Monday, December 28, 2009

Sometimes you can't save the world

There have been a number of diatribes in the blogosphere about why Bernanke shouldn’t be re-confirmed as Fed Chairman. Examples include Simon Johnson’s Should Bernanke be Reconfirmed? and comments from Cunning Realist such as Bernanke responds, Man of the Year and An Inadequate Answer.

Who bells the cat?
There was once a children’s story about the mice getting together and deciding that it would be great idea that the cat should wear a bell. The problem was, who bells the cat?

That’s the fantasy world that we live in now. I wrote back in July that there were few alternatives to Bernanke. If you get rid of him, who are the alternatives? The leading candidates at the time were Janet Yellen (an apologist for inflation) and Larry Summers (another disaster).

The corruption of Washington culture
In a perfect world, we would have a better replacement for Fed Chair, but we don’t. Dean Baker, co-director of the Center for Economic and Policy Research, wrote an article entitled Bernanke and the corruption of Washington culture where he railed on about how Bernanke actively encouraged and abetted the creation of the excesses that created the mess in the first place. He then concluded with:

How on earth can you do worse in your job as Fed chair then bring the economy to the brink of a total collapse? If this is success, what does failure look like?

But, in Washington no one is ever held accountable for their performance. The economic collapse is treated like a fluke of nature – a hurricane or an earthquake – not the result of enormous policy failures.

When Bernanke was first appointed to the Fed Chair, I told friends and colleagues that he was the Second Coming of Arthur Burns, the Fed Chair in the 1970's who had a head in the sand attitude about inflation. In fact, Burns was instrumental in the adoption of the core inflation (ex-food and energy) measure that is widely in use today. My investment conclusion at the time of the Bernanke appointment was to buy gold.

As individuals, sometimes we have to recognize that we can’t save the world and we can only save ourselves. My inner investor tells me to get long commodities but to be prepared for extreme volatility. My inner trader tells me that this will be a time of financial and economic instability and to rely on tactical timing models such as the Inflation-Deflation Timer.

Friday, December 25, 2009

A different kind of White Christmas

Here on the Wet Coast, we tend not have White Christmases. This morning I woke up to a different kind of white Christmas as a white fogbank enveloped Vancouver:

(Click to enlarge picture)

Tuesday, December 22, 2009

The greatest threat to capitalism

For many people, this is a time of year for reflection (instead of year ahead forecasts which I already touched upon here). So let me share with you my personal concerns about those who are less fortunate.

A growing class-based chasm?
This is a theme that I have expressed concerns about in the past. A fraying social fabric and a threatened middle class which endangers political stability.

Who is in the middle? Consider the following video, which depicts income distribution in the United States. While there are some inaccuracies, median household income is about 50K, not 40K, it does make the point about inequality.

The social elite these days is mostly Wall Street. Consider the I-am-more-deserving-than-you attitude in this Barrons article when bankers were asked as to whether they owed a social debt to society because of the bailouts (if you don’t have a Barrons subscription, see some excerpts here).

The greatest threat to capitalism are the capitalists themselves
In the past, this kind of let them eat cake mindset has led to peasant revolts. Already Moody’s has picked up on this theme and warned of social unrest. The UK is calling the bankers’ bluff to pick up and move elsewhere, but the US has caved to virtually every of the bankers’ wishes. Yves Smith at Naked Capitalism has suggested that the proper response by the UK government would be a combination of harassment or punitive tax policy for the likes of Goldman or any other investment bank who leave.

Policy bias favoring Wall Street is already institutionalized, the New Republic has an interesting article which indicates that the US may not be able to revitalize its manufacturing base because business schools are turning graduates oriented towards finance, not operations or manufacturing.

What’s more, no less than former Federal Reserve Chairman Paul Volcker has picked up a pitchfork and appears ready to join the peasant revolt. Joseph Stiglitz believes that banking troubles are worse than pre-Lehman crisis.

Others, like John Hussman, are outraged at the bailouts:

It's clear that financial institutions have made a mad dash to repay TARP money in hopes of being able to pay year-end bonuses, but what is not so clear is what happens after the year actually ends. Various policy makers (particularly Ben Bernanke, who is currently up for reappointment) have begun to take on a self-congratulatory tone, suggesting that the recent crisis is not only behind us, but that it has been resolved at a profit. What is not evident from these comments is how small these “profitable” inflows have actually been, in relation to what has been spent.

I will be convinced that the crisis has been resolved at a profit when the Fed disgorges the $1.5 trillion in Fannie Mae and Freddie Mac securities it has bought for us, and if the U.S. government does not end up having to bail those securities out because the cash flows from the underlying mortgages prove inadequate. Having no such assurance, the smug “mission accomplished” remarks of Bernanke and Geithner are reminiscent of a veterinarian who walks out of the operating room saying “I saved the life of your rabid dog … by giving it the vital organs of your children.”

The rebirth of the American Dream, or end of Pax Americana?
Most people who read a financial blog like this belong in the top 10% and a considerable in the top 1%. I believe that those of us who are in the top distribution of society must realize that unless America acts to restore the American Dream and dismantle the nascent class system that was formed with financiers at the top, the end of Pax Americana is at hand.

Monday, December 21, 2009

A sentimental warning for equity bulls

This is just a quick note, as blogging will be light until the New Year:

The latest reading from AAII shows the bull-bear ratio at a bullish extreme, which is contrarian bearish for the market.

Add to that came the news that Rydex timers really bullish. These readings serve as a warning for equity bulls that the upside for the market may be limited.

Thursday, December 17, 2009

I can handle (Rosenberg's) Truth!

In a special report entitled Year Ahead: Can You Handle the Truth, Gluskin Sheff chief economist & strategist David Rosenberg wrote [my emphasis]

Suffice it to say, we believe that the dominant focus will be on capital preservation and income orientation, whether that be in bonds, hybrids, hedge fund strategies, and a consistent focus on reliable dividend growth and dividend yield would seem to be in order. To reiterate, I see the range of outcomes in the financial markets and the economy to be extremely wide at the current time. But one conclusion I think we can agree on is the need to maintain defensive strategies and minimize volatility and downside risks as well as to focus on where the secular fundamentals are positive such, as in fixed-income and in equity sectors that lever off the commodity sector.

Rosenberg's observation before about the wide range of forecasts, is not new. I wrote about his comment about the huge range in the Fed's economic forecast in my post Get ready for Extremistan. As I understand it, Rosenberg's investment solution is to be defensive and preserve capital, while staying flexible enough to capitalize on opportunities as they arise.

Models for times of macroeconomic instability
Here is a better idea. The trend following principles of the Inflation-Deflation Timer model is the ideal tool for this kind of unstable environment. This class of model can identify changes in macro-economic expectations and investors can then profit from them.

Interview with Arjun Rudra

I was interviewed by Arjun Rudra of, where I talked about my views on:
  • Gold stocks
  • Stock market valuation
  • Inflation and deflation macro trends
  • Peak Oil

You can read the interview here, Seeking Alpha.

Wednesday, December 16, 2009

Another dovish FOMC statement?

With the news yesterday that producer prices came in at 1.8%, which was well ahead of market expectations of 1.0%, the markets should have been spooked. Instead of the DJIA being down 200 points, the market finish down only 49 on the day.

Perhaps it was in reaction to the news that China indicating that inflation was not likely to be a serious problem in the near future. Federal Reserve Chairman Ben Bernanke also had a very relaxed attitude towards inflationary expectations and asset prices. In a written response to Senator Jim Bunning (KY-R), Bernanke wrote:

The bulk of the evidence indicates that resource slack is now substantial. I continue to expect slack resources, together with the stability of inflation expectations, to contribute to the maintenance of low inflation in the period ahead.

In addition, the Fed Chairman doesn’t believe that there is an asset bubble:

Responding to questions about asset prices, Bernanke said “there is not much evidence to suggest that the stock market is currently in a bubble.” The Standard & Poor’s 500 Index has rebounded 28 percent in the past year while remaining 30 percent short of its high in October 2007.

Well, we can more or less guess that the FOMC statement will have a dovish tone.

A commodity and asset inflation friendly environment?
This sort of attitude by the Fed and the Chinese are ingredients for another Bubble and should continue to be bullish for commodity prices and bearish for the USD. The chart below shows the ratio of Amex Gold Bugs Index (HUI) to the S&P 500, indicating that gold stocks remain in a relative uptrend relative to the general market.

Dave Rosenberg explained yesterday why inflationary expectations are creeping higher:

It could have more to do with government mandated cost-push inflation than anything related to consumer demand-pull inflation. But we did see in today’s Investor’s Business Daily an article, which stated that governments have enacted 297 protectionist trade measures in the past year. (Amazingly, it was just over a year ago when the G-20 meeting was held in Washington when it was agreed that no such anti-trade measures would be taken.) The number of ‘planned measures’ has risen by 50 (!) in just the past three months — the pipeline keeps growing. This is why gold is a buy on pullbacks … like the one we have on our hands right now.

As well, my Inflation-Deflation Timer model continues to sport an “inflation” reading, which has been in place since July.

Financials signaling risk ahead
On the other hand, the relative behavior of the banking and financial sector is a warning sign for the longevity of this equity rally. The BKX made a plateau relative to the S&P 500 in the August to October period and has been falling since.

Watch the market reaction
If we do get the dovish statement, then I would watch how the market reacts. Does the “risk trade”, i.e. equities, commodities, etc., rally? If so, then how big is the rally?

I will be watching how commodities, exchange rates, equities and the financial sector reacts to the FOMC announcement for clues of future market direction.

Monday, December 14, 2009

Why you shouldn't buy gold stocks

My last post an embarassing question for gold bugs got a fair number of comments - which is to be expected whenever I write anything negative about gold or gold stocks.

My post then deserves a clarification. Supposing that you had a crystal ball that told you the price of gold were to triple within two years. Given this piece of information, what should you buy in order to maximize your gain?

Buying gold by itself will give you a gain of 200%. Buying a two-year call on gold with a $600 strike will give you a projected gain of about 300%. If you change the strike to $900, the projected gain is about 550%.

If you buy gold stocks given its poor fundamentals of rising production costs and their resultant pattern of disappointing leverage, gains are likely to be 200% or less. An investor would be taking on more volatility risk but at the price of little or no incremental gain.

Gold stocks are like leveraged ETFs
There are, however, times that gold stocks can be good trading vehicles. As many readers pointed out, they were a screaming buy compared to bullion early this year. Unfortunately, gold stocks are trading vehicles in the same way leveraged ETFs are trading vehicles. For longer term investors, their risk-reward characteristics are bound to disappoint.

Thursday, December 10, 2009

An embarassing question for gold bugs

Here is an embarrassing question for gold bugs. The chart below shows that price of gold decisively moved to all-time highs in early October, notwithstanding the recent pullback:

Meanwhile, the Amex Gold Bugs Index (HUI) barely challenged its old highs. What happened to the thesis that gold stocks are a levered play on the price of gold?

In case you thought I was cherry picking gold stock indices, the failure to make new highs is not exclusive to HUI, just look at XAU:

…and GDM, which is the base index for the GDX gold stock ETF:

Barry Sargent, writing at Mineweb, attributes the poor performance to the negative cash flows generated by the major gold miners:

Since the start of 2007 (and excluding the fourth quarter of 2009), eight of the world's Tier I gold stocks - AngloGold Ashanti, Barrick, Goldcorp, Newmont, Yamana, Kinross, Harmony, and Gold Fields - have generated negative free cash flow of USD 3.2bn (for the first nine months of this year, in line with rising bullion prices, generation of free cash flow has been positive to the tune of USD 1.1bn).

I believe that the story is simpler than that. I showed before that gold mines can be modeled as a series of call options on the gold price and production costs are rising at the major mining companies. Who knows, maybe the era of peak gold has arrived (see articles here and here).

I posted on this topic before and got a lot of hate mail for it. Now it’s time to revisit that issue again. For gold bulls who insist on a levered play on bullion, I would rather buy a long-dated deep in the money call option on gold than holding gold stocks.

Fool me once, shame on you. Fool me twice, shame on me.

You have been warned more than once. Gold bugs have no one else to blame if they underperform if there is another upleg in gold prices.

Monday, December 7, 2009

Consensus shifts ahead of Copenhagen

There are many crowded trades in life and in finance. One crowded trade that I am comfortable with is “the earth is spherical” trade. If the consensus was to shift off that paradigm, analysts would, after the fact, label that view a “bubble” and the market fallout from such a change would be extremely ugly.

After the hacker break-in at CRU, I speculated on what the possibilities might be should the consensus change. Today, as the world looks forward to the Copenhagen summit, the market consensus seems to be starting to shift as a result of the CRU incident. Avner Mandelman recently voiced his skepticism about climate change thesis and the issue of researchers either fudging data or denying others access to data:
Say that a pharmaceutical company's researchers were caught fudging their tests to make their drug look effective; then, when found out, conveniently lost the non-fudged data. If a doctor prescribed for your child the fraudsters' drug, would you let her take it? If you said yes, would we not be justified in saying you are acting irrationally?
If you missed the controvery, the issue isn't about just how a researcher might have used some "trick" to fudge data so that it would agree his model, but the distressing lack of discipline in the scientific method. Judith Curry, an American climate scientist and no skeptic of the climate change thesis, was appalled [emphasis mine]:

What has been noticeably absent so far in the ClimateGate discussion is a public reaffirmation by climate researchers of our basic research values: the rigors of the scientific method (including reproducibility), research integrity and ethics, open minds, and critical thinking. Under no circumstances should we sacrifice any of these values; the CRU emails, however, appear to violate them...

If climate science is to uphold core research values and be credible to public, we need to respond to any critique of data or methodology that emerges from analysis by other scientists. Ignoring skeptics coming from outside the field is inappropriate; Einstein did not start his research career at Princeton, but rather at a post office. I’m not implying that climate researchers need to keep defending against the same arguments over and over again. Scientists claim that they would never get any research done if they had to continuously respond to skeptics. The counter to that argument is to make all of your data, metadata, and code openly available. Doing this will minimize the time spent responding to skeptics; try it! If anyone identifies an actual error in your data or methodology, acknowledge it and fix the problem.
Meanwhile, the financial market consensus appears to be starting to shift. Donald Coxe, former Global Portfolio Strategist at BMO Capital Markets, also indicated his doubts about the global warming thesis. In reporting on Coxe, a reporter commented:
My purpose here is not to weigh in on Mr. Coxe's theory of climate change (which mostly has to do with sunspots) or those of the scientists who disagree with him. But he is worth listening to in this respect: The big money is always, always made by those willing to bet against a deeply held consensus. So if, five or 10 years from now, new evidence has thrown theories of global warming into doubt, enormous profits will be made by those putting their cash on that outcome now.

Quantitative finance = science
While I have my own personal opinions about climate change, I have learned to be flexible and open-minded about my beliefs as an investment and quantitative analyst.

Quantitative finance is much like science. We observe, we form our hypothesis, we test our hypothesis and we try to apply them. If the evidence changes, our models have to change too.

I have observed situations in the past where people have been dogmatic about models and investment processes despite evidence to the contrary. In the short term, these people may be successful in the short term. In the long term, the market will punish them for their views if they are wrong. Some of these models were built by analysts with incredible stature. Not only do some of these people have Ph.D.s from top universities, published in leading peer-reviewed journals, a few are even Nobel laureates.

In fact, why don’t we start a hedge fund with some Nobel laureates, we’ll call it Long Term Capital Management….

Here’s another idea. Let’s take some of these models of mortgages and apply them to how we package mortgage backed securities. We’ll slice up the mortgages into different tranches, from senior to junior and…

Oh, I remember how that turned out.

Good quantitative modelers observe, form hypotheses, test and apply them. So do good scientists.

We all need to thimk and watch out for errors in our data set and assumptions.

Thursday, December 3, 2009

A (Fed) house divided

Abraham Lincoln famously said that “a house divided against itself cannot stand.”

Today, we may have that exact state at the Federal Reserve. I finally go around to reading the last FOMC minutes. While there was great debate between the hawks and the doves, here is the position of the hawks about inflation risks [emphasis mine]:

But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public's concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation.

Wait a minute, did they just say that? The Wall Street Journal reported that there is around $1 trillion of excess reserves sloshing around in the banking system, which is indicative that banks don’t want to lend, and these guys are afraid of bank lending?

Maybe I am just dense but the position of the hawks appear to be inconsistent to me. Why did they vote for quantitative easing?

The current situation reminds me of the old Steve Martin/Lily Tomlin comedy All of Me, where Tomlin’s character was trapped inside Martin’s body but neither has complete control.

Meanwhile, you have the likes of
Bullard of the St. Louis Fed asserting that the recent commodity price spikes are not inflationary. No wonder there are such differences of opinion about the outlook at the Fed.

What's more, I see that Sen. Bernie Sanders said that he has placed a hold on the nomination of Ben Bernanke for a second term as chairman of the Federal Reserve.

A (Federal Reserve) house divided indeed, what does that say about its policy?

Monday, November 30, 2009

Buying hedge funds is still the risk trade

Does the pattern of this chart look familiar? It’s the performance of the HFRX Global Hedge Fund Index, but it could just as well have been the stock market.

This is the two-year anniversary of this blog. My first post was entitled what exactly are hedge funds hedging? I showed that there was a high level of correlation of hedge fund returns to equities and that pattern hasn’t changed.

Hedge fund bounce-back a facade
Despite the recovery in performance, not all is well in hedge fund land. The Wall Street Journal reports that many managers still can’t charge performance fees. About two-thirds of hedge funds have not recovered from losses of 2008 and are not ready to declare a profit on which managers can take fees, according to a report by Hedge Fund Research. About one-quarter of these funds were 20% short of their best level of performance last year.

Even worse, hedge fund due diligence remain problematical as studies have suggested that one in five hedge fund managers are lying.

Fool me once, shame on you...
Today, hedge funds still represent the risk trade and risk can be proxied in some ways by equities. Should the market correct, then it’s a safe bet that hedge fund returns would turn south as well.

So can someone please remind me why investors are paying 2 and 20 for beta exposure that can be so easily replicated?

Sunday, November 29, 2009

More signs of Extremistan

Imagine being on a bicycle. If you are moving forward, then you and the bike are stable. On the other hand, if you are stationary or barely moving, then you are apt to tip either to the right or left.

That’s the analogy of Nassim Taleb’s concept of Extremistan, an unstable state where we may be moving from one extreme condition to another. Last Friday David Rosenberg provided more evidence that the world may be in that state when he analyzed the FOMC minutes:

All you need to do is go to the Federal Open Market Committee (FOMC) minutes and see the wide divergence of views over the macro outlook, and this is coming from 17 of the nation’s top policymakers who also ostensibly keep in touch with each other. The range on 2010 GDP estimates is: 2.0% to 4.0%; for 2010, 2.5% to 4.6% for 2011, and 2.8% to 5.0% for 2012. These two percentage points are huge for a $14 trillion economy — we’re talking about differences that amount to $300 billion! The range on the unemployment rate forecast for 2010 is 8.6% to 10.2%; for 2011 it is 7.2% to 8.7%; and for 2012, the band is 6.1% to 7.6%. These ranges are massive. And, for the inflation rate, the range for 2010 is 1.1% to 2.0%; 0.6% to 2.4% for 2011, and for 2012, the range is 0.2% to 2.3%.

So consider that at the Fed, there is one official that sees the potential for a return to full employment by 2012; and another that sees the prospect of deflation. These views are worlds apart and attest to our assertion that the band around any particular forecast in a post-bubble credit collapse is huge.

The Fed has a 2010 GDP forecast that ranged from 2.0% to 4.0%? Can't they make up their minds?

That reminds me of a long ago comment from a commodity analyst that natural gas would be somewhere in the range of $4 to $14 in the coming year! (BTW, is that why we pay these analysts the big bucks?)

Balanced funds will not do well in Extremistan
What do investors do in these circumstances?

I would contend that trying a disciplined approach of holding a balanced fund, which is an approach optimized for non-extreme events, is the worst thing an investor can do. Andy Lo, leading behavior finance academic and the Harris & Harris Group Professor at MIT, agrees [emphasis mine]:

To achieve true diversification, investors must now have a broader set of asset classes and risk exposures, long and short, in their portfolios…In this environment, managing risk can no longer be easily accomplished via simple buy-and-hold portfolios as before, but requires more frequent rebalancing or “tactical risk management”.

Today, the extremes that investors face are the tropical heat of runaway deflation and the Arctic deep freeze of deflation. Tactical techniques such as the inflation-deflation timer are ideal for navigating this perilous path that our metaphorical bicycle is on.

Inflation-Deflation Timer model update: The Inflation-Deflation Timer model has remained at an inflation reading since July 2009, though any possible panic spawned by any contagion from a potential Dubai World default could quickly move it to neutral and then deflation in relatively short order.

Thursday, November 26, 2009

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.

Wednesday, November 25, 2009

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:




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.

Sunday, November 22, 2009

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...

Thursday, November 19, 2009

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.

Monday, November 16, 2009

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.

Friday, November 13, 2009

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.

Thursday, November 12, 2009

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!

Wednesday, November 11, 2009

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.

Monday, November 9, 2009

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.

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.

Thursday, November 5, 2009

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.

Wednesday, November 4, 2009

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.

Monday, November 2, 2009

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.

Friday, October 30, 2009

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.

Thursday, October 29, 2009

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.

Monday, October 26, 2009

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.