Sunday, June 28, 2009

Golden cross on the S&P 500

There has been a bit of buzz generated by the appearance of the golden cross, where the 50-day moving average crosses the 200-day moving average, experienced by the S&P 500.



Be contrarian? Or sheep?
The talk is that such golden cross events are bullish for the market. The premise is based on trend following models, which depend on persistence of price trends.



The question is, do you want to be a contrarian or do you want to a sheep (and jump on the bandwagon)?


Do price trends persist?
To state the obvious, if these trend following systems are to work, then price trends have to persist. In quantitative terms, these strategies are only profitable if there is auto-correlation in price movements.

To test those ideas, I analyzed the daily correlations of the returns of the S&P 500 with the previous day’s return to for the persistence of price momentum for the period from 1993 to the present. While the median correlation of one-day S&P 500 returns was -0.08, indicating a tendency for price reversion, I found that indeed there were periods of strong momentum. An optimized solution that forecasts those periods based on indicators of autocorrelation turned out to produce better risk-adjusted returns.

The chart below shows the results. The dark blue line shows the cumulative long-only returns of the S&P 500 from 1993. The red line shows the returns of a 50-200 day moving average crossing system, where the signals are defined as:

Long: 50 day MA > 200 day MA and the 50 day MA acts as trailing stop
Short: 50 day MA < 200 day MA and the 50 day MA acts as trailing stop

When a signal is generated, the action is taken the next day based on the next day’s closing price. There are no frictional costs and when the system generates no signal, a return of 0% is assumed.

The green line shows the optimized strategy, where it will only use the 50/200 day MA trend following model if the S&P 500 is indicated to be trending.



Looking at these results, it is clear that trend following models can make money and reduce risk compared to a long-only position. Comparing the results of the 50/200 day system (red line) to a long-only investment (blue line), the trend following system is generally upward sloping and has far fewer draw-downs than long-only. The chart also shows that the optimized system (green line) yields similar returns when compared to the un-optimized system (red line) but the optimized system exhibits far lower levels of volatility and draw-downs.


What if there was no trend?
The S&P 500 shown in the analysis above generally trending during the study period, which enables a trend following system to be profitable. What if a trend following system is applied to an underlying price stream that was generally trendless?

The chart below shows the same 50/200 day moving average trend following system applied to wheat futures for the period from 1959 to the present. During much of that time, wheat prices were relatively flat and trendless.

The trend following system (red line) performed poorly in such an instance. An investment of $100 in 1959 would net you roughly $17 today. The optimized system (the green line) also lost money, but it did performed better and with lower levels of volatility.

An investment of $100 in 1959 in the optimized system would net you $62 today, which is ahead of the simple 50/200 day moving average trend follower.



Understand your assumptions: build a meta-model
The moral of this story is to understand the assumptions behind your models. Once you understand the assumptions, analyze the market environment. You may be able to build a meta-model to forecast the performance of your model and optimize your model’s performance based on market conditions.


About that golden cross…
What about the golden cross on the S&P 500? Was that a good signal?

The optimized reading flipped from a trending signal to a non-trending signal at the close on Thursday June 25th. Moreover, the 50-day moving average trailing stop is not that far away at 903.

Model readings are volatile and the stop loss is not that far away. Trade carefully.

Friday, June 26, 2009

Is America going down the Argentine road?

The FT had a fascinating article comparing and contrasting the United States and Argentina [emphasis mine]:

A short century ago the US and Argentina were rivals. Both were riding the first wave of globalisation at the turn of the 20th century. Both were young, dynamic nations with fertile farmlands and confident exporters. Both brought the beef of the New World to the tables of their European colonial forebears. Before the Great Depression of the 1930s, Argentina was among the 10 richest economies in the world…

There was no individual event at which Argentina’s path was set on a permanent divergence from that of the United States of America. But there was a series of mistakes and missteps that fit a general pattern. The countries were dealt quite similar hands but played them very differently.

Is America going down road to Argentina (aside from the governor of South Carolina)?

This is a brief excerpt of a much longer letter that I wrote as part of my weekly newsletter on commodities and inflation. It generated a much larger than usual response that I thought I should feature it here. If you would like to see the rest, which is too long to reproduce here, drop me a line here. It's free and I promise that I'll keep your email address to myself.

Wednesday, June 24, 2009

What to watch at the Fed

As the markets intensely scrutinizes the upcoming FOMC statement, I will instead be watching for Obama’s statement on the appointment of the new Federal Reserve chair in the days to come as a far more important clue to long-term market direction.

Currently, intrade shows Bernanke to be the front-runner to be re-appointed as Fed Chairman when his term expires in January 2010. The fate of Helicopter Ben will be an important clue to future policy.


Where is Paul Volcker?
Remember the stories during the campaign about how Paul Volcker added gravitas to the Obama economic team? As Obama became president, Volcker’s voice seemed to get downgraded.

Given Volcker’s age, it is highly unlikely that he would be the next Fed chair. However, with the yield curve steeply upward sloping and inflationary expectations elevated, this may be an appropriate time to consider reducing the level of monetary stimulus.



It would take a “damned the torpedoes” Volcker clone to be brave enough to take away the punch bowl just as the party is starting to get going, especially in the face of severe political pressures and sensitivities.

If Bernanke is re-appointed, then it will be a definite signal to take a ride on the commodity train.

Monday, June 22, 2009

Financial modelers need to THIMK!

There was a cartoon from many years ago showing a man sitting at a desk. His eyebrows were furrowed and he was obviously deep in thought. He had a sign above him that read THIMK!

Long time readers of these pages know that I am an advocate of modelers to think long and hard about the assumptions behind their models before turning them on. Unfortunately, many are thimking instead of thinking.

Here is another example.


Using Altman Z for financials?
I recently participated in an online discussion in response to a financial modeler’s question about applying Altman Z to financial companies. (See my previous discussion on the limitations of Altman Z here.)

If you don’t know the Altman Z, the formula is a function of liquidity, balance sheet strength and earnings power:

Altman Z =
1.2 X Working capital/Total assets +
1.4 X Retained earnings/Total assets +
3.3 X EBIT/Total assets +
0.6 X Market value of equity/Book value of debt +
0.999 X Sales/Total assets

The formulation was originally conceived for operating industrials, not financials. It appeared to me that for someone to even ask the question about applying Altman Z to financials indicates that he hasn’t sufficiently thought about the assumptions behind the model.

You could plug it the numbers, it would give you an answer. GIGO: Garbage In, Garbage Out. It would be as useful as newly minted MBAs trying to apply Black Scholes to fixed income instruments.


The Financial Modeler’s Manifesto
Over at his blog, Paul Wilmott posted the Financial Modeler’s Manifesto, which starts with an echo of the Communist Manifesto:

A spectre is haunting Markets – the spectre of illiquidity, frozen credit, and the failure of financial models.

It concludes with “Modelers' Hippocratic Oath”:

~ I will remember that I didn't make the world, and it doesn't satisfy my equations.
~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
~ I will never sacrifice reality for elegance without explaining why I have done so.
~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

I wholeheartedly agree. Read the whole thing. Examine the assumptions in your models and apply them intelligently. If you haven’t seen Wilmott’s Newsweek profile, it’s also well worth a visit too.

Happy modeling!

Friday, June 19, 2009

Inflation trade faces critical technical test

As I write this on Friday morning, the gold price is at $934.50 and is testing the uptrend that began in October 2008. Prices are also hovering near the 23.6% Fibonacci retracement level.



For technicians this represents an important test for gold.


The Rand carry trade
South African has long been viewed as a commodity producer, mainly gold. The South African Rand has been thought of by FX traders as a commodity play currency, much like the AUD or CAD.

The ten-year benchmark South African bond is yielding 8.83%, considerably above the US ten-year at 3.83%, for a spread of 500 bps. Just for kicks, I looked at the cumulative P&L of this carry trade. As the chart below shows, this trade is also approaching a technical overhead resistance zone.



Which way any of these break, I have no idea. But it’s important to monitor these charts as they indicate a critical test for inflationary expectations.

Tuesday, June 16, 2009

A green shoot for sure!

This headline just crossed my desk:

FIRST QUARTER HEDGE FUND LIQUIDATIONS DROP BY 50 PERCENT FROM RECORD SET IN Q4 2008


A 50% drop in hedge fund liquidations! This is for sure another green shoot.

Time to party!

Seven fat cows

Remember the biblical story of Joseph and the seven fat cows?



For commodity bulls, this may be the era of the seven fat cows. In a recent article, Cynicus Economicus points out that the world has seen an imbalance between the supply of resources and labour:

[T]he availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available…

In such circumstances, the resources will flow to the labour that utilises the resource in the most cost effective way, and where there is the commensurately high return on capital.

Notwithstanding all of the fiscal and monetary stimulus, he believes that resource prices are on an upward trajectory. This may mean, that at an extreme, we may see a seven in front of gold or oil prices (and I don’t mean $700 gold or $70 oil).


Followed by seven skinny ones…
Don’t think that scenario has a happy ending, however, as the seven fat cows are followed by seven skinny ones (see my previous comment here). Commodity inflation would inevitably followed by a deflationary collapse caused by massive demand destruction.

James Hamilton, who blogs at Econobrower, wrote extensively on the connection between oil prices and economic growth [emphasis mine]:

When I first began working on my Ph.D. dissertation in 1980, I was intrigued by the fact that the oil embargo of 1973-74 and the collapse in Iranian oil production after the revolution in 1978 were both followed by global recessions. But when I called attention to the fact there had been a sharp increase in the price of oil prior to 6 of the 7 postwar U.S. recessions up to that point, the general response was one of skepticism.

By the time I was presenting evidence of this relation at various seminars in 1981-82, the Iran-Iraq War had produced yet another shock to world oil markets and the NBER declared that the U.S. experienced a new recession immediately on the heels of the previous downturn, meaning that the evidence had now become that 7 out of 8 recessions had followed oil price increases…

We received some more evidence on this relationship when Saddam Hussein invaded Kuwait in August 1990, causing oil prices once again to double and coinciding with the 9th postwar recession. The price of oil also shot up before the 2001 recession. Add in the conjunction of the oil shock of 2007-08 with our current economic pickle, and my count is now up to 10 out of 11.


Inflation and recession?
Gregor MacDonald at gregor.us believes that we are likely to experience higher volatility in commodity prices as the world economy oscillates between the forces of commodity shortages and deflationary growth:

We have very likely been in an inflationary recession for nearly two years now, with massive deflation in housing and yet stubbornly higher food, energy and health care costs–the latter well above the price levels of just a few years ago. The risk, in my view, is that both trends now accelerate. And, that we experience next something more akin to an inflationary depression.

For now, we are seeing the start of a commodity friendly environment that may culminate in a hyper-inflationary blowoff, especially if the world loses confidence in the USD.

By all means get on for the ride on the hard-asset train, but don’t forget to get off when you get to your station.

As a reminder, I have a weekly commodity email newsletter for those who are interested. It’s free and I promise that I’ll keep your email address to myself. Drop me a line at cam at hbhinvestments dot com if you are interested.

Sunday, June 14, 2009

When politics and economics collide

I have posted before on how the political pendulum is swinging from Right to Left. Before anyone starts getting upset about the utter injustice of higher taxes, the government trampling on property rights, etc., we need to consider what happens when economics collide with politics.


The American Dream unravels?
In the United States, the social consensus of the American Dream, that anyone can succeed, has been the aspirations of millions and fueled many decades of economic growth.

What if American society experiences a severe enough dislocation that the mythic character of the American Dream is shaken? (See the discussion about the problem of low social mobility and high Gini coefficients in the US here and here.)

When the consensus moves too far to the Right and an economic shock occurs - the political pendulum swings Left. Edward Harrison of Credit Writedowns comments [emphasis mine]:

In 2008, the Democrats benefitted greatly from Barack Obama’s election as President, taking large majorities in both houses of Congress. Their mandate was to work with the President to fix America’s economic problem. So, Obama’s and Congressional Democrats’ first priority is to end the recession as quickly as possible. I guarantee you there would be hell to pay if this is not done well before November 2010 when the next general election is held.

From Obama’s perspective, it is crucial that he fix the banks and fix the auto industry as these were the two economic issues front and centre in the election which he said he could tackle. With the banking industry stabilised, the Obama legacy rides crucially on how the Auto Bailout proceeds. Under no circumstances is the Obama Administration going to allow General Motors to do to the economy in 2009 what Lehman Brothers did to it in 2008. They are going to fix GM no matter what it takes. And if this includes heavy-handed tactics, so be it.

So, be very clear that the GM and Chrysler issue is an existential question for this administration. Handle it well and you get the Roosevelt treatment and ensure a good outcome for your party in 2010. Screw things up and the depression bears down on America and you’re out of office in due course. The key policy decision is how to ensure a favourable outcome. And when I say favourable, I mean one that ensures as many jobs as possible while minimizing any wider economic fallout. Other issues like treating bondholders well, not committing taxpayer monies to the effort, or keeping government out of the auto industry are going to be much less important.

Harrison's comments extended beyond America’s borders:

[I]f Obama is concerned about his political fortunes because of an election next year, you can bet that Germany’s Chancellor Angela Merkel is concerned given her election is later this year. In Germany, cars have a mythical status…

Today there are hundreds of thousands of jobs in Germany tied to the auto sector, which has huge importance in the Rhineland, Germany’s industrial heartland and part of the most populous German state North Rhine-Westphalia, as well as in Lower Saxony, Bavaria, and Baden-W├╝rttemberg. In short, destroying auto jobs is a sure-fire way to lose an election. The ruling coalition is keenly aware of this and that is why they too will be very involved in the GM bankruptcy as it affects Germany through GM subsidiary Opel…

And I haven’t even mentioned the politics in Sweden, the U.K., Austria, Canada or Italy where this expected bankruptcy is equally important.

In other words, politicians have no choice. In times of crisis, rights get ignored (think Japanese internment camps) and trampled on.


Marxism realized?
As individuals, we can argue about whether a policy is right or wrong. As investors, we have to understand political realities and orient ourselves accordingly. Pat Martin, a Canadian legislator from a left-wing party, recently stated:

When I announce that I am a socialist, I guess it is no surprise because we are all socialists now. We just bought General Motors … The fact is that we now have Marxism realized. We own the means of production and we did not have to fire a single shot. It is really quite phenomenal what went on today.

Paul Krugman, in recent a New York Times op-ed article, blamed Ronald Reagan for our ills because of deregulation. While it is true that the pendulum started to swing right with the election of Ronald Reagan, deregulation didn’t cause all our ills. Excessive deregulation did.

The pendulum is now swinging Left, like it or not. At some point in the future, it will swing back. In the meantime, investors need to be aware of the social, political and economic backdrop of this investment environment and deploy their capital accordingly.

Wednesday, June 10, 2009

Julian Robertson’s genius in the yield steepener trade

Recently I mentioned Julian Robertson’s yield steepener trade. The yield steepener, which is a bet on rising long Treasury rates, is a really a bet on rising inflationary expectations.

This trade demonstrates Robertson’s genius. For most investors, a bet on inflation means a bet on gold, or other commodities. Here is what Robertson had to say about gold:

While Julian certainly thinks inflation is in our future, he is hesitant to buy gold. In the Value Investor Insight interview, he goes on to say that, "I've never been particularly comfortable with gold as an investment. Once it's discovered none of it is used up, to the point where they take it out of cadavers' mouths. It's less a supply/demand situation and more a psychological one - better a psychiatrist to invest in gold than me."


The bond market is infinitely more liquid
Whether the statement about being a psychiatrist is true or not, I don't know. For people like Robertson who run large hedge funds, liquidity is a far bigger concern. While mere mortal like us play around with gold (including the likes of John Paulson). Robertson has moved onto the far more liquid U.S. Treasury market.

To give you an idea of the differences in scale, the U.S. debt clock shows the total U.S. debt outstanding to be roughly $11 trillion. By contrast, Federal Reserve holdings of gold bullion (assuming that it’s not encumbered by gold loans) amount to a little over $200b, even at today’s prices. If we were to look at gold stocks, the total market capitalization of components of the Amex Gold Bugs Index (HUI) total about $120b, which is roughly the market capitalization of Cisco Systems (CSCO).

Robertson has enormous investment capacity in this trade, compared to investors who just play gold and gold stocks.

Now that’s genius.

Sunday, June 7, 2009

Rorschbach tests

The Rorschbach inkblot test was supposedly an interesting psychological test. You looked at an inkblot and what you saw said more about the you than the inkblot.

Here are a couple of interesting Rorschbach tests for market observers.


Tiananmen Square anniversary
During this past week, the press was full of then and now stories about the Tiananmen Square massacre in 1989, some 20 years ago (example here). The following account tells the story of Prof. Chen, who was involved with the protests and then later purged by the Chinese authorities. He later emigrated to Canada [emphasis mine]:

Prof. Chen also was silent. The only way he was able to escape the memories of June 4 was, in some ways, by returning to China.

His prime motivation for moving back was for his children to be educated in a more competitive environment. “I don't think they can compete with Chinese children who study 12 hours a day, seven days a week,” Prof. Chen said, laughing.


What do these stories tell us or the media? Should the West maintain its focus on human rights in dealing with foreign countries? Or are has China and the Chinese changed so much in the last 20 that a purged professor feels compelled to return because he believes that the western education system is too soft? Who is more Darwinian and who are the true capitalists now?


Hedge fund regulation
Consider this new, ah, innovation in hedge fund investing:

Richard W. Fields says he has come up with a win-win financial strategy for the downturn. He is investing in lawsuits.

Not in trip-and-fall cases, mind you, but in disputes that are far larger, more costly and potentially more lucrative, often pitting major corporations against each other.

Mr. Fields is chief executive of Juridica Capital Management, which runs a fund that invests in one side of a lawsuit in exchange for a share of any winnings, The New York Times’s Jonathan D. Glater writes.

Does this demonstrate that hedgies are total amoral beings who will do anything for a profit? Or amidst the calls for greater hedge fund regulation, does this story demonstrates the utter futility of trying to regulate hedge funds as they are testaments to the power of innovation and human ingenuity?

There are no right answers. The answers only tell you something about your own nature.

Thursday, June 4, 2009

The bull & bear case for gold

Poor Tim Geithner! When he asserted that China’s Dollar assets are safe, he drew laughter from an audience of Chinese student. As well, an American delegation to the Gulf reportedly drew a blank back in May when it tried to get more petro-dollar investment into the U.S.

As the USD continues to plunge and price of gold heads for another test of the $1,000 level, I thought it is time to review the bull and bear case for gold. In this review, I consider the economic, technical, investor psychology and geopolitical viewpoints when making my assessment.


Inflation and inflationary expectations under control
I have written before that it is probably too early for commodities to boom. The price chart of the iShare Barclays TIPS Bond Fund (TIP) below gives an indication of inflationary expectations. The price of TIP tanked late last year but has recovered since. Nevertheless, inflationary expectations are elevated but nowhere near hyper-inflationary fear levels. (Remember James Carville’s comment about wanting to be reincarnated as the bond market – and that's because the bond market is usually right.)




Another measure of inflation is the Dallas Fed’s trimmed mean PCE, which some analysts consider to be a better measure of core inflation than PCE ex-food and energy. Trimmed mean PCE seems to be running ahead of PCE ex-food and energy on a consistent basis in virtually all time periods, indicating rising inflationary pressures. Nevertheless, the readings are not high by any standards and inflation appears to be under control – for now.



Investor sentiment is very bullish (contrarian bearish)
Investor sentiment surveys on gold show a high degree of bullishness, which is contrarian bearish. Mark Hulbert’s analysis also points to the same conclusion.

Longer term, however, the smart money is bullish. Some very successful investors, like Julian Robertson and John Paulson are either long the inflation bet or short the U.S. long bond (which is equivalent to a long inflation bet).


Technical indicators long-term bullish but appears overbought
When analyzing gold and commodities, historical price action can serve as a guide. Since gold has been fixed at $35 until the 1970s, we don’t have that much of a long-term history. So instead I looked at the Continuous Commodity Index, which is the a continuation of the old equal weighted CRB Index before its re-balancing in 2005.

The chart below of the CCI is supportive of a long-term commodity bull as it shows two episodes of upside breakout and consolidation since 1956. The last episode ended with the blow-off which took gold to its old high of $850 in 1980. Even if commodities don’t blow-off to new highs in the current regime, which is doubtful in this environment of hyper fiscal and monetary stimulus, the potential upside from current levels to the old high is 48% for the CCI. This is indicative of the minimal upside objective in a renewed commodity bull market.



Zooming in more closely, we can look at how commodities behaved when the economy emerged from past recessions. There the picture is mixed. In 1974, the initial price action was biased to the upside, but highly volatile. It wasn’t until 1977 that commodities settled down into a steady and sustainable uptrend.



The 1982 recovery was the start of a dis-inflationary era. That episode was marked by a minor uptrend, breakout and plateau, before a steady decline.



The 1990 recession also occurred in a dis-inflationary period. That period was marked by a continuing commodity price decline, which didn’t bottom until 1992, two years after the end of the economic downturn.



The 2000-2 recession was punctuated by the 9/11 shock to the markets in 2001. Commodity prices began a steady uptrend shortly thereafter. That commodity price bottom occurred well ahead of the S&P 500 bottom in October 2002.



Looking at the Continuous Commodity Index today, the CCI made a bottom in December 2008 and began an uptrend. Short term, prices are near top of the channel and commodities appear to be short-term overbought.



Looking at the longer term chart, does it stage an upside breakout and blow-off to new highs? Or does it remain in a consolidation pattern?

We’ll have to watch and wait. Even if it stays in a sideways pattern, the potential upside to the top of the trading range is about 48% from current levels.


The geopolitical wildcard
So far, the economic dimension and investor psychology both seem to tilt bearish on gold. But I didn’t mention the geopolitical dimension. Gold responds to geopolitical tensions. Could a geopolitical premium be building itself into the gold price?

What about the risk of war or conflict? Fabius Maximus sarcastically commented:

The plan for victory in Afghanistan is simple and sure:

1 stabilizing the country by garrisoning the main routes, major cities, airbases and logistics sites;
2 relieving the Afghan government forces of garrison duties and pushing them into the countryside to battle the resistance;
3 providing logistic, air, artillery and intelligence support to the Afghan forces;
4 providing minimum interface between our occupation forces and the local populace;
5 accepting minimal casualties to our forces; and,
6 strengthening the Afghan forces, so once the resistance was defeated, our forces can be withdrawn.

Does this like the U.S./NATO strategy in Afghanistan? Whether it is or not, it was actually the Soviet strategy in the 1980s. Oops! We know how that turned out.

I also found some more pointed criticism of the Afghan campaign strategy from the Fabius Maximus blog here.

Could Afghanistan be the geopolitical wildcard?

Meanwhile, here is a post over at The Cunning Realist:

I had an interesting conversation with a native of Pakistan's NWFP recently. He's young, well-educated (partially in the U.S.), and a member of his country's establishment. This won't exactly be news to anyone who's been following the situation there, but he's extremely worried about the effect of U.S. military strikes in Pakistan. Pakistanis see these strikes as targeting not a small group of high level terrorist leaders, but the deep-rooted, increasingly popular Taliban movement itself. One result is growing sympathy for the Taliban among his peers: the young, tech-savvy, well-connected elite who should be -- and traditionally have been -- opposed to everything the Taliban stands for.

Pakistan is a nuclear armed country. Could Pakistan be the geopolitical wildcard?

Right now, there doesn’t seem to be much of a geopolitical premium built into the gold price. The U.S./NATO conduct in Central Asia could be a long-term concern and a source of risk to stability.


Investors can average in, but traders should tread carefully
What’s the bottom line? What should someone do?

Given my long term bullish tilt of on gold and commodities, my inner investor tells me to dollar-average into gold and gold-related positions, especially if I have no positions in gold right now. My inner trader, on the other hand, tells me that while there are long-term opportunities to in gold, I would wait for a pullback before piling in.


Free commodity newsletter
I repeat my invitation to those who would like to sign up for my weekly commodity email newsletter. It’s free and I’ll keep your email address to myself. If you are interested please sign up here.

Wednesday, June 3, 2009

Pitchfork watch

I previously noted that Simon Johnson, the former chief economist at the IMF, wrote that “unless the government of the day is willing to take on the entrenched elites [read Wall Street and hedgies] and force them to take the pain, the path of least resistance is rising inflation and possibly hyperinflation.”

Social backlash?
Back on May 3 I wrote that the New York Magazine reports a quote from a Citibank executive as an illustration of the culture of entitlement:

No offense to Middle America, but if someone went to Columbia or Wharton, [even if] their company is a fumbling, mismanaged bank, why should they all of a sudden be paid the same as the guy down the block who delivers restaurant supplies for Sysco out of a huge, shiny truck?
When I start seeing items like this in the popular press, there is little question that the social backlash is starting.

Tuesday, June 2, 2009

Is a rising Baltic Dry bullish for equities?

Schaeffer’s Investment Research recently put out this note on using the Baltic Dry Index (BDI) as an indicator for the S&P 500[ emphasis mine]:

The Baltic Dry Index (BDI) continues to rise. Many consider this an excellent sign for the world economy. The BDI is an index that measures the price of shipping dry bulk cargo, which includes coal, iron ore, and grain. Since the index is used to gauge the demand for major raw materials used in the early stages of production, it is regarded as a leading indicator for the economy…

The theory sounds great: a rise in the BDI signals a growing economy and, therefore, is a bullish sign for the market…History seems to back up this theory, as the SPX's returns following this signal outperform the index's typical returns. In the eight instances that the BDI rose above its 200-day moving average, there were positive returns seven times during the six months following the signal. The average six-month return for the SPX following such a move in the BDI is 7.24%. That's more than double the SPX's typical six-month return of 3.02%.


Incomplete analysis
While the analysis based on the recent action of the Baltic Dry Index and the S&P 500 sounds intriguing, the long term picture shows virtually no relationship between the BDI and the stock market.

The chart below shows the indexed returns of the two indices from 1985. The correlation of monthly changes between the BDI and S&P 500 from January 2007 was 0.33, which is relatively high to suggest some causal relationship. Looking longer term, the correlation of monthly changes was a miniscule 0.07, indicating little or no relationship between the two indices.



Vincent Fernando, who wrote the following note at Research Reloaded, agrees:

I have actually done a rather in-depth BDI correlation study in the past during my tenure as shipping analyst at Citi. One important thing to note about correlation is that you need to look at correlations for many different time periods because if you just calculate a single correlation then it will be highly dependent on your start and end dates…

I think its even best to step back from numbers or historical correlations and think about some very important differences between the nature of the BDI and the nature of a stock price for a company or market. The BDI measures the rate to ship something around the world, ie. the COST to ship something around the world. On the other hand, the stock of a company represents ownership of a productive asset, a company. (well, at least usually they are productive!) A company is seeking ways to be more efficient, grow the size of its business and generally increase its value.

The analysis from Schaeffer’s was at best incomplete and at worse sloppy and not well thought out. This is an issue that I have talked about over and over again: Good quants need to think about the assumptions in their models.

Beware of quant models bearing gifts.

Monday, June 1, 2009

June Phoenix update

By request, here is the latest update on the Phoenix list:

ACCO Brands Corp (ABD), American Axle & Manufacturing Holdings I (AXL), ArvinMeritor Inc (ARM), Belo Corp (BLC), Clear Channel Outdoor Holdings Inc (CCO), Crosstex Energy Inc (XTXI), Dana Holding Corp (DAN), Delta Petroleum Corp (DPTR), Developers Diversified Realty Corp (DDR), Eastman Kodak Co (EK), Emcore Corp (EMKR), EW Scripps Co (SSP), FCStone Group Inc (FCSX), Ferro Corp (FOE), First Industrial Realty Trust Inc (FR), Gannett Co Inc (GCI), Great Atlantic & Pacific Tea Co (GAP), Hercules Offshore Inc (HERO), ION Geophysical Corp (IO), iStar Financial Inc (SFI), Phoenix Cos Inc/The (PNX), Sunrise Senior Living Inc (SRZ), Technitrol Inc (TNL), Warren Resources Inc (WRES), YRC Worldwide Inc (YRCW) and Zale Corp (ZLC).
There are 26 stocks on the list, compared to 39 stocks in the April update. As a reminder, the Phoenix stock list consists of stocks that pass the following criteria:
  • Stock price between $1 and $5 (low-priced stocks)
  • Down at least 80% from a year ago (beaten up)
  • Market cap of $100 million or more (were once "real" companies)
  • Net insider buying in the last six months (some downside protection from insider activity)

Few green shoots: Wait for the re-test

Mark Hulbert has said before that the market will likely re-test the March lows and I would tend to agree with that view.

In the short term, the bulls seem to have the momentum but the “green shoots” thesis is getting a little tired. There doesn’t seem to be much of a recovery from many of the people on the ground. The CEO of McDonald’s indicated that the company doesn’t see any “green shoots”. In addition, David Sokol, who Jeff Matthews characterized as Warren Buffett’s likely successor and who is currently CEO of MidAmerican Holdings Company reported that he was not seeing any green shoots either.


What to watch for
One of the indicators that I am watching is $BPNYA on stockcharts.com, which is the percentage of NYSE listed stocks that are on a point and figure buy signal. As the chart below shows, this indicator had a higher low in March – a bullish divergence. I would look for a similar positive divergence on the next re-test of the lows as an indication of a lower risk entry point.

$BPNDX, which is the percentage of NASDAQ stocks showing a P&F buy signal, also shows a similar pattern:

Both these indicators are looking distinctly overbought right now. I would wait for the pullback and re-test before entering the Phoenix trade.

Be patient.