Tuesday, May 31, 2011

Turning beta into alpha

Joe Weisenthal over at Clusterstock recently reported that quants have become beta chasers:
In a survey of quant investors done by BofA/ML, the number of respondents who say that beta is a key factor in their stock screens, has surged overtime, from less than 20% in the mid 90s to over 70% now.

This observation confirms what I suspected all along - we have returned to a single-factor CAPM framework from a multi-factor APT framework. In other words, investment decision making has returned to either "risk on" or "risk off".

Given the current environment, I chose to turn to active asset allocation and apply a momentum model to the beta decision of others, i.e. the Inflation-Deflation Timer Model, as my principal source of alpha.

Playing poker, not backgammon
Many quants think of investing as a structured game with some randomness thrown in, like backgammon. I believe that in investing, you have to watch what others are doing as well. Don't forget that Edward Thorp, who was one of the original quants, was a poker player.

Correction: A colleague pointed out to me that Thorp was known as a blackjack player, not a poker player. Despite the incorrect analogy, I continue to believe that quantitative analysts think about the structure of the game that they are playing - which resembles poker than a structured game like backgammon or blackjack.

Saturday, May 28, 2011

Time to sell? Roach turns bullish on China

When I was a portfolio manager in the 90's, my Morgan Stanley salesman used to invite me into New York from Boston for meetings and lunches, which I never attended. I used to quip that I would see him in New York when their (then) strategist Stephen Roach turned bullish. Even then, Roach was the perennial grump and bear, much like David Rosenberg and Albert Edwards are today.

So it was with some surprise that I saw Roach's bullish commentary on China entitled 10 Reasons Why China is Different.

When the perennial bear turns bullish, is it time to sell?

Wednesday, May 25, 2011

Which part of Goldman is right?

Many of you will have heard about Goldman's bullish call on oil (via ZeroHedge), with a target price of $130 for Brent. Not are they bullish on oil, but the entire commodity complex.

At the same time, Goldman is forecasting for an economic slowdown in China:
Our new GDP estimates show a significant slowdown in 2Q11 to 8.0% qoq (significantly below trend), then recovering towards trend in 3Q11 at 9.0% and returning to trend in 4Q11 at 9.3%. This is both a sharper and more extended slowdown than we had previously forecast.
How can Goldman Sachs be oil and commodity bullish when China consumes 25-50% of many key commodities?

Izabella Kaminska at FT Alphaville points out some analysis from Simon Hunt of Simon Hunt Strategic Services which suggests that rising copper demand seen in China is the result of re-stocking and not final demand, which remains weak:
What is now being seen is that fabricators who have been operating on a hand to mouth basis, now seeing prices having fallen by $1000+ , are replenishing those inventories. It is not a signal that actual production of semis, i.e material going into furnaces has improved. On the contrary, I expect to be told that business is pretty weak.
Who is right? Which part of Goldman Sachs is right? Are they all right?

I don't know. This is a "feature" of sell-side research, where you have encounter analysts with competing views.

Monday, May 23, 2011

On the fence, watching for an Apocalypse

Whew! The world didn't end Saturday. There is another form of Apocalypse - a financial one, that I am watching for. Already, the shares of Goldman Sachs appear to be in freefall (and on high volume).

A breakdown in Financials = Rising financial stress
Of greater concern is the performance of the PHLX Bank Index (BKX) against the market. The chart below plots the relative performance of the BKX to the market going all the back to 1993. Right now, the banks are now testing a critical relative support level. Instances in the past where it has broken these support levels have been signals of rising systemic risk in the financial system that ultimately culminated in market meltdowns. The first instance warned of the Russia Crisis, which brought down Long Term Capital Management. The second occurred in April 2007, which was the subprime crisis - whose ultimate conclusion was the Great Recession of 2008.

The bull case
While I just trade the signals and don't try to anticipate signals, the prognosis is mixed and I am on the fence on whether it is likely to break down. The banks have not shown me that they have definitively broken relative support - which would be a warning of severe distress. They are just testing support levels.

There is a bullish case to be made. Scott Grannis points out that systemic risks are low right now, largely because of the message from the bond market. I have learned over the years that given a choice between believing the message from the bond market and the stock market, I would tilt towards the bond market.

The bear case
On the other hand, a glance at the relative performance of the Financial Sector SPDR (XLF) for the past two-and-a-half years shows that the Financials may have already broken down on a relative basis. The sector is definitely in a relative downtrend. XLF may have already violated relative support, though arguably it is still in the process of testing a relative support zone.

A place to hide
Nevertheless, I remain conflicted. Certainly there are risks, but the presence of risk doesn't mean that the world is certain to blow up.

During these periods of analytical uncertainty, I believe that a disciplined model such as the Inflation Deflation Timer Model, coupled with secondary indicators such as the BKX or XLF vs. the market, are a good place to hide. If the Timer Model were to signal a period of heightened financial stress, then the model portfolio would rotate into the safety of the US Treasury long bond (unless the crisis is a US default, in which case I would find something else, e.g. Canadas). On the other hand, if things turn around because of a policy response, e.g. QE3, then the Timer Model would move into the aggressive, high beta trade of emerging markets and commodity producers.

Thursday, May 19, 2011

The bears in control

I got some push-back from readers after my last post, Ursa Major or Ursa Minor. The gist of the objection was that stock market leadership can rotate and a commodity price sell-off is not necessarily a precursor to a bear market. Stocks can continue to rise because of the stimulative effects of lower oil and other commodity prices.

I beg to differ.

Many secondary indicators of risk appetite and cyclicality are rolling over. The weight of the evidence suggests that the bears are now in control of the stock market. Consider, for example, the ratio of relative performance of the Consumer Discretionary sector (XLY) to Consumer Staples (XLP), my favorite measure of risk appetite. This ratio topped out in February and has been in a relative downtrend ever since, indicating that risk appetite is in retreat.

The market rally from the March 2009 bottom has driven by the expectations of a cyclical rebound. The accompanying chart of the Morgan Stanley Cyclical Index against the market shows a similar pattern of broken relative uptrends. Can the equity market continue to advance when cyclicals are going sideways relative to the market?

Also consider where market leadership is coming from: defensive sectors such as Consumer Staples. Is this the sign of a healthy bull?

Other defensive sectors, such as Utilities, are also leading the market.

Mark Hulbert pointed out that Ned Davis Research concluded that their studies of market sector rotation is pointing to a market top. I concur with that assessment.

The bigger question is whether this is just a minor pullback or the start of something bigger. For that answer we will have to watch and wait.

Monday, May 16, 2011

Ursa Major or Ursa Minor?

I have been getting increasingly more cautious about the equity markets, starting in early April and more cautious last week. Now that the markets seem to be in a pullback mode, the key question is: What's next?

Regular readers know that I use commodity prices as the canaries in the coal mine of global growth and inflationary expectations. The canaries are not behaving well, as shown by the chart of the CRB Index below. Commodity prices have broken out from a steady uptrend and they are now testing a critical support level. I am now watching to see if those key support levels hold.

Commodity sensitive stock markets like the Canadian market is showing a similar pattern of testing important support levels.

Looking further at emerging market equities, which is another important barometer of global growth expectations, EEM has already violated an initial support level, with the next support at 44. I will be watching if there is further weakness and if the critical support at 44 holds. Looking across the BRIC markets, both Brazil and Russia have broken down technically, with the former in a clear downtrend.

Then there is the elephant in the room - China. Given the fragility of the global economy, getting the China call right is going to be really important. I am now watching closely how the Shanghai Composite behaves at the different support levels.

A clearer picture can be seen by watching the Hang Seng and if critical support at around the 22,600 level can hold.

In short, the market is clearly in corrective mode and my inner investor believes the markets have the echoes of 2008 here. Then, we had a commodity price blowoff, just as we do now. Then, we had looming macro risks overhanging the market, just as we have now. Consider, for example, John Maudlin's excellent explanation of European sovereign risk here.

On the other hand, my inner trader tells me to listen to the markets and trade their whispers, rather than listen to my own biases. Though the major market averages in the US and Europe aren't behaving as badly as some of these charts that I have shown above, watching how the different markets behave at these critical support levels will give us clearer signs of whether we are dealing with Ursa Major or Ursa Minor.

Thursday, May 12, 2011

Take a ride on my demographic train

I wrote back on July 8, 2010 about an academic paper by Geanakoplos et al entitled Demography and the long-term predictability of the stock market, where the authors related stock market returns and long-term P/Es. Reading between the lines, they forecast a 1982-style (my words, not theirs) market bottom about 2018.

Now, I see that others have jumped on the story. Mark Hulbert has highlighted some analysis from Ned Davis Research indicating that American age demographics will be more youthful than China's by 2020. Hulbert pointed to a paper that concluded that investors don't pay much attention to demographics, even though age demographics is highly predictable and such trends exploitable by investors. Here is the abstract [emphasis added]:
Do investors pay enough attention to long-term fundamentals? We consider the case of demographic information. Cohort size fluctuations produce forecastable demand changes for age-sensitive sectors, such as toys, bicycles, beer, life insurance, and nursing homes. These demand changes are predictable once a specific cohort is born. We use lagged consumption and demographic data to forecast future consumption demand growth induced by changes in age structure. We find that demand forecasts predict profitability by industry. Moreover, forecasted demand changes 5 to 10 years in the future predict annual industry stock returns. One additional percentage point of annualized demand growth due to demographics predicts a 5 to 10 percentage point increase in annual abnormal industry stock returns. However, forecasted demand changes over shorter horizons do not predict stock returns. The predictability results are more substantial for industries with higher barriers to entry and with more pronounced age patterns in consumption. A trading strategy exploiting demographic information earns an annualized risk-adjusted return of 5 to 7 percent. We present a model of underreaction to information about the distant future that is consistent with the findings.
My conclusion has been equity markets are likely to go sideways until the end of this decade. I wrote that:
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, May 10, 2011

Sell in May?

In the wake of the commodity rout last week, the Inflation-Deflation Timer Model has moved into "neutral" from an "inflation" reading*. This told my inner trader that he should take some risk off the table. Given the high level of macro risk, I would be inclined to take more more defensive position than usual.

This signal to de-risk isn't a surprise. In early April, I wrote about negative divergences (see Getting ready to sell in May). How the market reacts to news is also a good short-term indicator of direction. The fizzled Osama bin Laden rally should have been as clear as ringing the bell in the town square to traders that this market was looking tired.

What happens now?
Now that the Timer Model has gone neutral, what happens now? Mr. Market could take one of two paths.

First, this could be the start of a run-of-the-mill 5-10% correction in the equity market, with an extreme downside limit of about 15%. VIX and More has tabulated the market pullbacks in the 2009-11 period and the average depth of these correction was 6.5%.

Macro risks everywhere
I am concerned that the market is acting vulnerably during a period of heightened macro risk. There are three major sources of macro risk:
  • Europe: As I write this, Greek 2-year debt is sporting an eye-popping yield north of 25%. These stratospheric levels reflect market fears that bond holders will have to take a significant haircut on Greek debt, which would be a devastating blow to the already fragile European banking system. If Greece re-structures, then it could very well take down Spain - which may be too large for the EU to rescue.
  • China: The PBoC has signaled that it will take further steps to cool its superheated economy and there are "no limit to how far it can raise the reserve requirement". Already, there are signs that its property bubble is being deflated. Recent reports indicate that Chinese property developer profits are falling and their debt is approaching $1T in a climate of rising inventory.
  • US default: The political horse-trading over the debt ceiling continues to be worrisome. A default by the US Treasury would send shockwaves all around the globe and it would be the financial equivalent of the comet that hit the Earth and created the Gulf of Mexico in prehistoric times.
The current market environment is likely to resolve itself with a plain vanilla 5-10% correction. However, if any of these macro risks were to manifest themselves during that pullback, the downside has the potential to extend itself to 40-50%.

My inner investor has already heeded these warnings and de-risked his portfolio. My inner trader is inclined to be more defensive than normally called for.

* The announcement of signal change was delayed on this blog out of consideration for the clients of Qwest Investment Fund Management.

Monday, May 9, 2011

Where's diversification when you need it?

One of the rationales for the formulation of the Inflation-Deflation Timer Model was the failure of asset diversification in the Financial Crisis of 2008. During that panic episode, investors found that asset class return correlations converged to 1. All assets moved together because it was one giant risk trade. Even balanced funds failed to diversify risk.

In response, the Timer Model was built in such a way that during deflationary, or panic episodes, I analytically identified assets, i.e. risk-free US Treasuries, as the safety trade - without reference to any historical correlations.

I see that a number of others agree with my analytical approach to risk analysis. John Authers wrote the following in his book, The Fearful Rise of Markets:

In the future, it would make more sense to divide the world by risk. If an investment is not prone to the same risks as the others you already hold, then buying it will reduce your overall risk. If it is subject to exactly the same risk, then buying it is pointless, even if it is in a different asset class or country. Rather than balance between stocks and bonds, for example, it might be better to balance the risks of inflation and deflation, which both affect stocks and bonds. Diversification itself is as good an idea as ever. You should not put all your eggs in one basket. But in the globalized world, you can put your egg into a different country an still find that it is in the same basket.
EDHEC said the same thing, but in a slightly different way. (Note that my Timer Model is a dynamic asset allocation model) [emphasis added]:
The postmodern quantitative techniques suggested as extensions of mean-variance analysis, however, exploit diversification as a general method. Although diversification is most effective in extracting risk premia over reasonably long investment horizons and is a key component of sound risk management, it is ill-suited for loss control in severe market downturns. Hedging and insurance are better suited for loss control over short horizons. In particular, dynamic asset allocation techniques deal efficiently with general loss constraints because they preserve access to the upside. Diversification is still very useful in these strategies, as the performance of well-diversified building blocks helps finance the cost of insurance strategies.
When do you want risk control the most? During "normal" periods when diversification dampens volatility and returns? Or during extreme crisis events when standard diversification techniques break down?

Thursday, May 5, 2011

Comparing private and government compensation

There is an assumption in many quarters of society that virtually any form of government is inherently bad. Private enterprise and the free markets can do things much better. Consider this essay entitled If Supermarkets were like Public Schools, as one of many examples. Donald Boudreaux lays out the scenario:
Suppose that groceries were supplied in the same way as K-12 education. Residents of each county would pay taxes on their properties. Nearly half of those tax revenues would then be spent by government officials to build and operate supermarkets. Each family would be assigned to a particular supermarket according to its home address. And each family would get its weekly allotment of groceries—"for free"—from its neighborhood public supermarket.

No family would be permitted to get groceries from a public supermarket outside of its district. Fortunately, though, thanks to a Supreme Court decision, families would be free to shop at private supermarkets that charge directly for the groceries they offer. Private-supermarket families, however, would receive no reductions in their property taxes.
He went on to assert that private enterprise, or the free market, could deliver those services much better [emphasis added]:
Being largely protected from consumer choice, almost all public supermarkets would be worse than private ones. In poor counties the quality of public supermarkets would be downright abysmal. Poor people—entitled in principle to excellent supermarkets—would in fact suffer unusually poor supermarket quality.

If the free market is the superior choice in virtually all instances, then incentivizing workers by their output, as well as a business friendly tax policy, is the correct solution. Nowhere else can this attitude be found than the gargantuan compensation packages found on Wall Street.
The Epicurean Dealmaker has a more nuanced interpretation of banker compensation. He explains that investment banks are networks that can be rented by clients. The investment bankers and traders are also valuable in and of themselves:
Clearly, a proprietary trader or an M&A banker is more powerful and effective if he or she works at a great platform with outstanding network resources, like Goldman Sachs. He or she can do more, bigger, and more profitable deals because of it. But Goldman Sachs itself is more powerful and more valuable to its clients because they have that person (and his or her network(s)) in place. To the question, "Who is more valuable, the banker or the platform?," the answer is always "Both." Take one away from the other, and both are diminished.
So discussions like this one, where an individual who arranged a massively profitable trade for his bank expects far more compensation than the bank wants or is likely to give him, are an annual staple of my industry. Clearly the trader could not have done such a trade without the capital and resources of his employer, so a huge bonus is not merited. But the bank has incentives to make him happy, too, lest he leave with the special knowledge or relationships he employed or developed in that trade to replicate it—and the accompanying profits—at a competitor. Investment banker compensation is always comprised of some portion of reward for business won and profits made plus an option on potential future business and profits from that same banker. This insight helps explain the fact, puzzling to most outside the industry, that investment bankers can get paid tons of money even when they or their firms lose it: they are being paid for future potential results.
So if you accept the principle that someone makes a zillion for the bank, he deserves a reasonable cut of the profit (with definition of the term "reasonable" subject to later discussion).

Greed is Good, but it isn't the only motivator
Contrast that to the paradigm of how government works. Civil service workers have little incentive to do a better job, largely because market based signals are largely absent.

Now think about the jubilation over the death of Osama bin Laden and the adoration of the anonymous SEAL team that executed the raid. Now think about these questions:
  • Why is there all this adoration over a bunch of people who work for the federal government?
  • There was a $25 million reward for OBL, why didn't that get results earlier?
  • Would we have seen better or faster results if these civil servants had been incentivized properly (perhaps to give a three or six sigma effort)? Should this SEAL team, along with the numerous intelligence analysts involved in the operation be incentivized with multi-million dollar Wall Street bonuses?
People do things not just because of greed. Greed is a powerful motivator, but it isn't everything.

Upcoming conferences

Here are some upcoming conferences of interest that I want to highlight.

Pacific Northwest Economic Conference: Fixing Global Finance

If anyone is around Victoria, BC next week, I will be on a panel at the Pacific Northwest Regional Economic Conference on May 13, 2011 discussing Fixing Global Finance, with Yves Smith of Naked Capitalism and Marion Wrobel of the Canadian Bankers Association. The conference runs May 12-13.

The inflation-deflation debate continues
In addition, AIMA Canada is running a debate on May 25, 2011 in Toronto entitled Inflation or Deflation, which risk should you prepare for? I have been writing about inflation-deflation debate since mid-2009. There are some well-thought analysis on both sides. I believe that many deflationists are confused about is the meaning of the term inflation (see my previous comment here). There is little or no inflation in consumer goods (TV and cars) but signs of massive asset inflation (commodities, collectibles, etc.) Those who watch CPI or core CPI will find little or no inflation, while those who watch commodity prices will find the opposite picture.

I expect to be in attendance. Come to the session if you are in or around Toronto. I am sure it will be worthwhile.

Wednesday, May 4, 2011

Cheap way to get Aussie exposure

I have written about the Australia/Canada pair trade before. Both economies and their stock markets are structurally similar. The major difference is that while Australian resource exposure is tilted towards mining, Canadian resource exposure is more heavily weighted in energy.

Buy Canada/Sell Australia
The chart below shows the relative performance of the iShare Canada ETF (EWC) compared to the iShare Australia ETF (EWA), both measured in USD. As you can see, Canada is near the bottom of a relative trading range.

The Canadian election held Monday gave the Conservatives a rare majority government. These results should take some of the political uncertainty out of the Canadian market.

Given the relative performance of the two markets, traders may want to consider going long Canada and shorting Australia. More risk averse investors can think of the Canadian market as a cheap way of gaining exposure to an Aussie-like stock market.

As always, pairs trading is not for the faint of heart and any trade should be entered with well-defined risk limits in mind.

Sunday, May 1, 2011

Is Bernanke more brilliant than we ever conceived?

Many analysts, myself included, have watched in horror as the Bernanke Fed seems to have ignored the perils of incipient inflation and monetary debasement in implementing QE and later QE2. Lately I've been thinking that Ben Bernanke is a evil genius with a secret agenda that is more brilliant than anyone has conceived before.

Nick Rowe, writing at Worthwhile Canadian Initiative, inadvertently laid out Bernanke's nefarious scenario. First, he wrote:
There's a general principle in economics: first you eat the free lunches; then you look at the hard trade-offs. Functional Finance says "first eat the free lunches". The Long Run Government Budget Constraint says "then look at the hard trade-offs".

Everyone likes a free lunch. The Washington Post reported that in a poll, Americans would like to cut the budget deficit, but they oppose entitlement, defense and across-the-board tax increases cuts.
The survey finds that Americans prefer to keep Medicare just the way it is. Most also oppose cuts in Medicaid and the defense budget. More than half say they are against small, across-the-board tax increases combined with modest reductions in Medicare and Social Security benefits. Only President Obama’s call to raise tax rates on the wealthiest Americans enjoys solid support.
In other words, they want a free lunch. (Consider, for example, this more realistic assessment of the budget from former Reagan budget director David Stockman where he blames both sides of the aisle.) Rowe postulated that there are certain circumstances where the American People could have their free lunch:
Suppose, just suppose, that if you kept on doing what you were planning to do, you never had to worry about inflation. Not now, not in the future, not ever. Because Aggregate Demand was too low now, and was projected to be too low forever. So you are not worried about inflation. Instead you are worried about deflation. And you were a government that could print your own money. What would you do?

You would print money and spend it. Or print money and use it to finance tax cuts. And you would keep on doing it, more and more, until you got to the point where you did start to worry about inflation. You first eat all the free lunches.
When the US Dollar is the de facto reserve currency of the global economy, there is a free lunch of sorts. But what about the consequences? Rowe has an answer to that as well, given that the global economy collapsed in 2008 and remains very fragile [emphasis added]:
Suppose inflation isn't a problem right now, because Aggregate Demand is currently too low. Does that mean the government should print money and spend it? Not necessarily. Print money yes, but instead of spending it on goods, or on tax cuts, it might be better to use it to buy back some interest-paying government bonds. Because even though inflation isn't a problem right now, it may be a problem some time in the future. So you can buy the money back in future, by re-issuing the bonds (and save on interest in the meantime) without having to raise future taxes or cut future spending.
Isn't that what the Fed is doing, in its own way, with QE2. Okay, it's not retiring government debt but putting the paper on the Fed's balance sheet. Nevertheless, the Treasury can now finance new debt at lower rates because Aggregate Demand is so weak.

Is this the evil genius Dr. Bernanke at work? Or just the government acting rationally? Either way, it's utterly brilliant!

Addendum: In a future post, I will write about an "out-of-the-box" plan to address the US federal deficit in a relatively painless way.