Thursday, July 29, 2010

The (market) spirits are willing, but the fundamentals are weak

Recently Barrons asked the question: “Do you believe in technicals or fundamentals?” The article pointed out that while the technical picture looks bullish, the fundamentals remain weak and caution is warranted.

I agree that the technical picture looks quite positive as the bulls seem to have regained their footing. On the other hand, respected investors and analysts such as John Hussman to David Rosenberg have been warning about the deteriorating economic backdrop.

The price of economically sensitive Dr. Copper tells the story of improving technical picture. As the accompanying chart shows, trend following models experienced a “dark cross” (circled), which point to a downtrend when the shorter 50-day moving average crossed below the longer 200-day moving average. However, copper prices have rallied significantly since that event, which points to further short-term price improvement.

On the other hand, Gluskin Sheff chief economist David Rosenberg wrote on July 27, 2010 (free registration required) that “the technical picture has improved. The data have really been unimpressive even if not horrendous. And I think we have the potential for a lot of disappointments in earnings to come as the plays on ‘domestic demand’ are in the offing.”

SocGen strategist Albert Edwards likens the current situation to Japan’s Lost Decade(s):

We are at the most dangerous stage in the Ice Age – the ‘post-bubble cycle’. For although it is clear that leading indicators have turned downwards, the choir of sell-side sirens is singing its song of reassurance. The lesson from Japan was that once the cyclical rally is over, any downturn in the leading indicators should find you stuffing beeswax in your ears to block out that lilting melody so as to avoid the jagged rocks of recession.
In the end, it depends on one’s time horizon and risk tolerance. My inner investor remains extremely cautious and looks for market strength to lighten up positions. My inner trader, on the other hand, tells me to go with the flow and stay on the bullish momentum train.

Tuesday, July 27, 2010

The “surprise” reflation trade?

A couple of weeks ago I wrote that war might be the surprise way for the US to dig itself out of a debt hole. After all, investors tend to care less about mundane things like debt service ratios when the shooting starts – and who knows what kinds of assets the winner may gain in a war?

The hawks circle
Avner Mandelman, who has been warning about the possibility of war, wrote on the weekend about the beat of war drums:

[L]ast month the U.S., British and French navies held an unprecedented joint exercise in the Mediterranean, and right after, the U.S. aircraft carrier Truman and its 10 accompanying battleships crossed the Suez Canal to join the two other U.S. carrier groups already in the Gulf. Even more interesting, two weeks later an air caravan of American and Israeli cargo planes landed in Azerbaijan, downloading "equipment," which caused the Iranians to protest loudly and go on war alert.

Such force concentration near the oil fields doesn't mean a conflagration is imminent, but it does mean the risk of one has gone up, with possible investment implications.
Michael Hayden, former director of the CIA, believes that the march to war with Iran is “inexorable”. Consider these two interpretations on his interview with CNN’s State of the Union. The first is from the viewpoint of the hawks from DEBKA and the second from the doves at the Fabius Maximus blog.

A bullish fat-tailed event
For investors, war would be the ultimate reflation trade that would make the bears really run for the hills. This is a possible fat-tailed event that we need to keep an eye on. While coverage is not easily found in the mainstream press, it is possible to find sources such as DEBKA, which is good source of information (or disinformation, depending on how you view things).

Don't just react to newsflow, analyze
Readers should be warned that DEBKA has a Likud Israel-is-under-continual-siege mentality and is prone to exaggeration as it has falsely pounded the war drums before. For example, this recent story about the deployment of a third US carrier opposite Iran sounds alarming. Upon closer examination, the third carrier turns out to be the USS Nassau, which is an amphibious assault ship carrying marines rather than a large Nimitz class carrier such as the USS Dwight D. Eisenhower or USS Harry S. Truman, which are reportedly deployed in the theatre.

Please be reminded that the United States has heavy troop presence in Iraq and Afghanistan and it would not be overly unusual to have one or two large Nimitz class carriers in the region.

Investors should be prepared for the possibility of war, but analyze the situation carefully before jumping to conclusions.

Monday, July 26, 2010

So you think you can be a portfolio manager?

The task of managing portfolios isn't as easy as it seems. Not only do you have to think about issue selection, you also need skills like portfolio construction and trading. Over the years, I have seen very smart and experienced sell-side analysts who have had great difficulty making the transition to the buy-side and portfolio management.

David Merkel at Aleph Blog wrote a terrific series called The Education of a Corporate Bond Manager (see Part 1, part 2 and part 3) that addresses many of these problems. For example, Merkel discusses the problems of putting together a portfolio when time is limited and there is no time for analysis:

But when the market was hot, and deals would close within an hour, I would work differently. When the deal would come, I would put in for bonds, so that I would get some allocation. I would ask for the high end of what I would normally ask for, knowing that I would get scaled back considerably. Then I would send the details to my credit analyst, telling them that if they did not like the company, I would sell the bonds.
Eventually, most of my analysts during the times when the market was hot would come to me and say, “How can you put in for bonds without an opinion from us?” First I would reassure them, and tell them that I valued their opinions, and that I would not hold onto a bond permanently unless they liked it. I would sell all bonds they did not like, but when the technicals favored it, within a few months.
And the problems with trading:

But I started selling away, and began to learn the art of price discovery. When you want to sell a bond, you first have to look at what investment banks ran the books of the deal. There is an unwritten rule that if they play that large role in origination, they have to make a market in the bonds thereafter.
I also wrote a series called What do you do after you've made your picks that looks at the problems from the viewpoint of an equity manager (see Part 1, part 2 and part 3).

Go and read them and you'll get some perspective.

Wednesday, July 21, 2010

How diversifying are commodities?

I would like to address the issues raised by my last post about buy-and-hold vs. dynamic asset allocation about the diversifying properties of other asset classes, specifically commodities.

Are commodities diversifying?
AllAboutAlpha recently wrote about the death of commodities as an asset class. One of the studies cited was from RS Investments, where they show commodity prices are increasingly correlated to equity returns.

AllAboutAlpha concluded that commodities remain a good source of diversification since they are highly correlated to inflation.

One giant risk trade
Izabella Kaminska at FT Alphaville addressed the commodity diversification issue slightly differently by observing that commodities are increasingly correlated to stock market returns because of the stampede of institutional funds going into the asset class. She went on to discuss the lengths that some dealers and institutions have gone to in order to minimize the loss of returns from rolling the contango.

The rising correlation to equities and correlation to inflation both point to the same thing. The commodity trade has become just a risk trade.

When I view commodity prices through the inflation-deflation macroeconomic lens in the Inflation-Deflation Timer model and put it on the risk-safety axis, commodities have become the risk, or inflation/reflation trade. The other end of the deflation, or safety axis is occupied by the US Treasury long bond. By the way, equities are correlated with commodity prices because they, too, represent the risk trade, or reflation trade, albeit in a less volatile fashion.

Are commodities a good diversification building block? I am afraid not. They are just an extension of the reflation or risk trade represented by equities.

Monday, July 19, 2010

How to cope in a low-return environment

MarketWatch published an article last week discussing the rise of trend based market timing strategies, compared to the more traditional buy-and-hold approach to investing. I also covered the same issue when I posted that we may have to wait eight years for a new equity bull to begin.

To recap, we may very well be in a secular bear market, where returns are roughly flat as illustrated by the chart of the DJIA below.

Zero return with portfolio volatility?
Let’s do a back of the envelope calculation. The stock market’s dividend yield is around 2% and the 10-year Treasuries yield around 3%. Assume that stocks have no capital appreciation over the next 5-10 years, the expectation of return of a buy-and-hold balanced fund is going to be around 2.5%, regardless how you play around with the asset mix decision.

Don't forget layer on the transaction costs and fees. After factoring in trading costs, which can easily be 1% or more for individuals, and investment management fees (conservatively estimated at 1-2% for an active solution, under 1% for passive solutions), the investor is left with little or nothing to show for his efforts, except for the volatility in his portfolio.

Why not just sock the money into a savings account?

Yield at a reasonable safety margin
To cope with a low return environment, the first-order solution for the buy-and-hold crowd has been to seek out yield. But there is no free lunch here either. Higher yield comes at the price of credit risk and credit risk could blow up in our faces in the current fragile economic environment. Some investment managers have sought to mitigate that with the concept of yield at a reasonable safety margin, which is not a bad solution under the circumstances and the constraints of a fixed asset allocation.

Dynamic asset allocation using trend following principles
My solution, along with some others cited in the MarketWatch article, is to trade the swings. The swings can be considerable – witness the trough-to-peak behavior of stocks since the March 2009 bottom.

I am not alone in my choice of modeling platform. My Inflation-Deflation Timer model is based on trend following principles, as applied to various commodity prices. The MarketWatch article cites others who use similar techniques. Mebane Faber uses similar kinds of principles to limit losses in asset allocation.

Coping with a low return environment is hard. Preserving financial staying power is of paramount importance under these circumstances. For those who believe in the static buy-and-hold asset allocation approach to investing, reaching for yield as a source of stability can be a reasonable approach if credit analysis is done properly. I happen to be in the dynamic asset allocation camp, where I believe the returns can be considerably higher given the likely volatility of the financial markets.

Thursday, July 15, 2010

The erosion of American competitive advantage

The news flash came across my desk: China's leading credit agency downgrades the US, Britain and France from AAA. This news is undoubtedly a sign of things to come. The question is, can America retain its status as a leading economic power?

The news is grim. I have written before about the analytical framework of deficit reduction. That kind of macroeconomic adjustment is only effective if Americans retain their underlying competitive advantage. John Hussman wrote this week that the basis of American competitive advantage rests on superior physical capital and human capital [emphasis added]:
The main source of this difference in productivity is that U.S. workers have a substantially larger stock of productive capital per worker, as well as generally higher levels of educational attainment, which is a form of human capital. This relative abundance of physical and educational capital has been a driver of U.S. prosperity for generations. Neither advantage in capital, however, is intrinsic to American workers, and it will be impossible to prevent a long-term convergence of U.S. wages toward those of developing countries unless the U.S. efficiently allocates its resources to productive investment and educational quality. This is where our policy makers are failing us.
The US is squandering its lead on both fronts. Instead of investing on productive physical capital, we have seen excessive malinvestment leading to bubbles in technology, real estate and finance over the past couple of decades. The internet and real estate bubbles were plain to see.

As for finance, what does all of the malinvestment of human talent into Wall Street say to the world? Despite the ineffectual efforts at financial regulation, American remain in denial about the role of finance in society. The news of the Alan Greenspan chair at NYU is just another sign of denial.

‘Nuff said.

Trouble in higher education
In addition, there seems to be signs of trouble in higher education, which is a key driver of the productiveness of human capital.

Firstly, the lead in education isn't what it used to be. A recent study concluded that elite universities are eroding their competitive edge. I had blogged about a Tiananmen Square protester returning to China for the sake of his children because of the lower quality the Canadian education system, which from first hand-experience equivalent or slightly higher quality than the American system.

As well, the cost of a university education is spiraling out of control. Consider Rolfe Winkler’s comments:

The market for college education looks a lot like the market for houses circa 2006 – very bubbly. And the reason is similar: There is too much credit.

Colleges can keep raising prices, despite the recession, because the government keeps lending students more money to pay them.
Rising prices and ample credit to finance purchase – does that sound like anything we saw before, such as the housing market? Carpe Diem shows this chart to illustrate how fast prices have been rising and went on to warn of a bubble in higher education:

Malinvestment in physical capital and failing human capital...there will a time to pay the piper and that day may be coming sooner than anyone expects.

Monday, July 12, 2010

A creative war to dig out of the debt hole

Since the G20 meeting there has been a lot of hand wringing over the level of sovereign debt. Calculated Risk posted alarmingly about the frequency of sovereign debt in the past.

Defaults tend to come in clusters, and the behavior of lenders often changes substantially after defaults. In the Volatility Machine, Michael Pettis asserts that sovereign default contagion follows predictable patterns, and that contagion is primarily due to investors in the first defaulting country also having investments in other countries which are vulnerable. This is especially the case with leveraged investors.
So far, investors have firewalled many of these debt default concerns in the US. In fact, every time something blows up somewhere, Treasuries have rallied. Can this state of affair continue indefinitely?

The answer is no. The United States has to find a long term solution to its problem of growing debt. But how serious is this problem? Deus Ex Macchiato posted a chart of the British debt-to-GDP ratio for a very long term perspective:

The first peak in debt to GDP occurred just after the Battle of Waterloo in 1815 and the second just after the end of World War II in 1945. Some market observers have pointed out that the US debt to GDP ratio has been higher than they are today. It is also instructive to go back to an earlier era to learn about how Britain dug itself out of her debt hole after the Napoleonic Wars.

The answer is India. It began with the British East India Company rule of India and progressed to the British Raj. Simply put, the British went to India and took things as part of their colonial adventures.

Could the US go down the same path? Tim Knight at the Slope of Hope posted that financial crises and crashes have led to wars. While the causation and historical links between financial stress and war look a little tenuous, there is a kernel of truth to the story.

War is a possibility, but not a highly probable one. Avner Mandelman has written about this very issue (see Watch out if a cash-poor U.S. seeks new spoils and Austerity in the West? Not if the generals can be useful).

During the 1990s, I said privately that the solution to Japan’s Lost Decade was to land 100 of the Japanese Self Defense Forces on the disputed Kuril Islands. The effects would be highly reflationary for Japan's economy. I also blogged on April Fool’s Day about A modest proposal to restore America.

Ironically, war would likely be bullish for the markets, though it is not a possibility that most of us would like to contemplate. It is nevertheless a path that we have to allow for in our investment planning scenarios.

Thursday, July 8, 2010

Wait 8 years for a new bull?

USA Today recently asked How will Baby Boomers' retirement affect stocks?

I may have an answer from academia. Further to my post about anxious and volatile markets, John Geanakoplos, co-author of the paper entitled Leverage cycles and the anxious economy, also wrote another intriguing paper called Demography and the Long-Run Predictability of the Stock Market, with Michael Magill of the University of Southern California and Martine Quinzii of the University of California at Davis.

In this study, Geanakoplos et al related demography to long-term stock returns. They found that P/E ratios were correlated to the ratio of middle-aged people to young adults, otherwise known as the MY ratio. When MY rises, the market P/E will tend to rise and when it falls, P/Es tend to fall.

If the conclusions of the study are correct, then we should see a continued fall in P/E ratios with a long-term bottom in stock prices forming about 2018, or eight years from now.

Back to the '70s
Recall that the previous anxious markets paper that I cited indicated that current macroeconomic conditions called for volatile markets in the aftermath of the economic crisis. This latest paper suggests that we are gripped by a secular bear market until 2018. Putting it all together, the current environment is reminiscent of the 1970s, which was gripped by inflationary fears, slow growth, volatile markets and flattish equity returns.

The chart below of the Dow Jones Industrials Average shows that, since the Second World War, the market has been gripped by two episodes of secular bull markets to be followed by secular bears. The secular bulls were characterized by a substantial advance lasting over a decade while secular bears were marked by sideways markets lasting over a decade.

These studies are also consistent with the big bear charts at, where Short shows the progress of the stock markets following the Great Depression and Japan’s Lost Decades.

Flat markets mean flat returns
Investors who accept such a scenario need to change their approach to investment policy. The buy-and-hold approach, long espoused by investment advisors during bull markets, will result in subpar returns in range-bound periods. Flat markets mean flat returns.

During secular bear markets characterized by flat returns, investors need to use dynamic asset allocation techniques such as the Inflation-Deflation Timer model to capture the swings of a flat market.

Tuesday, July 6, 2010

Dr. Copper teeters over the abyss

The market action last week was dominated by concerns of a double-dip. Indeed, the week began with John Hussman warning of a double-dip recession and ended with John Mauldin's hand wringing over the NFP release.

Dr. Copper, one of the most economically sensitive of commodities, is curiously showing weakness but hasn’t fallen apart. This is an indication to me that it may be a little early to over-react to recessionary fears.

By contrast, the SPX has shown a greater degree of weakness than copper. While the red metal is in a downtrend, it hasn’t even tested major support levels. By comparison, equities sliced through support like a hot knife through butter.

In fact, the entire commodity complex is showing the same pattern as copper – weakness but no freefall.

Apocalypse not yet
Does that mean all is well?

Not quite. Take a look at the copper to SPX ratio. While the ratio is indicating a near-term positive relative performance by copper, the ratio is displaying a rounding inverted saucer top pattern which is indicative of a long term decline.

These conditions are consistent with the readings of my Inflation-Deflation Timer model, which remains in neutral but perched at the edge of a deflation reading, which would be indicative of a 2008-style panic. The Inflation-Deflation Timer model is a trend following model, which can be late in calling economic trends.

These conditions are also consistent with John Hussman’s earlier essay outlining the tripwires of a double-dip recession. The only sign that remained to call for a full blown double-dip recession was the ISM Index at or below 54. The latest release of the index came in at 56.2, declining fast but not quite at 54 yet. Hussman did note, however, that the ECRI Weekly Leading Indicator, which has been in freefall, is highly correlated with ISM with a lead time of 13 weeks - and that's why he made the double-dip recession call.

Overall, I am tilting towards the views of Barry Ritholz, who wrote that "We do not rule out a double dip or a recession in 2012 — we simply do not have sufficient evidence to draw that conclusion."

Right now, my inner investor is extremely cautious and defensive in light of the risks of a hard landing. On the other hand, my inner trader tells me that a waterfall decline is not an immediate threat, but to be prepared for a short and sharp relief rally to lighten long positions and/or to initiate short positions.

Monday, July 5, 2010

Long-term bullish factors for oil

The headline on Marketwatch blared that the BP spill may lead to higher oil prices. Indeed, Jeff Rubin has expressed similar sentiments about how the Deepwater Horizon disaster is likely to affect the supply situation for oil (see examples here and here).

I agree wholeheartedly. My latest monthly comment for Qwest Investment Management details these same supply concerns. I would also add the possibility of higher heating demand from a global cooling cycle.

There is a controversial view that solar cycles are responsible for the warming and cooling cycles on earth. The English astronomer William Herschel noted a relationship between sunspot cycles and wheat prices and that link has been confirmed by other researchers.

Right now, the sun is undergoing an extraordinarily quiet period and tracking previous periods of global cooling. If the climate were to cool, which would raise heating demand, and oil supplies fall because of higher operating and environmental standards – look out!

Come and read it all here.

Saturday, July 3, 2010

Not regulation, but proper structures

There has been a lot of discussion over financial regulation lately. My view has always been that trying to regulate financial entities is like herding cats. Just when you think you’ve got them rounded up, one or two get away and trouble starts all over again.
Consider this exchange with a hedge fund manager about how clueless people participated in bubble creation [emphasis added]:

HFM: Look, bubbles create other bubbles, they’re like derivative bubbles, so to the extent that there was a bubble in credit or a bubble in the mortgage market, that created a bubble for people who could trade those products. There was a misallocation of resources not only into mortgages, let’s say, but also into the trading of mortgages, and it sucked talent into those areas that probably should be deployed other places. And the way talent gets sucked into those places is by a price signal, the compensation going out. So what was happening was that the pay scale for finance was just—incredibly out of whack. You had guys who were literally just a couple of years out of college, maybe they’d done a year or two at an investment bank, making several hundred thousand dollars a year doing pretty low-value-added Excel-modeling tasks…

It was kind of crazy what people were being paid. And for the more senior people, the kind of deals they were getting—because their pay tends to be not just a number range but a percentage of the profits they generate—they were getting very high percentages of the profits, and very high guaranteed income. The decision to pay those kinds of numbers was motivated by the fact that other places were paying those kinds of numbers, and their ability to pay those kinds of numbers was motivated by the fact that there were huge amounts of assets coming into hedge funds, and hedge funds are able to charge a management fee for the assets under management. So if you had tons of assets coming in, you needed people to manage those assets, you had to get quality people, you had a ton of money to spend, and everybody was looking for people who had a resume that singled them out, or that identified them as qualified to work at a hedge fund—there was just tremendous competition for those people, and it drove prices to ridiculous levels. It changed people’s attitudes—there was a palpable cockiness that one sensed from employees. And there was a lack of distinction I think between people who were really good, who you would want in any environment, and people who you could just fill a seat with because they had a resume that stamped them as minimally qualified.

There are a lot of very creative people working on Wall Street and they will engage in regulatory arbitrage. If you try to regulate one activity, e.g. how hot IPOs are distributed, that particular problem will go away but that creative talent will go elsewhere to do something else that creates the next regulatory problem.

It’s not that I am ideologically opposed to regulation, but in this case a heavy-handed regulatory approach just doesn’t work. The correct solution is to create the right operating structure for the financial marketplace:
  1. Complete and timely disclosure; and
  2. Symmetric incentives.
The disclosure part is easy to understand. Complete and timely disclosure doesn’t allow one side to stack the deck.

The second part is a little bit more subtle. The current structure at investment banks aren’t incentivizing people to get rich slowly by building long-term relationships, but to get rich quickly by doing the trade while ignoring the long-tailed risks that may come with the trade. That’s an asymmetric incentive structure. One very simple solution is to bring back the partnership investment bank. Barry Ritholz and I are on the same page on this issue and he correctly points out that none of the Wall Street partnerships got into trouble in the last financial crisis.

In praise of good government
While I am disinclined to regulate, it doesn’t mean that government is inherently bad. In fact, good government can be a positive force in creating the structure for economic growth.

For the Tea Partiers and Libertarians out there, consider this. Consider this modern account (from the same aforementioned hedge fund manager) of what happens when you don’t have good government:

[T]here’s something very attractive from an investment standpoint of going to a place like Lagos... You’d go to an office building or a hotel and in the course of the day the power goes out six times and the generator kicks on to power the building, and that generator is powered by diesel, and you see all these fuel trucks all over the place that have to bring diesel to fuel the generator, and the generators are noisy and loud. You’re like, “Wow, there’s an obvious opportunity here. Somebody should build a reliable power plant! It would just be tremendous, a tremendous economic efficiency, because you wouldn’t need all these diesel trucks zooming around, you wouldn’t need all these generators…”
Then you realize that the place sounds like a scene from The Sopranos:

But then you realize that it’s not like they can’t figure this out. It’s not like they don’t get the fact that it’s pretty annoying that the power goes out six times a day and it’s pretty annoying to have six fuel generators humming all the time. The reason investment doesn’t happen is because it’s in some powerful person’s interest that it not happen. There’s some guy who controls the diesel trucks who makes tons of money from being a diesel distributor, and there’s a guy with all these generators who would be out of business if power plants were built, and he stands in the way.
In fact, the structure of the fictional Soprano mobster family sounds an awful lot like the feudal states of a bygone era, where the baron (don) lorded over his estate surrounded by his knights (his "crew" of “made men”). But wait, are feudal states really from a bygone era? Wasn’t Ferdinand Marcos just a king by another name? What about Dear Leader Kim of North Korea? Consider this account from Foreign Policy about what is clouding our perception of Afghanistan:

Western observers attempting to come to grips with Afghanistan's fragmented state authority also find themselves drawn to other aspects of the medieval era, a period in which leadership in Europe was personal rather than bureaucratic and the state's power to impose its will quite limited.

The difficulty for a monarch was that the resources remained in the hands of his vassals, who then acted in their own interests. The rise of centralized states in Europe in the 16th through 18th centuries finished a process by which monarchs gradually centralized power and dispossessed their feudal nobilities. Then, in the beginning of the 19th century, the rise of the European nation-state took this process a step further and dispossessed the monarchs while keeping intact the centralized administrations they had built.

Foreigners encountering Afghanistan in the post-2001 era saw this devolution of power as an example of state failure. Many of the multiple competitors for legitimate authority at the local level had no desire to participate in politics in a state-centered system. Autonomous tribes and ethnic groups, local militia commanders, criminal syndicates, and even blood-feuding families sought to resist state power, but they did not seek to overturn or replace it. This arrangement is analogous to medieval Europe, where kings were frequently also unable to maintain a monopoly on the legitimate use of violence, but were still able to retain their thrones.
Is that what we really want? Be careful about what you wish for when you want the government off your back.