Is this the long awaited correction?

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

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

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


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

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

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


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

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

The elusive search for a quant alpha

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

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


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

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

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

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

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

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


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

The first is the geeky solution.

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

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

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

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

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


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

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

To each his own.


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

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

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

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

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

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

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

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

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

What kind of "inflation"?

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


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


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

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

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

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

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

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

He concludes with [emphasis mine]:

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

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

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


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

Where inflationary pressures show up is in commodity markets.

Would that be inflation?

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

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


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

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

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

Poltical stability & middle class: an update

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

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

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

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

A fragile and frothy market

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

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


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



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

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



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


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

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

Political stability and the middle class

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

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

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

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

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

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

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

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

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

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


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

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


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

That’s when things get really ugly.

A quant's view of The Fourth Turning

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

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

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

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

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

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


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

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


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




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

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

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


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

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

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


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

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


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

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

Why I am not a bottom-up equity quant

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

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

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

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

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

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

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


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


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

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

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


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

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

1.5% sounds pretty good.

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

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

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

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

Is the Fed changing its tune?

The headline read Bullard warns on inflation, unemployment. On the weekend St. Louis Fed governor James Bullard warned on the risks of inflation. The press release reads that:

Bullard also expressed concern that inflation risks in the medium term may be higher than widely believed. He said that too much emphasis is being given to the idea that the recession implies that the output gap is currently quite large, minimizing the risk of inflation.

What's going on? Isn’t this the same man that declared back in August that interest rates would stay low for a very, very long time and the “markets haven’t digested what that means?”


Inflationary expectations are rising
The answer can be found in a recent speech by Fed vice chair Don Kohn [emphasis mine]:

To be sure, we have not followed the theoretical prescription of promising to keep rates low enough for long enough to create a period of above-normal inflation. The arguments in favor of such a policy hinge on a clear understanding on the part of the public that the central bank will tolerate increased inflation only temporarily--say, for a few years once the economy has recovered--before returning to the original inflation target in the long term. In standard theoretical model environments, long-run inflation expectations are perfectly anchored. In reality, however, the anchoring of inflation expectations has been a hard-won achievement of monetary policy over the past few decades, and we should not take this stability for granted. Models are by their nature only a stylized representation of reality, and a policy of achieving "temporarily" higher inflation over the medium term would run the risk of altering inflation expectations beyond the horizon that is desirable. Were that to happen, the costs of bringing expectations back to their current anchored state might be quite high.

The Fed is worried about the “anchoring” of inflationary expectations, or inflationary expectations rising out of control. They have embarked on a policy of jawboning inflationary expectations down even as Bullard, in the same breath that he used to warn against rising inflationary expectations, admits that quantitative easing isn’t done yet. Just look at the projections shown in the chart he shows in his presentation:

Kohn reiterated this dichotomy of accommodation against the Fed's fear of rising inflationary expectations in a speech yesterday at the National Association for Business Economics [emphasis mine]:

But it's not the current level of inflation or of output that figure into our policy decisions directly--rather, it is the expected level some quarters out, after the lags in the effects of policy actions have worked themselves out. In that regard, the projection of only a gradual strengthening of demand and subdued inflation imply that that these gaps--of inflation and output below our objectives--are likely to persist for quite some time. In these circumstances, at its last meeting, the FOMC was of the view that economic conditions were likely to warrant unusually low levels of interest rates for an extended period.

Investors should prepare for reversals
What does this mean for investors?

Investor sentiment on US Dollar is universally bearish, as shown by the chart below. Stories like this about central banks diversifying away from Dollar reserves only adds to the hysteria (note that they aren’t selling Dollars, just buying fewer Dollar assets).



In the weeks ahead, I would expect the Fed to continue its program of jawboning inflationary expectations down. At some point, the slightly more hawkish tilt is going to show its effects.

If rates rise, the Dollar would rally. Dollar weakness would turn into Dollar strength, starting a countertrend rally. Commodity prices would then weaken under such a scenario. Stock prices, which had been buoyed mainly by the reflation trade, would correct. In his latest weekly comment, John Hussman characterizes the current state of US equities as expensive and overbought [emphasis mine]:

The Market Climate for stocks remained characterized by unfavorable valuations, general strength on the basis of major indices, a few emerging divergences (one notable technical one being the non-confirmation between the Dow Industrials and Transports), and a fresh overbought condition resulting from the recent advance.

The combination of an expensive and overbought market with an unfriendly Fed could be setting us up for a bearish reversal. Downside risks could rise even further if investor sentiment gets more bullish or by unexpected changes in fiscal policy such as the enactment of a tax on financial transctions.

Where are the bulls?

I have expressed my concern about the state of the equity market before, but indicated that the bulls appear to remain in control despite the poor fundamentals. In a post entitled the most hated rally in Wall Street history, Barry Ritholz wrote last week that:

Most bull moves do not end when they are hated, they come to a halt and reverse when they become over-owned and over-loved.

We are not there yet.

The latest data from the AAII survey shows that, despite the equity rally, individual investors are not super bullish yet.



Mark Hulbert’s survey of newsletter writers as of the end of September also tells the same story - there is no sign of bullish extremes. Morningstar also concluded that fund investors are still not buying into the stock market rally, based on their analysis of mutual fund flows data.


Another market bubble?
Is a bubble forming in the stock market?

I believe that the term “bubble” is over-used. Current readings from sentiment models suggests that the lack of investor bullishness may serve to put a floor on any near-term market weakness. While there are big risks from the fundamentals, it may be too early for traders to contemplate shorting the market here.

Bubble? No.

A frothy market? Definitely.

Bill Miller’s big bet

I see that Bill Miller made it to the cover of Barrons this week. His fund, LMVTX, has made a remarkable comeback after several years of poor performance.


Miller sticks to his guns
Given the headlines I thought that it would be a useful exercise to analyze Miller’s macro bets and see what he did to achieve his returns this year. The chart below shows the fund’s exposure to the Financial sector. Miller had known to be a big believer in Financials and had been overweight the sector going into the Lehman crisis and out. The bet in the sector was responsible for the freefall in returns but the recovery of the sector also contributed to his turnaround in 2009.



Miller’s critics might accuse him of being a stopped clock, but the next chart, which shows his fund’s exposure to the cyclical sector, indicates that he was prescient in his timing. LMVTX began to increase its cyclical exposure in mid-2008, pulled back and then went all-in with its pro-cyclical bet in early 2009. That bet has paid off handsomely in 2009. The timing of the cyclical bet was remarkable given the low level of turnover the fund has historically exhibited.



Is Miller a genius or just lucky? You tell me.

Commodity investing for non-US investors

In investing, market participants need to think through the implications of an investment theme before taking action.

Here is a case in point. There are headlines everywhere about gold prices hitting all-time highs. While that is certainly true when gold is viewed in US Dollars, it is not true when you look at gold prices in euros, Yen or other currencies.

This problem is particularly acute for investors based in commodity producing countries. The recent decision by the RBA to raise interest rates sent the Australian Dollar soaring. The Canadian Dollar, another commodity currency, also rose in sympathy. Australian and Canadian investors in gold saw prices rise, but not to the same degree and prices are certainly not at all-time highs.

In this case, investors who wanted to bet on a rise in commodities should have been betting on the rise in USD. Problems with the US economy, its current account and fiscal deficit, are well known. If inflation was going to show up, it would have been in commodities and USD weakness. The correct action for non-US investors who believed in this macro case would have been to buy commodities and hedge their currency exposure.

Think through the scenario before you act.

Not hedge fund clones, but half-brothers

Mebane Faber has a great post on the topic of hedge fund cloning. He is correct in saying that you invest in hedge funds as pure alpha vehicles (hence the high fees), not because of their correlation characteristics.

Consider the following thought experiment. If I showed you a fair roulette wheel where the house has no advantage and I told you that I was going to bet a controlled amount once a day on a spin and invest the remainder in T-Bills. Such an investment would be uncorrelated to virtually any asset class that you can think of and would have highly diversifying characteristics, but would have no alpha.

Would you invest in such a fund? Would you also pay 2 and 20 for that privilege?

If hedge funds had no alpha, then that’s what you would be doing.


Do portfolio holdings tell the whole story?
Faber goes on to survey hedge fund replication techniques and finds them wanting. He goes on to extol the results of his AlphaClone service.

While AlphaClone’s real-time out-of-sample returns appear to be impressive, does that get an investor all the way there in hedge fund replication?

As I understand it, AlphaClone tracks the holdings of top investment managers through their 13F and other filings. However, there are a number of limitations to this approach, even if we assume that we can identify a smart investor universe:

• The information may be dated, especially if the fund is a high turnover fund.
• Limited disclosure: Many filings disclose only the long portion of the portfolio and does not show the short portfolio.
• Less attention to weights: Some of this analysis focus on the names of the holdings only, without paying attention to the weight. For example, Julian Robertson reportedly entered into a yield steepener trade. How big a bet is it? Does it represent 0.1% of his portfolio or 10%? Focusing on picks ignores all the other parts of portfolio management (see my previous comments here, here and here) and Dash of Insight also has a timely post on the importance of weighting differences between ETFs. I don’t know how much AlphaClone pays attention to the weightings in the portfolio but a lack of attention to weighting can prove to be a problem. One solution is to reverse engineer a manager’s macro factor exposures like I have here.
  

A half-brother...
In short, I believe that approaches like AlphaClone is the next step forward in hedge fund replications, but it doesn’t get you all the way there. What you get is more like a half-brother rather than a true clone.

At this point in time, the only way to get the true exposure to these funds is to buy them, rather than to try to clone them. Whether the difference between AlphaClone like approaches and directly buying the funds is worth the 2 and 20 fees is up to you.

China at 60

As China celebrates its 60th birthday, it is useful to reflect on some headlines on the long-term trajectory of the Middle Kingdom.

Former Fed chairman Paul Volcker recently indicated that China’s rise highlights the relative decline of the United States:

I don’t know how we accommodate ourselves to it. You cannot be dependent upon these countries for three to four trillion dollars of your debt and think that they’re going to be passive observers of whatever you do.

He did temper his remarks that the decline wasn’t absolute:

I would like to think that given the history of the past, given the strength, actual and potential of the American economy, we can still provide a kind of indispensable element of leadership here, but it's not going to be dictatorial, I'll tell you that.

As an indication of how far China has come, it is instructive to see that a decade ago, China was a prime destination of choice for westerners looking to adopt female children. Today, it is far more difficult for foreigners to adopt from China and Beijing is actually welcoming former adoptees.

As a resource short nation, China has moved to a policy of securing its resource base – as I have posted on before. This analysis is confirmed by a comment at Gregor, who has a more insightful viewpoint on the geopolitical implications of the major oil-actors on the world stage.


No clear sailing ahead
While China is ascendant today, not all is rosy. It is still important to remember that the country faces important headwinds and limits to growth.

Narrow banking can be the solution

Martin Wolf has an article entitled Why narrow banking alone is not the finance solution. He writes that one of the solutions proposed by John Kay in a pamphlet for the London-based Centre for the Study of Financial Innovation to the banking crisis is to create “utility” banks and “casino” bank. Regulate the “utility” bank, Kay says, and let the “casino” bank take risks.

Wolf then goes on to criticize this approach:

A more profound issue is whether a financial system based on narrow banking could allocate capital efficiently.

Here there are two opposing risks. The first is that the supply of funds to riskier, long-term activities would be greatly reduced if we did adopt narrow banking. Against this, one might argue that, with public sector debt used to back the liabilities of narrow banks, investors would be forced to find other such assets.

The opposite (and greater) risk is that the fragility of banking would be re-invented, via “quasi-banks”. This is what has just happened, after all, with “shadow banking”. In the end, those entities, too, have been rescued. The big point is that a financial structure characterised by short-term and relatively risk-free liabilities and longer-term and riskier assets is highly profitable, until it collapses, as it is rather likely to do.

The answer to the second dilemma is to make banking illegal. That is to say, financial intermediaries, other than narrow banks, would have the value of their liabilities dependent on the value of their assets. Where assets could not be valued, there would be matching lock-up periods for liabilities. The great game of short-term borrowing, used to purchase longer-term and risky assets, on wafer-thin equity, would be ruled out. The equity risk would be borne by the funds’ investors. Trading entities would exist. But they would need equity funding.

A better solution
Martin Wolf has written many cogent and insightful analysis of finance over the years. This is one of the rare cases where I disagree with him. The problem isn’t one of defining a regulatory framework for a “casino” bank, but that the incentives for the management of the “casino” bank are asymmetric and mis-aligned.

Instead of building a convoluted regulatory environment for banking, just bring back the partnership investment bank.

Allow market forces to work. If the partners at the "casino" bank want to pursue short-term returns at the cost of excessive long-term event risk, let them. The ones with adult supervision will survive, the ones without will blow their brains out and their failure will serve as an example to others.

Significant new finds = the end of Peak Oil?

The October Qwest for Returns newsletter that I authored is out. Here is the abstract:

In this issue we present the case for peak oil, emphasizing that talking about peak oil today is not about how much oil there is in the ground, which we refer to as reserves, but the potential imbalance in oil extractive flows or, said differently, how much you can bring out of the ground at any one time. The facts are, the world is facing falling production and it is more difficult and expensive to replace production in the foreseeable future.

Six Saudi Arabias
Despite all of the headlines about discoveries, the IEA projects that the world needs to replace production equivalent to six Saudi Arabias by 2030. Meanwhile, the emerging market economies continue to grow and their resource demand will skyrocket as they grow. Even if we were to assume that demand stays flat to 2030, the world would need to replace production equivalent to four Saudi Arabias.