Trump's Liz Truss moment?

Mid-week market update: Is this Donald Trump's Liz Truss Moment? In the fall of 2022, UK prime minister passed a series of unfunded tax cuts. The bond market rebelled and sold off hard, especially in the long end of the yield curve. The massive sell-off forced a number of "hedged" pension funds into technical insolvency, which eventually led to the political downfall of the prime minister.

 

Here is where we stand today. The 10-year Treasury yield and other long yields have spiked. The MOVE Index, which is the VIX of the bond market, is up sharply. The yield curve is has marginally recovered from inversion, but nevertheless indicates tight monetary conditions. The trade war factor, which measures the performance of stocks with domestic revenues relative to the S&P 500, has surged.

 

Even as investors fret about how tariffs are affecting the stock market, the real action is in the bond market.

 

The full post can be found here.

 

Special announcement: Humble Student of the Markets will cease publication on March 31, 2026. See this announcement for more details and updates.

 

Sector leadership review: Bear market vibes?

Now that the 2s10s yield curve has un-inverted, a review of sector leadership is showing bearish vibes. In particular, the relative performance of defensive sectors is turning up.

 

I conducted an extensive sector and factor rotation review to determine the extent of the damage.
 

The full post can be found here.

Assessing the damage: Not just the carry trade

 

After strengthening rapidly, the Japanese Yen (bottom panel) has stabilized has stabilized in the 140-150 range. The 10-year Treasury-JGB spread also stabilized and found support. So did the Nikkei Average after suffering the greatest one-day decline since the Crash of 1987. The Bank of Japan sounded a dovish tone when deputy governor Shinichi Uchida said that the Bank would “refrain from hiking interest rates when the markets are unstable”. In addition, Bloomberg reported that “JPMorgan says three quarters of global carry trades now unwound”.
 

 

Is it all over? It’s time to assess the damage from the latest fright by diagnosing what sparked the sell-off.
Even though many market observers focused on the currency carry trade as the source of the mini-panic, I argue that the carry trade unwind was only a symptom of what’s plaguing the markets.

 

The full post can be found here.

A 2022 inflation tantrum investing roadmap

In the wake of the hot January CPI print, I have had a number of discussions with readers about the most advantageous way of positioning an equity portfolio in a rising rate environment. The most obvious strategy is to use an allocation similar to the Rising Rates ETF (EQRR) is to tilt towards value and cyclical stocks.

Beneath the surface, however, such an approach carries considerable risks owing to growing negative divergences. Instead, I present a framework for managing the inflation tantrum of 2022.

The full post can be found here.

Demographics and gold: Something doesn't add up

This is another in a series of occasional posts on quantitative analysis. I am indebted to Josh Brown for pointing me to an article by Larry Swedroe, which discusses a study on demographics and real interest rates. While I found that I can derive significant insights from single variable studies like these, the world is more complex and univariate analysis illustrates the pitfalls of relying on single variable models.

More at our new website here.




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Focus on small caps in 2015

I was reviewing my last weekend post (see The adults are back at their desks. Sell?) and noticed an interesting point about the trajectory of forward EPS estimates. In that post, I had shown this chart from Ed Yardeni indicating that forward 12-month EPS estimates were declining and but suggested that they would recover once the Street started to see and quantify the benefits of lower oil prices (annotations in purple are mine).

In fact, we are already seeing some of those effects. The contrast between the large cap SP 500 and the mid and small cap stocks are quite striking. While forward EPS for large caps have been falling, EPS estimates for mid and small caps are flat.

That`s because large cap stocks are more international in nature and these multi-nationals are more exposed to the headwinds of a strong US Dollar. If the investment thesis is to focus on the benefits of lower oil prices to the US consumer, a more targeted way of getting that exposure would be to focus on the US mid and small cap stocks, which have less foreign exposure.

The chart below shows the 10-year relative performance of the small cap Russell 2000 to the large cap SP 500. The small to large cap ratio recently turned up as it reached the bottom of a trading range that began in 2010 and these conditions are suggestive of better small cap performance.

Longer term, however, the relative performance of small and large cap stocks are dependent on the outlook for the USD. As the chart below shows, the USD Index is making a rounded multi-year bottom and it is now testing a key resistance zone.

As Marc Chandler pointed out, the both the fundamental and technical near-term outlook is for a stronger Dollar:

The US dollar is poised to extend last year's rally. The US economy is at least several quarters ahead of most of the other major economies. Barring a major surprise, the Federal Reserve will likely hike rates around the middle of the year, while the economies in Europe and Japan need more stimulus.

In the week ahead, investors will likely learn that the euro zone and Japanese economies continue to struggle, while US job growth continues. There are preliminary signs that labor costs are beginning to rise, helped by rising wages. This is expected to continue to underpin US consumption.

Still, it is unreasonable to expect the US economy to maintain the 4%+ pace seen in the April-September period. It also seems unreasonable to think that the drop in oil prices, lower interest rates, and weaker currencies will not have a positive impact on Europe and Japan. It will take some time. In the meantime, the divergence theme is the focus and this bodes well for the greenback.

Regardless of what the FX markets do in the next couple of months, small and mid cap stocks are likely to see better earnings growth as they reap the residual benefits of past USD strength. During the first half of 2015, I would be inclined to tilt my US equity exposure away from the large cap multi-nationals and toward the smaller domestically focused companies.

Why I am not a bottom-up equity quant

I spent close to two decades of my career building bottom-up equity quantitative models to pick stocks, in Canadian, US and international markets. I was asked why I don’t do that anymore.

My flippant answer was:“Been there, done that.”

My longer answer was that the competitive advantage of doing bottom-up quantitative analysis is being eroded to such an extent that alphas are rapidly diminishing.

Let me explain. Back in the 1970s and 1980s, the task of performing equity quantitative analysis required a large commitment by an investment organization. Sure, there were databases around, but the task of integrating them was a non-trivial task that required investment in staff and infrastructure.

Here are some sample issues. How do you marry an earnings estimate database (e.g. IBES) with a fundamental database (e.g. Compustat) when:

• The series have different periodicities (annual & quarterly for the fundamental and daily/weekly/monthly for earnings estimates)?
• The identifier for earnings estimates is for the security (stock specific) but the fundamental database is identified by company (as multiple share classes are not uncommon for non-US companies)?

Add to that the issues of adding data for new listings, deletions, name changes, etc. The investment organization quickly finds itself not in the investment business, but the database maintenance business.


Falling barriers to entry
Fast forward a couple of decades, the apperance of system integrators like Factset Research Systems have revolutionized the business and dramatically lowered the barriers to entry to bottom-up equity quantitative analysis. Today, you can build an equity quantitative research capability by subscribing to these services.


Opera singers don't belt, quants control for factor risk
Moreover, a generation of quants has been conditioned by the likes of Barra to decompose risk as industry plus a Fama-French like common factors such as Market Capitalization and Style (Value/Growth).

The implications of this analysis framework is that just as opera singers are genetically imprinted not to belt when they sing, bottom-up equity analysts are conditioned to believe that you shouldn’t try to forecast the returns to these risk factors. Instead, the appropriate way to forecast alpha is to forecast alpha based on residual risk, or stock pick after controlling for, at the very least, industry and sector risk.

The combination of lower entry barriers and groupthink has led equity quants into a crowded trade. They all uses some form of multi-factor stock selection model, but the data comes from the same databases. The factors all appear to be uncorrelated but we saw what happened in August 2007.


The low lying fruit is gone
Even when you succeed, it’s a really tough business.

I recently attended a seminar put on by a risk model vendor and a respected equity quant manager. The equity manager put up an analysis showing various ways of integrating their forecast alphas with the risk models that they use. The most optimal technique for a long only portfolio, with a 2-2.5% forecast tracking error, resulted in an annual alpha of about 1.5% a year.

1.5% sounds pretty good.

However, you have to consider that this is a forecast alpha from a model portfolio with no turnover costs. Once you throw in trading costs, the shortfall between the turnover of the forecast alpha and the actual portfolio, which could vary greatly, and even the fact that good managers with tight investment processes experience portfolio dispersion (difference in returns between accounts with similar mandates) of 2% or more, 1.5% doesn’t sound that good.

As I said before, it’s getting to be a really tough business.

So far my solution has been to do something that is truly queasy and nauseating to many equity quants. I have been using top-down investing and factor rotational approaches to quantitative investing. The approach disturbs quants because it's less disciplined, less risk controlled (according to the way they are trained) and appears to be so, well, empircally oriented.

My approach is not the only answer but bottom-up equity quants need to find new sources of alpha.