Monday, August 31, 2009

No recovery signal from semiconductors

Relative charts are useful devices for filtering out the effects of the overall market. Further to my last post on the homebuilders, I decided to look for signs of a recovery in other industry groups as the market has moved from rallying on signs of stabilization to rallying on indications of a cyclical recovery.

The semiconductor group (SOX) is an ideal indicator, as the semis were not directly impacted by the mortgage and banking meltdown. The chart below shows the relative performance of SOX against the S&P 500 Technology Index. Technology had led much of the rally since late last year and this relative chart shows the performance of the more cyclical semiconductor group against broader Technology stocks.



As the chart indicates, the more cyclical semiconductor group remains range bound relative to Technology stocks. Despite Intel’s positive report last week, there is no sign of a recovery from this cyclically sensitive industry.

Sunday, August 30, 2009

Turning on comment moderation

There has been too much spam lately so I am turning on comment moderation.

Any and all relevant comments are welcome. You are free to disagree with me. Just don't spam us.

Friday, August 28, 2009

Housing bottoming but recovery still uncertain

Bloomberg recent reported that Homebuilders are buying land after years of inventory cuts. Coupled with a buoyant new home sales report, some investors have concluded that housing has bottomed and is poised to rebound.


Wait for the relative breakout
The chart below shows the S&P 500 Homebuilders Index relative to the S&P 500. Relative to the S&P 500, the Homebuilding group is currently undergoing a basing process but calls for an upturn may be premature. Technically, the group needs to break out of its relative trading before we can definitely call for a recovery.



My gut feel tells me that sentiment isn’t quite washed out for an upturn. We need a magazine cover style capitulation, or for the popular media to really jump on the story. Here is an example from Britain’s housing bust from the 1980s:




Bottoms are a process
This form of relative analysis isn't new. I posted on the bottoming process undergone by the group last August and again in January. I suggest that investors shouldn’t get overly enthusiastic in anticipation of a rebound. We need to watch and wait for the relative breakout before sounding the all-clear.

Wednesday, August 26, 2009

Is the free market always the best solution?

Economics 101 taught generations of students learned about demand-supply curves and the supremacy and efficiency of the free market. The forgotten caveat of those microeconomic models was based on a number of assumptions that didn’t always hold, such as perfect information, frictionless costs, lack of entry and exit costs, etc.

Michael Porter, to take an example, has made a huge career and reputation on the idea that a firm can get more returns by capitalizing on advantages based on some of those market imperfections.


Market imperfections = Free market failure?
Recently, there has been some controversy over Goldman’s analyst huddles and how they affect the smooth functioning of the market. While this may turn out to be a tempest in a teapot and Goldman may not have done anything wrong in the technical sense, this is an example of a market imperfection.

Jeff Matthews also highlighted legal payoffs in the drug industry, which is another example of a market imperfection that results in a detriment to the public.


The Nature of Second Best
There is a very old economics paper dating from 1956, called The General Theory of Second Best. To summarize, if the current state of an economic system is one step away from the unconstrained optimum (the free market), the best single move is to towards the optimum. However, if the current state is two or more steps away from the optimum, or Second Best, then everything is up for grabs. The best single move may not be to move towards the unconstrained optimum. (If you didn't understand that, there is another explanation here).

The Theory of Second Best was a controversial paper when it came out. It was attacked by many theorists unsuccessfully for many years. Finally, it was ignored by economists, perhaps on the hopes that if you ignored it it would go away.


Greedy optimization algorithms
Quantitative analysts have performed constrained optimizations. We have all experienced optimization problems where too many constraints have yielded solutions that appear to be highly counterintuitive. The fact is, if you impose too many constraints on a system, a greedy algorithm that moves towards the unconstrained solution may give you a solution that is locally optimal, but suboptimal on a global basis.


Imperfect world, imperfection solutions
The lesson here is to understand the model, its assumptions and when the model may break down.

In the real world, there is no room for dogma and ideology. There is no doubt that an unconstrained free market solution (unconstrained as in assuming frictionless costs, participants having perfect information and equal bargaining power, etc.) is the most efficient economic system. However, we live in an imperfect world where many of those assumptions do not hold. Under these circumstances, moving towards a free market solution may not be the optimal solution. Each problem has to be studied on a case by case basis.

Sunday, August 23, 2009

No repeat of the Great Depression

There have been a number of analysts like Bob Prechter and Doug Short who believe that the pattern shown by the US stock indices look like a repeat of the 1930s and the Great Depression.

It is difficult for me to make the case that the current conditions make a repeat of the Great Depression inevitable, or even likely. James Hamilton of Econbrowser commented on Short’s analysis this way:

Among the factors that turned the hoped-for recovery of 1930 into the debacle of the Great Depression were a sharp hike in interest rates in October 1931 and a decline in the overall price level of 10% per year in 1931 and 1932. Whatever else happens, I don't expect those particular mistakes to be repeated by the Bernanke Fed.

In addition to Hamilton’s assertions about the Bernanke Fed, I would add a couple of other points that should be encouraging for the bulls.


Protectionist hounds are in the kennel
Countries raising their protectionist drawbridges was one factor that exacerbated the effects of the downturn in the 1930s. This time, it doesn’t seem to be happening. Recently, the Economist reported that global trade seems to have flattened out. Floyd Norris recently wrote in the New York Times that there are even hints of an upturn in global trade.

Countries all around the world seemed to have learned to open markets and free trade lesson this time around. Consider these headlines in the last few months:


What’s interesting about some of these headlines is that free trade is being embraced around the world, which is highly encouraging for the long-term macroeconomic backdrop. The fact that the EU, which has a history of bickering and isn’t known for being friendly to open markets, is negotiating free trade deals around the world is a bit of a surprise to me.


What if peace breaks out?
There are also geopolitical wildcards. What if the US and Iran made peace?

Bruce Bueno de Mesquita, a specialist in game theory at NYU, forecasts precisely such an outcome:

Last year, Bueno de Mesquita decided to forecast whether Iran would build a nuclear bomb. With the help of his undergraduate class at N.Y.U., he researched the primary power brokers inside and outside the country — anyone with a stake in Iran’s nuclear future. Once he had the information he needed, he fed it into his computer model and had an answer in a few minutes…

...Iran won’t make a nuclear bomb. By early 2010, according to the forecast, Iran will be at the brink of developing one, but then it will stop and go no further. If this computer model is right, all the dire portents we’ve seen in recent months — the brutal crackdown on protesters, the dubious confessions, Khamenei’s accusations of American subterfuge — are masking a tectonic shift. The moderates are winning, even if we cannot see that yet.

Should these events come to pass, which are not on any market analyst’s radar screen, oil prices would like fall because of a reduction in the geopolitical premium and equities would rally.


No Armageddon
In conclusion, it is highly unlikely that the world is going to repeat the mistakes of the 1930s. I am concerned, however, that it would make new mistakes.

In the short term, I continue to believe that the market is extremely vulnerable to setbacks. China seems to be the bellwether. The trajectory of the Shanghai Composite seems to indicate that China’s stimulus mini-bubble is bursting and the world is in danger of getting dragged into a double-dip slowdown as China appeared to be the last engine of growth.

If a double dip does occur, investors should keep in mind that it is only a bear market, not Armageddon.

Wednesday, August 19, 2009

The inflation vs. deflation debate

I have written before that the inflation vs. deflation bet is likely the Call of the Decade.

That topic is becoming hot. I have had several exchanges in the last few days about the inflation vs. deflation outlook for the economy. Some have pointed to Barry Ritholtz’s post at Big Picture indicating that deflation currently has the upper hand. Dave Rosenberg also pointed to the same theme today.

On the other hand, Warren Buffett wrote an op-ed in the New York Times warning of the risks of USD devaluation and debasement should the US government continue on its current trajectory of deficit spending, which would lead to inflation for US residents.

I will repeat what I said to everyone that I discussed this topic with.

When I read the analysis, both camps are persuasive. Both camps are populated with some very smart investors (who wants to bet against Warren Buffett?)


Let the model decide
It is becoming evident that the future will be dominated by either inflation/hyper-inflation/USD devaluation, or deflation, but little in between. In this case, I would prefer to allow a trend following model do its work and tell me which way the wind is blowing (see an explanation of the model here).

Sunday, August 16, 2009

More bearish data points for equities

I spent the weekend looking over some of my sentiment model indicators and things look ugly for the bulls. First of all, the latest AAII survey of individual investors shows a spurt in bullishness, which is contrarian bearish.



Moreover, the latest Commitment of Traders report shows that large speculators (read: hedge funds) are now in a crowded long in the high-beta NASDAQ 100 and the net long position has started to decline, which is another bad sign for the bulls.



Shanghai Index breaks down
China has become the last hope of growth in a growth starved world but the Chinese stock market is rolling over. The chart below shows the Shanghai Stock Exchange Composite Index, which has fallen through an uptrend line that began in November 2008, as well as the 50-day moving average. Both of these are important signposts for technicians that point to an interruption of the rally.



Given some of my recent warnings about the equity market (see here and here), these additional data points are more indications of the precarious state of the US equity market.

Wednesday, August 12, 2009

A V-shaped recovery with 4-8% GDP growth?

I've written about macro headwinds for the stock market before. Recently David Rosenberg, former chief economist at Merrill Lynch, now chief economist at Gluskin Sheff, indicated that the stock market is pricing 4.25% GDP growth:


Based on past linkages between earnings trends and the pace of economic activity, believe it or not, the S&P 500 is now de facto discounting a 4¼% real GDP growth rate for the coming year. That is what we would call a V-shaped recovery.

Raising the GDP growth stakes
Over at Hussman Funds, William Hester wrote an article entitled Earnings Growth Forecasts May Require a Robust Economic Recovery, which may have raised the stakes on Rosenberg's analysis.

Hester analyzed the relationship between implied earnings growth and nominal GDP growth, shown in his chart below. (Note: I have annotated the chart to interpolate a nominal GDP growth of about 10% and the 10% interpretation is strictly my own.) If we assume an inflation rate of around 2% and look at the interpolated nominal GDP growth of 10%, it suggests that the market is discounting real GDP growth of about 8%.




Is 4-8% real GDP growth realistic? It would be quite a V-shaped recovery.


Deteriorating technical conditions
Meanwhile, Barry Ritholz at The Big Picture wrote that the market is rallying on lower volume and deteriorating breadth:

Ron Griess of The Chart Store points to the rally continuing on decreasing volume. I would also note that breadth is softening as well.

An exuberant and over-the-top-giddy equity market derived macro outlook and deteriorating market technicals isn't exactly encouraging for bulls.

Don’t say that you weren’t warned.

Monday, August 10, 2009

Timing the inflation/deflation trade

For investors, the inflation vs. deflation call is probably the Call of the Decade.

Never in my investment career have I seen opinions so bifurcated. While there are many smart investors calling for rising inflation because of the wall of money coming from fiscal and monetary stimulus around the world. At the same time, there are equally convincing arguments indicating that there powerful deflationary force at work and the global economy is facing, at best, an L-shaped recovery.


Enter the trend following model
In addressing the inflation vs. deflation conundrum, trend following models are especially useful as they tend to pick up on macro-economic trends, which are persistent. Using trend following modeling techniques, I have built an inflation/deflation timer. Here is how it works. While the details of the model are proprietary, I can say that they use common trend following techniques (crossing moving averages, trailing stops, etc.) to identify and profit from long-dated persistent price trends.

Here is how it works. When the timer model signals:

Inflation: Buy the Continuous Commodity Index
Deflation: Buy the long bond (iShares Barclays 20+ Year Treas Bond, Ticker: TLT)
Neutral: Buy the S&P 500 SPDR (SPY)

The results of the simulation are shown below. Returns are total returns, which include interest and dividends. Signals are generated at the end of day and then executed at the close of the next day. The simulation assumes no frictional costs.

The chart and table below tell the story. The timing model’s returns beat all the other asset classes, with a downside risk profile that is similar to the long bond.





Timing model shines at the inflation/deflation tails
When I compare the returns of the timing model compared to a passive 60% stock/40% bond asset mix benchmark, the timing model performs roughly in line with the 60/40 benchmark during normal periods. The real value of the model stands out during crisis periods, when fears about inflation and deflation dominate investment psychology.



Such a model could prove to be invaluable in the days ahead as investor sentiment oscillates between the extremes of rising inflation (or hyperinflation) and deflation. Under these kinds of circumstances, active management could significantly add to returns.


Stay long the inflation trade
So what is the timing models saying now?

It is currently showing a bullish reading on inflation. For those who are interested, I will endeavor to update these readings regularly on this blog. Please check back regularly.

Thursday, August 6, 2009

NFP in perspective

As the market holds its collective breath waiting for the NFP figures to come out at 8:30, let me give you my take on the employment situation.


Stabilization, but upturn?
The chart below shows the relative performance of the S&P Supercomposite Human Resources & Employment Services Index (Temp agencies and headhunters) compared to the S&P 500. The period depicted shows the current cycle and the previous cycle. By analyzing the relative returns of the temp agencies and headhunters, we can get a real-time perspective on the market's perception of the employment situation.


The chart shows that the current and previous cycles show similar technical patterns. The relative performance of the index first breaks the relative downtrend line and spends some time basing before starting new relative uptrends. Currently, the index appears to be in a basing period, indicating that the employment situation has stabilized. It may be too early to be postulating a new uptrend.

However the NFP figure comes out, keep the longer term perspective in mind and don’t get too excited over a single number.

Wednesday, August 5, 2009

Siegel vs. Zweig: What are long-run stock returns?

I see that Jeremy Siegel replied to Jason Zweig’s criticism that Siegel’s studies of stock returns contain sample size biases. One of Zweig's criticisms is that for the early periods, e.g. 1815 and 1834, Siegel’s data is composed of only a few stocks. The results biased the returns upward.

Siegel responded that while there are problems with the early data, he pointed to Goetzmann and Ibbotson’s work, A New Historical Database for the NYSE 1815 to 1925: Performance and Predictability, as being free from survivorship bias and supportive of his conclusions about long-term stock returns of about 7% per annum.


But there is survivorship bias in the data!
All this bickering about the data still doesn’t make sense to me. Let’s do a sanity check, as I did in my post What actually happens in the long run:


What if your family had managed to save the equivalent of $100 at the time of Augustus Caesar (give or take 2,000 years ago) and put it into equities or an equivalent investment? At 7% a year, the value of your family’s $100 original investment would now have 60 zeros behind it. Your family could finance TARP and the bailout by the world’s central banks from the chump change derived one day’s interest.

What happened?

What happened was in the intervening 2,000 years, there were many upheavals that destroyed wealth. Empires fell, starting with the Roman Empire, barbarians sacked cities and a lot of people died in very unpleasant ways.


Quantitative analysis without context
Children draw pictures by coloring the numbers. This is an example of quantitative analysis by coloring the numbers. Proper analysis needs proper context. Many of these quants are far smarter than me, but sometimes they need to step back and really, really think about the assumptions behind their models.

Here is an example from David Halberstam’s The Best and the Brightest about Robert McNamara, who I consider to exemplify the greatest quant failure of our time:
[His] mind was mathematical, bringing order and reason out of chaos. Always reason. And reason supported by facts, by statistics — he could prove his rationality with facts, intimidate others. He was marvelous with charts and statistics.

Once, sitting a CINCPAC for 8 hours watching hundreds and hundreds of slides flashed across the screen showing what was in the pipe line to Vietnam and what was already there, he finally said, after 7 hours, “Stop the projector. This slide, number 869, contradicts slide 11.”" Slide 11 was flashed back and he was right, they did contradict each other.

Everyone was impressed, and many a little frightened. No wonder his reputation grew; others were in awe. For it was a mind that could continue to summon its own mathematical kind of sanity into bureaucratic battle, long after the others, the good liberal social scientists who had never gone beyond their original logarithms, had trailed off into the dust.

Though finally, when the mathematical version of sanity did not work out, when it turned out that the computer had not fed back the right answers and had underestimated those funny little far-off men in their raggedy pajamas, he would be stricken with a profound sense of failure, and he would be, at least briefly, a shattered man.

Monday, August 3, 2009

Swine flu a market killer?

Remember SARS? SARS took 2-3% off GDP Asian growth. I don’t know how serious this outbreak of H1N1 swine flu is, but there are indications that Asia is under-reporting the incidence of swine flu.

Damjan DeNoble, who produced the table below, wrote that “reported cases of H1N1 as a percentage of their populations correlate almost exactly with the corruption ranking of each country relative to its neighbors.” In other words, the heavier the level of corruption (I am shocked! shocked I say! that is corruption in China), the more likely it is that they are hiding or under-reporting swine flu cases:

Incidence of Swine Flu by country


Studying the table above, some questions pop to mind:
  • How does Hong Kong, which has 0.5% of the population of China, have more reported cases of swine flu than China?
  • If China actually experiences 190K cases (a conservative estimate), would the markets panic?

As the winter flu season approaches, this could mean trouble.