key risk to this trade is that the South Korean market is generally thought as as being highly sensitive to world growth and a significant slowdown in the US could affect it disproportionately.

Tuesday, April 1, 2008

A secular warning for the airlines

I don’t normally comment on fundamental analysis here, despite having been a small cap analyst early in my career. However, since Mrs. Humble Student of the Markets is a pilot and has numerous contacts in the aviation industry I thought I would make an exception.

There seems to be a dearth of flight instructors in North America, largely because of the low paying nature of the job. Recently, Mrs. Humble Student of the Markets was involved in a feasibility study to bring students from China to Canada to be trained as pilots. To make a long story short, she found that there was little spare educational capacity at Canadian flight schools, largely because of an instructor shortage. The parallel situation exists in the US (and in any case the US is not suitable for foreign student flight training in the post-9/11 era.)

Why does that matter? It matters because pilots, and airline pilots in particular, need to be trained as older ones retire. This shortage of flight instructors will eventually feed into a shortage of pilots, which will shift the bargaining power of pilot unions vs. the airlines. In fact, the shortage is starting to be felt in the emerging markets, where there is not a ready supply of experienced pilots. In one instance, an airline based in an emerging market country offered a job to a recently a qualified pilot (commercial multi-engine IFR rating) as a First Officer (co-pilot) with the understanding that he would be promoted to Captain (pilot) after 500 hours of flight time. This would be the equivalent of allowing a fresh intern, one or two years out of medical school, to perform brain surgery.

Back in North America, it probably doesn’t make a huge difference in the medium term as the United States heads into recession, which would likely result in layoffs at the airlines and create a surplus of pilots. Longer term, however, the shortage of flight instructors and eventually pilots is like the plankton disappearing from the ocean – it eventually makes itself felt all the way up the food chain.