The limitations of Altman Z

As s we go through a period of economic stress, I thought that it would be timely to review the Altman Z formula as a predictor of bankruptcy. The formula is a function of liquidity, balance sheet strength and earnings power:

Altman Z =
1.2 X Working capital/Total assets +
1.4 X Retained earnings/Total assets +
3.3 X EBIT/Total assets +
0.6 X Market value of equity/Book value of debt +
0.999 X Sales/Total assets

The original Altman Z score assigned fixed weights to each of the components. Different ranges for Altman Z score represented different levels of risk of bankruptcy. Subsequent versions of the formula varied the weights depending on whether the analyzed company is public or private and also varied the cutoff ranges for bankruptcy risk.


Altman Z was formulated for operating industrial companies
The main problem with this formulation of solvency risk is that the formula is not suited for many industries. As an example, when I first tried to apply Altman Z I found that many regulated utilities showed up as having high bankruptcy risk.

I found that Altman Z was not industry specific enough to my liking. For instance, low or negative working capital doesn’t score well on Altman Z but some industries can operate with zero or negative working capital. For example, a restaurant gets paid in cash, but their suppliers will generally give them net 30 on their payables and the inventory (food) turns over very quickly.

Another sector that the Altman Z doesn’t analyze is the financial sector. What does “sales” mean for a bank? Financials tend to be highly levered and their operating risks and exposures are not well disclosed.


A heuristic for solvency analysis of non-financials
In a recession, the combination of high operating risk and excessive leverage combine to produce insolvency for non-financial company. A better way of forecasting solvency risk is to look for companies that show:

• High operating risk: The top two deciles of standard deviation of EBIT or EBITDA margin over the last 5 or 10 years (pick your horizon)
• High financial leverage: The top two deciles of financial leverage, by total debt to market equity or interest coverage. Normalized decile scores by sector.

I have found that this heuristic, or simple rule of thumb, serves as a better forecaster of solvency risk as it neutralizes many of the industry specific effects that Altman Z failed to address.

Solvency analysis of Financials is difficult
The problems of creating a solvency test for financials that operate in real-time or relative real-time is not easy. It’s not hard to do after the fact, but at any one time, no one – not even the directors of the company really know what is embedded on the books at a financial. Société Générale, Barings, Northern Rock, Bear Stearns – the list of blowup surprises go on and on.

I have had some successes with a solvency risk test for lending institutions based on the following two characteristics:

• Excessive lending growth as a sign of lending portfolio quality: In good economic times, a bank can produce earnings growth by growing its assets, or loan book. In the long run, not all banks can grow their loan books significantly in excess of GDP. High asset growth comes at a cost of lower asset quality.
• Loan loss provisions as a measure of the current level of stress: Instead of the standard ratio of loan loss provisions to total assets, I like to use loan loss provisions to assets three years ago. It’s not the loans that you make today that go sour, it’s the ones that you made two or three years ago that tend to get into trouble.
  
  

Economic storm clouds still gathering

With headlines like Buffett: Economy in a recession, will be worse than feared and McCain & Clinton Fail Economics 101, I thought that it is time to focus on the possible effects of the November presidential elections.


Clinton or Obama presidency = Double dip?
With the US fiscal situation as it is today, a Democrat in the White House, regardless of whether it is Clinton or Obama, would likely raise taxes to try to bring the budget more into balance. Can you say double dip recession?

It’s usually in the first two years a new administration will try to take its economic medicine and blame it on the previous president. Remember how the current Bush administration tried to position the post-Tech Bubble slowdown as the “Clinton recession”?


McCain presidency = ???
When John McCain was quoted in 2005 as “I'm going to be honest: I know a lot less about economics than I do about military and foreign policy issues. I still need to be educated” in that bastion of left wing politics, the Wall Street Journal, the country could be rudderless economically.

A more recent quote shows that he still has no economic direction: “The issue of economics is not something I’ve understood as well as I should. I’ve got Greenspan’s book.”

Still waiting for a market bottom

As the S&P 500 seems to have formed a double bottom in January and March, the question in many investors' minds must be "Have we seen the bottom?" My review of some of my market indicators indicate that it’s probably a little early to flash the all-clear signal for US equities.

In particular, the problem areas of the market, namely the investment banks, housing and employment, continue to struggle, suggesting that the worst may not be over for this bear market. Here are some of the indicators that I am watching:


Insiders are bullish
Mark Hulbert reports that insiders have been buying their own stock at levels that are comparable to other market bottoms. Insider signals tend to have a very long time horizon but their actions does have bullish implications.


Investment bank valuations - more downside?
Since much of the recent stresses that have shown up in the investment banks and brokers, I go back to my rule of thumb that I would like to see a price to book ratio of 1 for the investment banks. The P/B of 1x was a good signal of a market bottom in the 1974-5 and 1981-2 bear markets.

While Lehman (LEH) did reach a P/B of 1x for one day at the time of the Bear Stearns panic, other investment banks and brokers such as Morgan Stanley (MS), Merrill Lynch (MER) and Raymond James (RJF), which is an interesting bellwether as it has no significant prop trading operations, are trading at valuations of 1.5 to 1.8 times book. Goldman Sachs (GS) is trading at valuations that are even higher than that.

I could be wrong here but my guess is that there needs to be more pain in the brokerage stocks before the market bottoms.


Smart funds defensive while overall sentiment is bullish
A check in with my group of smart funds shows that their posture remains defensive. The accompanying chart shows the market beta of the “smart funds” compared to the “consensus funds”. Smart funds have a market beta, or implied market exposure, that is lower than the market while consensus funds are at or positive market exposure. Moreover, the recent Barron’s Big Money Poll shows 50% of their respondents to be bullish or very bullish, compared to 13% as bearish. This is a contrarian bearish reading.

Problem areas of the economy not stabilizing yet
This economic downturn was the result of overbuilt housing fueled by overly aggressive real estate lending. The chart below shows the S&P 500 Homebuilders relative to the S&P 500. The homebuilders remain in a relative downtrend and show no signs of stabilization, which is not a good sign for the health of the overall market.

Addendum: When you get stories like KB Home's Broad Says Home Prices May Drop Another 20%, it doesn't exactly inspire confidence that housing has bottomed.

Similarly, we have seen employment statistics starting to weaken, as is the case in any recession. Rather than looking at the payroll numbers, which are backward looking, I prefer to look at market discounting real-time statistics. My proxy is the price action of S&P Supercomposite Human Resources and Employment Services, consisting mainly of temp and employment agencies. The chart below of these stocks relative to the S&P 500 indicate that, like the Homebuilders, the Temp Agencies remain in a relative downtrend with no convincing signs of stabilization.

How far or how long before a bottom?
If my assessment is correct then the next question would be “how long or how far down before we see a bottom in the market?” William Hester at Hussman Funds, in his recent article Recessions and the Duration of Bad News, suggests that if this was an “average” recession we will likely see much more bad news in employment, housing, earnings, etc. If this was an “average” recession the chart he shows suggests that we are currently seeing a bear market rally but a more convincing market bottom is a few months off (see the last two charts in the article).

Is this an average recession? I have no idea. All I can do is keeping watching my indicators for signs of a market bottom.

A reprieve for hedge funds but challenges remain

We all know the story. The hedge fund industry grew from a handful of funds on a relatively small asset base in the early 1990s to over $2 trillion in assets today. What really spawned the explosive growth were hedge funds’ positive returns which were uncorrelated to the equity market in the post-2000 Tech Bubble bear market.

Since then, the chart below of the HFRX Global Hedge Fund Index and the S&P 500 shows that hedge funds returns have become highly correlated to the S&P 500. In the current equity market downturn, hedge fund returns has fallen with the S&P 500 but the level of correlation has decreased in the last few months.

Challenges remain for the hedge fund industry
Despite the near term recovery, several challenges remain for the hedge fund industry. Firstly, no doubt many hedge fund investors feel chastened by their experience and caution will be the watchword going forward. In addition, various studies have shown that hedge fund returns can be replicated using factor betas. Larger sponsors that I have spoken with echo the sentiments of Russell Read, chief investment officer of the $225 billion California Public Employees Retirement System: “We can get average market risk very cheaply. We hate paying a performance fee for something we can get very cheaply.”


The industry is getting more institutional
These problems are well known and many commentators have given their views on how the hedge fund business is likely to evolve so let me throw me my two cents worth.

• The industry needs to move away from a strict absolute return based focus and need to better understand clients and customize solutions
• Fee compression pressure will intensify as a result

Understanding the client
For most of their history, hedge fund managers have marketed themselves as absolute return vehicles, with low correlations to other asset classes. As returns came down, they clung to the low correlation idea but that line is wearing a little thin these days.

Low correlation, in of itself, has limited value. Supposing that I told you that I had access to a fair roulette game, i.e. the house didn’t have an edge. Returns would be uncorrelated to virtually any asset class that you could think of. Would you fund me on a 2% and 20% fee structure?

I believe that the key to surviving and prospering as an alternative asset manager is to learn to listen more to clients and understand how sponsors put together portfolios. You represent a piece of a jigsaw puzzle to them and know what the benefits you offer.

This William Mercer study for the State of Arizona is typical of the new thinking. Mercer suggests, among other things, that sponsor portfolios should be optimized to alpha exposure. Expected alpha, alpha volatility and alpha correlation all matter in how you pick managers. This is part of the move toward the “portable alpha” concept where a sponsor moves towards a liability driven investing framework. He builds a passive portfolio based on that benchmark and then overlays a “portable alpha” on top of the passive portfolio.


Fee compression pressures to rise
If the concepts in the Mercer study become accepted and widespread then fee compression pressures are likely to rise. Reading between the lines the terms of “expected alpha”, “alpha volatility” and especially “alpha correlation” sound suspiciously like the hedge fund factor betas concept that Bridgewater Associates and others have documented in their studies. The obvious conclusion is you shouldn’t be paying the same level of fees for beta as alpha.

Further fee pressures could come from portable alpha implementation. A sponsor can gain access to a portable alpha in two ways. The high cost route would be to buy it from a hedge fund or a hedge fund of funds. The cheaper way would be to synthetically create an alpha stream by hiring a traditional long-only manager and shorting the manager’s benchmark against the long portfolio. As an example, the sponsor could hire a small cap equity manager and then simultaneously short the Russell 2000 using derivatives. The hedge fund solution would cost 2% and 20% or more. The synthetic alpha solution would run around 0.5% and 1.0% for a reasonably large sponsor.

If you were a pension fund or endowment fund, what you choose?

The limits to China’s growth

I have a seven year old daughter. Despite her Chinese heritage I am not in a huge rush to enroll her in the Chinese Mandarin classes as many of the other parents have enrolled her peers. There are two reasons for this. First, Chinese is a difficult language (no alphabet, all characters must be learned by rote memorization) that is learned best in an immersion environment. Second, I believe that by the time she is ready to move into the working world China will no longer be ascendant the way it is now. The Chinese language courses that parents are rushing to put their children into now will turn out to be as useful as the Japanese courses in the late 1980s (anyone remember Theory Z?)

A bearish call with a very long term horizon
Before you start flaming me, note that I am talking about a very long term time horizon. While I believe that China will grow at very high rates in the next five to ten years, there are two main long-term problems with China which will limit her growth path:

• China is a nation of small business entrepreneurs but the small business model is not scalable
• Chinese age demographics are getting more unfavorable
  

First, some good news and bad news about China’s growth: From personal observation I have found the Chinese tend to be very entrepreneurial. This effect is demonstrated by the business dominance of the overseas Chinese in much of Southeast Asia, which has created friction in the past in countries such as Malaysia, Indonesia and the Philippines. This entrepreneurial spirit has created a nation of small businesses and an enormous dynamism which is fueling much the growth in China.

However, Chinese business culture has not fully developed a professional manager class (with some limited exception in Hong Kong and Singapore). The business model of much of these small businesses consists of a single person at the top with managers and workers below, most of whom have little or no authority. Small businesses are not scalable into large businesses if there are no professional managers. Such a culture can create a nation of shopkeepers but not a nation of industrialists. This will create barriers to further growth at some point in the future.


Demographics another headwind
China has undergone over a generation of the one-child policy, which has served to restrict her population growth. The law of unintended consequences raised its head along the way.

The population is aging rapidly. The accompanying chart shows that the UN projects the proportion of China’s elderly population, which is defined as those over age 65, will rise from 6.8% of the population in 2000 to an astounding 22.9% in 2050. China’s dependency ratio (ratio of non-working to working population) will rise from 10 per 100 workers in 2000 (19 for US in 2000) to 37 in 2050 (vs. 32 for US). The demographic bonus of a rising young, productive, working population will have been spent in the next 20-30 years.

Source: US GAO, The Future Sustainability of Social Insurance Programs

A nation of little emperors
Beyond the mere numbers of age demographics, the cultural effects of the one-child male-preferred policy may further inhibit the growth dynamism of China’s economy. The family pyramid has become inverted, with parents and grandparents doting on the single child. This has created a nation of spoiled “little emperors” many of whom have grown up with a sense of entitlement and may not have the same work ethic as older generations. Many of these “little emperors” are now in their 20s. Can we really expect the same entrepreneurial drive from this age cohort as from older cohorts? Culturally, this will further inhibit China’s growth potential in the future.


Too early to short China
I began this post by referring to my seven year old daughter. It is with that time horizon in mind that I refer to China’s longer term challenges. In the meantime, China remains a powerhouse of economic growth for the next 5-10 years. Shorting it now would be like standing in front of a speeding freight train.

Storm clouds starting to lift for commodities

I am on record as a long term bull on commodities. The near term risks that I see for this trade are:

• Cyclical: A US slowdown will spread to the rest of the world and reduce cyclical commodity demand
• US$ rally: A countertrend rally in the US$ will create headwinds for commodities

Cyclical risks are abating
A look at some real-time indicators for the world economy shows signs of stabilization and recovery. Dr. Copper, which is an indicator of world cyclical demand, is at or near new highs. The Baltic Dry Index, a shipping cost benchmark, fell from all-time highs in 3Q 2007 and has stabilized (see the chart here, click on the BDI & Copper link to see the two together).

While I continue to be concerned about a counter-trend rally in the US Dollar as the US economy shows signs of recovery later this year, the cyclical risk in the commodity trade is greatly lessened.

As an investor, I would be inclined to raise from an underweight to a neutral position in the commodity sensitive plays in my portfolio.

More on the secular pilot shortage

My recent post entitled a secular warning for the airlines elicited a lot of comments from the pilot community. The comments fall mainly into the category of “if there is a pilot shortage why am I so badly paid/poorly treated?”

Don't confuse secular with cyclical effects
My answers consist of several parts. First, don’t confuse the secular effect with the cyclical effect. With airlines from Aloha to Frontier going into Chapter 11, a possible Delta-Northwest merger in the works and the US economy in recession, there should be a surplus of pilots in the short term – that’s the cyclical effect. The longer term secular effect is found at the age demographics of most flying clubs that I have visited – there are few members in their 20s and 30s. Members below the age of 50 seem to be the “young pups”.

Some airlines have begun to address this problem by doing their own training, which takes a long time to pay off, or moving to the multi-crew pilot concept in which someone gets qualified as a member of a cockpit crew instead of a pilot. Under this scheme, it is possible to qualify as a member of a cockpit crew without being qualified as a private pilot. This solution seems to be just a case of the blind leading the blind.

Pilots reap what they sow
The history of poor pay for pilots is related to the number of people who love flying. There are many pilots who would still say that they have the greatest job in the world despite the mediocre pay scales, long hours away from home, etc. If you are willing to accept those conditions in exchange for the experience of flying for a living, who do you have to blame for that?

Still a lot of denial out there about the secular trend
Nevertheless, I continue to be disappointed by the reaction to this secular trend. A recent discussion of air travel in 10 years by a number of observers in the aviation industry was mostly a case of people talking their own “book”, an indication that the industry remain in denial over the looming pilot shortage.

Smart funds still underweight financials

A reader recently wrote and asked if the smart funds had reacted to the Fed’s rescue efforts of Bear Stearns et al. A check in with the analysis of Smart Funds show that they remain more underweight Financials than they ever have in the last four years, though they have somewhat moderated their underweight. By contrast, consensus mutual funds have moved to a slight overweight in the sector.

Another shoe to drop?
This posture is suggestive that the Smart funds believe that there are more trouble ahead for banks. Barry Ritholtz at Big Picture recently posted on a RBC Capital Markets research report on 5 reasons why bank stocks have not bottomed. I would also add my comment that in extreme market conditions the brokers tend to trade at about book value. Today, most are trading at 1.6 to 1.7 times book. JPM and C moved to a price/book of 1 in the recent turmoil, but they are financial conglomerates and not pure brokers.

In addition, John Mauldin at Thoughts from the Frontline wrote in his weekly newsletter that:

In an opinion letter posted on the SEC website last weekend clarifying how banks are supposed to mark their assets to market prices is this little gem (emphasis [his]):

"Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability."

…There are two problems with this rule. First, it clearly creates a lack of ransparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company. Second, can a forced liquidation or distress sale be from a margin call? Obviousy [sic] the answer is yes. but as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then they find out that the investment bank is valuing them differently on their books than the price at which they were forced to sell, there will be some very upset managers and investors. Cue the lawyers.

In other words, this is going to be a mess.

Have we quants been brainwashed by Barra (II)?

Further to my first post have we quants been brainwashed by Barra, I received a response from Jen Bender of MSCI/Barra who indicated that “it's not use of the same risk models that causes increased correlation in times of meltdown/liquidity crunch.”

I did not wish to imply that it was the common use of the Barra or any other risk model that got equity quants into trouble in August 2007. What got quants into trouble in August 2007 was the mindset of the only active risk that should be taken is stock selection, or residual risk, and that we should control for industry risk and common factor risk such as size, style, etc.

Dan diBartolomeo of Northfield wrote (italics are mine):

…it is common practice to measure risk using the assumptions of uncorrelated residuals, while using stock selection strategies that can only work if equation (1) does not hold (no factor bets). Since active mangers will be concentrating their portfolios in those securities expected to act alike in providing superior returns, the average residual covariance will be positive…Hence, if we use a risk model which assumes uncorrelated residuals we will have a downward biased estimate of the risks not identified by the factors of our risk model.

He went on to say:

One should also be particularly careful with multi-factor selection strategies where some but not all of the selection factors are in common with the risk model. In such cases, the risk model will tend to neutralize exposure to the risk factors, which will lead to the selection of a security set which are weak on the selection factors which are in common with the risk model, while having extremely high exposure to the selection factors which are presumed independent of the risk model. As such, it is easy for a multi-factor selection strategy to become dependent on a single component, defeating the purpose of the multifactor construct.

(I am grateful to George Wolfe for pointing this out to me.)

If the “stock selection alpha is the only acceptable source of alpha” mindset is becoming a crowded trade, then it’s time to move outside of that box. Goldman Sachs published a research report entitled “A Stockpicker’s Reality: Part III, Sector strategies for maximizing returns to stockpicking” in 2002 where they “examine the degree to which risk management strategies can be used to increase returns. This question differs substantially from the normal application of risk control, which is focused on tracking error rather than returns.” Their conclusion was:

- Value-driven methods are most compatible with quantitative risk management of benchmark-driven portfolios.
- Growth-driven methods are far less compatible with strict quantitative risk limits and are more effective in relatively more concentrated, less risk-controlled portfolio construction applications where risk management is handled at the asset allocation level by diversifying across managers.

In other words, different strokes for different folks. (If you would like a copy of that Goldman Sachs research report please email me. )

Sheep can make money too!

As a counterpoint to my post Channeling my inner contrarian I thought that I would write about being a sheep and the advantages of following the crowd.

A few years ago, I managed equity market neutral portfolios at a firm that was mainly known for commodity trading using trend following techniques, which are well described by Michael Covel in his book. During my tenure there I noticed that while the commodity positions were spread out among various futures contracts they often amounted to a few macro bets (i.e. on interest rates, on the US$, etc.) I came to the conclusion that these models were identifying macroeconomic trends that are persistent and exhibit serial correlation, which creates investment opportunities for patient long-term investors. For example, if the Fed is raising rates the odds are they will continue to raise rates until they signal a neutral or easing bias, i.e. there is a trend to interest rates, which is information that investors can use. The key risk in this class of models is knowing when to exit the trend, as short and long term reversals can be devastating to the bottom line.

With those principles in mind, here are some of the big macro trends that could be investment opportunities (and this shouldn’t be a surprise to most people):

• The falling US Dollar
• Worldwide inflation, especially in commodity prices
• Growth in China

The falling US Dollar

The accompanying chart shows the US Dollar Index in a multi-year downtrend (this is where technical analysis is useful as it spots long term trends). The currency is reflective of investor concerns of the current account and fiscal deficits going out as far as the eye can see and no meaningful policies to reverse them. The recent Fed actions of rescuing the system from collapse have led to some to question the Central Bank’s inflation fighting credentials, which have resulted in additional Dollar weakness. In the short term, however, the US Dollar is near the bottom of its channel and seems to be poised for a counter-trend rally.


Worldwide inflation, especially commodity inflation
Inflation is everywhere and spreading. You just have to read stories like Stop the inflation in the US and Workers strike at Nike contract factory and demanding 20% raises in Vietnam, a low-wage country that had previously been a source of deflation.

Commodity inflation is not just restricted to headline commodities like gold and oil, but is very broad based can be seen in foodstuffs (which begs the question of whether Core CPI = CPI ex-food and energy is a good indicator of inflation). The accompanying chart shows the Continuous Commodity Index (CCI), which is a continuation of the old equal-weighted CRB Index before its re-constitution to a liquidity-weighted index in 2005. The CCI has been advancing in the major non-US currencies as well as US Dollars, indicating that the commodity advance is 1) broad based and 2) independent of US Dollar weakness.





Similarly, gold prices have also been showing a similar pattern to the other commodities. Gold appears to be regaining its former status as the alternative reserve currency. As I indicated before, the US Dollar is likely to rally in the short run and gold and other commodities would run into a headwind under such a scenario.




"Peak Oil" is an additional possible bullish dynamic for oil prices
Crude oil has a possible bullish dynamic of its own in addition to the rising trend in commodity prices: Peak Oil. Much has been written about peak oil by the likes of Matt Simmons, various contributors at the Oil Drum and by many others at APSO so I won't repeat them here. If the peak oil theory is correct and world oil production is indeed rolling over, then we are in for a period of very tough adjustments in not only energy usage but in the pattern of economic growth.

Growth in China
The China growth story is well known and likely to persist. However, direct investment in China is problematical because of an ill-formed culture of corporate governance. A recent article in the FT indicates that:

Board structures at Chinese companies can lead to “confusion, ambiguity and potentially ... undermine the board of directors”, according to a study [by Risk Metrics] of the corporate governance risks faced by investors in China.

Even Hong Kong has its problems:

Risk Metrics noted minority shareholders in the two jurisdictions [Mainland China and Hong Kong] do face some common risks. The state’s firm grip over China’s largest industrial and financial companies is mirrored in Hong Kong by the influence of tycoons and their families.

Instead of investing directly into China, I would suggest vehicles such as the Korean market (EWY: iShares MSCI South Korea) as a way of participating in Chinese growth. Countries such as Japan and Korea supply China with capital goods to facilitate growth in the Chinese economy. The accompanying chart shows the relative returns of the South Korean KOPSI Index in US Dollars relative to the S&P 500. The Korean market bottomed out relative to the S&P 500 in 1997 and has been in a relative uptrend since. A trend following investor would look at that chart and say “stay with the trend!”



The key risk to this trade is that the South Korean market is generally thought as as being highly sensitive to world growth and a significant slowdown in the US could affect it disproportionately.

A secular warning for the airlines

I don’t normally comment on fundamental analysis here, despite having been a small cap analyst early in my career. However, since Mrs. Humble Student of the Markets is a pilot and has numerous contacts in the aviation industry I thought I would make an exception.

There seems to be a dearth of flight instructors in North America, largely because of the low paying nature of the job. Recently, Mrs. Humble Student of the Markets was involved in a feasibility study to bring students from China to Canada to be trained as pilots. To make a long story short, she found that there was little spare educational capacity at Canadian flight schools, largely because of an instructor shortage. The parallel situation exists in the US (and in any case the US is not suitable for foreign student flight training in the post-9/11 era.)

Why does that matter? It matters because pilots, and airline pilots in particular, need to be trained as older ones retire. This shortage of flight instructors will eventually feed into a shortage of pilots, which will shift the bargaining power of pilot unions vs. the airlines. In fact, the shortage is starting to be felt in the emerging markets, where there is not a ready supply of experienced pilots. In one instance, an airline based in an emerging market country offered a job to a recently a qualified pilot (commercial multi-engine IFR rating) as a First Officer (co-pilot) with the understanding that he would be promoted to Captain (pilot) after 500 hours of flight time. This would be the equivalent of allowing a fresh intern, one or two years out of medical school, to perform brain surgery.

Back in North America, it probably doesn’t make a huge difference in the medium term as the United States heads into recession, which would likely result in layoffs at the airlines and create a surplus of pilots. Longer term, however, the shortage of flight instructors and eventually pilots is like the plankton disappearing from the ocean – it eventually makes itself felt all the way up the food chain.

How cheap are gold stocks relative to bullion?

My recent post entitled “A short term warning for US Dollar bears and commodity bulls” must have struck a nerve. I received a torrent of responses regarding gold, gold stocks and how the US economy was going down the tank.

In response, I analyzed the question of the relative value of gold stocks compared to gold bullion. The above chart shows the ratio of the PHLX Gold & Silver Index (XAU), which has a longer history than the popular Amex Gold Bugs Index (HUI), to gold bullion. Since the line is near the bottom of its historical range, it suggests that gold stocks are a bargain compared to gold.

A synthetic gold stock tells a different story: Rising production costs
Back in 2006 I wrote a research report (How to Watch for Signs that the Gold Correction is Ending, 15 March 2006; if you are interested in the full details email me and I will send it to you) detailing how to make a synthetic gold stock.

Conceptually a mine can be thought of as a series of call options on the underlying commodity, with the exercise price as the cost of production. If the commodity price falls below the cost of production, the mine operator has the option to either close or mothball the mine until prices improve. I created a synthetic gold stock by building a model based on these principles. Key features of the model are:

• A series of eight deep-in-the-money call options on the price of gold, with terms of 1, 2, 3 … 8 years, which models a mine with an eight year life, a common estimate of long-lived gold mines;
• An exercise price equal to cash production cost of $250, rising each year by the current inflation rate. ($250 appeared to be a common estimate of cash costs for existing gold stocks in 2006);
• Equal amount of gold mined each year; and
• The position is rolled forward once a year at a cost of 1.5%.

Of course, there are some important differences between the synthetic gold stock and the actual gold stocks themselves:

• Gold miners have exploration upside and operational risk, which the synthetic gold stock does not;
• Gold mining companies may hedge the gold price with forward sales and other derivatives;
• Actual gold mines can somewhat manage the cost of production by high-grading when gold prices are low and mining a lower grade of ore when prices are high. The synthetic gold stock’s assumed cost is inflexible.
  

Production costs are rising
The synthetic tracked the actual index reasonably well until 2006 (which was, of course, the out of sample period) when the synthetic began vastly outperforming the actual index. Delving further into the model, I found that the price divergence was explained by rising production costs of shown by the actual gold miners. Recent analysis by David Galland of Casey Research confirms this trend of rising costs at major producers Barrick and Newmont.

So what’s the answer? Are gold stocks cheap or not?
Gold miners are experiencing higher costs than historical experience, which deflates the case that gold stocks are cheap compared to bullion because their margins are lower. However, higher costs can be explained either by companies mining a lower grade of ore in the current high price environment in order to preserve their reserves and asset value (which is bullish), or costs escalating out of control and squeezing bottom lines (which is bearish).

The truth probably lies somewhere in between the two explanations. Given the recent experience of NovaGold at Galore Creek, I would lean towards the latter as a more likely explanation of higher costs.

Here is a stupid question: rather than agonizing which is the correct explanation for rising production costs, why not just buy the synthetic? That way an investor can customize and control his desired risk profile and exposure to gold.

(Warning for individual investors - don't try this at home. The synthetic is a highly sophisticated instrument that even professionals can get wrong if implemented incorrectly.)

Have we quants been brainedwashed by Barra?

This is a line from Star Trek Next Generation when the Enterprise encounter the Borg and the Borg say something like:

We are the Borg, you will be assimilated – resistance is futile.

As a quant I feel like that sometimes when I encounter Barra and its software. The head of a prop desk once complained to me that everyone is using Barra and they were all getting the same solutions. So when the hedge that the software suggested turned sour, the effect was worse because it seemed that everyone else was rushing for the same exit at the same time.

There are also second order effects. Barra has taught us that the sources of equity risk are industry and common factor (style, size, etc.) and it has affected many quants' analytical frameworks. I was recently at a meeting of quantitative analysts when someone presented some equity analysis. There was general agreement was that the solution wasn’t very well-risk controlled as no self-respecting equity quant would compare two stocks (one in Autos, the other in Media) in the same sector against each other (Consumer Discretionary) as they would normalize for industry effects.

Have we been brainwashed to control risk by industry and common factor (and not much else), after being exposed to the Barra risk framework all this time or is this just another example of a crowded trade?

Comments welcome.

Smart funds still more defensive than the consensus

Was Tuesday's FOMC equity rally for real? Or should we take Wednesday's pullback as the real trend in the stock market?

A check in with the smart funds show that they are still more defensive than the consensus. Smart funds are showing a market beta that is lower than 1, or the market. By contrast the consensus funds' beta is at or slightly above 1.

There are very good technical reasons why this market should rally. It is extremely oversold and due for a bounce. However, smart funds don't seem to be convinced yet that this is THE BOTTOM. By this measure, rallies should be viewed as trading opportunities to sell into strength.

A short term warning for US Dollar bears and commodity bulls

As the cacophony of voices calling for doom for the US Dollar (and conversely a rise in commodity prices) come to a crescendo (example here) and gold tops $1,000/oz. and oil tops $110/bbl, I would like to reiterate my word of short term warning for the Dollar bears and commodity bulls. Signs of a speculative blow-off are everywhere.

Sentiment is getting a little extreme for this trade to continue too much further in the short term. Recently Bob Moriarty of 321gold.com sounded a note of caution (italics are mine):

Nothing goes straight up and nothing goes straight down. As edifying as it is to see silver and gold go up almost every day, now and again all markets take a breather.

I run a gold site and it's considered heresy to suggest commodities correct but they do. Even the lowly dollar goes in the opposite direction on occasions.

Ten days later, he hedged his earlier comment and conceded the bullish case for gold based on an apocalyptic scenario for the US economy and Dollar:

It's a time for caution. We SHOULD have a violent correction in gold and silver and the dollar based on emotion and government intervention but we could see $3,000 gold in a week or the start of a living nightmare brought to you by the Gang of Fools in Washington. No one knows.

To me, that was the first sign of a speculative blow-off in the USD and commodities. The second sign: Both Energy and Gold stocks are at or near the top of their relative uptrend channels against the S&P 500. Can they go higher? Yes. However, the relative downside risk in the near term appears to outweigh the upside rewards.

The third sign of excessive bullishness: The Commitment of Traders chart from CFTC data of large speculators in gold show that they are in a crowded long position, which is contrarian bearish:

My inner trader says that we are in the final stages of a speculative blow-off in commodities and has the potential to correct violently. My inner investor agrees with the consensus view, however, that we are in a long multi-year decline of the US Dollar and multi-year rise for commodities.

Hedge fund bodies floating to the surface

A followup to my posts on hedge fund problems here and here, I see that there are more news headlines such as Hedge funds on the brink as US Federal Reserve cash fails to ease crisis. This market is not likely to make a definitive bottom until some dead bodies (literally or figuratively) start to float to the surface. We are starting to see the bodies.

In the short term, however, there could be trouble. The Yen has strengthened against the US Dollar through the 100 level. As I mentioned before, this could portend a panic selloff.

Wall Street nursery rhymes

It's Friday. For your amusement I reproduce some of the traditional nursery rhymes adopted to a Wall Street theme that we used to recite and sing to our daughter:


The five little piggies
This little piggy put in a market order...
This little piggy put in a limit order...
This little piggy traded derivatives...
This little piggy traded cash [market]...
And this little piggy got caught insider trading and went
wee wee wee wee wee...
...all the way to Club Fed.



Old MacDonald
Old MacDonald had a farm,
Ee-ii-ee-ii-oo,
On this farm he had an investment banker,
Ee-ii-ee-ii-oo,
And a Strong Buy here and a Strong Buy there
Here a Buy there a Buy
Everywhere a Strong Buy!
Old MacDonald had a farm
Ee-ii-ee-ii-oo...


Happy Friday!

An idiot's equity market neutral fund: More on Morningstar rankings

I received a lot of feedback on my original post about a month ago entitled An idiot's equity market neutral fund, where I used Morningstar rankings to pick a series of mutual funds in order to produce an alpha. Much of the criticism centered around the use of Morningstar rankings. Numerous studies have shown that relying on Morningstar rankings alone did not produce positive excess returns and that they formed inefficient portfolios (for examples see here, here, here and here).

The key to success of the synthetic equity market neutral strategy's forecast alpha seems to be the change made in 2002 when Morningstar normalizated fund ranks within style groups. This effect was documented by a new study (Morey & Gottesman 2006). In addition, I picked relatively low cost funds with expense ratios < 1%, which should reduce any "headwind" in the process of alpha production.

Hedge fund implode-o-meter

I discovered a neat site called the Hedge fund implode-o-meter, which lists hedge fund blowups. It also shows funds on an ailing list - check it out.

As US equities continue to perform poorly and hedge funds remain highly correlated with the S&P 500, the Implode-o-meter list is likely to grow.

Yen carry trade at a critical juncture

In the last few days much has been made about the Euro going through 1.50 against the US Dollar. I am more concerned about the systemic risks posed by the recent strength of the Japanese Yen as it may lead to a rush for the exits on the Yen carry trade.

The accompanying chart is an index (31 Dec 2000 = 100) of a equal weighted basket of high yielding currencies (New Zealand Dollar, Mexican Peso, Indonesian Rupiah, Turkish Lira and Hungarian Forint) against the Japanese Yen as an pedal-to-the-metal version of the Yen carry trade. The index hit all-time highs in the July 2007 but have fallen about 14% since then and is reaching a critical technical support.

Hedge funds and currency traders who put on such trades tend to be highly levered and they are not well capitalized enough to withstand large losses. In such instances everyone becomes a technician and chart reader. I am sure that there are many stop loss orders placed just below the support line. Should the Yen strengthen further against these high-yielding currencies and these stops are hit, it would be pandemonium as everyone rushes for the exits, leading to a highly disorderly re-pricing of risk by the markets .

If that happens, this risk-avoidance contagion could very likely spread to other markets. Watch out below!