Global healing

I've been pretty bearish in the last few months, but it may be time to change my outlook. Last week, the Asset Inflation-Deflation Trend Model moved from a deflation to a neutral reading. As a confirmation of this trend, my review of the charts show a picture of global healing after the trauma last year of a near banking crisis meltdown in Europe.


Is LTRO the Draghi Put?
Most notable is the performance of the banks. The relative performance of the Banking Index shows a pattern of a rally through a relative downtrend. The ECB's LTRO program of providing unlimited liquidity for up to three years to eurozone banks has bought the politicians time and created the perception of a Draghi Put for the market. The recent relative performance of the BKX, which is heavily weighted with the large TBTF banks, is reflective of this relief.

Similarly, the performance of the Euro STOXX Index shows a pattern of global healing. Despite all of the financial stress evident in the eurozone, this index formed a wedge and the wedge resolved itself to the upside.

In addition, we have been seeing positive European price action in the face of bad news, which is bullish. I wrote last week that European banks have been testing a key support but that level has been holding up, despite all of the bad news in the last few months. Italian 10-year bond yields, which is a key measure of investor confidence, has stayed below the important 7% level in the face of the downgrades.


Inter-market analysis confirms the turnaround
Sectorally, I am seeing signs that the market expects a cyclical rebound, at least in the US. The chart below shows the relative performance of the Morgan Stanley Cyclical Index against the market, which has been rallying and is now in the process of testing a relative resistance level.

The Industrials are also showing a similar pattern of relative strength as the sector began a relative uptrend in October.

So have the Materials sector, which show the familiar pattern of rallying through a relative downtrend:

...while defensive sectors such as Utilities have lagged the market and is now in the process of testing a relative support level.

Constructive on commodities
Commodity prices are also showing signs of global healing. The chart below of the CRB Index shows that commodities have rallied through a minor downtrend and it tested the longer term major downtrend, which remains intact.

The commodity heavy Canadian market is also showing a similar pattern of rallying through a short-term downtrend, though the longer term major downtrend remains intact.

Regular readers know that I am a long-term commodity bull. These charts indicate a constructive outlook on the commodity complex. Mary Ann Bartels of BoA/Merrill Lynch recently showed that large speculators (read: hedge funds) have unwound their crowded long in commodities and readings have retreated to a level where previous bull phases have begun in the past:

Positive breadth divergence
Tom McLellan, writing at Pragmatic Capital, has confirmed my observation of a market turnaround. He wrote that the Ratio Adjusted Summation Index is showing strength:

So all of this leads us to the current RASI reading, which at +618.2 is above the +500 level but still below the peak of +763 seen on Nov. 15, 2011. So it is a divergent lower high, but it is still high enough to say that the uptrend which started in October 2011 is not over. There can be ordinary pullbacks along the way, but the message of the RASI is that the final highs of this current new uptrend have not yet been seen.

Not out of the woods yet
To be sure, it's not up, up and away here for stocks and numerous risks remain. Greece is edging closer to a default as talks with creditors appeared to have broken down. The situation in Hungary remains volatile and has the potential to take down the Austrian banking system. Just because there is a Draghi Put in the market doesn't mean that investors are immune from losses, but I would encourage investors to think of the Draghi Put as an insurance policy with a deductible where you have to incur the first X% in losses.

In addition, China isn't out of the woods. While the Chinese leadership is making noises about stimulus, the property bubble in China is deflating in a dangerous way and it is unclear whether the authorities can achieve a soft landing. The Shanghai Composite has been rallying in line with global equity markets but the index remains in a downtrend. The one silver lining for the bulls is that there appears to be a turn-of-year effect in Chinese equities. The current rally is consistent with the pattern of market updrafts seen starting at about the time of past Lunar New Years.

Since China's economy remains a major engine of growth in a growth-starved world, this is one indicator to watch carefully. The bulls can also take solace in the Hong Kong market, which formed a wedge that resolved itself to the upside recently:

In addition, Nomura believes that Chinese real estate may be in the process of forming a bottom. The firm's analysts pointed to a positive divergence between land purchased by property developers and new construction activity:

Cautious short-term, constructive medium term
Putting it all together, what does this all mean?

My inner trader tells me that in the short-term, the rally looks overdone. Over the next few weeks, continue the strategy of buying weakness and fading strength. Indeed, Macro Story confirms a high risk level for equities by pointing out that AAII sentiment is at a bullish extreme, which is contrarian bearish.

With US equities now testing a resistance level, expect some short-term weakness but be prepared to buy the dips:

Longer term, my inner investor tells me to expect a period of sideways consolidation, likely followed by a bull phase in equities with an expected return of 5-15% in 2012 - assuming that there are no accidents.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Which Merrill sentiment indicator to believe?

A former Merrill Lynch colleague pointed out to me last week that the Sell Side Indicator, a contrarian indicator based on the average recommended equity weighting of Street strategists, is edging towards a buy signal:

The record of the Sell Side Indicator has been fairly decent:

On the other hand, Surly Trader also pointed out that the bull-bear ratio based a survey of institutional managers compiled by BoA/Merrill Lynch is flashing a sell signal:

Which sentiment indicator should we believe? It's hard to be a contrarian investor when two sentiment indicators tell completely different stories.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The ECB's exclusive party

I came across this chart from Bank of America/Merrill Lynch showing how central bank balance sheets have expanded

The report states that balance sheet expansion does not necessarily represent quantitative easing, but the result of liquidity operations such as LTRO:

The ECB’s balance sheet quietly reached a record size of €2.7tn in late December, with a growth of over 40% in the past six months. Both the size and pace of the balance-sheet expansion have attracted the market’s attention since the start of 2012. Questions have been raised as to whether such an expansion should be regarded as quantitative easing or not. We highlight below that the ECB’s bond purchase program was not the major driver of the expansion but that, instead, increased bank borrowings played a more important role. Also, we note that unlike the Fed, the ECB does not have full control over the size of its balance sheet. The latter could continue to grow in the coming months but it could also shrink on lower reserve requirements and improved funding conditions.

Such liquidity operations they are. Joseph Cotterill at FT Alphaville pointed out that banks can now get instand and unlimited liquidity by issuing themselves unlisted bonds and then use those bonds as collateral at the ECB:

[W]e said the ECB’s decision in September to accept unlisted bank bonds — i.e., bonds that the banks could have issued purely to themselves solely in order to pledge them as collateral for central bank funding — was “potentially very significant”.

Is this an exclusive party, by invitation only?
It's obvious by now that the ECB is throwing a liquidity party. What's more significant, like the Sherlock Holmes story about the dog that didn't bark, is that we haven't heard a thing from the Germans despite the rapid expansion of the ECB balance sheet and tsunami of liquidity unleashed on the market.

The effect of this liquidity pump has been to support European banking system. A look at the Euro STOXX 600 Banking Index shows that, despite Unicredit's well-known troubles with its share price, the index is testing a critical support level.

These developments begs a couple of questions:

1. Are European banks a screaming buy at these levels? The extraordinary intervention of the ECB has taken the risk of a catastrophic banking failure off the table.
2. Why aren't there more institutions at the ECB's party? The last LTRO auction saw 523 banks at the ECB's party. In the wake of the Lehman Crisis, the Fed's liquidity dump saw everybody and his brother turn themselves into banks to feed at the Fed and the Treasury's troughs. In today's Europe, why haven't we seen more institutions of financials and near financials, e.g. Allianz, Munich Re, the finance arm of auto companies, brokerage firms such as the European operations of Goldman Sachs, even hedge funds, etc., turn into banks to avail themselves of cheap LTRO money? Is the ECB throwing a highly exclusive party, by invitation only?

The answer to question 1 depends on the answer to question 2.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Distilling alpha with factor betas

One of the hardest questions any portfolio manager has to answer is, "What can go wrong with your strategy?" If he doesn't know, then it's a sign that he hasn't fully thought out all the nuances of his investment approach.


How to untangle alpha using factor betas
Here is one example of how I used to evaluate investment strategies when I worked at and with hedge funds.

A couple months ago, we were approached by an experienced bond portfolio manager with an idea for a bond strategy for the Canadian market. The idea involved overlaying a call option writing strategy on the US Treasury market on top of a Canadian bond portfolio. The resulting portfolio had the following benefits:

• Same duration exposure as the benchmark, i.e. no significant interest rate directional bets;
• Higher credit quality compared to the benchmark
• Significantly higher realized return than the benchmark

I interviewed the portfolio manager and found out that the most significant risks of the strategy are, in no particular order:

• Basis risk between the US and Canada yield curve
• Currency risk
• Volatility risk as it relates to option pricing

Disaggregating the alpha using factor betas
He had been running a "live" paper portfolio in real time for a little over a year. The backtest looked good as it added an alpha of over 3% in that period. Given my assessment of his risk exposures, I wanted to see whether the outperformance was the result of a favorable factor beta exposure, i.e. the strategy bet on a certain kind of exposure and it worked, or the alpha was relatively independent of factor beta.

We got the weekly returns of the paper portfolio and I made the following table:

I averaged the weekly alpha of the strategy under different scenarios. On the first line, I asked, "What is the average weekly alpha when the US long bond price is up, down or relatively flat?" In that case, the strategy underperformed when the long bond rallied, largely because it was selling call options at the long end of the yield curve and the premiums weren't enough to offset the gains in bond prices, and outperformed when the long bond price was either flat or falling.

Similarly, I performed other forms of scenario analysis. What happens to the alpha when the Canada and US curve diverge? What happens when implied stock volatility (I didn't have a good proxy for bond volatility) moved up or down?


Stress testing factor beta exposures
I used scenario analysis to project an annual alpha. The average case analysis assumes a Gaussian distribution where 50% of the time exposure to that factor beta is neutral, 25% of the time it is favorable and 25% of the time unfavorable. Using the example of the long bond price factor, I calculated an expected alpha assuming that 25% of the time, the bond price was falling, 25% of the time it was rising and 50% it was neutral. In this case, that came to an expected alpha of 3.90% per annum.

I wanted to stress test the strategy some more. What if the market gods aren't with us?

In the second column labelled "Adverse Case", I assigned weights of 50% neutral, 33% unfavorable and 16% favorable. Using the example of the long bond price factor, the expected alpha came to 0.80% per annum.

What happens if a catastrophic scenario? In the third column labelled "Worst Case", I assigned weights of 2/3 neutral, 1/3 unfavorable and 0 favorable. (Remember that these are weekly alphas and it would be difficult to believe that, in the case of the long bond price, it would fall for a single week in an entire year and would be rallying 17 weeks out of 52 weeks in the year.) The expected alpha in the worst case analysis for the long bond price factor came to -2.13%.


Conclusion
Putting it all together, the strategy looked pretty good. We could expect an alpha in the order of 3.0-3.6% a year - which is an astounding figure for a bond portfolio. In a typical bad year, we could still expect outperformance of 0.8% to 1.8%. If the roof caved in and everything went wrong, alpha deteriorated to between -2.1% and a positive 0.2%.

This is an example of a simple method of evaluating any investment strategy using scenario analysis with factor betas. This is another way of asking the question, "What can go wrong with the investment strategy and how badly could things fall apart?"

Ultimately, we passed on implementing the strategy not for investment reasons, but for business ones. If anyone is interested in further details or in funding such a bond strategy, please contact me at cam at hbhinvestments dot com and I will be happy to refer you to the bond manager.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Will good news be good or bad news?

In the wake of the "beat" by the ADP release and as traders wait for the Non-Farm Payroll figures due out at 830 Eastern Time, here is something to ponder.


Is good news (better growth) good news or bad news?
The most recent string of economic releases have been pointing to an American economy that is growing, albeit slowly at a 1-2% real rate of growth. The WSJ reports that primary dealers are expecting that QE3 is on the way:

The primary dealers also see a 60% chance of the Fed adding to its System Open Market Account holdings — embarking on QE3, in other words — in the next two years. That also gibes generally with what many on Wall Street seem to expect.

In addition, Zero Hedge has reported that Deutsche Bank believes that the market has discounted $800b in QE3:

Analyzing historically the reaction function of real rates to QE announcements, we find that USD19bn of new QE tend to reduce real rates by 1bp. Based on this estimate and on the model dislocation, we find that the 10Y real yield was fully pricing in Operation Twist in September and that since then the dislocation has increased to price in another full QE package, similar in size to QE2, of about USD800bn (excluding reinvestments of maturing agency and MBS holdings).

Here's the Big Question: Supposing that the high frequency economics releases are right and GDP is growing at a 1-2% rate. Wouldn't that restrain or delay QE3? (As an aside, star bond manager Jeff Grundlach said during the Q&A after yesterday's presentation that he doesn't believe that we will see QE3 between now and the election.)

How will stocks react? Positively because organic growth is rising, or negatively because the Fed won't be unleashing a tsunami of liquidity that accompanies quantitative easing?

Are the markets already to price in such a scenario? Ed Yardeni wrote that while the Street consensus revenue estimates have been ticking up, earnings estimates have been falling. This sounds like an environment of good news is bad news for the markets and bad news is good news.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

A stark reminder of the north-south eurozone divide

The FT had an interesting article highlighting the north-south divide in the eurozone:

The starkly contrasting economic trajectories of countries inside the eurozone were highlighted on Tuesday as Germany reported unemployment at 20-year lows while Spanish jobless figures rose for the fifth consecutive month.

Moreover, there is an interactive graphic in the article showing the different unemployment rates by country.

While the latest eurozone seasonally adjustment unemployment rate is 10.3%, compared to 10.1% a year ago, there are vast gaps in unemployment rates between member states. Most notable are Germany at 5.5% (vs. 6.8% a year ago), the Netherlands at 4.8% (vs. 4.4%) and Austria at 4.1% (vs. 4.2%). The underperforming PIIGS are suffering vastly higher unemployment, with Greece at 18.3% (vs. 13.9%), Ireland at 14.3% (vs. 14.2%), Portugal 12.9% (vs. 12.3%), Spain at an astounding 22.8% (vs. 20.5%) and Italy an outperformer at 8.5% (vs. 8.4%). As a point of reference, the unemployment in France, which is the other major partner in the eurozone leadership, stands at 9.8% (vs. 9.7%).


How badly will austerity bite?
Please note that these unemployment figures are dated October 2011, before the full brunt of many announced austerity programs have been felt. As the effects of these cutbacks start to wind their way through these economies, will unemployment go up or down?

How long before the elites are faced with a political backlash?

The Guardian reported that the new Greek government is fed up with new demands and playing a game of brinkmanship again [emphasis added]:

Greece was promised a second emergency bailout worth €130bn (£108bn) in October after it became clear that the first rescue package, agreed in May 2010, was not enough to stabilise its debts.

But talks about this second deal, including a writedown for Greece's private-sector lenders, are still continuing. Kapsis told Greek television: "This famous loan agreement must be signed, otherwise we are outside the markets, out of the euro and things will become much worse."

Reports have emerged since the weekend that the troika could demand fresh austerity measures from Athens in exchange for a new loan to ensure that it meets its targets for reducing the deficit. But Kapsis also said imposing more cuts on a recession-hit nation could be very difficult.

They have threatened to leave the euro within three months unless they get relief:

The Greek government has stepped up the pressure on its eurozone paymasters by warning that unless a new bailout for the recession-hit country is agreed within the next three months it will be forced out of the single currency.

No doubt much of this rhetoric is typical of the posturing that goes on in negotiations, but as austerity programs begin to bite all over Europe, investors will start to worry about and price in the tail-risk of social upheaval and political instability.

The ECB's LTRO program of unlimited liquidity has bought the politicians some time. Don't be too surprised if that window of time may be shorter than expected.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Buy the dips & sell the rallies

I recently wrote that 2011 was a choppy market where it was very difficult for institutional investors to beat the market and for hedge funds to make any money because of the tendency of the market to whipsaw. In that case, my inner trader has observed that there is potential for nimble traders to profit from trading the swings of a range-bound market by buying the dips and selling the rallies.

The chart below shows the relative performance of SPY, which represents US stocks and the risk-on trade, against TLT, which represents long Treasury bonds and the risk-off trade. I have overlaid on top a short horizoned RSI indicator of 7 days. Note how it has been profitable to sell stocks and buy bonds when RSI approaches the 60-65 level and buy stocks and sell bonds RSI goes below 30.

Where are we now? With the opening day rally yesterday, the SPY/TLT 7-day RSI stands at 55, which is very near the sell zone for stocks, indicating that the upside is limited - unless you believe that stocks are on the verge of a major upside move.

My short term liquidity measures is also telling my inner trader to sell this rally. Measures of MZM growth are flattening out, which is generally not conducive to a sustainable equity rally, after an uptrend that largely coincided with QE2 earlier last year.

This chart of the growth of broader monetary aggregates also tell the same story. Money supply growth is now either flattening out or decelerating after a period of acceleration that began in mid-2010. Everything else being equal, an environment of slowing money supply growth usually provide headwinds to further advances in equity prices.

My inner traders is telling me that the upside in stocks is limited at these levels and to fade this rally, but to be prepared to buy the dips.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Have a plan for 2012

Sometimes the investment process is more important than the investment decision. In the past few days, I have outlined:

• My bull and bear cases for the stock market (see The road ahead: bull & bear case);
• The difficult environment for active managers (see A terrible 2011 for hedge funds); and
• How it's likely to change (see Back to fundamentals in 2012).

I urge all investors to have a game plan for the year ahead and beyond. Despite all of our best efforts, our forecasts can and will fail and how you react to the change in direction is more important than the decision you take today.


Strategies for different parts of the cycle
Barry Ritholz recently showed a series of charts of the economic cycle and how investors should react to them, two of which I show below. However you approach the market, whether it's asset and sector rotation, or stock picking, recognizing your investment environment is key to alpha generation. This chart shows the analytical framework for the asset and sector rotators:

And this one is a framework for the stock pickers:

Be tactically aware of the investment environment
My approach is to become more tactical in my asset allocation using my Asset Inflation-Deflation Trend Model. An article in Registered Rep shows how many investment advisors are turning to tactical asset allocation as an investment solution to dampen portfolio volatility:

Following the twin market implosions of the past decade—first tech, then real estate—many retail financial advisors are looking for more tactical, meaning active, asset allocation solutions for client portfolios to dampen volatility, improve total returns and avoid market catastrophes. At least some of them fear that if they don’t dramatically change the way they allocate client portfolios, moving away from traditional buy-and-hold investing strategies, they could lose clients. So say a handful of advisors and an investing expert. 

Not becoming more tactial could pose a business risk:

Things could get especially bad if another bear market hits, says Ron Carson, founder and CEO of Carson Wealth Management Group. “[Investors] are hanging on by a thread right now, and I don’t think they’re going to forgive.” A Natixis Investor Insights Study found that 63 percent of investors are now paying more attention to risk than ever before. If the market nose-dives, advisors are going to want to have a different story to tell. They can’t just tell clients to hang on and wait it out like many of them did in 2008.

The movement to tactical asset allocation has turned from a trickle to a flood:

According to a survey by Cerulli Associates, the number of FAs using either a pure tactical allocation or strategic allocation with a tactical overlay is now at 61 percent, up 8.3 percent from 2010. A Jefferson National survey from September 2011 found that 75.5 percent of advisors believe that active portfolio managers can outperform an index over the long term. In Jefferson National’s 2010 survey, 66 percent of advisors said clients were more confident with a tactical asset management strategy, while only 34 percent said clients were more confident with a traditional buy-and-hold strategy.

Are you betting the farm?
Stocks didn't go anywhere in 2011. In fact, they haven't gone anywhere since the NASDAQ peak in 2000. In the current low-return environment, advisors find that clients are less forgiving of draw-downs in their portfolio.

In days past, the practice of overweight a portfolio with a manager to make a big style or macro bet that "looks through the economic cycle", e.g. a value manager, was perfectly acceptable. The downside to managers that make such style bets is they tend to badly underperform during certain periods when their style is out of favor - and investors are far less tolerant of such draw-downs in the current volatile and low return environment.

As an example, there were numerous managers who were wary of internet stocks during the Tech Bubble runup. I had watched many good managers and strategists go down in flames because they were one or two years early because their investors couldn't stand the underperformance. Today, investors are highly intolerant of negative volatility, largely because of the low return environment that we have been stuck in for the last decade.


Have an investment plan
The message is clear. Take control of your portfolio. Be aware of the investment environment. Your investment philosophy and objectives are up to you. However, you should make sure that you have engineered your portfolio's risk profile sufficiently so you survive to get to your objective.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Back to fundamentals in 2012

Imagine playing a football game in a driving rainstorm on a muddy field. Players slip and slide all over the place. The quarterback has trouble throwing the ball. Receivers can't grip thrown balls. Running backs are virtually skating on the field and can only occasionally get good footing. Kickers can't judge the wind as it shifts at a moment's notice.

That was the story of disappointing returns in 2011 for many hedge fund and active investment managers, which I wrote about last week.

Consider the experience of star hedge fund managers like Mark Kingdon and John Paulson, who can be described as the proverbial smartest guys in the room. The Wall Street Journal reported that Kingdon and Paulson were whipsawed by the market action in 2011:

Like other high-profile investors, Kingdon has been whipsawed throughout the year by stock market swings that have been hard to predict, turning on a dime. John Paulson (who had a terrific 2008) has had the most humbling year of his own storied career, with his largest funds sinking in value amid wrong-headed bets on an economic recovery.

Indeed, the chart below of the S+P 500 shows that the stock market was trendless in the first half of the year and trendless and marked by extreme volatility in the second half. Investable swings, shown in red, were few in number. Many of the swings seen in the second half, shown in green, lasted less than a week – and woe to anyone who tried to invest on news flow in the second half as whipsaw would be the inevitable result.

 

 
2011 was an extremely unfriendly environment for investment managers because politics and policy, not fundamental and economics, drove market returns. The market began to worry about an extreme tail-risk, or black swan, event such as a Lehman-like crisis in the second half of 2011. Every news headline moved the markets and it, in a binary risk on/risk off framework, it was virtually impossible for an investment manager to discern direction.
 
It is therefore no surprise that managers with the freedom to be long or short performed poorly in 2011 because of the lack of a trend, or direction in the market. On my previous post, I showed that the worst performing hedge fund managers were Market Directional, Equity Hedge, or long-short equity managers, and Fundamental Value.
 

Bimodal distributions and multiple equilibria

Like the metaphor about the football players, the reason why hedge fund managers had disappointing returns in 2011. The environment was unfriendly to their approach. Like the football players, it didn’t matter how skilled they were, they kept slipping in the rain.

That’s because most managers are trained to focus on fundamentals and economics while largely ignoring politics. In a year where politics and policy decision dominated the investment environment, it is no wonder that managers showed disappointing returns.

Moreover, the investment term “multiple equilibria” or “bimodal distribution” began to pop up in year-end letter to investors. As an example, Pimco manager Vineer Bhansali wrote about this topic in an article entitled Asset Allocation and Risk Management in a Bimodal World. In the article he wrote:

For example, the policy risk that pervades the markets today causes high correlations among asset classes and a temperament of “risk on/risk off” among investors. This phenomenon can be traced to the connectedness of markets, the ease by which market participants can access these connected markets, and the speed of assimilation of information in response to political events. (See V. Bhansali, The Ps of Pricing and Risk Management, Revisited, Journal of Portfolio Management, Vol. 36, No. 2, Winter 2010.) This environment creates the possibility of multiple equilibria in the market, as well as trends that move markets between these equilibria, and once settled, restraining forces that trap markets in those equilibria (See V. Bhansali, Market Crises -- Can the Physics of Phase Transitions and Symmetry Breaking Tell Us Anything Useful?, Journal of Investment Management, 2009).

Even though predicting which force will win is next to impossible given the real-time evolution of the interaction between markets and policy, we can still ask an important question: What would happen if the distribution of returns from a hypothetical portfolio looked more like the one shown in the chart on the right of Figure 1, i.e. a “bimodal” distribution with more than one peak? The bimodal distribution has two peaks, and interestingly, even though it is generated as the result of mixing two normal distributions, each from a different regime, it can exhibit both fat tails (a higher probability of larger losses due to unusual events results in a “fat tail” on the left side of the distribution curve) and skewness (a lack of symmetry between the left and right sides of the peak).

In other words, classical investment theory posits that investment returns follow a bell-shaped distribution, like the figure above on left. In the current environment where investors oscillate between a “risk-on” and “risk-off” trade, the true distribution may look like one with two peaks like the figure on the right. Under these circumstances, techniques used to manage funds assuming a bell-shaped distribution will not work in a multiple equilibrium world (like 2011).



The outlook for 2012
What happens now? Will the environment of 2011 persist into 2012 and the future?

The market should return to focusing on fundamental and economics in 2012. The financial market was largely driven by European news in 2011 as it was concerned the possibility of a Lehman-like market crash. When the news flow indicated that the Financial Apocalypse might be near, stocks sold off. When the European governments tabled a plan that indicated that the day of execution might be delayed, the markets rallied.

The events of 2008 are instructive for evaluating the current market environment. In 2008, the markets were concerned about the housing collapse and its effects on the markets and economy. Fast forward three years, the problems with the US housing market hasn’t gone away, nor have the concerns about the weakness of the American consumer and his balance sheet. But the fear of another Lehman-like Apocalypse in the United States is gone today.

Similarly, the ECB’s Long-Term Refinancing Operation (LTRO), which offers to lend eurozone banks unlimited amounts of money for up to three years, has largely taken the risk of Lehman-like event off the table. The long term problems of over-indebted eurozone sovereigns, weak European banking system and the competitiveness and productivity gap between Northern and Southern Europe remains.

Is the panic getting overdone? Probably. Given that the ECB has taken the market crash scenario off the table, the markets can now go back to focusing on what matters, such as earnings, growth outlook, interest rates, etc.
 
Under these circumstances, fundamentally driven investment strategies that depend on traditional techniques such as valuation, growth, momentum and trend spotting are likely to perform better in 2012 and beyond.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The road ahead: bull & bear case

As 2011 draws to a close and we 2012 dawns, it's time to consider the bull and bear cases for the stock market and risky assets. I had already outlined my bull case for the market on December 19 (see The bull case for stocks). The bull case consists of:

• The coordinated central bank liquidity injection of November 30 has taken a Lehman-like event off the table.
• In the US, the Fed does QE3 in the 1H, which would send asset prices flying.
• In Europe, the ECB is already engaged in a form of QE though the back door using LTRO, which should heal banking balance sheets over time.

Go and read my previous post, there is little more to be said.


The bear case for stocks
From a macro viewpoint, the three regions to watch are Europe, the US and China and the emerging markets. The market was focused on the possibility of a European banking crisis during much of 2011. No, the bear case for stocks in 2012 does not rest with Europe. I believe that market's focus will shift from Europe to the other regions of the world in 2012.


Europe: From heart attack to cancer
The ECB's LTRO program, which offered banks unlimited liquidity for up to three years, has virtually eliminated the possibility of a banking failure. In addition, coordinated central bank intervention that offered unlimited USD liquidity also showed that central bankers around the world are well aware of the risks of a Lehman/Creditanstalt credit event and have taken steps to address the problem. Nevertheless, problems remain and all Draghi & Company has done is bought time for the politicians to address the long term issues.

What is the market saying about Europe? Scott Grannis wrote in his PIIGS Update that conditions in the bond market are normalizing, though far from ideal. The ECB's balance sheet expansion does not appear to be leading the eurozone down the hyperinflation path, but problems remain. In other words, Europe has gone from avoiding the imminent heart attack to a lingering but treatable cancer. We will have to watch and see how the politicians address the longer term problems of the competitiveness disparity between North and South, as well as the debt situation of the PIIGS. No doubt, we will continue to have crises and summits, but the risk of a catastrophe is lower than it was in 2011.


A US recession in 2012?
One thing that investors shouldn't forget that stock prices depend on fundamentals, i.e. earnings, growth outlook, interest rates, etc. An American recession would affect the outlook for earnings and therefore depress stock prices as a result. The question for the bears is, "Will the US experience a recession in 2012?"

Certainly, a recession would not be out of the question here. This post from Pragmatic Capital shows that the US was in recession 18.3% of the time in the 2000-2011 period and a whopping 30% of the time if you consider the 1855-2011 time span. The likes of ECRI and John Hussman have been trumpeting their recession forecasts for the American economy. On the other hand, recent economic releases have largely been coming in ahead of expectations, which point to an economy with subpar growth, but no signs of a slowdown.

Should the US experience a recession, the S+P 500 could easily fall to the 900-1000 level, though it is unlikely to revisit the post-Lehman panic low of 666.


Watch out for China
I believe that the bear case for stocks rests largely with China and the emerging markets. I wrote on December 13 to watch for the China is slowing stories to emerge (see A "China is slowing" scare?). Whether China slows to a hard landing, i.e. sub-5% growth, or not is less relevant to the markets as the scenario of the markets starting to discount the possibility of a Chinese hard landing.

Since I wrote that post, the scare stories are starting to appear. Consider:

• Patrick Chovenac: China Data, Part 1A: More on Property Downturn
• Zero Hedge: China insolvency wave begins, Nation's biggest provincial borrowers defer loan payments
• Pragmatic Capital: Understanding China's property bust
• Advisor Perspectives: Vitaliy Katsenelson on Krugman's missed call (and China's pending property crash)

I could go on, but you get the idea. More worrying is the fact that other analysts are starting to pile on, not just the China is slowing story, but the prospect of slowing growth in the emerging markets. As an example, Stephen Roach recently penned an article entitled Why India is riskier than China.

I wrote here that the stock indices in India and China are not behaving well. I believe that the biggest risk for the stock markets is a rising level of risk aversion as investors price in the increasing likelihood of a slowing growth from the emerging market economies.


Listen to the markets
In the end, I stand with the bears on the recession, or economic slowdown, call. Commodity prices remain in a downtrend, which is a signal of slowing global demand for raw materials.

The CRB Index is liquidity weighted, which means that it is more energy heavy. As you can see below, oil prices have been behaving relatively well lately.

We can get a even better picture of global commodity demand from the Continuous Commodity Index, which is the CRB Index on an equal weighted basis. The picture of the CCI looks even worse than the CRB as it has undercut its October lows and remains in a well-defined downtrend.

As well, you can tell a lot about short-term direction by the way the market responds to news. In the past couple of weeks, we saw a couple of important signs that much of the good news is priced into stocks. The first occasion occurred when the market sold off in the aftermath of a better than expected LTRO at €489 billion. The second was when it sold off again when Italy sold six-month bills at yields that were roughly half of what they were in November.

When the markets go down on good news, the bulls should be wary. In addition, signs of a global slowdown are on the horizon.

That's why I stand with the bears.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

A terrible 2011 for hedge funds

I started this blog four years ago and my first post was about how hedge fund returns have been correlated with stock returns. That correlation hasn’t changed.

That’s because hedge funds and stocks are all part of the risk trade. Hedge funds take risks and so do stock investors. In the current environment where the market oscillates between “risk-on” and “risk-off”, it’s not unexpected that hedge funds returns be correlated with stock returns. The chart below shows the returns of the HFRX Global Hedge Fund Index, which is a representative index of all investable hedge funds, compared to the S+P 500.

Even though hedge fund returns were correlated to the S+P 500, the above chart shows that they tended to be less volatile than the S+P 500. What that means is that when stock returns are down, hedge fund returns should be counted on to be down less and beat stock returns. In 2011, the chart below shows that they didn't and lagged the S+P 500 instead.

A funny thing happened in 2011. First of all, hedge funds had a terrible year as they substantially underperformed the S+P 500. On a year-to-date basis to December 16, 2011, the HFRX Global Hedge Fund Index was down -9.0% after fees compared to -1.3% for the S+P 500.

The negative performance occurred across the board. The chart below shows the YTD returns of the various HFRX sub-indices. The Global Index was down 9.0%, but every single category of hedge fund returns underperformed the S&P 500.

The poor performance of hedge funds in all categories is illustrative of the headwinds faced by active managers in 2011. Nothing worked!

Two categories that performed particularly poorly were directional strategies, namely Market Directional and Equity Hedge, which allowed a manager to go long or short. Fundamental Value was the laggard at -23.6% for the year.

The carnage in hedge fund performance can be seen anecdotally from the headlines. John Paulson's Advantage Plus flagship fund's performance through December 16 is down -9% in December and -52% on a YTD basis. Legends like George Soros exited the business of managing money to focus on his own funds. I could go on, but you get the idea.

I am working on a much longer post analyzing why hedge funds performed so poorly in 2011. More on than later.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

The ECB's non-party: What does it mean?

What happened? The ECB throws a party but no one shows up?

The size of ECB's LTRO was far ahead of expectations at €489 billion (see my previous discussion here). That should have been bullish, right? Instead:

• The EURUSD exchange rate fell
• Yields for Spanish and Italian debt rose across the yield curve
• Shares of key troubled banks (SocGen, Credit Agricole, Comerzbank, Intesa and Unicredit) are mostly down on the day
• European stocks retreat and US stocks retreated but rallied to finish the day roughly flat

Why?

There are a number of plausible explanations for the market reaction, but they could amount to little more than rationalizations. First, the EBA effectively nixed the carry trade by requiring banks to mark-to-market, so much of that €489 billion amounted to liquidity injections into the eurozone banking system. If the banks need that much liquidity, what could they be hiding? Or does this just show that the European banking system is just getting by on ECB life support?

Ambrose Evans-Prichard wrote that the size of yesterday's LTRO wasn't enough:

Roughly €300bn of today’s eagerly awaited LTRO tender is recycled old money from earlier support operations. The new money is €200bn. This alone is not going to shore up the sovereign states of southern Europe as they grind deeper into recession/depression.

He wrote that European banks need to shore up their Tier 1 capital base to the tune of "€2.5 trillion adjustment according to the BIS’s Global Stability Board". In addition, "Eurozone sovereigns must raise €1.6 trillion in 2012, and banks must raise another €700bn."


The LTRO was a liquidity injection operation that took a Lehman-like event off the table. Maybe the markets are now finally focusing on what typically matters, such as earnings, growth, interest rates, etc. and it didn't like what it saw? Indeed, Christine Lagarde of the IMF warned emerging market economies to prepare for a downtrun in Europe.

 
A glass half-full
Putting on my technician's hat, I would say it doesn't matter what the explanation or rationalization is. The market's inability to rally on good news, namely €489 billion in QE from the ECB, has to be interpreted bearishly.

When I look at the one-year charts of most markets, I see the charts mostly forming triangles indicating indecision. The direction of the next break will likely determine the next intermediate term move. This chart of ACWI representing the All-World Index is a typical example.
 

 
Going around the world, a similar pattern can be found in the US stock market:
 

 
..the UK market:
 

 
...and the European market:
 

 
 
A bearish tilt
There are clues of which way the market might break. Much the evidence points to a bearish break. For example, commodities are in a downtrend. If there was a triangle, they experienced a downward break in early or mid December:
 

 
Similarly, the yield on 10-year US Treasury note shows a similar pattern of a downtrend and break downward in early to mid December:
 

 
The commodity sensitive Canadian market is also not behaving well.
 

 
The Chinese market, as represented by the Shanghai Composite, has broken down decisively and is in a well-defined downtrend.
 

 
In sympathy, Hong Kong experienced a downside break in its triangle in the last week.
 

 
India isn't behaving well either.
 

 
The South Korean KOSPI experienced a downside break recently, but that could excused because it could be viewed as a special case of a market reaction to geopolitical tensions.
 
 
Bullish data points are few
To be sure, the picture isn't entirely bearish and there are a couple of bullish data points. The Brazilian market rallied above a downtrend line in October.
 

 
The Australian All-Ords Index is showing a similar pattern of broken downtrend and sideways consolidation.
 

 
Both Australia and Brazil are major supplier of resources to China. So these chart patterns must be regarded as somewhat supportive that a hard landing may not be in the cards for the Middle Kingdom.
 
However, the weight of the evidence suggests that while the trend breaks have not shown up definitively, the bias for the next intermediate term move is to the downside.
 
 
 
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

ECB's LTRO experience a cautionary tale for the Fed

The markets have been anticipating the onset of QE3 by the Federal Reserve. Indeed, Deutsche Bank believes that the market has already discounted $800 billion in QE3 purchases, which is anticipated to be concentrated in Mortgage Backed Securities (MBS).

Recall how the focus on MBS came about. QE2 involved $600 billion in the purchase of Treasuries, which pushed down the Treasury yield curve, flooded the system with liquidity and prompted investors to take more risk. The net effect of QE2 was to push up stock and commodity prices, but didn't do very much for the real economy. In effect, it found that it was pushing on a string. In response, the Fed wanted to concentrated on risk premiums where it mattered, such as mortgage rates, in order to stimulate the housing market. Thus the impetus for QE3 was born. Target MBS, it was said, and you will push down the cost of home ownership and stimulate housing.


Watch out for unintended consequences
The European Central Bank is currently conducting a Great Experiment with its LTRO (Long Term Repo Operation), where it is offering unlimited amounts of three year liquidity to banks, collateralized by paper with credit ratings as low as Single-A.

There was some hope that LTRO would prompt banks to put on the carry trade. Borrow from the ECB at 1%, buy PIIGS debt at 5% or more and earn the carry (see my discussion of LTRO here). The banks repair their balance sheets. The sovereigns get access to loans. Everybody wins!

The program has resulted in some unintended side-effects. Izabella Kaminska at FT Alphaville wrote that LTRO has created a two-tiered market for collateral and the two markets are diverging:

Simply put, back in the pre-crisis days the two markets worked in tandem. Participants engaging with the ECB did not differentiate on the type of collateral they delivered to the ECB versus the type of collateral they held back for use in private funding markets.

The crisis changed all of that.Suddenly the cheapest collateral to deliver became the collateral of choice for ECB use. The most expensive or ‘quality’ collateral was held back for use in private markets.


A tale of two collateral markets
This is how central bank transmission mechanisms began to be compromised.

The private funding markets, dictated by interbank participants, could from now on only be influenced by large quality collateral holdings — which the central banks increasingly lacked. The public funding market, dictated by central banks, became the domain of trash collateral — which no one really cared about.

The central bank monopoly on the ultimate cost of money thus became based around access to trashy collateral, not quality collateral — which remained the preferred funding option for private markets.

Unfortunately, it’s private liquidity which ultimately determines the scale and depth of the eurozone crisis — and it’s in this market where ECB influence is waning.

Lead a bank to liquidity, but you can't make it lend
In other words, you take your junk lower quality paper to the ECB and you reserve your high quality collateral (e.g. bunds) for the private repo market. The problem is that the private repo market continues to seize up because of a lack of high quality collateral and a rising sense of risk aversion over counterparty risk, i.e. you don't trust that you are going to get paid back so you demand really, really good collateral.

No matter how the ECB steps in to inject liquidity into *ahem* second-tier debt market, Kaminska wrote that the market has lost confidence and there is little the ECB can do [emphasis added]:

Private markets must be convinced to lend unsecured or invest money in more than just the last few remaining AAA bond markets.

But as they say, you can lead a horse to liquidity but you can’t make it drink. Which is a shame, because that’s the main problem the ECB and other central banks are now facing: they are leading banks to liquidity but they can’t make them lend in private markets.

The ECB's experience with LTRO should be a cautionary tale for the Fed as it considers a QE3 program of purchasing MBS. You can lead a market to liquidity, but you can't make lenders lend and borrowers borrow.

Beware of unintended effects, Mr. Bernanke.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
 
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 article 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 Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.