Thursday, July 31, 2008

Many headwinds for this market rally

You can tell a lot about a market by the way it reacts to news. Merrill Lynch’s announcement of more writedowns and capital raising, ten days after its quarterly earnings report, should have been a shocker to the market. The stock opened down but closed up strongly on the day. This suggests to me that this oversold rally in the Financials has more to go in the very short term.

Yet I am under no illusions that this is a bear market rally. A bear market serves to shake out the excesses of the last boom. In the medium term, I continue to be concerned that the shakeout and adjustment process is nowhere near complete.

Interest rates are rising
The chart below shows the yield on 10-year Treasuries, which has risen since the market began to rally. Mortgage rates have been rising in along with the 10-year yield (see comments here and here) and such a development can’t be good for the beleaguered housing market.

An old-fashioned credit crunch
In typical recessions, lenders pull in their horns and tighten up their lending standards. When done to excess these actions result in a credit crunch, which the IMF is now warning about and is also being reported elsewhere in the press. The Fed has already in place a new alphabet soup acronyms of emergency lending facilities, how much more can it do?
More importantly, what will a credit crunch do to the real economy?

Longer term imbalances remain
Brad Setser also pointed out that many of the long-term imbalances, which a recession should correct, are unresolved. US savings rates have stopped falling but remain low.

In mortgage lending, he writes that the US government is becoming the lender of last resort:
Mortgage lending hasn’t even collapsed. Demand for “private” mortgage-backed securities has disappeared. But the Agencies stepped in and bought mortgages both for their own book and for the mortgage-backed securities that they guaranteed.

Enjoy the ride but trade with tight stops
In the short term, the fact that the market rose on bad news from Merrill Lynch is bullish. However, many of the problems remain unresolved and we will likely see further adjustments that will affect the real economy. In the medium term, this can’t be a bullish sign for US equities.

Friday, July 25, 2008

Don't confuse correlation with causality

One of the first things that I learned as a quant is “don’t confuse correlation with causality”. Unless there is a direct relationship (e.g. interest rates go up, bond prices go down), statistical correlations don’t necessarily hold up.

Correlations move around
The folks at Bespoke have an interesting study showing the correlations of different asset classes and sectors over two time frames, one longer and one shorter. In the short term, S&P 500 sectors have become slightly more correlated with each other. The Yen has become more correlated with virtually all assets while Treasuries have become less correlated.

The lesson of this study is: asset correlations move around. In this case, U.S. Treasuries have become a much better diversifier to U.S. equities in the short run. Which correlations should an investor rely on when building a portfolio?

Understand the fundamental case
My inner quant tells me to ignore the short term figures as the time frame is too short to matter. My inner fundamental investor tells me to figure out why the correlations are moving around. In fact, there may be a perverse causal relationship at work with asset classes that show negative correlations. Here are some examples:

  • EAFE (1980s) – International equities were sold as diversifiers as they exhibited low correlation to US equities. Money moved in and eventually correlations rose.
  • Emerging markets (1990s) – Emerging markets were sold as diversifiers to US and international equities. Even during periods of stress, their correlations were historically low. Money moved in and correlations rose.
  • Hedge funds (starting about 2000) – Hedge fund returns were uncorrelated to equities, especially during the post-Tech Bubble bear market. Money moved in…

Tuesday, July 22, 2008

The secret of Warren Buffett’s success

Years ago I was asked what kept us from being Warren Buffett. My reply was "how Buffett picked stocks was fairly well-known. The problem was the inability of managers to tolerate excessive tracking error." This was quant-speak for "portfolio managers spent too much time building benchmark hugging portfolios for business reasons".

There has been much written about how Warren Buffett picks stock. Jeff Matthews had a great series of posts on this topic:

It's not just about picking stocks
One of the effects of Buffett’s approach is that he won’t buy companies whose businesses he doesn’t understand or he deems “too difficult to run”. As a result, the portfolio will contain very few companies in certain industries, such as Technology. As any good quant can tell you, a lot of return risk can be explained by industry weightings and such a lopsided portfolio will have returns that are very different from the S&P 500.

I have written before that running a portfolio is a lot more than picking stocks, which people have focused on for Buffett. It’s also about benchmarking, portfolio construction and trading.

Warren has a plan - and sticks to it
Could the secret of Warren Buffett’s success be the way he benchmarks himself? Indeed there is some evidence of that as this study shows that despite Berkshire's vaunted investment results, its Sharpe ratio is only 0.64.

In many cases, Berkshire Hathaway buys the whole company and seems to only consider the value of that cash flow stream at purchase time. Buffett et al seems to care less about the value of the company in the marketplace after its purchase. After all, the value of Berkshire Hathaway’s unlisted subsidiaries are not reported anywhere nor can they reported since there is no publicly listed value for these companies. After BRK acquires them, they only get valued by the market based of their aggregate cash flows, asset values, etc.

Could Berkshire's investment policy be just a form of Economic Value Added (EVA), as popularized by Stern Stewart & Co? Under the EVA analytical framework, your objective in running a company is to make sure the returns on your investments are above the cost of your funding. Since Berkshire buys and doesn't sell, its investment policy seems to be consistent with the concepts of EVA: buy cheaply and never mind what the market thinks in the interim because you are managing through the economic cycle.

You can build your own Berkshire Hathaway
You may argue that “Warren Buffett has the means to buy the whole company, but I don’t. I don’t have the luxury of doing the same thing.”

It can be done. I once worked with a taxable family trust that held an equity portfolio with many positions with very low cost basis (and therefore large capital gains liability if the position were to be sold). The objective of the trust was to provide its current beneficiaries with an income stream while preserving the inflation adjusted value of the capital for future generations.

The trustees decided to focus the portfolio on holding dividend paying stocks with good growth prospects. They created a synthetic benchmark based on the dividend growth metrics to measure the portfolio’s performance. Returns were measured on an after-tax basis. The hurdle rate for selling a stock with an embedded capital gain therefore was higher than normal because of the higher after-tax cost of replacing the dividend stream.

As the portfolio manager for one of the trust’s portfolios, I found myself in the unusual situation of apologizing every time the market went up, even if the portfolio had outperformed: “Sorry, we made money for you this quarter (but that means that we can’t re-balance the portfolio and sell anything without taking the capital gains hit)”. Conversely, market declines were welcome because it afforded an opportunity to harvest some capital losses so that the portfolio could be re-balanced on a tax-efficient basis.

Know yourself, be disciplined and march to your own drumbeat
The story of this trust is an example of an investor knowing his objectives and sticking to them. In this case, the trust knew its objective and created its own benchmark. The trustees focused on dividends and their growth rates (just as Berkshire Hathaway focuses on cash flows and their growth). What the market pays for those investments in the interim was mostly noise that could be ignored.

If you know yourself and can be disciplined in the same way, you can do the same.

Friday, July 18, 2008

Was that THE BOTTOM?

The market action this week showed the classic signs of investor capitulation. The most important sign was the enormous volume seen in XLF. My trading desk sources reported huge buying interest in XLF on Wednesday and Thursday, indicating that there was real institutional money buying the Financials – a sign that these stocks may have seen an intermediate bottom.

Phoenix not rising yet
Despite these bullish indications, I don’t think that this marked THE BOTTOM for the S&P 500 this cycle. I may live to regret this but I am not buying the low-priced, near bankrupt Phoenix stock basket that I described here and here.

Sentiment indicators are bullish
Sentiment certainly got very bearish. Short term sentiment indicators such as AAII got to bearish extremes, which is contrarian bullish. As mentioned previously, high volume market action in the Financials, the most troubled sector of the market, was consistent with capitulation. We also have the news that superbear David Tice is selling his firm, another contrarian bullish indicator.

Low expectations going into Earnings Season
We are also going into Earnings Season with low expectations. Bespoke Investment Group reported on Thursday morning that with 11% of the S&P 500 reporting, the beat rate is 72%. What is most surprising is 34% of the reporting companies have been in the Financials sector, which has been the most challenged of companies in the market. (These statistics are pre-MSFT, MER, GOOG reports after the close Thursday).

Valuations are constructive
As I mentioned before, one of my personal rules of thumb is to look for the investment banks to trade at 1x book value. The stock prices of Merrill Lynch (MER) and Morgan Stanley (MS) did touch their stated book value this week. However, there are well documented problems as to what book really is for a bank and MER reported a $4.6b loss after the close Thursday, which took book value down further.

But long-term sentiment isn't bearish enough
In many ways this has been a classic cycle like the ones we saw in the 1960s, 1970s and 1980s. For the market to bottom, we need some recognition that we are in a recession. This poll is showing that sentiment is getting to near that point but it isn’t quite there yet. Even Europe is weakening and soon there may be nowhere to hide.

Wait for late cycle stocks to weaken
In a classic cycle, the late cycle resource stocks collapse as economic growth slows and inflationary expectations fall. While the near term corrective action in oil prices represent a start, resource stock investors need to feel more pain before this cycle is over. These charts from Bespoke Investment Group show the relative strengths of the different sectors within the S&P 500. While Energy and Materials have weakened, the action in the last two days is barely a blip in the overall trend and that trend needs to be in serious reversal before we can see an overall bottom in the market.

Wrong leadership in the rally
Another important indicator that this is not THE BOTTOM: in past bottoms, we saw large caps lead the way (see chart here). In the last two days of the rally, the small cap Russell 2000 has been the leadership. I would theorize that with an important market bottom institutions jump in with both feet and buy the most liquid part of the market. To put the relative liquidity of the stock market in context, the top 20% of the S&P 500 by market cap represents roughly two-thirds of the weight of the index. If you had a large amount, say $10-20 billion, to put into the market while everyone else is buying, what would you buy?

A bear market rally
After considering all of the evidence, what are we left with?

This has the feel of a bear market rally, which can see the S&P 500 move up 10-20% before the bear market resumes. No doubt there will be volatility as we go through Earning Season but the path of least resistance is up. Enjoy the ride and see this as an opportunity to lighten up your long positions.

Wednesday, July 16, 2008

Is Size the answer for the hedge fund industry?

I received a number of responses from my post hedge fund shakeout continues that suggests that the current trend of size and consolidation seems to be the answer for the hedge fund industry. Indeed, the WSJ (subscription required) reported:
By the end of last year, 87% of all the money in the business was handled by funds managing $1 billion or more, and 60% was held by managers sitting on $5 billion or more. The dominance by the largest funds has been accelerating: In the past two months alone, the world’s largest public hedge-fund company, Man Group PLC, increased assets by $4 billion, to $78.5 billion.

Size is not a panacea
There are a number of problems with this approach by hedge fund investors. Firstly, while larger funds may be better positioned to weather downturns, a look at the hedge fund implode-o-meter shows large funds are not immune to blow ups.

In addition, as hedge funds gain in size, their capacity constraints will begin to kick in and the opportunity for alpha can diminish.

Fix the business model
The hedge fund industry doesn’t offer a good value proposition. Fees are too high and returns are getting commoditized. I wrote in the past that Bridgewater Associates reported that many hedge fund strategies could be replicated by simple passive strategies. For example, emerging market hedge funds could be replicated using a 50% weight in emerging market bonds and 50% emerging market equities – all without the high costs. Already, there is a mutual fund starting up to replicate hedge fund returns using ETFs (see announcement here).

Warren Buffett reported made a bet that the S&P 500 would beat any hedge fund of funds picked by the other bettor over a 10 year period. He believes that the high fee structure embedded in hedge funds would overcome any alpha generated.

Hedge funds used to be highly differentiated investment vehicles. Returns were good and un-correlated to other asset classes. You didn’t mind paying 2% and 20% or more for the likes of Soros or Tiger. Today, the returns are being commoditized. Size, which confers the benefit of economies of scale, is not an answer. The industry needs to fix its business model and value proposition.

Friday, July 11, 2008

$100 oil before $150, but $200 before $50

I previously pointed out that the Bank Credit Analyst, or BCA, wrote that “emerging markets will be key to timing a slowdown in oil [and other commodity] demand”. Today, we see signs of slowdown in many emerging markets. Vietnam is a disaster. India is slowing down and problems are becoming more evident (see comments here and here).

China slowing?
Risks are also increasing in China. BCA also summarized the risks the China well here and the Economist wrote about China’s macro risks here. Recently Stratfor summarized the risks to the Chinese economy well in the following commentary (emphasis mine):

Ruling China has always been a difficult prospect, as the country is riven with urban-rural and coastal-interior splits. But while the Olympics were supposed to have been a celebration of China's "arrival" as a modern state, they are instead serving as a showcase for all the ways in which China falls short. But dealing with these issues — entrenched corruption, financial dysfunction, (unapproved) regional autonomy, unaffordable energy subsidies — is difficult for Beijing in the weeks leading up to the Olympics because, under the glare of international spotlights, it can no longer use the tried-and-true tools of an authoritarian state. The result is a string of patchwork fixes that highlight China's weaknesses, making the Asian giant vulnerable to any foreign power with an interest in demonstrating that the emperor is less than fully clothed. Not exactly the global celebration that Beijing intended when it bid for the
Olympics all those years ago.

In China, the chickens may be coming home to roost. Recently we saw that China’s June trade surplus declined $21.3b, compared to an expected $22.0b. While one data point does not make a slowdown, it does point to a trend of slowing growth, which would be negative for commodity prices.

Emerging market slowdown is commodity bearish
Some commodity prices are starting to show the strain and may be starting an intermediate term correction. Demand destruction is already being seen in oil and petroleum products.

Be prepared for volatility
Is it all over for the commodity bulls? I was asked that question recently and my answer was “expect $100 oil before $150 oil, but expect oil to hit $200 before $50.”

We remain in a hard asset cycle and the long-term fundamentals for commodity remain intact. However, investors need to be prepared for commodity corrections, which can be nasty and violent. The chart below shows the price action of the Continuous Commodity Index, which the old equal weighted CRB index before CRB went to a liquidity weighting. The index has moved up tremendously in the last few years and the bull trend can still remain intact should we see a 20% correction.

Tuesday, July 8, 2008

Idiot’s market neutral fund: A mid-year report card

I first wrote about construction of the idiot’s market neutral fund here and I further addressed the controversy of why the technique may work here. A mid-year update of this hypothetical fund shows that estimated YTD returns to June 30 was 3.5%. This is ahead of the HFRX Equity Market Neutral Index of 2.3% for the same period. Other investable hedge fund equity market neutral indices (e.g. Dow Jones Equity Market Neutral at 1.5%) show even worse performance than HFRX.

Smart funds remain defensive
The idiot’s market neutral fund’s alpha is mainly derived from the market positions of a group of smart funds. The question in many investors' mind must be what are the smart funds doing now?

The orientation of smart funds hasn’t changed significantly since my last update in late April. Smart funds continue to be more defensive. The managers of these funds seem to believe that the worst may not be over for the US economy.

As the chart below shows, smart fund market beta shows that they are defensively positioned. By contrast, the consensus funds, a group of funds run by the largest mutual fund complexes have market betas roughly in line with the S&P 500:

Smart funds continue to be underweight Financials, while consensus funds are slightly overweight:

…and smart funds are roughly market weight Consumer Cyclicals, while consensus funds are overweight:

Thursday, July 3, 2008

A LT demographic headwind for the US$

What if we had a time machine that could tell you how the world markets and economies are going to behave? We do – it’s called demographics. While this time machine won’t tell you the winner of the Super Bowl in 2015, it will tell us a lot about the probable behavior of world economies, consumer behavior and investment and saving preferences.

We all know about the Baby Boomers in America. The appearance of this cohort has dramatically affected American consumer and investment behavior for the last half of the 20th Century and will do so into the 21st Century.

There are other “baby boom” that have occurred around the world. Japan is the oldest. It had a baby boom whose demographic peak preceded the US one by about ten years. The US, Canada, Australia and New Zealand had a post WW-II baby boom all about the same time. The EU also had one, albeit with lower intensity, that lagged the US boom by about ten years.

Poole’s projections for Japan
With that in mind, we can roughly forecast what America will look like by looking at Japan and lag it by ten years. William Poole, the former president of the St. Louis Fed, gave a paper in 2005 analyzing the probable demographic effects on the Japanese economy. He argued that with her aging population, Japan’s trade balance will slide inexorably into the red (see graphs here). Left unsaid is the pressure on the Yen as Japan’s current account deteriorates.

Japan is known to have a very high savings rate. With American savings rates so low and the US current account in severe deficit, what will be the probable path of the US Dollar once this demographic storm hits?

China saves the world, but…
Laurence Kotlikoff is an academic that has written extensively on demographics and their effects on the economy. In a 2005 paper entitled Will China eat our lunch or take us to dinner? he wrote that all is not lost because China can save the world:

If successive cohorts of Chinese continue to save like current cohorts, if the Chinese government can restrain growth in expenditures, and if Chinese technology and education levels ultimately catch up with those of the West and Japan, the model’s long run looks much brighter. China eventually becomes the world’s saver and, thereby, the developed world’s savoir [sic] with respect to its long-run supply of capital and long-run general equilibrium prospects. And, rather than seeing the real wage per unit of human capital fall, the West and Japan see it rise by one fifth percent by 2030 and by three fifths by 2100. These wage increases are over and above those associated with technical progress, which we model as increasing the human capital endowments of successive cohorts.
However, this doesn’t mean that the developed world is out of the woods:

On the other hand, our findings about the developed world’s fiscal condition are quite troubling. Even under the most favorable macroeconomic scenario, tax rates will rise dramatically over time in the developed world to pay baby boomers their government-promised pension and health benefits. As Argentina has so recently shown, countries can grow quite well for years even with unsustainable fiscal policies. But if they wait too long to address those policies, the financial markets will do it for them, with often quite ruinous consequences.
How ruinous are the consequences for the US? Here are some current options that he suggests:
- 70% increase in personal and corporate income taxes;
- 109% hike in payroll taxes;
- 91% cut in federal discretionary spending; or
- 45% cut in Social Security and Medicare benefits.
While you ponder those questions - Happy 4th of July!