Humble Student turns one

This blog, Humble Student of the Markets, turns one this weekend.

Even though I now live in Canada, on this US Thanksgiving long weekend I would like to reflect upon my personal journey for the past couple of years and how Humble Student of the Markets came into being.

I left Merrill Lynch in early 2007 after 27 years of involvement in the financial markets. My intention was to spend some time to decompress and enjoy some time with my wife and daughter. In my farewell email to friends and colleagues entitled Cam really is leaving to spend more time with his family, I quoted Todd Harrison of Minyanville:

I'm not going to say that success is insignificant, we know that's not true, but I can tell you, from experience, that if you look for happiness in a bank account, you're missing the bigger trade.

The first few months were great. However, I discovered that I still had a market analysis itch that needed to be scratched. There were too many things that I wanted to say and didn't know who to say it to. The result was this blog. I began to write for myself, with no expectation that anyone would even read it.


On humility
I named this blog Humble Student of the Markets for a couple of reasons. First, we are all mere students of the market, regardless of our experience level. Moreover, if an investor isn't humble - the market will eventually make him that way.

Little did I know what a tumultuous year this would be. This past year has seen upheavals that would be worthy of telling my grandchildren about.

As I began my hiatus from financial services with a Todd Harrison quote, I would like to add another one of Todd Harrison’s pearls of wisdom on the value of humility:

I was giving a lecture at a university this past year and I was asked what my proudest accomplishment was. I paused as I reflected on my professional journey and the gravity of each step. I then said that:

"My failures are what I’m most proud of, as they remind me that I’ve got the resolve to continue and the depth to respond.”

Happy Thanksgiving.

An alternate (simple) explanation for market volatility

Recently, there have been many articles referring to the equity market’s volatility. Barron’s reported that daily volatility is approaching 1929 levels. Bespoke reported that the recent average daily swing for the S&P 500 is now an astounding 3.8%! Floyd Norris blogs that:

We have just completed two consecutive trading days when the Standard & Poor’s 500-stock index rose more than 6 percent each day — the first time that happened since 1933. They followed the first two consecutive 6 percent declines since 1933.

For the four days, the S.& P. is down 0.9 percent. We may not be accomplishing much, but it sure is a lot of fun.

In this environment, VaR and other risk control estimates all go out the window.


Why is the market so volatile?
There are many explanations for this volatility. The most obvious one is the macroeconomic uncertainty that grips the financial markets. I have noted that many hedge funds have gone to cash for the remainder of the year. Given the decrease in “fast money” trading and the lack of conviction by other market participants, it is not surprising that daily volatility has risen.

Other analysts have suggested more esoteric explanations. Some have turned from the equilibrium models used by many economics to agent based models to explain the swings int the market. Others have modeled stock market volatility using predator-prey models. (Yeah - The early bird gets the worm, but does the early worm get eaten?)


A simpler contributing factor: low stock price
No doubt there is some element of truth in all of these explanations. I would like to suggest a far simpler contributing factor to this market volatility: lower stock price.

Bespoke recently reported that the number of high priced stocks and low priced stocks are at levels seen at the last market bottom in 2002, no doubt a result of the market's severe downdraft. While this market decline creates a far larger universe of Phoenix candidates, the lower price per share of stocks also contributes to increased volatility.

The chart below shows the median standard deviation of one-day returns in the past month for the components of the Russell 3000, categorized by stock price. As you can see, as the per share prices of stocks fall, volatility increases monotonically. Though not shown in the chart, I found that this effect can be seen whether you measure volatility using the standard deviation of daily returns, average daily percentage swings, or the difference between daily high and low.

With the shares of such venerable names such as GM and C are trading at low to mid single-digits, it’s no wonder we are seeing huge jumps in daily swings.

Constructive long-term sentiment readings

Last week the market broke down decisively below its October lows. In the ensuing panic, the S&P 500 melted down (ho hum, what again?) to levels below its 2002 lows.

Amidst the carnage, the market is extremely oversold and long-term sentiment measures are at bear market extremes. With the caveat that long-term sentiment indicators can’t pinpoint the exact low on this bear, this is an indication that downside may be limited for this bear market.


Death of buy-and-hold
Financial planners tell their clients to build an asset allocation plan and to stick with it. However, there are numerous signs that individual investors are abandoning their buy-and-hold discipline. Barry Ritholtz pointed out that AAII data shows that individual investor stock allocations are at levels consistent with previous bear market lows. CNBC recently aired a segment on the Death of buy and hold as an investing discipline.

In conjunction with that news, Mebane Faber's market timing system is shooting the lights out compared to a buy-and-hold strategy, with returns at all-time highs comparable to 1974 bear market low levels. These results are not surprising given the terrible environment for equities.


Market is at oversold extremes
At the time of this writing, most US market indices are down 50-55% from their highs. Bloomberg reports that “[t]he worst annual decline in the Standard & Poor's 500 Index since 1931 has dragged down every industry in the benchmark gauge and 96 percent of its stocks.” Bespoke recently reported that the spread of stocks from their 200 day moving average is consistent levels not seen since the Great Depression. They conducted a recent poll that indicated the consensus low for the Dow is 6,000. Tickersense documents the damage here:

Most notably, the decline in the S&P 500 has been as severe as any of the last fifty years, but it has occurred in half of the time. Typically declines such as the current one occur over two years, this has taken just over one.

They seem to have thrown up their collective hands and moved into panic mode as they went on to say that market history may not provide a good guide anymore.


Speculation is dead
It is said that bear markets don’t die of panic but of neglect and boredom. Trading volume on pink sheet stocks, the most speculative in the US market, are now moribund. A recent Minyanville article reports that:

In October, total dollar volume in over-the-counter stocks fell to less than 0.07% of total NASDAQ dollar volume, the first time it has dropped below 0.1% since the inception of the data in 1995.

A setup for a bottom, but not yet
To be sure, shorter term sentiment indicators such as AAII are not at bearish extremes. Mark Hulbert came to a similar conclusion based on newsletter writer sentiment as well. This readings indicate that the bull is not quite ready to charge yet.

My inner technician's interpetation of these conditions is that there is limited downside in the market. However, equities need to spend some time and base before the bull can revive again.

Some bullish divergences

You know the psychology is really bad when the market breaks its October lows and the press is full of stories about the upcoming Great Depression II and economic and social collapse. While this is undoubtedly a bear market, this is also a maximum frustration market where traders get whipsawed in their positions on a daily and hourly basis. Macro Man pointed out the one-day range for the S&P 500 on November 13 is roughly equivalent to the annual range for all of 2005.

What could cause such a whipsaw? I have identified a number of positive divergences that indicate the market is in the process of forming a bottom. These signs, however, are medium term indicators and will not prevent the market from going lower from current levels.


It all started with real estate
This whole crisis began in the real estate sector. Excess homebuilding, overly aggressive lending practices – we all know the story. The chart below shows the relative returns of the homebuilders against the S&P 500. An interesting thing happened in this latest downleg as the relative support levels seems to have held. The homebuilders are no longer leading the market down. This could be an early sign that the worst of the carnage may be over.



The trouble with financials
As we all know, the excesses in the real estate market eventually showed up in the banking sector. A look at the relative chart of the KBW Bank Index (BKX) shows that the banks are outperforming the S&P 500 in this latest downleg. This is another positive divergence and indication that the market is trying to base and make a bottom at these levels.



Some investors may quarrel with my conclusions from reading the above chart. The financial services sector, not just the more narrowly defined banking group, continues to underperform the market.

The chart below shows the relative returns of the XLF to the S&P 500 and the XLF has broken down to new relative lows. The difference between the XLF and the BKX can be traced to the greater weights of the (former) investment banks and brokers in the XLF, which are dragging down returns. I interpret this as Mr. Market’s worries have shifted from the banking to derivatives and the worst of the storm may be over for pure banking, which represents some partial relief for the macro outlook.

Other rays of hope for the bulls
I pointed out in a past post the positive divergence shown by the more constructive market action of the Shanghai Index. In addition, Todd Harrison at Minyanville also mentioned a number of catalysts that could result in a rally, which would likely be very sharp.

Also remember that there should be support coming in at the 770 level on the S&P 500, which was the 2002 low.

China the next shoe or the final capitulation? (2)

In my previous post China the next shoe or the final capitulation? I referenced a link to analysis from stocktiming.com:

Stocktiming.com refreshes its analysis on a weekly basis and therefore the link to the Chinese market analysis will be overwritten on Monday November 24, 2008.

Stocktiming.com has kindly supplied me with a new link which doesn't expire next week. The link in my previous post has been corrected.

China the next shoe? or the final capitulation?

China, with its enormous reserves, had long been regarded by many investors as the last bulwark against the financial conflagration sweeping the globe. Now comes this story indicating that China itself could be a source of deflation:

After a recent visit to China, Nobuyuki Saji, chief economist and equity strategist for Japanese investment bank Mitsubishi UFJ Securities, issued a report warning that China could be on the verge of pushing the world into a deflationary spiral. The problem? Swelling industrial overcapacity, which threatens to undermine prices both for China's exported goods and its imports of raw materials.

He estimated that China's production is running as much as 50 per cent below capacity, as many industries that have been expanding rapidly are now being hit by slowing demand both domestically and abroad. Based on his estimates, China alone represents 7 per cent of the global supply/demand gap.

Excess Chinese capacity would crater capital investment
News of the Chinese economy slowdown is not new. What is new is the amount of excess manufacturing capacity in the country. (Remember those stories of all that dark fiber networks after the NASDAQ crash of 2000?)

I had called for a rally into year-end and then another leg down in the stock market. This Chinese overcapacity story, if it becomes widespread, could be the catalyst for the next downleg. It would serve to take US and European stocks down further. It would also be extremely negative for commodities of all types, as the hopes of commodity demand from future Chinese infrastructure investment would evaporate.


China slowdown: The final capitulation?
One ray of hope, however, comes from the analysis from Marty Chenard of stocktiming.com. He recently wrote a piece indicating that the Chinese stock markets may be in the process of forming a bottom. He highlights the point and figure chart of Shanghai Composite as an example. The Shanghai market recently broke out of a downtrend, indicating that it is in a bottoming process.

Point & Figure Chart: Shanghai Composite Index

If we were to juxtapose the analysis about China’s overcapacity to this technical formation, it suggests that the news is already discounted in the market. After all, when the story makes it to the pages of a Canadian newspaper, how late are we in the trade? (My Asian based readers are invited to comment).

Perhaps the final down-leg in the US equity market will occur when the China overcapacity story becomes widespread and hits the pages of US newspapers. That would serve to prompt the final capitulation that washes out the last weak and desperate holders of equities to sell out and form the basis for a new bull market.


Addendum: Stocktiming.com has kindly supplied me with a link so that the Shanghai analysis doesn't expire. The link in this post has been changed accordingly.

A Rorschach test for investors

As the US equity market tests its October lows, I would concur with John Hussman’s cautious bullish stance on the market:

On the issue of valuations, I want to reiterate that while I believe that stocks are (finally) priced to deliver acceptable and even modestly attractive long-term returns, valuations are still not deeply depressed on a historical basis. Valuations might indeed move substantially lower over the course of an extended recession and “bear market.” I do believe that significant new lows are unlikely in this particular leg. [Emphasis mine]

From a bottom-up perspective, stocks look cheap and they are getting cheaper. My list of stocks that are worth more dead than alive is growing daily.

Yet macro worries continue to mount.


Would you buy this stock?
The case of Anvil Mining serves as a Rorschbach inkblot test for investors. Anvil is a small cap Canadian miner, listed in Toronto and also trades pink sheet. The company's principal assets consist of three copper mining operations in the Democratic Republic of Congo.






The latest quarterly report was, shall we say, less than perfect. The company went from being profitable to bleeding cash at the rate of about US$20 million in the quarter. With US$125 million cash on hand, solvency could become an issue. Not only did falling copper prices affect financial results, the company went on to state that:

In Anvil's case, the impact of these events has been compounded by uncertainty regarding the review of mining agreements by the Government of the Democratic Republic of Congo ("DRC"), operational difficulties at the Dikulushi underground mine, delay in the commissioning of the Electric-Arc Furnace ("EAF") at Kinsevere and increases in operating costs.

Oops! The stock plunged over 40% from the previous close after the release of those results.


A Ben Graham buy?
On the other hand, an opportunistic value investor would examine the financials of the company and note that with the stock under $1, it trades well under net-net working capital (current assets less all liabilities) of US$2.76 per fully diluted share.


The investor's dilemma
As an investor, stare into the Anvil Mining metaphorical inkblot and tell me what you would do. That is the investor dilemma in today's market.


Disclaimer: I have no position in Anvil Mining and this is not a recommendation to either buy or sell the stock.

Are they even slamming the barn door properly?

I have repeatedly hammered on the theme that quantitative modelers need to spend more time thinking about the assumptions behind their models (see my recent posts What actually happens in the long run and There are no models for all seasons). Analysts need to understand under which conditions the assumptions hold and under which conditions the model will fall off a cliff.

While this comment isn’t directed at any specific firm, I recently came upon this job ad as an example of possibly the blind leading the blind:

Morgan Stanley is seeking Quantitative Modelers to join the new Market Modeling Group at Morgan Stanley. Candidates must have demonstrated excellence in mathematics, programming, statistics and Quantitative modelers must have a background which would enable them to develop models that would positively impact the revenue-generating capabilities of their trader counterparts.

While it is admirable that Morgan Stanley is forming a Market Modeling Group, this job description seems to call for a junior or intermediate level quant (3-5 years experience). I hope that this isn’t a case of the blind leading the blind and there are people in the firm with the sufficient maturity and “grey hair” to lead the group and understand the nuances of modeling.

Trend following CTAs no panacea

Regular readers of my blog are aware of my skepticism about the value of hedge funds as investments. While I have the greatest respect for some hedge fund managers who are capable of adding significant value, aggregate hedge fund returns have been far too correlated with S&P 500 returns and undiversifying for them to justify their fee structure. See my some of my past comments here, here, here and here.

Today, it gives me no pleasure to see the hedge fund industry in disarray and implode. Returns are going south, redemptions are rising and the fee structure is under scrutiny. Investors didn't get the results they expected. In addition, hedge fund industry employment should not have ballooned the way it did in the boom years and now the downward adjustment is going to be painful for a lot of people, many of whom didn't make the obscene amounts of money reported in the press.


Trend following models work…
Recently I saw the news item from the WSJ indicating that trend following Commodity Trading Advisors (CTAs) exhibited positive returns for the year. No doubt some investors will allocate funds to this group of managers in search of a “safe haven”.

There is no doubt that tremd following models add value. I once wrote the following about my experience working for a hedge fund that began life as a CTA:

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 [Trend Following]. 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.

…but CTAs have no alpha after fees
Trend following models identify and capitalize on long-dated economic trends, which are persistent. However, academic studies show that an investor can replicate those effects in a relatively simple fashion with techniques that are in the public domain.

In other words, CTAs just don't seem to have any alpha on an after fee basis.

Watch for the Obama Treasury nominee for policy direction

America has a new president-elect. Barack Obama has been embraced not only by traditional Democrats but by many social liberals/fiscal conservatives (just one of many examples here).

Expectations are extremely high. It’s irrelevant whether the woman in the TV clip believed that Obama’s policies would directly or indirectly alleviate her concerns. The world seems to be expecting miracles from the new president-elect.




Can St. Barack of Chicago deliver?
The atmosphere today is somewhat reminiscent of the elevation of Nelson Mandela to the presidency of South Africa. During the election people stood in line for hours to vote. There was no violence. People were just happy to be enfranchised. Foreign election observers came away with tears in their eyes. He had magnanimously stated that he held no animosity towards the whites and said in so many words that we are here to build a new nation. Yet South Africa faced many economic challenges that it was not able to solve.

The new Obama Administration also faces daunting economic challenges today. The fiscal implications of the Obama’s election promises remain problematical. Longer term, America is a country with high levels of income inequality and low social mobility, which can result in a class structure that inhibits innovation. That issue was raised by Larry Summers, who is rumored to be a leading contender for Treasury Secretary. In addition, the US government seems to be continuing down the inflationary path of serial bubbles.


Watch the Treasury appointment
If the Obama Administration is to be truly transformational, then the first signal would be the choice of a Treasury Secretary. There are rumors that a new nominee would be named as early as this Friday.

I wrote that Paul Volcker, who is one of Obama’s principal economic advisors, commented that:

• When the dust settles, he would favor policies that 1) create more financial regulation and oversight; and 2) encourage savings and less spending.
• Beware of inflation: “Inflation is the ultimate destructive result.”

Will America take the easy road down to serial bubbles or will she take the harder and painful road to restructure the economy now? Or could our fate be as Barry Ritholz speculated:

Inflation from 2002-07, Deflation from 2008-09, hyper inflation from 2010-???

Stay tuned.

There are no models for all seasons

My recent post entitled What happens in the long run seems to have struck a nerve but was wrongly interpreted in some quarters (example here). All models are approximations of the real world. Good models work most of the time, but will break down when it hits a “boundary condition”. Good modelers continually ask: “What are the model's assumptions? Under what circumstances will the model break down?”

In the case of my aforementioned post about long run equity returns, the world doesn't seem to be on the verge of war or revolution, so the assumptions DO hold. Macro fears are overblown. The bottom-up investors are right and stocks are cheap and are undergoing a bottoming process here.


Keep questioning assumptions
With those comments in mind, this is another in a series of warnings for quantitative modelers to examine their model assumptions.

The CFA Institute is sponsoring a conference on Equity Research and Valuation Techniques. With that theme in mind it is useful to ask:

• Do you know what your models are doing?
• More importantly, are they designed for the upcoming market environment?

Back when I was young and naïve I believed that quantitative investing was easy. I could build quantitative models, plug them in and they could run on autopilot. As we saw with the recent mortgage debacle, models don’t work in all environments and analysts need to continually question the assumptions behind the models.


Phoenix markets are challenging for many quant models
A case in point, this market and economy will turn up one day (which I believe will occur in the first half of 2009). For the purposes of this discussion, the timing is not relevant. Whenever the recovery happens we will see a Phoenix effect that will see the low-priced shares of near bankrupt companies spurt to eye-popping levels.

Many multifactor quantitative equity selection models will perform poorly during such a turnaround period. Most mainstream quant models tend to buy stocks of companies with positive cash flows, positive earnings momentum, positive estimate revisions and good potential for positive earning surprise, cheap valuations, good GARP characteristics and so on. Phoenix stocks have terrible balance sheets and highly negative earnings (how does a P/E of -5 strike you?) What's more, low stock price or low trading volume that get screened out because of investability criteria. As a result, most multifactor quant models will simply not buy Phoenix stocks.

When the junk flies, as we saw during the Tech bubble and in 2003, multifactor quantitative equity stock selection models fail. I wrote that Jeff deGraaf reported in late 2003 that the return spread between the lowest and highest decile of the stock price factor was about 70% - an astounding return. If your multifactor stock selection model is as I have described, then be prepared for a year or so of bad relative performance.


Inflation vs. deflation: How would your model behave?
One of the keys to success in quantitative investing is to have an understanding of the macro issues. I wrote in a recent post that we are facing a fork in the road between inflation and deflation and the result was highly dependent on policy and market response. Given these hugely disparate outcomes it would be surprising that the same quant model would behave the same way in both environments.

In a deflationary environment, cash is highly prized. Companies with clean balance sheets and low financial leverage tend to outperform. When prices are falling, the ability to maintain margins would depend more on the power of a brand and the product and service a company is selling. Even with the consumer staple sector, there are differences. Nielsen recently put out a study showing consumer product categories were more recession resistant than others (e.g. beer is but tobacco is not).

By contrast, companies with levered balance sheets tend to win in an era of rising inflationary expectations as debt becomes a cheap source of capital. Hard assets and commodity producers are also winners in inflationary eras as they can maintain or even raise their margins in the face of rising prices. Middlemen lose. When we went through the recent bout with inflation, we heard numerous stories from the likes of Starbucks and Hershey’s about the cost of their inputs (milk, cocoa, etc.) squeezing their margins. Yet it is precisely these companies that would tend to stand up better in a deflationary period because of the strength of their brands.

A sea change could very well be underway, is your model suited to all macro backdrops?

Does the market bottom in 1Q/2Q 2009?

Did anyone sit out October?

I wrote in early October that Mebane Faber had done a study indicating that equities could see positive returns in November and December because of the horrible month that stocks saw in September. Faber followed up with a further study entitled What happens after two bad months that point to median gains of 7% for the rest of the year if history were to be any guide. VIX and more came to a similar conclusion on market direction by comparing the current period in the US to Japan:

Japan's "lost decade" does bear some resemblance to the problems in the U.S. Looking at the historical record with a global perspective, it is tempting to conclude that the current situation ripe for another volatility bounce of at least two months.

Waiting for the retest of the lows
Without a doubt, last week’s market was a bottom fishers’ paradise. In addition to running my recent screen of beaten up financials, I ran other deep value screens and found all sorts of companies that were worth more dead than alive. There were 14 stocks trading below net cash (cash – total debt) that were profitable and therefore in at low risk of bankruptcy. There were also 42 stocks trading below net-net working capital (current assets – all liabilities) and were profitable. These are all indications of extreme cheapness that bottom-up value investors are fond of.

However, my sources tell me that many hedge funds have moved to cash and called it quits for the rest of the year (SAC Capital is just one well-known example). Any rally that we may see in the stock market for November and December cannot be regarded as enduring until it can be confirmed in January when hedge funds return to the market.

What bothered me was that a lot of individual investors have been too eager to jump on this rally. I wrote that sentiment was too bullish for this to be a durable bottom. However, sentiment models are not great at timing markets in the very short term. Come January, my guess is that the overly optimistic sentiment chickens will come home to roost and this market will retreat again to test the October lows.


Market undergoing a bottoming process
This market action points to the scenario of the stock market undergoing a bottoming process. Consider this NY Times chart of previous bear markets. While the depth of this bear is comparable to other Great Bears, this bear has been remarkably short so far compared to the others.

What's more, most bear market bottoms have been formed by two or three tests of the lows before the bulls take control. I went back and looked at previous bear market bottoms since the 1970s. The table below shows the time between the first and last tests of the market lows. In most cases, it takes 3-6 months before a low is established and proven to be durable.

Previous Bears: Time between first and last market low

2002 7-8 months
1991 3-4 months
1987 1 ½ months
1982 6 months
1974 3 months


Recession to bottom out in the Spring?
This market analysis is consistent with a study from Bespoke indicating that the recession would likely bottom out in the Spring:

The average length of US recessions is 14.4 months. Using the assumption that the recession began at the start of 2008 (using Industrial Production and Employment statistics), if the current period ends up just as an average contraction, we could expect the economy to bottom some time next spring.

The shape of the yield curve is also pointing to a growth revival in 2009. Now, some may say that all these financial problems are going to create an incredible drag on the economy and the US is not likely to emerge from recession any time soon. However, the historical evidence shows that while recessions induced by financial stress tend to be deeper, they don’t seem to any longer.

For investors trying to time the market bottom, Northern Trust put out a study that showed the S&P 500 generally bottomed out 2-5 months before the actual economic bottom. If we were to accept Bepsoke’s forecast of a recessionary bottom in the Spring, then this would also suggest a market bottom in early 2009.


Base case: The market bottoms in early 2009
In summary, the technical and economic analysis both point to the same conclusion. The market is likely to rally for a couple of months into year-end. Then expect a decline and re-test of the October lows in the January-April timeframe and that test would mark the bottom of this bear market. At that point, I would be getting ready and orienting my portfolio to take advantage of a Phoenix effect.

The greatest risk to this forecast is that the world’s financial system is extremely fragile and future events are highly dependent on policy response. Given that the US is facing an election and we will likely not see the economic team until early next year, anything can happen.

What actually happens in the long run?

I recently posted that bottom-up and value-oriented investors tend to be bullish on the US equities but noted that top-down investors continued to be concerned about the macro environment.

There are exceptions. Here is a top-down analysis that concluded that equities are cheap. Based on Jeremy Siegel’s observation that stocks have historically returned about 7% a year, the authors of this study showed that currently equities are trading well below the 7% trendline and concluded that stocks are cheap.

This is an example of an analysis whose data suffers from a severe problem of survivorship bias.


Survivorship bias colors the data
What if your family had managed to save the equivalent of $100 at the time of Augustus Caesar (give or take 2,000 years ago) and put it into equities or an equivalent investment? At 7% a year, the value of your family’s $100 original investment would now have 60 zeros behind it. Your family could finance TARP and the bailout by the world’s central banks from the chump change derived one day’s interest.

What happened?

What happened was in the intervening 2,000 years, there were many upheavals that destroyed wealth. Empires fell, starting with the Roman Empire, barbarians sacked cities and a lot of people died in very unpleasant ways.

We don’t have to go back 2,000 years to look at survivorship bias or wealth destruction. Going back 100 years, people mainly invested in bonds and equities did not represent a liquid asset class. Supposing we were to look at the bond markets 100 years ago, the “developed” market consisted of Britain, France and Germany. The “emerging” markets were America, Argentina, Canada and Russia. (Please forgive me if I have forgotten a market or two.)

Any analysis of the capital markets today that focuses on the principal survivor markets (US and UK) would have missed a number of markets that tanked horribly during that 100 year investment interval. Any care for some Argentinean railway bonds from 100 years ago? Russian ones? How about some “safer” German bonds? After all, it was a developed market - which subsequently went through one world war, subsequent hyperinflation and then the physical devastation of its infrastructure after another world war.


War and revolution the risk
Today, people are cranky and getting crankier. The risks of political turmoil are front and center. The gentlest example I have is a chart of the electoral map before and after the Great Depression. We could very well see the trend favoring open markets and the free flow of capital and ideas reverse itself. War is a possibility.


Think about your assumptions
This is a warning for quants and other modelers. Think about your assumptions to avoid making fundamental errors in judgment.

Bottom-up investors are finding bargains today. Top-down investors continue to be worried about the macro risk of a sea change that may devastate their wealth just as some of the events in the past hundred years have destroyed wealth. Were it not for those very real concerns, equity prices would probably be a lot higher than they are today.

The kid in the candy store

Top-down oriented investors seems to have significant concerns about the macroeconomic backdrop right now. On the other hand, many value and bottom-up oriented investors who were previously cautious on the market have either become more constructive on stocks or turned outright bullish. The list goes on: Warren Buffett, Jeremy Grantham, Ken Heebner, John Hussman, John Neff and return estimates based on the ValueLine Survey.

Putting on my bottom-up investor’s hat on, I can sympathize with the bullish assessment. Just for fun I ran a quick screen of low-priced beaten up financials with heavy insider buying and came up with a moderately sized list, which is shown below. It’s easy to see how some of the bottom-up managers are behaving like kids in a candy store. You don't see these kinds of values every day. The P/Es of these financials are low and they have had significant insider buying in the last six months and no insider sales, which is an indication of management confidence. In addition, other deep value screens are also showing long lists of stocks with good upside potential with solid asset value support.

Click for larger image

However, my inner top-down investor remains concerned that there is too much macro downside risk. The market is too dependent on policy response for me to sound the all-clear for the bulls.

Disclaimer: I don’t have a position in any of these stocks. You should not consider this as a recommendation to trade any of them. You are responsible for your own portfolio and you should do your own homework.

A barbell portfolio for a fork in the road

Whew! The official intervention in the last few weeks seems to be finally taking effect. Credit markets are finally starting to normalize as we see that LIBOR starting to edge down.

Now that the panic seems to be starting to end, I began to muse the implications of the events of the past few weeks and months on investment policy. Note to traders: investment policy isn’t about what happens in the next day or next week, but orienting the portfolio for the next 3-5 years (or more).


Inflation or deflation?
I have written before that future events depend much on the policy response to the crisis. Much of the investment outlook for the next 5-10 years depends on how the authorities and market participants behave in the next few months.

The world is in a fork in the road. Down one path is the specter of Weimar Republic style hyperinflation. Already the Treasury yield curve has steepened as the bond market starts to wonder how the authorities are going to pay for this bailout. There are two key risks. First, all this liquidity doesn’t or can’t get drained from the system after risk premiums retreat to normal levels. Former Fed Chairman Paul Volcker summarized the second risk of this massive intervention succinctly: “Those banks have been nationalized, overtly or not overtly, which is something that hasn't happened before in the history of developed countries. How to wean them from government support? That is the challenge of the future.”

On the other hand, down the other road is the terror of deflation and Depression. If America’s lenders (China, Japan, Middle East states, etc.) decide that enough is enough and it’s time to put the US on a diet. We could witness a Brady-like debt restructuring plan, most likely with draconian adjustments in the manner of IMF prescriptions (here's an example).


Serial bubbles: The Greenspan put becomes the G-7 put
The inflationary case is easy to make. Politicians of all stripes loath to make unpopular decisions and would rather pay the piper later. With one in six homes in the US showing negative equity and the pain spreading on Main Street, the political pressure for further relief is intense. A plethora of measures have been enacted that indicate that the government is well down this path. For instance, the Fed has written a blank check to G-7 central banks for USD assets (emphasis mine):

The BoE, ECB, and SNB will conduct tenders of U.S. dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction. Accordingly, sizes of the reciprocal currency arrangements (swap lines) between the Federal Reserve and the BoE, the ECB, and the SNB will be increased to accommodate whatever quantity of U.S. dollar funding is demanded.

This week we have news of the Money Market Investor Fund Facility (MMIFF), a Federal Reserve facility of up to $540 billion to help money market funds. This is the latest in the alphabet soup of rescue packages from the Fed and Treasury.

Other examples of excesses abound. TARP is already spawning moral hazard at the individual level. High sounding principles of corporate governance, first espoused at the initiation of the bailout, are being watered down. The suspension of mark to market accounting is already laying the groundwork for the next bubble. Companies like AIG are acting like nothing has happened and business goes on as usual, even after becoming the recipient of the Fed’s largesse (see this, this and this).

Foreigners may be already reacting to this heightened inflation risk. Robert Mundell, the father of the euro and an advisor to the Chinese government, was reported quoted as saying that China should purchase all of the IMF’s gold if it came up for sale. While I would somewhat discount this report as it originates with GATA (Gold Anti-Trust Action Committee), which many scoff at as being part of the tinfoil hat brigade, it does represents another piece of the puzzle in a mosaic that indicates we are well down the path of the next bubble. As they say: just because you are paranoid doesn’t mean people aren’t out to get you.


The deflation case: Where is the growth?
Right now, emerging markets (notably China) is the main source of world growth but emerging market growth is teetering. If the emerging markets falter, then the world would descend into a serious synchronized global recession. Brad Setser speculated that the current crisis may mark the end of Bretton Woods 2:

The Bretton Woods 2 system – where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports – will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won’t be exporting much.

China cannot plausibly hold up the entire world. Emerging market economies are more fragile than we think. Already we can see Korea as an example of a country having difficult with getting access to USD liquidity in their banking system. The list of emerging economies in trouble or is seeking IMF help is growing daily (Argentina, Belarus, Hungary, Pakistan, etc.).


Paul Volcker: No serial bubbles
According to the latest polls and Intrade, Barack Obama is a virtual shoo-in to win the presidency in November. Paul Volcker is known to be one of his principal economic advisors and the Obama campaign reportedly consults Volcker on virtually all economic issues. Therefore, it wouldn’t be a huge surprise to see Volcker appointed as Treasury Secretary should Obama become president. While Volcker may not accept the appointment because of his advanced age of 81, he would undoubtedly be an influential voice in an Obama Administration.

With that in mind, let’s look at two recent interviews that Paul Volcker had with Charlie Rose (here and here. Warning – the interview videos are long). A summary of his comments follows:

• The Fed and Treasury have the tools to fix this crisis and they are now doing the right things.
• Japan and China will (have no choice) but to continue to finance the US. In other words, Bretton Woods 2 is not dead.
• The US economy is fundamentally sound (similar to my previous comment that if the US were a company, it could be best described as right business model but bad balance sheet.), Volcker’s comment was “we need more electrical and chemical engineers and fewer financial engineers”.
• When the dust settles, he would favor policies that 1) create more financial regulation and oversight; and 2) encourage savings and less spending.
• Beware of inflation: “Inflation is the ultimate destructive result.”

The last point is particularly important about “inflation is the ultimate destructive result”. There would be no serial bubbles with Paul Volcker in charge. He would likely advise the new president to take the pain now and prepare the groundwork for a sustainable recovery. Should Volcker become Treasury Secretary, we can expect a couple years of pain in the form of restructuring, debt destruction and deflation.

A barbell portfolio for uncertain times
Given these two disparate outcomes, both of which are very real, what does an investor do?

Under a scenario of rising inflation and possibly hyperinflation, hard assets are the best hedge. The equities of emerging markets, the most likely source of growth, would likely lead any rebound should the world reflate relatively quickly from this crisis.

On the other hand, hard assets and emerging market stocks will not fare well in a deflationary scenario where defaults abound and investors seek safety. Cash, in the form of default-free paper, would perform best in that environment.

Given the risks involved, perhaps the most prudent course of action to create a barbell portfolio. Split the portfolio between inflation hedge vehicles and cash, preferably in the form of T-Bills. As I have no idea what anyone’s investment objectives and risk tolerances, the weights and how you pick the inflation hedge vehicles is up to you.

Where are the equity bears?

After one of the biggest equity market declines we’ve seen in recent memory and a looming worldwide recession, investors should be worried and bearish, right?

It seems not. Maybe this all stems from Warren Buffett's clarion call to buy US equities last week. Readings from sentiment models indicate that either investors are not bearish enough or plain outright bullish on the market, which makes me concerned that there is more downside to come.


AAII survey not bearish enough
The chart below shows the AAII sentiment survey. After the recent freefall in the stock market, it is amazing to me that sentiment readings are less bearish than they were at the last short term market bottom:



Hulbert indicators confirm lack of bearishness
We also have several confirmations of this lack of bearishness. Mark Hulbert recently wrote that the newsletter writers who advise buy-and-hold strategies haven’t thrown in the towel yet and moved to market timing:

Historically, buy-and-hold tends to reach its peak of popularity at market tops, just as market timing becomes most out of favor. The inverse tends to be the case at market bottoms.

On Thursday October 16, Peter Brimelow also confirmed that newsletter writers’ sentiment wasn’t bearish enough:

The Hulbert Stock Newsletter Sentiment Index, which reflects the average recommended stock-market exposure among a subset of short-term stock market-timing newsletters tracked by the Hulbert Financial Digest, stood on Wednesday night at negative 12.8%. That's sharply higher than last week, when it was at negative 33.5%, although the Dow was 1,400 points higher and Mark Hulbert was already worried for contrary opinion reasons.

Bloggers are wildly bullish, individuals not panicked
What’s more, I was shocked to learn that there isn’t a single bear in the recent TickerSense’s blogger sentiment survey.

My own private conversations with individual investment advisors indicate that their clients are not panicked and some have even been buying. While these advisors mostly advocate asset allocation and buy-and-hold strategies, the lack of panic among individual investors is a huge concern for bulls.

On the other hand, there is a pervasive sense of doom on the economic front. The lack of doom among equity investors, however, point to more downside for the stock market.

Advice for the hedgie walking wounded

As the list on the Hedge Fund Implode-O-Meter grows, my sources show that the average diversified hedge funds were down about 16% YTD (to early October) and they were exhibiting current drawdown of about 17%. Convertible Arbitrage, Equity Long/Short and Event Driven strategies were the worst performing strategies with average current drawdowns of over 20% each. Moreover, there have also been stories floating around that even some large brand name hedge funds are down 10-15% YTD.


Living to fight another day
If you are one of those walking wounded hedge fund managers who survived, congratulations! Periods of negative returns are useful for reflection and analysis of your investment process. If you are undergoing such a review, here is some free simple advice on how to put together a strategy and portfolio:

• Diversify, diversify, diversify your factors! As any baby quant knows, combining uncorrelated factors to put together a strategy makes for more stable results.
• Distill your bets and focus on what you are good at. In other words, don't forget risk control.

I show two examples of these principles below.


Factor diversification
I have written about the benefits of factor diversification before. Here is another example. This was a strategy that I was heavily involved in developing for an equity market neutral portfolio. The chart below shows the out of sample returns of two stock selection models.

Model A is a bottom-up derived multi-factor model with an average holding period of 1-2 months. Even though the process was bottom-up oriented, it acquired decided top-down trend following like characteristics (which was extremely powerful during the backtest period). My solution was to complement Model A with Model B, a short-term price reversal model with an average holding period of 4-5 days. The portfolio returns, which consist of a 67% weight in Model A and 33% in Model B, are less volatile.

The chart below shows the rolling correlation of the two models. Intuitively, one would expect that the trend following/momentum Model A and the price reverting Model B to have a correlation of close to -1. In fact, their rolling correlations have fluctuated around the zero line over the out of sample period.
The bottom line: The combination of Model A and B made for a far more stable stock selection model, as shown by its positive (though somewhat volatile) returns during a difficult period for hedge funds. The results were updated to 14 Oct 2008. Portfolio returns were stable in the panic market selloff last week and subsequent rally on Monday.


Distilling your bets
I have my reservations about the blind application of Grinold’s Fundamental Law of Active Management. Nevertheless, the ideas behind his principles remain true:

In so many words, Grinold said to size your bet according to your skill. If you have no skill, the solution is to eliminate or minimize that bet.

A case in point. About a year ago, I was involved in a risk-control project for a long/short equity manager. He had shown very good returns over the years but results were volatile.

The manager had an eclectic top-down rotation investment process. At any one time, he may latch onto one or more interesting investment themes, e.g. biotech, emerging markets, etc., and make a big bet on any one of those themes. The result was a long/short equity portfolio with a decidedly long bias.

Unfortunately, the portfolio was taking on excessive and unnecessary market risk. While long term returns were excellent, the fund suffered large draw-downs in bear markets. Our solution was to sizably reduce market and common factor risk in the portfolio, as the manager admittedly didn’t have any market timing ability. We used standard risk models, from Barra and from Northfield, to estimate the factor exposures of the portfolio in order to form a hedge and overlay on top of the actual portfolio. The chart below shows the returns of the original portfolio and a portfolio hedged using ETFs, such as ETFs on the S&P 500, Russell 2000, as well as country and sector ETFs.

The table below shows the returns of the simulation. The returns of the hedged portfolio over the simulation period outperformed the original unhedged portfolio by 3%. The hedged portfolio avoided much of the drawdown experienced by the unhedged portfolio and outperformed both the S&P 500 and the HFR Equity Hedge Index. In addition, the hedged portfolio had superior risk characteristics as it avoided much of the drawdown in the bear market after the Tech Bubble top of 2000.

The moral of this story: Figure out what you are good at, stick to it and eliminate/minimize the other bets in your portfolio.

Data problem = commodity rally?

The Baltic Dry Index has been falling for the last three months and in free fall for the last month. I had originally interpreted that as slackening world demand and particularly by China indicating a worldwide economic slowdown. Now a report from Naked Capitalism suggests that shipping volumes have seized up because of the financial crisis:

I spoke to another friend of mine this afternoon, whose father has been in the shipping business forever. Pristine credit rating, rock solid balance sheet. He says if he takes his BNP Paribas letter of credit to Citi today for short term funding for his vessels, they won't give it to him. That means he can't ship goods, which means that within the next 2 weeks, physical shortages of commodities begins to show up.

Readjust growth expectations?
If this condition of inability to ship because of problems in inter-bank credit market is widespread, then we have a case of analysts getting fooled by the data. The steps taken by the authorities to ease these conditions could then spark an enormous rally in the markets, in equities and especially in commodities.

How long and deep the slowdown?

There is little doubt that the US is entering a recession. The IMF's latest report also forecast that the world is entering a major downturn. The bigger questions are:

• How long and how deep is the US slowdown?
• Most importantly, will the US slowdown drag down the rest of the world?

As for the depth question, we have a good idea. Econobrowser pointed to a study that indicate the presence of financial stress is indicative of deeper recessions. How long it lasts and the its effects on the world depends on the policy response.


What’s the policy response?
In Charlie Rose’s interview with Warren Buffett, Buffett stated that the depth of the slowdown is dependent on the policy response:

Unemployment is going to go up under any circumstances. The 6.1 is going to go higher. But whether it goes and quits at seven or whether it quits at ten or 11 or 12 depends on, among other things, the wisdom of Congress and then the wisdom of - in terms of carrying out the plan that Congress authorizes.

Best and worst case scenarios
As the financial markets went into cardiac arrest in the last few weeks, many observers began to compare the current period in the US to either the Great Depression of the 1930s or Japan’s Lost Decade in the 1990s.

I beg to differ. I have constructed best and worst case scenarios that may be better analogies for today's situation.


Best case: German reunification
When the Berlin Wall came down, West Germany made the political choice to exchange West German Marks for East German Marks at a 1:1 ratio. The decision shocked the financial markets. I recall describing it at the time as a giant LBO of unproductive Soviet era assets which would create a drag on the German economy. The world began to slow down because of this macro shock and the Iraqi invasion of Kuwait toppled the world over into recession.

Yet the adjustment period was surprisingly mild. Germany underwent a couple of years of tough adjustments, followed by a period of anemic growth in the mid-90s (see analysis here). The former East continues to have problems, but overall Germany, Europe and the rest of the world were not dragged down by the macro shock in 1990. Germany has the reputation as an engineering powerhouse, whose principal export is its intellectual property.

The US parallels are obvious. Like Germany, the US is being weigh down by unproductive assets. Like Germany, much of US exports is intellectual property. It has an open economy, people from all over the world flock to its universities and its intellectual property exports have enabled it to re-invent itself periodically. I lived in Boston for nearly a decade and has seen it first hand. Research on radar was done in Boston during the Second World War. Over the successive decades, companies based in the area have demonstrated that Boston is a center of innovation. Examples include Digital Equipment, Lotus Development, the dot-coms during the tech bubble. The biotechs that dot the landscape today are a testament to the brainpower that is the source of intellectual property exports and America’s competitive advantage.

If the US were a company, it could be best described as right business model but bad balance sheet. The solution to such cases is to re-capitalize the balance sheet so that the enterprise could continue. In his interview, Buffett opined that:

[W]e've got the same plants out there we had two years ago. We got the houses. We've got people that are more productive than they've ever been in the history of this country. We've got a wonderful economic formula in this country. But right now it is being - it's been brought to a halt by …the de-leveraging that's going on right now that has caused the credit crisis…

I think confidence will come back. I will tell you this, this country is going - will be living better ten years from now than it is now. It will be living better 20 years from now then ten years from now. The ingredients that made this country, the miracle of the world. We had a seven for one improvement in the average American's standard of living in the 20th Century.

If the German reunification analogy holds true, then the United States will likely suffer a deep recession for 1-2 years but the rest of the world will recover relatively quickly.


Worst case: Depression of 1870s
There have been some in the blogosphere that have suggested a better analogy for the current times is the Depression of 1870s, which lasted for about a decade:

The parallels are striking—it started with a housing bubble which popped and generated a mortgage crisis. Financial markets fell apart when investors, relying on complex financial instruments, did not consider counter-party risk.

The financial troubles began initially in Europe but eventually spread to America, culminating in the Panic of 1873. Such episodes of booms and busts no doubt heavily influences works of later economists such as John Maynard Keynes as he sought out policy responses to smooth out these periods of volatility.

While a decade long depression is possible, it is less likely and represents the worst case apocalyptic scenario imaginable. The authorities did not have the policy levers that are available today, however flawed they may be. Bernanke is known to have studied the Great Depression of the 1930s and he is no doubt determined to avoid such an outcome.


Policy response is key to resolving the crisis
Surprisingly, policy response so far has been relatively ineffective. I have written before that the overwhelming issue is solvency in the banking system and not liquidity. So far the economic consensus concurs with that view. A partial list include the following: BCA Research, John Cochrane, Paul Krugman, Greg Mankiw, Nouriel Roubini, and Luigi Zingales and Diamond et al. Warren Buffett also agrees with the approach:

So there is - there are two things needed in the system. The one that's needed overwhelmingly is liquidity. When people are trying to de-leverage, there has to be somebody there to buy. And they don't have to buy at fancy prices, but to buy.

And then there's also a capital problem with some of the institutions. We have provided capital here with a couple institutions recently. The federal government did that in the '30s for the RFC and I think there could well be a proper role for government in that.

The UK is partially nationalizing its banking system and Gordon Brown urged the world to follow suit. The New York Times reported that the US Treasury is considering similar steps and the WSJ reported that it may insure all bank depts. Hank Paulson is quoted as saying: “We will use all the tools we’ve been given to maximum effectiveness, including strengthening the capitalization of financial institutions of every size.”

Former Fed Chairman Paul Volcker wrote in the WSJ indicating that we have the tools to fix the problem, we just need the leadership. In other words, all is not lost.

Signs of a panic bottom?

This week I have had several calls and emails from friends, acquaintances and former colleagues to discuss the state of the market. Mrs. Humble Student of the Markets also got this "joke email" from one of her friends.

The Treasury Department is putting out a new Dollar bill...

Bespoke also reports that the S&P 500 is 26% below its 200 day moving average, which is an extremely rare event.

While I continue to have concerns about the market, the combination of this level of panic and more reasonable valuations is highly suggestive that a tradable bottom is in place.