Monday, November 30, 2009

Buying hedge funds is still the risk trade

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

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

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

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

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

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

Sunday, November 29, 2009

More signs of Extremistan

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

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

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

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

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

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

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

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

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

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

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

Thursday, November 26, 2009

Could Dubai be the spark for a correction?

In my last post I indicated that the US Dollar was poised to rally because of excessive bearish sentiment. Many market analysts had opined that the stage was set for a USD rally but any USD reversal needed a spark such as a geopolitical event.

We may have seen that spark. The world awoke this morning to the surprise news of the potential default by Dubai World.

As FT Alphaville puts it [emphasis mine]:

Dubai’s government stunned the debt markets on Wednesday by asking for a 6-month standstill on the debts of its flagship holding company Dubai World.

The shock move came just hours after the Government of Dubai raised $5bn via a bond issue, the proceeds of which traders had rather naively assumed would be used to pay back a loan issued by Nakheel, Dubai World’s property arm.

This may seem like a stupid and naïve question, but how can someone ask for a debt standstill just hours after raising a bond issue without some disclosure in the prospectus document?

Overnight the markets have moved from euphoria over the prospect of a V-shaped recovery to the despair over a potential sovereign default. Get ready for Extremistan.

Wednesday, November 25, 2009

Is the USD poised to rally?

As good market analysts know, when the public gets on board a story, chances are everyone is already in the trade and the trend is likely to reverse soon. So it is with interest that I got the following viral email entitled "What good is a Dollar?"

The answers: Make a penguin
A dragon:




You get the idea. With investor bearishness on the US Dollar at an extreme reading, who is left to sell?

The USD is the funding currency for a lot of carry trades (buy the high yielding currency and sell the low yielding currency). Should the greenback rally, it would mean a lot of hedge funds and currency desks would have to immediately de-risk and the ensuing sell-off as market participants rush to safety won't be pretty.

Sunday, November 22, 2009

Global cooling?

I woke up on Saturday to see the New York Times headline Hacked E-Mail Is New Fodder for Climate Dispute. The New York Times headline editor was restrained while others were far more outraged. As an example, Mish’s blog stated the story as:

It's now official. Much of the hype about global warming is nothing but a complete scam.

Thanks to hackers (or an insider) who broke into The University of East Anglia's Climatic Research Unit (CRU) and downloaded 156 megaybytes of data including extremely damaging emails, we now know that data supporting the global warming thesis was completely fabricated.

He went on to detail some of the incriminating emails in his blog post about the alleged conspiracy to fudge the data. You can also see the emails here.

Sunspots and global cooling
Before the news of this hacker break-in, there had already been skepticism about the global warming thesis. I had previously speculated on this topic in a post:

What I am writing here may be sacrilege to some people. The popular consensus about Global Warming is that the Earth is undergoing a warming period caused by the effects of industrialization. However, there is another view that global warming is caused by solar activity – sunspots and solar winds.

Currently, the forecast for the latest solar cycle is that it’s late. Such extended cycles have been associated with cooling periods such as the Little Ice Age experienced a few hundred years ago. Indeed, there have been reports that there is more ice in the Arctic (yes – it’s only one data point) and there has been some hand wringing among the scientists about the timing of the solar cycle.

Is this theory about solar activity correct? I have no idea. I do have allow for the possibility that it is a valid one and should the Earth enter a cooling period, this would be bullish for energy demand and result in higher energy prices.

There are links between solar activity, climate and commodity prices. In 1823, William Herschel reported finding a correlation between sunspot activity and wheat prices. In June 2009, NASA announced that a Dalton Minimum is possible, which implies that world could undergo a period of cooling.

I am not investing based on global cooling as my base case, but what happens if Mr. Market decides to price in the possibility of global cooling?

What do you think that would do to energy demand if the Earth were to undergo a period of global cooling?

What are the possible effects on food production and commodity prices?

Just thinking out loud...

Thursday, November 19, 2009

The price of cheating death

I was at dinner with some friends and the conversation turned to the topic of undiscovered investment opportunities. One of my nominations for undiscovered investment theme was life extension technology. In October 2009, the respected medical journal Lancet published a study indicating that given the trend of progress in life extension strategies, people born in the year 2000 in today’s major industrialized countries will likely live to 100.

What does that mean for investors? Who are the winners and losers under such a scenario?

Biotech a winner?
The natural winner in life extension is the biotechnology industry. But not so fast! The real winners may not be available for investment.

Here is a case in point. Back in 1979-80, I correctly identified the microcomputer (they were called microcomputers back then as IBM didn’t introduce the PC until August 1981), would be the growth industry of the future. I told anyone who listened that the microcomputer would be as common as the office photocopier in five years. I was wrong, it was more common than the photocopier as there were multiple PCs in most offices.

Who were the major publicly listed players in the microcomputer then? They were Commodore, Tandy (Radio Shack) and Atari, which was a division of Warner Communications. Apple hadn’t gone public yet and hadn’t gotten into the business at the time. Microsoft was just a small private concern.

This story shows that it is possible to identify a long-term trend, but the winners may not be available to the ordinary investor for quite some time.

If we can’t invest in the more obvious primary winners of a trend like life extension, we can identify the winners and losers from second order effects of longevity.

Loser: Pension funds
There has been an implicit social contract in Social Security and other defined benefit pension plans. Contribute to it and we pay you when you retire, but you promise to die on time.

What if people stopped dying in accordance to the actuarial projections? Today, the leading edge of the post-World War II Baby Boom cohort are now beginning to face retirement. There have also been a tremendous amount of work being done on life extension strategies, which will likely to bear fruit in the next ten years or so. If these strategies begin to take effect for the Boomers as they enter retirement, then the extension of even a few years of expected lifespan would increase pension fund liabilities.

Already there have been a number of terrifying articles on the path of the U.S. budget and Social Security by Laurence Kotlikoff. Here is an example of Kotlikoff’s projections (and this was written in 2006 before the advent of the trillion dollar deficits):

To close our fiscal gap, we face a menu of pain: raise income taxes 70%, hike payroll taxes 109%, cut Social Security and Medicare a combined 41%, eliminate 79% of federal discretionary spending, or some combination.

In a later study, however, Kotlikoff revised his projections by stating that China can save the day but the results wouldn't still be pretty.

At the extreme, pension benefits may have to get modified. David Merkel at Aleph Blog wrote that retirement is a modern invention. If things get bad enough, we may have to un-invent the concept.

Winner: Life insurance companies
The reverse side of the pension plan liability coin is the life insurance business. If you are paying premiums based on an expected life expectancy of, say 78 years, and you die at 85, then you will have overpaid for insurance protection. The life insurance company wins, at least from a financial viewpoint. Multiple that by several million people and you get an idea of the gains the industry faces.

Winner: Equities and real estate
In America, the effects of the Baby Boom generation are well known. They grew up, dabbled in alternative lifestyles, went into the work force, bought houses and now they are now approaching retirement. Standard retirement planning prescriptions has been to heavily invest in equities when young and lower the equity allocation with age. The question is, with the huge number of Boomers, who are they going to sell their stocks and houses to? The next age cohorts, popularly dubbed Generation X and Y, don’t have the same sheer numbers as the Boomers.

If the Boomers live longer, then the selling pressure on their equity and residential real estate holdings will lessen.

Possible losers: Gen X and Y
If these life extension technologies arrive in time to affect the Baby Boomers and combined with pension pressures, will the Boomers be tempted, or forced to stay at the wheel and work longer than expected? If so, what happens to the cohorts behind them? Will the Gen X cohort and Gen Y behind them be frustrated by lack of advancement because the Boomers refuse to relinquish their mantle of leadership?

What about Europe? There is a smaller Baby Boom generation in Europe, but that cohort is about ten years behind the post-World War II baby boom effect well-known in North America, Australia and New Zealand. This European age cohort will have more time to take advantage of these technologies. What will happen to social and demographic pressures were that to happen?

Other winners and losers
The purpose of this post is to encourage debate and comments are welcome. Can you think of any other winners and losers?

I have tried to avoid the simple analysis of “leisure industries would be the winners” as people live longer and tried to think more about the longer term implications. I would welcome any comments on this long-dated theme, especially from actuaries.

This is a “big picture” investment thesis with a time horizon that is longer than the horizon of most investment managers, much like the controversial Peak Oil thesis (which gained greater attention last week from the controversy over IEA’s projections). As such, I expect that the theme wouldn’t get a lot of investment traction. Nevertheless, it’s important to keep your eye on the horizon as you invest.

Monday, November 16, 2009

Fundamental meets technical analysis

The mark of a good fundamental analyst is the ability to dig and look for data points that the rest of the market hasn’t really focused on. So it is with great interest that Jeff Matthews, who often has good fundamental insights, indicated that the economy may be improving or poised to improve because of extremely low inventory levels that he is seeing on a bottom-up basis. In addition, FedEx had reported improving volumes back in September, another sign of economic improvement.

Matthews concluded that this argues for buying transportation stocks and went on to speculate that this was one of the reasons why Buffett wanted to buy Burlington Northern:

But given the fact that he stands at the center of an economic supply chain that stretches from a candy maker in South San Francisco to a high-tech machine tooling supplier in Israel, we think it’s no wonder Warren Buffett decided the time was right to buy the rest of Burlington Northern.

There’s going to be a lot of—to be technical again—stuff that will need to be getting moved around in the next twelve months.

It’s the inventories, and Buffett isn’t stupid.

Where is the market consensus?
One of the failings of fundamental analysis, however, is that fundamental analysts may be correct in their analysis but they can get their timing wrong. So is Jeff Matthews early?

To get an idea of the market consensus, the chart below shows the ratio of the Dow Jones Transportation Average relative to the Dow Jones Industrials Average. As you can see from the chart, the Transports show no sign of life on a relative basis and could be argued that it is in a minor downtrend.

Is Jeff Matthews mistaken? early or what?

For Buffett to be so tactical with an investment the size of a Burlington Northern would be out of character for him. As for Matthews' call for a growth surprise, I prefer to wait for some confirmation that market perception has turned before hopping on board his train.

To each his own.

Friday, November 13, 2009

Possible Chinese re-valuation: Why now?

Ahead of Obama’s visit to China, the markets have been abuzz with a statement from the People's Bank of China that it will consider “changes in international capital flows and the trends of major currencies”. This is a departure from the broken record mantra of keeping its currency “basically stable at a reasonable and balanced level”. These statements have created speculation that China is ready to either revalue the RMB upwards or allow it to float.

Analysts have said for years that China will start to move when it is ready. So why now?

I can think of several reasons that, put together, might have prompted this change in attitude, as evidenced by several headlines that have crossed my desk:
  • China is preparing the ground for the RMB as a regional currency, which lowers the demand for the US Dollar as a medium of exchange for world trade (hat tip Ron Liebis). There is the news that HSBC is facilitating trade using the RMB as a medium of exchange.

  • China wants to continue to inflate, at least in the short term. When you read through the rhetoric, China is to continue its loose monetary policy despite its high growth. Isn’t loose monetary policy under these conditions inflationary and would tend to devalue your own currency?

  • Chinese culture is big on "face". Making this statement ahead of Obama's visit gives the president "face" and shows for US consumption that he is making progress with the Chinese on the currency issue. They are more or less ready to move in any case so making these statements now cost them nothing.

What is not a reason? Tim Geithner’s statement that “I believe deeply that it’s very important to the United States, to the economic health of the United States, that we maintain a strong dollar.”

Watch the wheels within the wheels of Chinese policy.

Thursday, November 12, 2009

Unemployment and stock prices

I normally have a live and let live attitude toward other people's market analysis. Once in a while, I come across research that seem so misguided that I feel compelled to speak up.

A blogger recently posted an intriguing bit of analysis on a discussion group that I subscribe to and it was entitled 10% Unemployment: A Remarkable Signal for Stocks. He shows the chart below and concluded that “[h]istorically the stock market has performed exceptionally well after unemployment has peaked.”

How do you know unemployment has peaked?
That’s interesting analysis, but how do you know that unemployment has peaked? The latest NFP figures don't seem to be pointing toward any peak in unemployment. By contrast, David Rosenberg of Gluskin Sheff believes that U.S. unemployment is going to see 12-13% before this is all over [emphasis mine]:

There are serious structural issues undermining the U.S. labour market as companies continue to adjust their order books, production schedules and staffing requirements to a semi-permanently impaired credit backdrop. The bottom line is that the level of credit per unit of GDP is going to be much, much lower in the future than has been the case in the last two decades. While we may be getting close to a bottom in terms of employment, the jobless rate is very likely going to be climbing much further in the future due to the secular dynamics within the labour market

Think about it. We haven’t yet hit bottom on employment but that will happen at some point. Employment is not going to zero, of that we can assure you. But when we do start to see the economic clouds part in a more decisive fashion, what are employers likely to do first? Well, naturally they will begin to boost the workweek and just getting back to pre-recession levels would be the same as hiring more than two million people. Then there are the record number of people who got furloughed into part-time work and again, they total over nine million, and these folks are not counted as unemployed even if they are working considerably fewer days than they were before the credit crunch began.

So the business sector has a vast pool of resources to draw from before they start tapping into the ranks of the unemployed or the typical 100,000-125,000 new entrants into the labour force when the economy turns the corner. Hence the unemployment rate is going to very likely be making new highs long after the recession is over — perhaps even years.

Buyer beware
This is a lesson for individual investors of buyer beware. This analysis sounds like generic boosterism for the stock market. While I understand that investment advisors may have their own agenda in promoting a certain viewpoint, experienced advisors know that success comes from serving their clients’ long-term interests.

Investors and analysts need to learn to thimk!

Wednesday, November 11, 2009

Bookstaber goes to the SEC

I see that Richard Bookstaber is moving to the SEC. Good for him!

I hope that this is the start of some adult supervision by the regulatory authorities. Consider what Bookstaber had to say about the banking system in an older post on his blog:

The last thing a bank wants is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.

How is this done? Well, I can quickly think of two ways. First, by creating informational asymmetries, by having products that are difficult for the users to understand and price. And, second, by designing innovative products, which, due to their non-standard nature, allow the banks to extract higher transaction costs.

There is a lot of asymmetries in the i-bank business, according to Bookstaber:

Innovative products are used to create return distributions that give a high likelihood of having positive returns at the expense of having a higher risk of catastrophic returns. Strategies that lead to a ‘make a little, make a little, make a little, …, lose a lot’ pattern of returns. If things go well for a while, the ‘lose a lot’ not yet being realized, the strategy gets levered up to become ‘make a lot, make a lot, make a lot,…, lose more than everything’, and viola, at some point the taxpayer is left holding the bag.

If we were to look at the sorts of strategies employed by large investment firms and banks, my bet is we would see a bias toward short volatility, short gamma, short credit and short liquidity. All facilitated with innovative products – you can’t really do the first two without derivatives – and all leading to these sorts of return characteristics.

Government support = regulation
If banks want to pursue these asymmetric strategies and get the government to backstop them, then they have to accept some form of regulation. David Merkel at Aleph Blog, has just put up a good post on the nuts and bolts of how to approach banking regulation.

Otherwise bring back the partnership i-bank
The other alternative is to bring back the partnership investment bank and eliminate government support. Having most of your own net worth tied up in your business will focus the partners on the risk side of the business a lot more. Isn’t it funny that partnership based entities like legal and accounting firms generally don’t have the same problems as investment banking? The last time we had a big blowup (Arthur Anderson), we didn’t see accountants running to the government for a bailout.

Monday, November 9, 2009

What if the social fabric tears?

I have written before about what academics call anchoring, or expectations. My previous post was about the anchoring of inflationary expectations. This time, it’s about the social fabric of America, which is far more important.

The American Dream
The mythic story of America has been the American Dream. America has long held to be the Land of Opportunity, where people like Michael Dell could build an empire by selling computers out of his college dorm.

How much unravelling can the Dream take?
I posted previously that an OECD study showed that social mobility in the United States is actually lower than more “egalitarian” countries like Denmark and Norway. But those are only statistics and statistics don’t really impact the social psyche.

What is a greater concern to me is how the American Dream is unravelling in some parts of America in the wake of the Great Recession. A good example can be seen in a post at Naked Capitalism about the trials and tribulations of a family struggling with unemployment and credit card debt. Here are some messages from the family:

We haven’t eaten out in years, never pick up fast food, ever, don’t walk the malls, never received any public assistance, have a 2000 Tundra and a motorcycle to save on gas, make everything from scratch (even my own homemade laundry soap!)… frankly, I don’t know many folks around here that have saved for a stormy day. Saved? That’s a joke to most of us. We’ve gotten our phone disconnected and share a cell phone, we plan each and every trip to the store with a list of necessities, haven’t had a vacation in over 15 years, and up until my husband got a job last week, we were selling everything we could sell in the house on ebay. At least I am cleaning out the closets that haven’t been cleaned in years.

We had lentils and cornbread last night…yum yum, and we’ll heat them up tonight as well. I did mention that my husband got his first paycheck last Friday. Sent from Heaven. We celebrated with brats and homemade kraut and hard rolls! Beats a t-bone any day in our book. Hubby is from Austria, so he can make some great kraut.
A Naked Capitalism reader responded [emphasis mine]:

I am astonished at how many readers you have who have no idea whatever how the financial bottom fourth or fifth of America lives. When I was a kid in western Kentucky I had a few classmates who lived in unpainted old clapboard houses out in the country, in some cases former slave quarters and so a century old. I remember one such house that even had a dirt floor. When I was little my mom’s parents lived in a tiny mountainside house in Appalachia that had no indoor plumbing. They hand pumped water from a well and heated it on a coal stove, and for a toilet across the dirt road there was an outhouse that hung out over and dumped onto the weeds on the descending slope. Stunk to high heaven, of course, and there were lots of bugs. At eight years of age, having to go in the middle of the night armed only with a flashlight was a character-building experience.

Things are a little better in the rural south now, but they sure aren’t good, now that the small farms are gone. In my adult life I’ve seen one relative living in a broken-down trailer with a caved-in roof and a goat tied up in the yard. And I’ve seen my cousin, with a small-college degree in math no less, getting by for a good while in the middle of nowhere, south Carolina on $9,000 a year from intermittent and part-time jobs. We can be all snooty about the poor not working hard enough, but I’ve also seen a sister quit a job pulling visibly diseased tissue off of Tyson chickens on a production line rather than get campylobacter one more time. We demand they live and act all middle class, but as a society we honestly don’t give them half a chance.

These guys who talk about saving hundreds of $thousands in small-town rural America are particularly irritating. How do you do that on $9K/year or $12K/year exactly? The US Census Bureau says in 2007 the bottom 20% of US households earned less than $19,178, so these are not trivial numbers of people. We never won our war on poverty really. We just forgot about it when the conservatives become obsessed with the hordes of welfare queens (and drag queens) that they imagined were filling our cities.

One of my big shocks when I started traveling more was to discover that compared to a lot of places a large part of the central and southern US (including parts of the upper Midwest) was actually what used to be called a third-world country, with way more poverty, illness, and borderline illiteracy than Europe et al. Re literacy I remember in Turkey seeing Chekov plays for sale at a truck stop in the middle of nowhere. My Turkish friends thought it odd that I’d find that odd. To them it was perfectly reasonable that a truck driver might want something interesting to read.

Does the social fabric tears? How do people anchor expectations?
As the Great Recession takes its toll on the bottom half of the US population, what happens if people anchor move from America the Land of Opportunity to Third World America the Land of “broken-down trailers with a caved-in roofs and a goat tied up in the yard”?

The mood of America could very well turn from being aspirationally driven to one where “I want my slice of the pie.” The former promotes growth while the latter leads to social turmoil and highly investor unfriendly. At its worst, it can result in socialist and communist tendencies if dominated by the Left, or skinhead-like tribalism if dominated by the Right (think KKK or even Hitler).

Where the middle class goes, so goes social stability. If there are significant tears in the social fabric, then does the world start anchoring on America the Superpower to America as another country, just like Brazil is another country?

Before you dismiss this as leftish claptrap, consider this Randall Forsyth commentary in that bastion of socialism Barrons about the captain and galley slaves who are at risk of getting thrown overboard. (And if this mentality is getting into the pages of Barrons, what does this say about the rest of the country?)

Watch this space. While I don’t believe that a descent into chaos is inevitable, it is definitely a risk and would create incredible social, political and financial upheaval not only in the United States, but the rest of the world.

Those risks are now just starting to show up in the currency and commodity markets.

Thursday, November 5, 2009

Are the bulls exhausted?

What more do the stock market bulls want? The latest statement is dovish as you can possibly ask from the Fed [emphasis mine]:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

Despite the tone of the FOMC statement, the stock market rolled over in the last hour of trading. The leaders of this rally, such as small caps, are now leading the charge to the downside relative to the S&P 500:

Similarly, the banks, as measured by BKX, is showing a similar pattern:

You can tell the tone of a market in the way it reacts to news. This reaction tells me that the bulls are exhausted and the path of least resistance is down.

Wednesday, November 4, 2009

Get ready for Extremistan

Nicholas Nassim Taleb, the author of The Black Swan, has been talking about the states of Mediocristan and Extremistan. The two concepts has been described as follows:

"Mediocristan" and "Extremistan" are two world domains. In the former, extremes exist but are inconsequential, in the latter, extremes are not expected, but play a massive role. In the former, the ordinary plays a massive role. In the latter, one's wealth can change massively in a second.

What makes the pre-conditions for Extremistan? John Robb, who blogs at Global Guerilla, describes the conditions for extreme events.

  • More winner take all competitions. As in: a small number of individuals or companies win everything. More inequality and less social justice are inevitable.
  • Actions by individuals and small groups generate increasingly extreme results (this is akin to the superempowerment thesis for global guerrillas readers). As in: "eventually, one man might be able to declare war on the world and win."
  • Systemic events, both negative and positive, will occur at a high frequency, faster and with more extreme outcomes than ever before (this is also a common feature of unstable, high performance systems that lack a correspondingly high performance control system -- as in, you don't need to predict far in advance if you can correct fast enough).

These conditions sound much like the circumstances described by Simon Johnson, former chief economist at the IMF, in his Atlantic article. Johnson describes a society where there are class differences and when crisis hits, the elite gets bailed out and the middle and lower classes take the brunt of the adjustment. In the end, the rich get richer.

What about China?
Can China save the world? In the current financial crisis, China is held out as the last refuge of hope. Its economy is growing while other major industrialized countries are mired in no or slow growth. It has massive reserves, which could serve to forestall the worst effects of deflationary adjustments.

Mike Pettis, who blogs at China Financial Markets, believes that Chinese growth is not sustainable in the medium term. If and when Chinese growth is perceived to be rolling over, then the markets could fall hard [emphasis mine]:

I spend a lot of time talking to large hedge funds and institutional investors – with at least three or four one-on-one meetings a week – on China and market conditions. It worries me that recently I have heard investors say many times, generally very sophisticated investors, that we are clearly in a bubble and the best strategy is to ride it out as long as we can. This has almost become one of the mantras of sophisticated investors – the less sophisticated, I guess, assuming that the crisis is safely behind us.

It worries me because of course we can’t all collectively ride the bubble and bail out before everyone else does. I wonder if this means that an awful lot of the big funds can be expected to rush to the doors at the same time when things turn bleak. If so, of course, that means we are likely to see both the upside and the downside market risks increase. Several of my fund management friends have insisted the problem has to do with the nature of hedge fund compensation. Most of the hedge funds were hurt pretty badly in the financial crisis, but a very large number of them were very pleasantly surprised by how quickly they’ve been able to make back a substantial share of their losses.

In China, we also find elements of Extremistan.

What can investors do?
This all adds up to an Age of Instability. Jim Welsh, writes in his newsletter:
History suggests that these extended periods of instability (1929-1949, 1966-1982), do not reward investors who buy and hold, or the institutions that disdain cash. As a kid growing up in the Midwest, during July and August, I always wore a t-shirt and shorts and wore a crew cut. In January and February, my hair was longer and I never went outside in shorts and a t-shirt. (Well maybe once on a dare.) If my parents had known, they would have rhetorically asked me if I was stupid. So here’s a worthwhile question. Why do investment professionals advise their clients to simply buy and hold, whether we are in a period of stability or instability?
This brings me back to a theme that I have talked about before. There are no models for all seasons. Buy and hold may not be appropriate in the Age of Extremistan.

In an era of instability, you need to use models that capture and profit from the instability. An example is the inflation-deflation timer, which would be well-suited for an environment where market expectations oscillate between the Arctic deep freeze of deflation and the equatorial heat of runaway inflation.

The Inflation-Deflation Timer for Canadians
Incidentally, I have also updated the Inflation-deflation timer for Canadian Dollar investors. The analysis resulted in a model whose back-tested returns beat all other asset classes by 10% or more during the test period. As the chart below shows, the Inflation-Deflation Timer slightly outperformed a 60% stock/40% bond portfolio in “normal” times and stood out during crisis periods. Downside risk was slightly better than the 60/40 balanced fund.

What’s more the Inflation-deflation timer appeared to be a highly diversifying asset to a 60/40 balanced portfolio. A minimum risk portfolio would indicate a 45% allocation to an Inflation-deflation timer strategy.

You can find the full details of the Canadian model here.

Monday, November 2, 2009

Watching central banks for direction

As the markets wait this week for statements from the FOMC and other central banks around the world, here is what I am watching for in the central bank announcements.

How worried is the Fed about inflation?
Central bankers don’t speak off the cuff. Paul Volcker was once joked that when he went out to dinner, he felt compelled to say “I’ll have the steak but that doesn’t mean I don’t like the lobster.”

It is therefore interesting that several Fed governors have started talking up the dangers of inflation. I wrote in a previous post that Don Kohn made a speech indicating that they were concerned about the “anchoring” of inflationary expectations. If inflationary expectations rise, then it would take a lot of tightening (e.g. Volcker’s painful and tight policies of the early 1980’s) to get them back down again.

If the Fed is becoming worried about anchoring, then expect a more hawkish statement.

How do you define inflation?
In my post What kind of inflation I pointed out that inflation would like show up in commodity prices. (Isn't it funny that that the countries that have raised rates so far, i.e. Australia and Norway, are mainly resource based economies?)

If you were to measure inflation by core CPI, it is likely to be subdued. Indeed, other core measures such as trimmed mean PCE has been trending down. Commodity price inflation may show up a bit more in headline CPI, but rises in headline CPI is likely to be restrained by the deflationary effects of all the excess slack present in the economy.

How worried is the Fed about inflation? And what how do you define inflation?

What happens to the USD carry trade?
What do the other central bankers do this week? Will the Fed’s comments be in sync with the announcement from the ECB or BoE? The tone of policy coordinarion (or lack thereof) could have huge effects on the US Dollar and FX markets.

As Art Cashin pointed out, the USD has been the funding currency of choice in the carry trade. The downdraft seen in the markets last week has been the result of a rally in the greenback, which led to a general de-risking of portfolios and trading books.

After the dust from the central bank statements settles and if the USD continues to rise, then we may be witnessing a sea change in expectations and market tone. In such a case, we can expect further downside in the equity and commodity markets.