More evidence of a low-return equity outlook

When I was a young pup (in the era when we used to program computers with punched cards), the three most commonly used valuation ratios for stocks were the P/E ratio, the P/B ratio and dividend yield. Now all three of these metrics are pointing a long-term low return environment for equity prices.

In a recent post, I showed that the trailing P/E ratio for the SP 500 was elevated relative to its own history, even adjusted for the current low level of interest rates (see A secular steer?).

Jack Bogle of the Vanguard Group provided further evidence that equity valuations are high relative to their own history based on the P/B ratio. Like the chart above, the P/B chart goes back to the early 1900s.

Using a time frame of over 100 years for analysis,Scott Krisiloff of Avondale Asset Management showed that dividend yields are historically low as well:

Krisiloff commented (emphasis added):

The SP 500′s current dividend yield is 1.94%, which echoes the interpretation of most other valuation metrics.  Stocks are not necessarily expensive relative to their average value over the last 15 years, but are very expensive relative to long term history.  In past posts, I’ve toyed with the idea that this might be justified–maybe we’re in a new paradigm for value.  But if we are in a new era of structurally higher values, then we have to consider an important result that comes with that.  If stocks are structurally more expensive than they were in the 20th century, can we expect to receive the same rates of return that we did in that era?  If we are leaving the 20th century behind, then maybe we have to leave behind our concept of fair returns on investment.  Dividends are one signal telling us to lower our expectations.

I would tend to agree. Equity valuations appear to be elevated but they are not stupidly high. None of these metrics are pointing to a market crash around the corner. However, as the major US equity averages have broken out to new all-time highs, I have seen technicians calling for a new secular bull market, with the expectation that returns would be similar to the 1982-2000 era, or the 1947-1966 era.

Long term Dow Jones Industrials chart

Historically, secular bulls start at compressed valuations, not elevated ones. If this is indeed a secular bull, then investors should expect long-term returns to be far more muted than the last two secular bull markets.


Effects of a 25% rally and 15% correction
This valuation analysis puts some context into my most recent call for a midterm election year correction (see Should you sell in May?). Let's do some simple math and assume that 10 year return expectations is 5.0% (an arbitrary assumption, but roughly in the right ballpark).

Supposing that instead of correcting, stocks were to rise 25% in a single year, but 10 year returns stay at 5%. Simple math tells us that the return for the remaining 9 years comes to 3%, which would make equity prices highly stretched as they would be unattractive relative to 10-year Treasury yields.

On the other hand, a 15% pullback in a year would raise 9 year expected returns to 7.5%, which is a level that is far more interesting for investors. You can play around with some of the assumptions, but the bottom line is that equities do not have room for the kinds of rallies that we saw in the 1980's and 1990's.

The moral of this story: Lower your return expectations.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

What risk unwind?

In a recent post, I postulated that the carnage in momentum stocks was a case of risk exhaustion (see A case of risk exhaustion?). Fast and institutional money had gotten overly long risk across the board (e.g. high yield, momentum stocks, etc.) and they were in the process of unwinding the trade.

I then came upon the Barron's Big Money Poll from the weekend, which had a number of eye popping results.

First of all, money managers were more bullish on stocks than their clients (55% manager bulls vs. 31% client bulls). More notably, the most favored sector was Technology, which has gotten creamed lately, while the least loved was Utilities, which has become the new sector leadership as stocks have wobbled.

What risk unwind? If institutions are indeed de-risking, then we have a long, long way to go.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Should you sell in May?

The technical warning signs of equity weakness are clear to see. For the past several weeks, I have been voicing technical concerns about the stock market. This year seems to be a market where the adage of ”Sell in May and go away” is applicable. What puzzles me is the lack of a fundamental trigger for the decline.

Risk appetite is falling
In early April, I wrote about risk appetite rolling over (see Bears 2 Bulls 1 and A case of risk exhaustion?). My Risk Appetite Index, which consists of an equally-weighted long position in the NASDAQ 100 and Russell 2000 (high beta risk-on index) minus an equally weighted short position in the defensive sectors of Consumer Staples, Telecom and Utilities (low beta risk-off index), continues to decline. The chart below shows that the index also displayed similar behavior (trend line breaches and general weakness) ahead of the market corrections in 2011 and 2012.

Rising volatility
Underlying the weakness of the risk appetite index is a change in sector leadership from the high-beta sectors like Tech, Consumer Discretionary and Financials to defensive sectors like Utilities and Consumer Staples (see Interpreting a possible volatility regime shift). As well, I highlighted a possible regime shift where equity volatility appears to be headed higher. As knowledgeable readers know, volatility is inversely correlated with stock prices.

Deteriorating internals
What has puzzled me is the robustness of the Advance-Decline Line, which has continued to make new highs as these signs of market weaknesses appeared. While the weakness in the A-D Line can warn of major bear markets, it is less effective in spotting corrective action as it failed to flash warning signs in the market declines of 2011 and 2012.

The chart below tells the story. The top panel is the SP 1500 A-D Line, the second the % of stocks in the SPX above their 50 day moving averages, the third % of stocks in the SPX with point and figure buy signals and the four panel the SPX. In the decline of 2011, which was sparked by the combination of worries over a eurozone debt crisis and political impasse in Washington, the A-D Line did breach an uptrend line, but rallied to make a new high shortly after. The shallow correction of 2012 was also accompanied by a breach in the A-D Line uptrend, but the breach did not provide any advance warning of the decline, which was similar to the 2011 experience.

The combination of the % of stocks above their 50 dma and % of stocks with point and figure buy signals can provide some warnings of weakness, but these indicators are somewhat iffy as well. The condition of the % of stocks above their 50 dma is less than 60% (currently 54%) and % of stocks with point and figure buy signals is less than 70% (currently 68%) has been present in past corrective periods. These two indicators flashed a warning sign when the market weakened in February, but that was a false signal as a major correction did not follow.


Todd Harrison: Smart money is selling
In addition, Todd Harrison pointed out that the so-called Smart Money Flow Index is ominously bearish. The SMFI is defined in the following way:

The Smart Money Flow Index (SMFI) is calculated by taking the price of the Dow Jones Industrial Average at 10 a.m. on any given day, subtracting it from the previous day’s close, and adding it to the next day’s closing price. The first 30 minutes represent “emotional buying,” driven by greed and fear of the crowd; smart money typically waits until the end of the day. If/when the DJIA makes a new high that is not confirmed by the SMFI, there is usually trouble ahead.

In other words, SMFI measures money flow by ignoring the movement in the Dow in the first half hour. While I would not necessarily characterize the first half hour of trading as dominated by dumb money, it is certainly emotional money. The chart below of the SMFI tells the story. While the Dow (in orange) has been holding up relatively well, SMFI has been dropping precipitously since mid March:

This second chart shows a longer term perspective. The top panel shows the Dow and SMFI, as above, back to 2005. The green line on the bottom panel shows the spread between the Dow and SMFI - and the spread is as negative as it was in 2007.

Harrison followed up with a caveat to his analysis:

You will notice that we are still at levels last seen in 2007, which may prove to be a false “tell” but should, at the very least, be considered when making financial decisions. 

Following the midterm election year pattern
When I put these technical patterns together, the stock market seems to be following the historical pattern of a midterm election year. Ryan Detrick showed the typical pattern of such years, where the market peaks out in late April and bottoms out in September.

The good news is that the bottom in the Fall has historically been a durable bottom and a superb buying opportunity for stocks, as per this analysis from J.C. Parets:

Bullish fundamentals
While the technical picture is warning of a major correction, what puzzles me is the lack of a fundamental trigger for a decline. The US economy is behaving relatively well and seeing signs of a snap-back of winter related weakness. So far, Earnings Season has not proved to be a major disappointment. As per Bespoke, the EPS beat rate is 62%, which is in line with historical average. On the other hand, the sales beat rate is a bit low at the 50% mark. Across the Atlantic, the ECB looks like it may finally edge towards QE, which should be supportive of European equities.

Jeff Miller summed up the "Sell in May" hysteria perfectly here:

The seasonal slogans often substitute for thinking and analysis. The powerful-looking chart that leads today's post actually translates into a 1% monthly difference in performance. The "good months" gain 1.3% on average while the "bad months" gain about 0.3%.

The bear case then rests on a case of risk exhaustion and unwind (see A case of risk exhaustion), which is a funds flow driven bearish trigger. Any resulting correction would likely be a brief and possibly sharp which would be a good buying opportunity.


The 2011 parallel?

Nevertheless, the technical picture is a stock market that is poised to decline, but needs a bearish trigger. One historical parallel would be the events of 2011. In 2011, market internals started to deteriorate before the bearish triggers manifested themselves. The proximate cause was rising tail-risk of a eurozone crisis and debt ceiling fight in Washington. Rising bear of the dire consequences of these events served to crater stocks, but neither of these Apocalyptic scenarios ever materialized.

If 2011 is a parallel, then perhaps the answer is to consider the possibility of the markets pricing in rising tail-risk, namely Russia-Ukraine and a China meltdown.


Russian tail-risk
I have discussed the tail-risk from the Russia-Ukraine situation before. Ambrose Evans-Pritchard wrote that the US is preparing sanctions that could bring the Russian economy to a screeching halt by freezing the external financial transactions of Russia and Russian companies:

An elite cell at the US Treasury has developed an arsenal of financial weapons that can in theory bring even large countries to their knees through use of “scarlet letters” that cause global banks and insurers to pull back. Japanese banks are already retreating from Moscow to pre-empt problems with US regulators. 

In a separate article, Evans-Pritchard indicated that western energy companies like BP and Shell may have trouble operating in the US should the next stage of sanctions be imposed. It would be measures like these that would spook the markets and force a re-pricing of Russian related tail-risk.

Sources in Washington say the US Treasury may soon extend the black list to Igor Sechin, president of the oil giant Rosneft, the biggest traded oil company in the world. Any such move would be a costly headache for BP, which owns 19.75pc of Rosneft’s shares under a deal reached in 2012 ending its stormy misadventures in TNK-BP.

It is unclear whether BP could continue to operate in the United States or even carry out its global business smoothly if it continued to be a Rosneft shareholder with Mr Sechin still in charge, yet it would be difficult to find buyers for a holding worth $12.5bn in the midst of a crisis. America's Exxon Mobile would have to reconsider its drilling plans with Rosneft in the Arctic `High North'.

The US Treasury is also eyeing some form of sanction against Gazprombank, the financial arm of the gas monopoly Gazprom. This would greatly complicate Shell’s joint operations with Gazprom at Sakhalin Island and in the Arctic, though this would depend on the exact wording and how the US Securities and Exchange Committee chose to enforce it.

Zero Hedge has also speculated that the US may target Putin's personal $40 billion stash. The ZH postulated Russian response would be to retaliate in kind, regardless of whether Putin's personal funds are involved in the sanctions:

Russian presidential adviser Sergei Glazyev proposed plan of 15 measures to protect country’s economy if sanctions applied, Vedomosti newspaper reports, citing Glazyev’s letter to Finance Ministry. According to Vedomosti as Bloomberg reported, Glazyev proposed:

• Russia should withdraw all assets, accounts in dollars, euros from NATO countries to neutral ones

• Russia should start selling NATO member sovereign bonds before Russia’s foreign-currency accounts are frozen

• Central bank should reduce dollar assets, sell sovereign bonds of countries that support sanctions

• Russia should limit commercial banks’ FX assets to prevent speculation on ruble, capital outflows

• Central bank should increase money supply so that state cos., banks may refinance foreign loans

• Russia should use national currencies in trade with customs Union members, other non-dollar, non-euro partners

In other words, a full-blown scorched earth campaign by Russia.

While I tend to take anything published at ZH with a grain of salt, they may not be that far off this time. Oleg Babinov of The Risk Advisory Group wrote the following in March about the Crimean crisis and the likely response from the Kremlin is roughly in line with the proposals outlined in ZH (via Moscow Times):

If Russia does not rush in to incorporate Crimea as its "administrative unit" and the sanctions are limited to its dropping from Group of Eight and some limited visa sanctions and asset freezes for politicians and businessmen who are directly involved in separatist activities, Russia's response would be relatively small-scale. If this is the case, there will be little effect on investors, except those who may be involved in cooperation with Russian companies in the field of military technology — but this is possible only if the U.S. and the European Union do not decide to freeze cooperation with Russia in this field.

But if sanctions are applied to Russian state-owned companies and banks, Russia might want to retaliate by freezing foreign companies' accounts here. There was an announcement that the constitutional law committee of the Federation Council has invited legal experts to study whether such sanctions would be legal, but no draft law has been produced yet.

Ambrose Evans-Pritchard has also speculated that Russia may escalate the conflict to cyber-warfare:

The greatest risk is surely an "asymmetric" riposte by the Kremlin. Russia's cyber-warfare experts are among the best, and they had their own trial run on Estonia in 2007. A cyber shutdown of an Illinois water system was tracked to Russian sources in 2011. We don't know whether US Homeland Security can counter a full-blown "denial-of-service" attack on electricity grids, water systems, air traffic control, or indeed the New York Stock Exchange, and nor does Washington.

"If we were in a cyberwar today, the US would lose. We're simply the most dependent and most vulnerable," said US spy chief Mike McConnell in 2010.

The US defence secretary Leon Panetta warned of a cyber-Pearl Harbour in 2012. "They could shut down the power grid across large parts of the country. They could derail passenger trains or, even more dangerous, derail passenger trains loaded with lethal chemicals. They could contaminate the water supply in major cities, or shut down the power grid across large parts of the country,” he said. Slapstick exaggeration to extract more funds from Congress? We may find out.

For now, these scenarios are all speculative and remain tail-risks. However, should the events in eastern Ukraine spiral out of control, watch for the markets to start pricing in the possibilities of these risks - and they could be the trigger for a significant sell-off in the equity markets.


China: Whistling past the graveyard
The tail-risks in China are also rising. It all starts with problems in the overbuilt property market. Nomura estimates that in 2013 alone, China added roughly 400 square feet of new construction per urban resident:

Zhang Zhiwei, chief China economist at Japanese investment bank Nomura, said in a report last month that after building around 13.4 percent more floor space every year for the past several years, the country finally has too much housing. Zhang estimates about 2.6 billion square meters (about 28 billion square feet) were added in 2013, or 400 square feet of new residential floor space per urban resident.

These charts from Nomura show the scale of the overbuilding, even by developed market standards:

Despite the apparent overbuilding, expansion is continuing, especially in the smaller cities:

The overbuilding was not a problem until property prices started to cool of this year. The price decline is particularly acute in the Tier 3 and 4 cities (via Xinhua):

The slowdown of the property market that was mainly seen in China's third- and fourth-tier cities last year has spread to more areas, and analysts warn of a tough 2014 for developers.

Figures released by the National Bureau of Statistics (NBS) last Friday showed that 178.25 million square meters of residential property were sold in the first quarter, down 5.7 percent year on year.

Falling prices in the real estate market feeds into problems in the financial system:

Added to the property market woes is the credit crunch for both developers and buyers.

Stringent bank loans since the end of last year have dealt real estate firms, medium- and small-sized ones in particular, a blow in securing their fund chain, said Hu Baosen, board chairman of Central China Real Estate Ltd.

A credit crunch is developing:

Meanwhile, banks have not loosened their control over personal housing loans, making it more difficult to purchase property on mortgage.

Among the 35 major cities surveyed by Centaline Property Agency Ltd., 25 have seen their banks suspend housing loans.

While I have heard China bulls say that a cooling property market does not present that much of a problem because most real estate is not purchased with debt, there are secondary financial effects from suppliers such as the steel industry, which is suffering from over-capacity, and other producers of construction materials. The balance sheet of these companies are not pristine and have substantial debt. These credit risks are now manifesting themselves in the form of defaults in the shadow banking system, which leads to a credit crunch, which can result in cascading defaults and...you get the idea.

Patrick Chovanec believes that the Achilles heel of the Chinese financial system is declining property prices. That`s because Chinese lenders lend based on collateral value, which is mostly property based, rather than cash flow because financial statements are unreliable:

If China’s housing market crashes, the ripple effect could be even more cataclysmic for its economy than the recent housing market collapses in the US and Europe were for their economies. A fifth of outstanding loans and a quarter of new loans are to property developers, says Nomura; untold billions more have been lent out off bank balance sheets. As falling prices crimp margins, small developers—like the one in the news this week—will start defaulting.

But the fallout will be bigger still, says Patrick Chovanec of Silvercrest Asset Management. “Not only is property important because it’s a key component of that investment boom, but it’s essentially the asset that underwrites all credit in the Chinese economy, whether it’s local government loans, whether it’s business loans,” Chovanec says, explaining that lenders require “hard” assets as collateral because financial accounts can easily be doctored.

Western bank are not immune to a financial crisis in China. Aggregate foreign currency denominated debt totals about USD 1 trillion (see EM tail-risks are rising). Should events spiral out of control, the financial damage may not be limited to the Chinese banking system and financial contagion could very well spread throughout the global banking system.

Even as the economy slows and cracks appear in the financial system, Premier Li Keqiang has stated that the government is not consider any large scale stimulus programs but rely on targeted mini-stimulus instead:

Chinese Premier Li Keqiang said his government is not considering any strong stimulus measures or policies which would risk enlarging the fiscal deficit but will push through reform in order to support economic growth.

"There is no consideration about expanding the deficit or using 'strong stimulus,'" Li said, adding that China's official "proactive" fiscal and "prudent" monetary policy biases won't change.

"But the government won't do nothing. It will rely on reforms, structural adjustments, to increase effective supply and meet new demand," he said.

His comments, which were published late Wednesday, were delivered at a State Council meeting at which the executive decision-making body decided to lower the reserve requirement for some rural financial institutions.

That move, which analysts expect to pump a miniscule CNY15 billion into the market, may bring relief to a struggling corner of the financial system but isn't expected to do much to shore up the broader economy.

In the meantime, the markets are relatively relaxed about looming financial tail-risk. My so-called Chinese canaries, the prices of HK-listed Chinese banks, are not showing signs of extreme stress:

In addition, Reuters reports that there are few takers for tail-risk insurance on China (emphasis added):

Selling insurance against a financial crisis should not be difficult, five years after the last one nearly wrecked the global economy.

But when it comes to China, the world's second-largest economy, the probability of a full-blown crisis is apparently so remote that hardly anyone will buy an insurance policy against it, no matter how cheap.

Financial wizards have been trying to sell peace of mind to investors in China for years, but fewer and fewer of those investors are interested, despite some worrying headlines.

In the past few months alone, China has seen its first domestic bond default, a small bank run, its weakest export performance since the global financial crisis, a marked slowdown in its property market and a rise in labor unrest.

Steve Diggle, a Singapore-based hedge fund manager who crafts strategies to protect investors against financial catastrophes, says investors have faith that the Chinese government, armed with almost $4 trillion in foreign exchange reserves, will simply not allow things to get out of hand.

He had to close down a fund that used to bet on doomsday outcomes in Asia last year.

While I am not saying that catastrophe in China is my base case scenario, but it seems that the markets are whistling past the graveyard of a Chinese hard landing. Should the Chinese situation deteriorate, the possibility of a stampede for the exit is very real - and could be the trigger for a sudden downdraft in the price of risky assets.


Something's not right...
As I mentioned, market internals started to deteriorate before the eurozone crisis fully developed in 2011. Then, the trigger were worries about a Greek default and the possible repercussions on the euro, as well as a political impasse over the debt ceiling in Washington.

One possibility for 2014 is that the markets would follow the midterm election year pattern of a 10-20% summer correction into September or October. Already, the market technical picture is flashing warning signs. The trigger might be a combination of risk exhaustion by fast money accounts and rising tail-risk from one of these aforementioned events.

Despite the positive fundamental backdrop, my inner investor is siding with the technicians and he is becoming increasingly cautious. The technical message from Mr. Market is, "Something is not right about this bull." If the fundamentals were to hold up equity prices, then the technical outlook would improve and he would re-adjust his portfolio accordingly. Jeff Miller's prescription of what to do sounds about right to him:

To make a wise decision you need to make an objective quantitative comparison between the economic trends and the small seasonal impact. The Great Recession has been followed by a slow and plodding recovery. We have an extended business cycle with plenty of central bank support. Since I am expecting the current cycle to feature (eventually) a period of robust growth, I do not want to miss it. The 1% seasonal effect will be minor in a month where we get a real economic surge.

If instead we get the typical sideways market with some volatility, it is a perfect environment for selling short-term calls against attractive, dividend-paying stocks.

My inner trader, who is more aggressive,  is watching the developing head and shoulders pattern and waiting to the break to put on a leveraged short position on the market.

Just be aware that developing head and shoulders patterns often fail`and they do not become bona fide patterns until they are triggered. The bearish trigger is a breach of neckline support, which is at about the 4000 level. Should that occur, the downside target would be in the 3600-3650 region.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

"Did you expect GOOG to trade at a PE of 10?" & other "smart beta" and factor investing questions

This is another of an occasional series on how good quantitative investors use both the left and right brains to create robust investment processes. Elisabeth Kashner at ETF.com wrote an intriguing series of blog posts about smart beta and factor funds. In Part 1, she showed that the idea of "smart beta" is mostly a marketing concept, where commonly used "dumb beta" ETFs have "smart beta" features:

Many of our favorite “dumb” funds, it turns out, have smart-beta features.

• The SPDR SP 500 ETF (SPY | A-98) and the iShares Core SP 500 (IVV | A-98) both share an index that screens components for profitability, just like the index underlying the FlexShares Quality Dividend ETF (QDF | A-78) does.

• The PowerShares QQQ (QQQ | A-53) has a tier of equally weighted securities, partially mimicking RSP, thus giving it a smart-beta tilt to small-cap stocks.

• The iShares Russell 2000 ETF (IWM | A-82) accesses the small-cap premium—that’s factor investing.

• The iShares Russell 1000 Growth (IWF | A-89) has momentum exposure—that’s also factor investing.

The surprises go the other way, too—“smart funds” have some pedestrian features. VIG, the smartest-seeming of the top 10 above, is cap-weighted. So, what happened to alternative weighting as a hallmark of smart beta?

In Part 4, she went on to discuss the idea of "factor exposure":

Designer funds promote the smart-beta label. However, branding all funds with factor exposure as smart beta will start arguments. In terms of our ground rules, sorting ETFs by factor exposure produces results that are not widely acceptable to the ETF community.

If factor exposure defines smart beta, then all funds with factor exposure must be smart beta. As you will soon see, most funds have some kind of factor exposure.

Factor vs. smart beta investing
For non-quants, a factor is a way of ranking stocks. One simple example of a factor might be P/E, ranked from low to high. Kashner went on to demonstrate different flavors of value ETFs as way of illustrating the factor investing idea. She demonstrates that there is really little difference between "smart beta" and factor investing:

Look carefully at the table below. Which better captures the value premium: VLUE or IWD?

IWD beats VLUE with the lower P/B—the classic value metric. IWD also has the higher dividend yield. VLUE sports the lower P/E ratio. VLUE’s correlation with IWD is 0.98, with a .99 beta. The two are largely indistinguishable, but if I had to pick a value fund, I’d go with IWD.

Security selection can produce powerful portfolio tilts, just as weighting can, because any security not in a portfolio has a weight of zero percent.

If VLUE is a factor fund, then IWD is a factor fund.

Pitfalls of smart beta and factor investing
If "smart beta" is really another way of packaging active, or semi-active, factor investing, then you have to understand the pitfalls of the factor investing approach. The one valuable lesson I learned as a quantitative investor is that not all factors do not necessarily work well across sectors and industries.

BARRA taught us that one of the ways of determining the sources of equity risk is industry exposure. If a portfolio tilts away from the market index (however you want to define it) with different industry exposures, then that portfolio has an active bet, or exposure. The above examples of value ETFs, they have differing industry bets that form part of their active exposure. If it is marketed as a passive or semi-passive portfolio, then the investor has to make a decision of whether those more or less permanent industry bets make sense as a way of creating alpha.

One drawback of naive factor investing is that practitioners are overly analytical but have not subjected their ideas to practical sanity checks. For instance, some studies have shown that portfolio of stocks weighted by sales, rather than capitalization, have yielded better risk-adjusted returns. If you were to naively weight a portfolio of stocks by their sales, then you would tilt the portfolio towards companies with high sales and low margins. Do you want to necessarily bet that low-margin businesses, such as grocery chain stores, will outperform in the long-run?

Even if you were to engage in industry-neutral factor investing by neutralize the industry bets by setting the same industry exposure in the portfolio as the market portfolio, factors do not necessarily behave the same way across all industries. Let us suppose that you were to screen for low-PE stocks and overweight them in your portfolio. Low PE is a value factor and it does not necessarily work well in growth industries. For example, did you really think that a growth-oriented technology stock like Google would trade at 10 or 12 times earnings? If it were to trade at those kinds of multiples, would you really want to own it? A so-called growth stock sporting a low PE is really a busted growth company with a turnaround story (whatever happened to PALM?) which encompass a very different style of investing than the usual growth and momentum theme. For instance, see what Stan Druckenmiller thinks of Amazon.com (stratospheric PE) compared to IBM (trailing PE 13).

Just remember that "Value works. Growth works. Momentum works. Quality works. They just don`t all work at the same time." (see A quant lesson from a technician). To leave any of those factor sets out is to leave out part of the market and alpha generation opportunity set.

The moral of this story is, if you were to engage in factor investing, whether indirectly through "smart beta" concepts or directly in an active or semi-active fashion, you are making a deliberate bet against the market portfolio. Just make sure that your approach to factor investing is done in an intelligent way and it has not taken on any bets that don't pass human sanity checks. In other words, use both your left (analytical and reasoning) brain as well as your right (creative and intuitive) brain to approach factor investing in an intelligent way.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Interpreting a possible volatility regime change

The job of a good market strategist is to use both the right and left brain to analyze the markets. The left brain is usually thought of as the analytical and reasoning side - and investors can always use the reason, rigor and discipline of investment models. The right brain is the creative and intuitive side. Here, investors can benefit from the observation, intuition and experience of the analyst to know when the underlying assumptions of investment model might be going off the rails and make the right kinds of adjustments.

Here is an example of what I have observed from the signals from the equity option market.


A possible volatility regime change
Left brain: In a previous post (see A case of "risk exhaustion"?), I had highlighted a comment from MacNeil Curry of BoAML that the stock market has not seen a meaningful bottom until the VIX spikes above 20 (via Zero Hedge):

Since 2012 most tradable market lows have come only after the VIX has pushed north of 20%. It is currently only 17%.

In such an environment, US Treasuries should rally further. Indeed, US 10yr yields have broken below key resistance at 2.608%/2.632%, exposing the long term pivot zone of 2.469%/2.399%. The Japanese ¥ should benefit as well. The 200d in $/¥ is key (100.81) A break below would do significant psychological damage and force out many trend followers.

The analysis certainly makes sense, but...

Right brain: I was thinking about it was funny that the look-back window only went back to 2012, which was not a very long time. Just for fun, I charted for the last five years the VIX Index  (bottom panel), the equity only put-call ratio (in grey), its 21 day moving average (in blue) and the SPX (red).

True enough, the bottom panel showing the VIX verifies Curry`s observation that the market did not see a tradable bottom until the VIX spiked over 20. However, that rule would not have worked pre-2012 as the VIX traded at significantly higher levels. It appears that there was a regime change to lower vol in late 2011 or early 2012 and we may be seeing signs of a shift back to higher vol now.

The equity-only put-call ratio seems to provide an early warning sign of such a change. Note how its 21 dma rallied through a downtrend line in early 2011 while the VIX was falling during this period. Soon after, volatility rose dramatically and stock prices rolled over.

Note how we are experiencing a similar pattern of the 21 dma of the equity only put-call ratio rising through a downtrend and a rounding bottom in the 21 dma. This may be an early warning sign that equity volatility is set to rise.

Other signs of rising volatility

There is support for the idea of rising vol. SocGen has noted that hedge funds have changed to buying volatility from being a seller for a prolonged period (via FT Alphaville). It is interesting that hedge funds turned to be large sellers of vol in late 2011 and early 2012, when the vol regime seemed to have changed:

The SocGen team justified the change this way:

Somewhat lower levels of volatility recently, combined with a risk of a spike in volatility due to geopolitical tensions with Russia, are likely to have an influence, but alone do not explain the trend. Hence our conclusion that the period of low volatility is coming to an end.

Here is more "color" of the SocGen view, according to this Bloomberg report:

“You may be seeing the first indications that the days of very low volatility are numbered,” Arthur van Slooten, a strategist at Societe Generale SA, said in a phone interview from Paris on April 11. “Expectations for rate hikes may become more aggressive when the data from the U.S. starts heating up.”

While bearish contracts on the VIX have increased in the past two weeks, the level is about half the average from 2012 and 2013. They are net short 31,746 futures on the gauge, compared with a mean 61,953 in the last two years, data from a Commitment of Traders report by the Washington-based CFTC show.

A simpler explanation may just be a case of hedge funds getting into a crowded short position in volatility:

U.S. stocks had one of their most tranquil years in 2013 as investors became more confident in the bull market and began returning cash to mutual funds. The VIX averaged 14.3 last year, the lowest level since 2006. It has fallen more than 18 percent annually in four of the past five years.

The persistent decline lured hedge funds to short the volatility gauge, which is based on the cost of options on the SP 500. Large speculators had a record 116,000 net-short positions on VIX futures in August, CFTC data show.

They’ve all but disappeared as equities suffered the biggest weekly decline in almost two years. Investors are questioning stock valuations as the Federal Reserve reduces stimulus during a strengthening economy.

Model re-calibration under a regime change
If there is indeed a change in vol regime, then there are a number of important implications for investors. For one, analysts like MacNeil Curry may have to re-calibrate their models. We may not see a tradable bottom in stocks until the VIX Index rises much higher than just 20.

Other analysis, like this observation from Sheldon McIntyre about the VIX-VXV ratio flashing a buy signal may not necessarily be applicable under the new vol regime. The VIX-VXV ratio measures the term structure of volatility and McIntyre observed that when the ratio falls below 0.92, especially if it had inverted (risen above 1), it has been a good buy signal for the stock market:

I had studied this ratio in the past (see Waiting for a Santa Claus rally) and came to a similar conclusion as McIntyre. However, a possible change in vol regimes raised some concerns of the "buy when VIX-VXV falls below 0.92" rule. I backtested a simple trading rule based on the VIX-VXV ratio for the last five years. The buy rule is based on the following two conditions:

1. The VIX-VXV ratio falling below 0.92; and
2. It had inverted, ratio more than 1, in the recent past.

The results of the backtest are charted below. The black line shows the VIX-VXV ratio, the red line the SPX and the vertical lines are the signals generated by the system. I then classified the signals as being successful (blue vertical line) if the market was higher one month after the signal, while the unsuccessful signals were in red and flat returns colored in black.

Backtest of VIX-VXV trading system

Pre-2012, the batting average for this trading system was so-so as all of the red vertical lines occurred during that period. The win-loss-tie rate in the period was 4-3-1, which is ok but not enough to build a trading system from. In the post-2012 period, when vols were much lower, the buy signals showed a 100% win rate.

Now that we have a buy signal from this system but a possible vol regime change, what success rate should be applicable to this latest signal?


Other implications of a vol regime change
Since volatility is inversely correlated to stock market returns, another important implication of a vol regime change is the expectation of a correction in stock prices. The recent change in market leadership from growth to value stocks is further evidence of a sea change occurring in the markets.

J.C. Parets at All Star Charts recently highlighted analysis by JC O’Hara from FBN Securities expressing concerns over the shift in sector leadership (emphasis added):

The recent sector performance has been troublesome. It is not an encouraging sign to see the market being led by utilities. Even more concerning is the lack of performance in Discretionary, Industrials and Financials. The last 90 days we have seen just that. Examining prior market peaks (too early to confirm we are currently at one), we note that Discretionary weakness combined with Utility outperformance was a forewarning of market weakness to come. Smart money hides in Utilities, Staples, Health Care and Energy, while Financials, Discretionary and Technology get hit the hardest. While there has certainly been active sector rotation from 2013, the market has not turned lower yet. If the recent sector performance is a canary in the coal mine, we expect to see shallow bounces where traders lighten up on their riskier assets, and continue to rotate money into the historical sectors that held up the best.

I have observed a similar effect about risk appetite (see Bears 2 Bulls 1). I constructed a risk appetite index based on an equally-weighted long position in the NASDAQ 100 and Russell 2000 (high beta risk-on index) minus an equally weighted short position in the defensive sectors of Consumer Staples, Telecom and Utilities (low beta risk-off index). As the chart below shows, risk appetite is rolling over:

What's more, I further created my own composite index of small cap vs. large cap relative performance, consisting of the an equal weighted composite of the Russell 2000, SP 600 small cap index and the equal weighted SP 500 index relative to the SP 500. The signs of falling momentum in high-beta small cap relative performance (and therefore a regime change) is unmistakable.

What was more disturbing about O’Hara analysis is his historical parallel with the sector market leadership change at the market top in 2007, which also showed a major leadership shift from Financial and Consumer Discretionary to defensive sectors:

A similar pattern occurred at the market peak in 2000:

Parets concluded:

JC O’Hara sent this over to me at what I think is the perfect time to point out this rotation. This seems all too similar to prior market peaks. We’re going to want to see Financials, Tech and Discretionaries start to turn back up on a relative basis in order to take this scenario out of the equation. But the consistent underpermance out of these sectors and money flow into Utilities and Energy can’t be ignored. The market is speaking. Are you listening?

To be sure, we are not seeing the same fundamental backdrop that could cause the sort of bear markets that began in 2000 and 2007, but I am seeing preliminary signs that earnings growth are starting to face headwinds because of the lack of capex revival (see Capex: Still waiting for Godot). Nevertheless, these kinds of warning signs of regime shift from changes in sector leadership should not be ignored.


An out-of-favor strategy
Finally, if volatility were to increase, investors may wish to consider a highly hated strategy to consider - trend-following managed futures. These strategies have shown good long-term results, but their short-term results have been so terrible that even the legendary hedge fund manager Paul Tudor Jones shut down his managed futures Tudor Tensor Fund after its asset base collapsed (via AllAboutAlpha):

The Tensor Fund went from over $1 billion ($1.5 per our numbers) down to just $120 million times over the last three years, and that is the reason the fund is closing, not anything to really do with performance, the skill of the manager, or expertise of the team. The closing of Tensor is more of a commentary on investors buying in at the top of a cycle and getting out at the bottom than anything else.

It does appear to be a business decision rather than purely an investment decision. Here is the performance of Tudor Tensor:

Longer term, the numbers looked ok:

Now consider the fact that trend following models have an implicit long-volatility bet (see analysis via Attain Capital Management). This chart tells the story by defining volatility as global volatility rather than just VIX:

Today, we have an instance of a hated strategy that has been abandoned by investors and a possible regime change that favors that strategy. What more could you ask for?


Left and right brained analysis
The bigger point I am trying to make here is that experienced quantitative analysts have to combine both their left and right brains to make investment processes that create alpha. You can't simply rely on models that have worked in the past, you have to use your observation, intuition and market experience in knowing how to use those models.

I may be wrong on this, but I am seeing evidence of a regime change going on in the markets. Volatility is poised to rise and sector leadership is shifting. Are you and your models prepared?





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Is greed truly good?

Here is something to ponder on Easter weekend, when Christ was said to have sacrificed himself for the Sins of Humanity. You don't necessarily have to be Christian, or even religious, to consider these questions. You just have to consider the trade-offs between the ideas of self-sacrifice and self-interest.

David Brooks wrote a New York Times piece called "The Moral Power of Curiosity" about HFT, but framed as a morality tale (emphasis added):

As you’re probably aware, this book is about how a small number of Wall Street-types figured out that the stock markets were rigged by high-frequency traders who used complex technologies to give themselves a head start on everybody else. It’s nominally a book about finance, but it’s really a morality tale. The core question Lewis forces us to ask is: Why did some people do the right thing while most of their peers did not?

The answer, I think, is that most people on Wall Street are primarily motivated to make money, but a few people are primarily motivated by an intense desire to figure stuff out.

Brooks concluded that greed isn't necessarily good, but greed could be defeated by the pure thirst of knowledge:

One lesson of this tale is that capitalism doesn’t really work when it relies on the profit motive alone. If everybody is just chasing material self-interest, the invisible hand won’t lead to well-functioning markets. It will just lead to arrangements in which market insiders take advantage of everybody else. Capitalism requires the full range of motivation, including the intrinsic drive for knowledge and fairness.

Second, you can’t tame the desire for money with sermons. You can only counteract greed with some superior love, like the love of knowledge.

Third, if market-rigging is defeated, it won’t be by government regulators. It will be through a market innovation in which a good exchange replaces bad exchanges, designed by those who fundamentally understood the old system.

And here’s a phenomenon often true in innovation stories: The people who go to work pursuing knowledge, or because they intrinsically love writing code, sometimes end up making more money than the people who go to work pursuing money as their main purpose.

Greed is good?
Brooks' thoughts are herectical to the tenets of capitalism, at least in the purest Libertarian form. If the profit motive alone, or greed, is insufficient to create an efficient economic system, then what is? Do we need to depend on *gasp* altruism?

Here is what the high priestess, Ayn Rand, had to say about altruism:

What is the moral code of altruism? The basic principle of altruism is that man has no right to exist for his own sake, that service to others is the only justification of his existence, and that self-sacrifice is his highest moral duty, virtue and value.

Do not confuse altruism with kindness, good will or respect for the rights of others. These are not primaries, but consequences, which, in fact, altruism makes impossible. The irreducible primary of altruism, the basic absolute, is self-sacrifice—which means; self-immolation, self-abnegation, self-denial, self-destruction—which means: the self as a standard of evil, the selfless as a standard of the good.

Do not hide behind such superficialities as whether you should or should not give a dime to a beggar. That is not the issue. The issue is whether you do or do not have the right to exist without giving him that dime. The issue is whether you must keep buying your life, dime by dime, from any beggar who might choose to approach you. The issue is whether the need of others is the first mortgage on your life and the moral purpose of your existence. The issue is whether man is to be regarded as a sacrificial animal. Any man of self-esteem will answer: “No.” Altruism says: “Yes.”

Rand came down on firmly on the affirmative side of the question of whether greed is good.




No room for altruim?
From personal experience, I would agree with Brooks' assertion that most people on Wall Street are primarily motivated to make money. While not everyone is cut from that mold, but Wall Street does have more than its fair share of people for whom avarice is the primary motivation. I can say that it is the purest embodiment of capitalism in its rawest form. It attracts a lot of bright young men and women who hope to get paid well - and they do.

This video presents a contrasting tale of another profession that has attracted a lot of young men (and a few young women) - the training of United States Marines. This story is about training people to be prepared for self-sacrifice, which is antithetical to everything that Ayn Rand advocated.



There is a key passage which starts at about the 28:00 mark, It shows the DI telling the young recruits a story about a marine who is wounded in a rice paddy. Another marine who is sheltered behind a dike crawls out to drag the wounded soldier to safety, even though one or both are likely to get die. The reason: You do it because he is a marine. Then watch the reaction - the story moves the recruits to tears.

The video is somewhat cynically entitled "Anybody`s Son Will Do", because it is about the business of training young soldiers. That is because the idea of self-sacrifice doesn't come naturally to most people and they have to be indoctrinated that way. Soon after the passage about story of the wounded marine in rice paddy, the narrator Gwynne Dyer sums up the indoctrination process for soldiers this way:

Armies everywhere try to catch their recruits young, because they are vulnerable and more easily influenced about dying. You CAN train older men to be soldiers - and it's done in every major war, but you can never get them to believe they like it.

"Anybody`s Son Will Do" is well worth watching in its entirety. But are you offended by the cynicism of the video? Now consider your comments in the context of Ayn Rand`s thoughts about suicide, altruism and self-sacrifice. Who is right? Either these recruits are unwitting pawns (as per Rand) and you would have to be either an idiot or desperate to enlist, or they are the noble representatives of the American citizenry and United States Marine Corp.


Greed vs. Altruism or...
Here is some questions to ponder for this Easter weekend:  Is greed good? Can the profit motive alone be relied on to create a well functioning economic system? If not, then do we have to depend on the ideas of altruism and self-sacrifice? If you, like Rand, do not believe in the power of altruism, then is the mythic value of self-sacrifice of soldiers mean nothing and it is a curtain that needs to be pulled back like the story in the Wizard of Oz?

To be sure, David Brooks tried to skate around these issue by declaring that the antidote to pure greed is “some superior love, like the love of knowledge“, but that sounds like a cop-out to me as it represents altruism in another form.

I can tell you that there are no right answers to these questions. The answers just define what kind of person you are.

(Philosophy lesson over. Back to your regular programming tomorrow...)




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

CapEx: Still waiting for Godot

In a recent post, I wrote that the US economy is mid-cycle and we need to see signs of capital expenditure acceleration for stock prices to meaningfully advance from current levels (see What equity bulls need for the next phase). One of the clues would be the earnings reports from companies in capital goods conglomerate like GE.

GE reported on Thursday and Honeywell, another capital goods conglomerate, reported on the same day. The best description of my reaction of both reports is, "Meh!"


GE: Flat top-line growth
The GE earnings report was a solid report for shareholders, but I was not looking at it from a shareholder perspective, but using it to look for clues of global, or at least American, capex acceleration. The presentation, which can be found here, left me a little wanting. 

In particular, this page showing the progression of their order backlog was a little disappointing. Backlog growth from 4Q to 1Q was flat, having increased from $23.6 billion to $23.7 billion. 

The oil and gas division provided much of the source of capex growth, but that should be no surprise. David Kostin of Goldman Sachs broke out capex by sector and showed that the energy sector had been increasing its share of capex within the SP 500 for several quarters (via Business Insider). While there were some bright spots in the other GE divisions, there appears to be no broad based capex acceleration an ex-energy basis.

Little sales growth at Honeywell either
The Honeywell report, which is available here, was also somewhat disappointing. The company beat Street expectations on earnings but missed on sales (remember we are looking for sales acceleration). Sales was up only 1% on an organic basis YoY. The environment in the Defense and Space division was problematical and HON saw good top-line acceleration in Europe from sales of their turbochargers.

The company expected organic sales growth, my key metric, is 3% in the next quarter and 4% in the 2H2014, ex-Defense and Space. While they did raise earnings guidance, sales guidance was unchanged.

If HON were to be representative of the capex outlook, 3-4% isn't a bad number, but it falls short of a picture of capex acceleration that the Street has been expecting. The same comment would also apply to GE. To top it all off, Bill McBride at Calculated Risk recently highlighted an environment which features a sluggish recovery for US heavy truck sales:

In short, waiting for a capex revival can still be likened to Waiting for Godot.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

EM tail-risks are rising

As the events in Eastern Ukraine unfold, Ambrose Evans-Pritchard wrote about the risks of a an American-Russian confrontation:

The United States has constructed a financial neutron bomb. For the past 12 years an elite cell at the US Treasury has been sharpening the tools of economic warfare, designing ways to bring almost any country to its knees without firing a shot.

The strategy relies on hegemonic control over the global banking system, buttressed by a network of allies and the reluctant acquiescence of neutral states. Let us call this the Manhattan Project of the early 21st century.

"It is a new kind of war, like a creeping financial insurgency, intended to constrict our enemies' financial lifeblood, unprecedented in its reach and effectiveness," says Juan Zarate, the Treasury and White House official who helped spearhead policy after 9/11.

The weapon is not military, but financial in nature:

The stealth weapon is a "scarlet letter", devised under Section 311 of the US Patriot Act. Once a bank is tainted in this way - accused of money-laundering or underwriting terrorist activities, a suitably loose offence - it becomes radioactive, caught in the "boa constrictor's lethal embrace", as Mr Zarate puts it.

This can be a death sentence even if the lender has no operations in the US. European banks do not dare to defy US regulators. They sever all dealings with the victim.

In a different article, Evans-Pritchard outlined Russia's financial vulnerability:

Russia is at increasing risk of a full-blown financial crisis as the West tightens sanctions and Russian meddling in Ukraine pushes the region towards conflagration.

The country’s private companies have been shut out of global capital markets almost entirely since the crisis erupted, causing a serious credit crunch and raising concerns that firms may not be able to refinace debt without Russian state support.

“No Eurobonds have been rolled over for six weeks. This cannot continue for long and is becoming a massive issue,” said an official from a major Russian bank. “Companies have to roll over $10bn a month and nothing is moving. The markets have been remarkably relaxed about this, given how dangerous it is. Russia’s greatest vulnerability is the bond market,” he said.

In particular, he singled out the Russian external debt of $714 billion as a source of vulnerability:

A report by Sberbank said Russia has $714 bn of foreign debt: $427bn for compaines, $207bn for banks, and $62bn from state bodies. The oil group Rosneft relies on foreign debt for 90pc of its funding. Foreigners also own 70pc of the free-float of Russian stock market, which has not yet dropped heavily but has been held back by 15pc relative to emerging market peers since late February.

While financial sanctions would no doubt hurt the Russian economy, Evans-Pritchard indicated that Russia is not helpless and she could respond with other means, such as cyber-warfare:

Chancellor George Osborne must have been let into the secret of US plans by now. Perhaps that is why he issued last week's alert in Washington, warning City bankers to prepare for a sanctions fall-out. The City is precious, he said, "but that doesn't mean its interests will come above the national security interests of our country".

The greatest risk is surely an "asymmetric" riposte by the Kremlin. Russia's cyber-warfare experts are among the best, and they had their own trial run on Estonia in 2007. A cyber shutdown of an Illinois water system was tracked to Russian sources in 2011. We don't know whether US Homeland Security can counter a full-blown "denial-of-service" attack on electricity grids, water systems, air traffic control, or indeed the New York Stock Exchange, and nor does Washington.

"If we were in a cyberwar today, the US would lose. We're simply the most dependent and most vulnerable," said US spy chief Mike McConnell in 2010.

The US defence secretary Leon Panetta warned of a cyber-Pearl Harbour in 2012. "They could shut down the power grid across large parts of the country. They could derail passenger trains or, even more dangerous, derail passenger trains loaded with lethal chemicals. They could contaminate the water supply in major cities, or shut down the power grid across large parts of the country,” he said. Slapstick exaggeration to extract more funds from Congress? We may find out.

While some analysts may have factored the economic and financial effects of western sanctions on Russia, I bet that the consequences of the shutdown of the US power grid is not in anybody's spreadsheet.


Another giant with gargantuan external debt
Incidentally, when I read the $714 billion external debt figure, I had to laugh. Can you guess who other EM country has external debt in that order of magnitude?

If you guessed China, you win the prize. This chart comes from an article by Ambrose Evans-Pritchard in October 2013:

Foreign loans to companies and banks in China have tripled over the last five years to almost $900bn and may now be large enough to set off financial tremors in the West, and above all Britain, the world’s banking watchdog has warned.

“Dollar and foreign currency loans have been growing very rapidly,” said the Bank for International Settlements in a new report.

“They have more than tripled in four years, rising from $270 billion to a conservatively estimated $880 billion in March 2013. Foreign currency credit may give rise to substantial financial stability risks associated with dollar funding,” it said. China’s reserve body SAFE said 81pc of foreign debt under its supervision is in dollars, 6pc in euros, and 6pc in yen.

Note that the last date of the chart is in early 2013. Given the pace of the increase, Chinese external debt could easily be very close to $1 trillion or more today. To put the $1 trillion external debt into context, the most recent Chinese GDP release came in at 7.4%, which was ahead of expectations of 7.3%. However, the issue is not whether is China is growing at 7.0% or 7.5%, but whether it will experience a financial crisis. China bulls have pointed out that most of Chinese debt is in RMB and therefore it is unlikely to experience an external debt crisis given the size of its foreign exchange reserves. Nevertheless, an external debt position of roughly $1 trillion is nothing to sneeze at, even if your reserves is a multiple of that figure.

Under a scenario where China undergoes a financial crisis, no doubt western banks would get hurt - and that would spook markets. That tail-risk is probably not in too many analysts' spreadsheet models either.


Remember the "tail" in "tail-risk"
I am not trying to engage in fear mongering. I only bring up these possibilities of events in Ukraine or China spiraling out of control not because they represent my base case scenarios, but as tail-risks. Just remember the "tail" in the term "tail-risk".

To be sure, the latest economic releases out of China suggests that the economy may be turning up and therefore financial risks are receding, as per Tom Orlik at Bloomberg:

A WSJ report came to the same conclusion:

Official data shows China’s economy in the first quarter grew at its slowest pace in 18 months, but two proxies point to some resilience.

Electricity output—an indicator favored by Premier Li Keqiang over gross domestic product—and crude steel production grew faster in March than in the preceding two months. In addition, steel output in March hit a record high, the National Bureau of Statistics said.

Back in 2007, when he was party boss of Liaoning province, Mr. Li quipped that when it comes to growth data, officials might lie—but volts do not.

Electricity output in March was up 6.2% from a year earlier to 453 billion kilowatt-hours, faster than the combined 5.5% pace of January and February (the two months were counted together to limit distortions from the Lunar New Year holidays). Steel production was up 2.2% to a record 70.3 million tons. That compares with a 0.6% expansion in February and a contraction of 3.2% in January.

The data added to a sense China’s economy may have stabilized in March. Other data released Wednesday—including retail sales and industrial production—edged up from the previous two months.

As well, speculation about asymetric warfare like cyber attacks is just that - speculation. If Moscow orchestrated the initial provocations in Eastern Ukraine, the military response by Kiev was no doubt expected and the Kremlin has a plan to deal with what comes next. We will just have to watch how this elaborate dance plays itself out.

Nevertheless, the technical picture of the stock market is starting to look like the Spring of 2011. Market internals are deteriorating and risk appetite is rolling over. The crisis then came from the combination of a political impasse in Washington and the eurozone crisis. It was a volatile mixture which eventually sparked a major market sell-off. In 2014, investors have to be aware of the nature and the rising level of tail-risks that could affect financial markets in the months to come.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.