Can the melt-up continue?

Mid-week market update: The week began on a bullish note this week as the melt-up theme dominated early in the week (see Jeremy Grantham`s call for a possible melt-up, and my own views published last November: Embrace the blow-off, but with a stop loss discipline). On Monday, the market rose for a fifth consecutive day, which flashed a First Five Day (FFD) buy signal. Ryan Detrick at LPL Financial detailed the historical evidence of this momentum effect for the remainder of the year.

In addition, analysis from Jeff Hirsch of Almanac Trader showing a shorter positive momentum effects of the FFD for the remainder of January, shown as JB in the table below (January Barometer). Since 1950, whenever the first five days was positive, the rest of January went on to be positive 86% of the time, with an average return of 2.6% and median return of 2.1% for the remainder of the month (N=29).

The market celebrated with another win on Tuesday, making its winning streak an astounding six consecutive days. The risk-on rally came to a screeching halt when China reported was considering slowing down or halting its purchases of Treasury paper. The initial reaction saw the yield on 10-year Treasury note spiked and a steepening of the yield curve, though both ended the day roughly unchanged. At the same time, the stock market took a risk-off tone. Here is the Bloomberg report:

Senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter. The news comes as global debt markets were already selling off amid signs that central banks are starting to step back after years of bond-buying stimulus. Yields on 10-year Treasuries rose for a fifth day, touching the highest since March.

Arguably, the response from Beijing was a warning shot to the Trump administration over the prospect of a trade war (see Could a Trump trade war spark a bear market?).

China holds the world’s largest foreign-exchange reserves, at $3.1 trillion, and regularly assesses its strategy for investing them. It isn’t clear whether the officials’ recommendations have been adopted. The market for U.S. government bonds is becoming less attractive relative to other assets, and trade tensions with the U.S. may provide a reason to slow or stop buying American debt, the thinking of these officials goes, according to the people, who asked not to be named as they aren’t allowed to discuss the matter publicly.

Is this the end of the momentum rally?

The full post can be found at our new site here.

Time to sell Australia

Back in late May I suggested that a cheap way to buy Canadian-like equity exposure would be to buy the Australian market, as both markets and economies are fairly similar. The chart below shows the relative returns of the iShares Australia ETF (EWA) relative to iShares Canada (EWC) and what the pair has done since the call:

Since my post, the Australian market has beaten the Canadian market by about 8%. The maximum outperformance of this trade was about 11%. The pair trade has reached parity. It's time to take profits.

Buy Australia, sell Canada

Recently Bill Hester of Hussman Funds did some analysis of average country valuation based on a composite of cyclically adjusted P/E ratios and dividend yields and concluded that US equities remains overvalued compared to its own historical average.

What fascinated me about the chart was the degree of overvaluation exhibited by Canada, compared to Australia, which is trading at roughly its own historical average. The economies of Australia and Canada are similar in character. Both are resource based economies and about the same size. There is a minor difference as Australian resource industries tend to be more tilted toward the bulk commodities (i.e. coal and iron ore) whereas Canada has a higher weight in energy.


Long Australia/Short Canada
The chart below shows the relative total performance in USD, which takes out any currency effects, of the iShares Australia ETF (EWA) and the iShares Canada ETF (EWC). This chart suggests that Australian and Canadian markets have tracked each other relatively closely since late 2002 and Australia is now at the bottom of a trading range relative to Canada.

Hester’s analysis, combined with the above chart, screams out for a trade of going long Australia and shorting Canada.

The risk in the trade is seen in the recent steep selloff in the Australian market, attributable to the news of a super-tax of up to 40% being imposed on resource companies. Nevertheless, the trading range is indicative that the risk-reward ratio is positive for this pair trade and that most of the bad news is already in the Aussie market.

Here are some of the things that could go right for the trade:

• Australia took the lead, but the super-tax contagion could spread. How long would it take for budget constrained countries like Canada or Brazil to consider a form of super-tax on resource extraction companies? The 40% tax rate is awfully tempting and forms a very high ceiling rate from which to impose a new tax. Sympathy for resource extraction companies is low, especially in offshore oil extraction given BP’s environmental and public relations nightmare.
• The Australian government has indicated that the door is open in changes to the tax regime. While the news is bad right now, the Aussie market could rally should the government step back and ease up its tax proposal.
• The Reserve Bank of Australia is ahead of the curve in its monetary policy, as it has moved into tightening mode. By contrast, the Bank of Canada remains behind the curve in its monetary policy. What would happen to the Australia/Canada spread if and when the BoC tightens?

A long Australia/short Canada trade is a highly speculative position. As such, I would be entering into such a trade with a target and pre-defined stop loss levels.

Readings and my reactions

Here are selected readings from the past few days and my reaction to them:

Is this the tipping point for Peak Oil? Matt Simmons, the author of Twilight in the Desert, has asserted numerous times that when Saudi oil production rolls over, then we are looking at the peak of global oil production as there is little chance of replacing Saudi production. Now Khalid al-Falih, head of Saudi Aramco, has warned that Saudi Arabia will start to wane in the coming years as domestic demand surges and spare capacity drops.

What's the difference between a single hedge fund’s hiccup and a hedge fund strategy's return? Zero Hedge reports that market neutral funds are getting “carted out feet first” and cites the performance of the Highbridge HSKAX Index:

The Highbridge HSKAX index just suffered its biggest drop since March 2009. Market Neutral players are getting carted out feet first…

Actually, HSKAX is actually a fund, not an index. Here is the performance of the HFRX Equity Market Neutral Index. While performance has hit an air pocket, the chart below shows that drawdowns are not that serious and market neutral funds can’t be characterized as getting “carted out feet first.”

Is a crowded long threatening the bull run in equities? Further to my last post about the fragility of the financial system, the combination of excessive bullishness stock sentiment and bearish bond sentiment is highly worrisome for equity bulls. Alan Abelson noted in Barrons:

Alan Newman, a crack technician, and chief cook and bottle washer at newsletter CrossCurrents, offers another intriguing contrary-sentiment indicator in his latest commentary. It’s based on investor preferences in mutual funds, and he credits some Rydex charts on the Decisionpoint Website with supplying the necessary info.

Recently, Alan relates, money-market and bear-fund assets both fell to multiyear lows, while bull- and sector-fund assets mounted to their highest levels since the October 2007 market peak. Currently, he reports, there is roughly $7.50 in bull and sector funds for every $1 in bear-market fund assets, which he calls “the most ridiculously one-sided sentiment we have seen since the tech mania convinced folks that no price was too high to pay.”

The Barrons Spring 2010 Big Money poll also shows an unbelievable reading of 1% of institutional money managers bullish and 78% bearish on the safe haven of US Treasuries.

As a confirmation of the cautious view from the sentiment indicators, Mark Hulbert also reported excessive bullishness among short-term Nasdaq market timers. All these signs point to likely corrective action by the stock market in the near term.

Sell in May...

Smart funds surprisingly defensive

The "Idiot’s Market Neutral Fund" 2008 report card
I first wrote about construction of an idiot’s market neutral fund about a year ago here and I further addressed the controversy of why the technique may work here. For the year 2008, this hypothetical strategy was down -0.7%. These returns are roughly in line with the HFRX Equity Market Neutral Index return of -1.2%. (Recall that this strategy goes long 5 Morningstar top rated, low cost and no-load large cap growth funds and 5 top rated value funds, called the smart fund sample, while shorting the S&P 500 Spyder (SPY) against the long positions.)

2008 was a tumultuous year and these returns are not bad considering the market environment the strategy had to contend with. The strategy had a good first half as the mid-year update showed that returns to June 30 was 3.5%. Given that the average annual turnover of the long portfolio was about 50% per annum, it was virtually impossible for any manager, even with good foresight, to outperform the market both in the first half and the second half of 2008. He would have had to be long the inflation bet in the first half and then switch to a low-beta bet in the second half. Indeed, the consensus sample of 20 large cap blend funds from the top mutual fund complexes, which usually perform in line with the market, underperformed by about 5% in 2008.

This strategy has also shown remarkably low turnover. Of the 10 funds in the portfolio, the strategy kept all of the growth funds and turned over only 3 of the value funds. Two value funds were taken out for style drift and only one was taken out for performance reasons.


What are smart funds doing now?
I reverse engineered the macro exposures of the smart fund sample, as well as the exposures of the consensus funds, and looked for significant differences. Smart funds show a surprising level of defensiveness considering the number of well-known investors who have turned bullish in the last few months.

As the chart below shows, the estimate beta of the smart fund investors is significantly lower than the consensus:

Analyzing the exposure by sector, smart funds are underweight Financials:

...and Energy:

While smart funds are overweight traditionally defensive sectors such as Consumer Staples:



…and Health Care:

Surprising defensive readings
I find these readings surprising given the bullishness shown by investors like Ken Heebner (see his record here), John Neff, Warren Buffett, the ValueLine Survey, and many others too numerous to name. After all, the annual turnover of the smart fund sample is about 50% (as is the consensus fund sample) and these funds really don’t turn their portfolios around on a dime. So if these managers see value in the market, I would expect that they would start to be raising their beta exposures now.

Idiot’s market neutral fund: A mid-year report card

I first wrote about construction of the idiot’s market neutral fund here and I further addressed the controversy of why the technique may work here. A mid-year update of this hypothetical fund shows that estimated YTD returns to June 30 was 3.5%. This is ahead of the HFRX Equity Market Neutral Index of 2.3% for the same period. Other investable hedge fund equity market neutral indices (e.g. Dow Jones Equity Market Neutral at 1.5%) show even worse performance than HFRX.


Smart funds remain defensive
The idiot’s market neutral fund’s alpha is mainly derived from the market positions of a group of smart funds. The question in many investors' mind must be what are the smart funds doing now?

The orientation of smart funds hasn’t changed significantly since my last update in late April. Smart funds continue to be more defensive. The managers of these funds seem to believe that the worst may not be over for the US economy.

As the chart below shows, smart fund market beta shows that they are defensively positioned. By contrast, the consensus funds, a group of funds run by the largest mutual fund complexes have market betas roughly in line with the S&P 500:

Smart funds continue to be underweight Financials, while consensus funds are slightly overweight:

…and smart funds are roughly market weight Consumer Cyclicals, while consensus funds are overweight:

An idiot's equity market neutral fund

Here is a simple way of do-it-yourself way of making an equity market neutral fund without having to pay the big fees:

1. Buy the top large cap Growth and Value equity funds, as ranked by Morningstar
2. The funds must be no-load mutual funds, have assets of at least a billion dollars and expense ratios less than 1%
3. Short the S&P 500 Spyder (SPY) against the portfolio
4. Re-balance the dollar amounts allocated to the funds monthly and re-balance the fund components annually

For the period from December 1998 to Janaury 2008 the synthetic equity market neutral portfolio showed a very respectable annualized return of 6.4% (after fees) and a Sharpe ratio of 0.9. Comparing to the HFRX Equity Market Neutral Index using that index's inception date of March 2002, this portfolio returned 4.5% vs. the HFRX return of 0.6%.

I have been running this simple portfolio out of sample for since December 2003 and the results are similar to the in-sample results. In 2007, the synthetic market neutral portfolio also beat HFRX with 6.8% to 3.4%.

Sometimes the simple solutions are the best.

Are Quants victims of their own success?

Are there too many quants? In the past few months I have repeatedly heard similar versions of the same complaint:

You guys are all using Compustat, IBES, First Call, Barra, etc. and building the same models and coming to the same solutions….

In August 2007, equity quant fund performance blew up to what were then called 10 and 20 sigma (standard deviation) events. I call it being in a crowded trade. Andy Lo wrote a paper suggesting that it was:

...initiated by the rapid unwind of one or more sizable quantitative equity market-neutral portfolios…likely the result of a forced liquidation by a multi-strategy fund or proprietary-trading desk.

in other words, they were was in a crowded trade and tried to get out at the same time.


Be an Architect, not an Engineer
The easy availability tools such as MarketQA, Barra and Matlab, just to name a few, have vastly brought down the cost of entry into quantitative investing. The price of that low cost of entry is that many quants are framing the problem of alpha generation and risk control in similar ways. Given the large allocation of funds to quantitative equity investing, the events of August 2007 were inevitable.

Recently a career ad for a quant asked for an “architect, not an engineer”. I have referred to this in the past as combining quantitative skills with market knowledge and experience, others have called it “domain knowledge”.

The advantage of quantitative investing is the ability of a computer to systematically process a large amount of information. Your advantage as a human being and an experienced investor is your knowledge of the markets. A smart way of being a good quant is to combine those two elements by using the computer to model the way fundamental investors think about the markets.

As an example, the chart below shows the returns of an alternate quantitatively driven US equity market neutral portfolio during August 2007. The underlying model is not the Holy Grail and has its limitations, but it is still possible to build quant models that don’t put you in a crowded trade.