Watch smart funds on their long bond position

Further to my last post which shows that smart funds are long the commodity trade (inflation) and long the US long bond trade (dis-inflation), a further word of explanation seems to be in order. I believe that the key macro view underpinning this position is:

• The secular trend is for more inflation and official inflation rate is understated
• The cyclical trend is for inflation to fall, setting up for a rally in the bond market

Official inflation rate understated
The Fed focuses on core inflation and that statistic has been consistently lower than the other measures of inflation. The chart below shows the progression of headline CPI, core CPI, or CPI ex-food and energy, and PPI.

As the chart shows, core CPI is consistently lower than the other measures of inflation. PPI, or one, is more sensitive to commodity prices, which has been rising. Moreover, PPI has none of the hedonic and other adjustments that the CPI has from the recomendations of the Boskin Commission. Others have also commented that even the headline CPI has problems and doesn’t reflect true changes in the cost of living.

Even if you were to focus on one of Greenspan’s favorite indicators of inflation, PCE, the Dallas Fed’s measure of trimmed mean PCE seems to be consistently higher than core PCE.


Inflationary pressures cyclically easing
Recently, there have been abundant signs that the economy is weakening. The latest Beige Book report indicates sluggish growth. Reconstituted M3 growth is falling off a cliff. Various Fed officials have been signaling that inflationary pressures are easing and therefore the pressure to hike interest rates are lessening. In response to these signals the bond market has responded and the spread between TIPS and the 10-year Treasury are in retreat.


What does an investor do?
Mutual funds tend to have longer term time horizons than the average swing trader. Smart funds have been saying: “We are not fooled by the official inflation rate and our long term view is for inflation to stay high. In the short term, however, the weak economy is going result in a bond market rally.”

One of the keys to spotting a bottom to the US equity market will be to watch for smart funds to switch their stance on the long bond.

Smart funds: Still early in the inflation trade

I have written about smart mutual funds and reversed engineered their macro exposures before. One of the benefits of such an exercise is to formulate a longer term macro scenario and examine it for internal consistency and to see if I am comfortable with the general thesis. In looking at smart funds today, their macro exposures can be summarized as follows:

• Still believers in the Inflation Trade;
• Still underweight Financials; and
• Long the US long bond!

Still overweight Energy vs. Consensus
The chart below shows the imputed exposure of smart mutual funds and consensus mutual funds in the Energy sector. As the chart shows, smart funds remain overweight Energy while consensus funds have cut back their exposure to roughly market weight:

Consistent with the hard asset and inflation theme, smart funds are also overweight Materials vs. the consensus (chart not shown).


Underweight Financials
Smart funds are still heavily underweight Financials compared to the consensus:

…but smart funds are long the US long bond
Surprisingly, the imputed duration of smart fund portfolios seem to be higher than the S&P 500 compared to the consensus:

Long inflation, Fed in a bind and behind the curve
On the surface, the macro position of smart funds lack internal consistency. Usually, if you are long the inflation (Energy and Materials) bet, you are short the bond market. The experience of the 1970s showed that if inflation wins, bondholders lose.

However, I believe that the portfolio managers of these funds believe that longer term, inflation is here and rising. Moreover, the Fed is behind the curve in its inflation fight. It is further handcuffed by the fragility of the financial system (hence the underweight position in Financials). In the short term, the combination of the cyclical effects of the economic slowdown and the Fed’s focus on core inflation, which appears relatively benign, will serve to put a lid on long rates (and therefore the long bond bet).

In other words, they are betting on inflation rising and believe that it’s very early in the trade. The long bond exposure implies that inflationary expectations remain contained and are not yet ready to rise.

Ominous sign for the world, long-term bullish for oil

The world woke up today to the scare that Russia may use its oil as a weapon. In addition to the geological peak oil thesis that I have espoused before, this Russia development is a form of the political peak oil thesis, which Fabius Maximus has been beating the drums on for some time in his blog.

Another example of political peaking occurred in April 2008, where

Saudi Arabia's King Abdullah said he had ordered some new oil discoveries left untapped to preserve oil wealth in the world's top exporter for future generations…

This “we want to keep the oil for ourselves” policy would exacerbate any shortages, especially if it started spreading to other countries (Brazil, Mexico, Norway, Canada, etc.) The Saudis have already indicated that they want to diversify away from oil. While we’ve heard that before, but combined with the April 2008 announcement it may be an indication that they are preparing for a time when the oil runs out.

These developments are long-term bullish for the oil price. In the short term, however, oil appears to be undergoing a relief rally from an oversold condition from storms in the Gulf of Mexico and geopolitical considerations – I would be less inclined to chase it here.

Why you can’t stop bubbles

Now that we are in the recrimination phase of the cycle, we are seeing more and more of what happened and how do we stop it happening again questions and investigations. While the article focuses on Europe, a parallel process is occurring in the US.


Asymmetric payoff is the problem
I would humbly submit that it is virtually impossible for stop excesses from recurring in a capitalist society. As one quote from a risk manager put it:

…the job we do has the risk profile of a short option position with unlimited downside and limited upside. This is the one position that every good risk manager knows he must avoid at all costs.

Remember the IPO allocation scandals from the last cycle? There were all sorts of controls put into place. In the next cycle, excesses popped up elsewhere. That’s because of the asymmetric nature of risk. Risk managers have are burdened with short option position phenomena in risk control: limited upside and unlimited downside. On the other hand, revenue producers (whether in a hedge fund, broker, or other financial services entity) have the reverse position of being long a call option. These people get handsomely rewarded by making money for their firm and for themselves through financial engineering, but they face limited downside risk if the structure they build all comes apart at some point in the future.

A modest proposal (for hedge fund investors)

The news of the demise of former CNBC anchor Ron Insana’s venture has been a catalyst for more questions about the hedge fund business model. Are these project returns persistent (also here)? Are there cheaper alternatives?


Looking for uncorrelated pure alphas
I have a modes proposal for hedge fund investors in light of these difficulties. The story of hedge fund investing has been to look for a pure alpha stream, however you want to define it, that is uncorrelated with the return pattern of existing asset classes.

If that’s the case, why not go into the gaming (or casino) business?

In the gaming business, the house has an edge in any game you play and takes steps to enforce that edge (e.g. tossing out the card counters at Blackjack, etc.) The customers know it, but they still keep coming.

Statistically, the return pattern of every game that a customer plays is uncorrelated with any other. The advantage of being in the gaming business means that you don’t have the problem of the shifting correlation problem: The return correlations of seemingly uncorrelated factors and asset classes converging to 1 during periods of financial crisis.

The main difference is the fee structure. In a hedge fund, you typically pay 2% and 20% with a lockup. In the gaming business, the lockup remains. However, there are significant overhead cost to keep the lights on in a gaming operation. However an investor can gain some of the benefits of economies of scale if there are such a venture can achieve sufficient size.



Addendum: After reading the comments, maybe some readers didn't get the joke which was modeled on Swift's satire A Modest Proposal. This post was meant as a call for a thought experiment as to the rationale behind hedge fund investing.

What this post was not:

• A call for hedge fund investors to gaming: I am well aware that the gaming industry is economically sensitive and cyclical. These are obvious limitations to the gaming industry.
• A call to buy gaming stocks: See comment above about the gaming industry. However, do think about the cash flows of the business because when you engage in direct investment you need a long-term horizon, much like the lockups that you see in the hedge fund industry.

to have to explain my jokes...

Crude oil close to a bottom

In contrast to my last post on gold indicating that the correction in bullion has further to go, the sentiment picture for crude oil is far more constructive. I now have doubts as to whether my near term $100 oil call will come to pass.


Investor sentiment now very negative
Sentiment surveys on crude oil show that readings are now at bearish extremes, which is contrarian bullish. In addition, the CFTC Commitment of Traders data shows that large speculators, or hedge funds, have sold down their crude oil positions near levels where bottoms are seen. Indeed, COT Timer has flashed a buy signal for crude oil this week.




My estimate of mutual fund positioning is also encouraging for the energy sector. Consensus mutual funds have sold down their energy holdings to a market weight from an overweight position. By contrast, smart funds remain overweight the sector.




Long term bullish on oil
I have stated the case to be long-term bullish on oil before. In addition to those reasons, Barry Ritholtz at Big Picture found a great chart showing the growth path of world GDP and oil demand as another reason to be long-term bullish on crude.


Volatility a function of tight supply?
Commodities have always been volatile. Recently the oil price has been more volatile than usual with the market seeing regular $3-5 daily swings. Kurt Cobb postulated that queueing theory could explain oil's wild price swings. You could also argue that the current tight supply condition is acting like an inventory control model. The shifts in demand and the fact that incremental production can be brought on at much lower pricing, though with a lead time, suggest that the level of minimum inventory is highly variable. Include the fact that some of the investments are highly levered also adds to the volatility of minimum inventory level.


Buy oil/short gold?
Given these conditions on gold and oil traders could consider buying crude oil and shorting gold. Note that this is a tactical trading call and there are considerable risks involved. Most notably, the chart of the oil to gold ratio below shows that oil is already extended in favor of oil.

Gold correction has further to run

With gold below $800 and investor sentiment surveys in the bearish zone (contrarian bullish), one might think that we may be close to a turnaround on bullion.

Not so fast!


Average bear down 34% in 18 months
Bespoke Investment Group’s report on typical gold market behavior suggests that there is further downside. The average bear market in gold is down 34% over a period of 18 months and we are only down about 21% right now.


Watch what they do: The selling is not over yet
Sentiment surveys are interesting but they don’t tell the whole picture. While readings are low enough to spark a temporary oversold rally, investors haven’t sold enough of their positions to warrant a call for an intermediate term bottom.

The latest data from CFTC’s Commitment of Traders report show that large speculators (read: hedge funds) have begun to liquidate their gold long positions. However, they haven’t gone short yet and so readings aren’t sufficiently bearish to see a sustainable up move.

I reverse engineered the positions of the average mutual fund using the technique shown in the sidebar titled Reverse Engineering a Manager's Macro Exposure. Consensus mutual funds, which consist of 22 large cap blend funds managed by the largest mutual fund complexes, have also started to liquidate their overweight positions in the S&P 500 Materials Index. However, they remain overweight the sector and have further selling to go.

Some reasons to stay long-term bullish
Not all is lost for the gold bulls. The above analysis shows that the smart funds, by contrast, remain stubbornly overweight the Materials sector indicating that they haven’t given up on their commodity bet. Moreover, some of the smarter commentators such as the Aden sisters, who have adroitly navigated the gold bull and bear markets over the years, remain bullish on bullion.

Time to cover housing shorts

I write these words with great trepidation as I hate to agree with Greenspan and his housing call as he has been consistently wrong in his analysis for a long time.

However, I do believe that the easy money shorting the housing crisis may be over. There are signs that valuations are starting to become more attractive in housing, value players are now entering the space and the homebuilding group is now technically undergoing a bottoming process relative to the market.


Buying a house is starting to make economic sense
In California, which has been one of the hardest hit markets, buying a house is starting to make economic sense again. This recent report shows analysis indicating that in California, “home prices are dropping to a point where the cost of a mortgage and taxes equals rent”.


Sovereign funds buying real estate
There is also this report indicating that sovereign funds are buying US real estate: “one sovereign fund, said to have earmarked $29 billion to purchase foreclosed residential real estate, recently hired a West Coast mortgage broker and is starting to search for bargains.”

These funds tend to have a long time horizon and are typically value players. With the caveat that value investors do tend to be early, sovereign funds have the advantage of being not directly constrained by the tight credit conditions that exist in the US right now.


Homebuilders making a relative technical bottom
The chart below shows the chart of the S&P 500 Homebuilders relative to the S&P 500. As the chart shows, the group has broken out of a relative downtrend. The next phase is likely to be a sideways consolidation pattern.

Warning: I am not calling of a real estate bottom!

The Homebuilders are likely to go from free fall to market performer. Since my belief is that the market has a negative bias, this group is likely to continue to fall. However, the easy money is over from shorting this group. If you are short, cover your shorts.

Substantial downside risk remain in the group. Recently Barry Ritholtz at Big Picture outlined the risks to housing. Though his comments are directed toward the NAR Housing affordability index, these comments are valid with regards to my valuation comments. To paraphrase, my California affordability and valuation analysis:

• Assumes 20% down payment – who has that anymore?
• Ignores debt carried by homeowner – household balance sheets have deteriorated substantially
• Ignores falling FICO scores – see comment above about poor household balance sheets
• Other ownership costs are rising – e.g. property taxes, maintenance, heating, etc.

Tightening credit = more downside for housing?
Meredith Whitney, who correctly called the credit and housing crisis, is also forecasting further downside in housing because of tightening credit conditions.



Cover your housing shorts
An improvement in housing would be positive in general for the equity markets and the US economy. Bottoms don’t happen overnight and this is part of a process.

I would cover any housing shorts. The downside here is limited – don’t be greedy.

Algo trading – too much of a good thing?

Back in the Olden Times when I started watching the markets, 30-40 million shares on the NYSE were considered to be big volume days. Institutional execution was done in the upstairs market by brokerage block traders calling around their accounts: “we have 100,000 XYZ for sale, do you have any interest?”

That has all changed.

Today, there are automated trading bots, or algos (short for algorithm), everywhere. It began with algos trading VWAP (volume weighted average price) orders. With the advent of day trading automation inevitably followed and today you can find specialized trading bots on the internet and even floor brokers are now using algos (see report). There are even some blogs, such as Skill Analytics and Zen Trader to name a few, devoted to this topic.


Flying on autopilot is not always a good thing
With so much automation around, some “reality check” questions come to mind:

• Is anyone doing a reality check on these algorithms?
• Can someone game these algos?

For example, there are brokers offering VWAP algos and guaranteed VWAP trading for individual investors for very low cost. Given the widespread adoption of these algos, don’t you think that someone could write a pattern recognition program to watch for a VWAP algo buying or selling a stock? This information is worth something to someone. As a trader once told me, portfolio insurance program trading (that exacerbated the Crash of 1987) was a huge boon to him because you knew that once the portfolio insurer had started the trading program he had more orders behind it.

If you must use algos and go on autopilot, do it intelligently. As I wrote in a previous post:

Mrs. Humble Student of the Markets, who is a pilot, calls it “raising your head up from the instrument panel and looking out the cockpit window once in a while”.

More constructive on crude oil (correction)

The chart in the previous entry showing the estimate of the CGM Focus position in Energy has been corrected as the previous x-axis was incorrect. Apologies for any inconvenience.

More constructive on crude oil

In retrospect it was easy to call the top in oil. When cartoons like this appeared it was clear that high oil prices had penetrated the public consciousness – a contrarian sell signal.

Now that the oil price has descended about $30 from its peak and other commodities have also been hammered, it’s time to become more constructive on crude. While downside risks remain (e.g. cyclical US slowdown affecting commodity prices, China slowing, US$ in rally mode, etc.), I would like to review the bull case for oil prices and detail the reasons why I remain a long-term oil bull.


Peak Oil
I could go on and on about Peak Oil but I refer you to the site Oil Drum and Matt Simmons’ speeches for more detail. It isn’t about the world running out of oil but more about world oil consumption running into extraction limits. Robert Hirsch wrote an important report for the US Department of Energy back in 2005 discussing these concepts and how to mitigate their effects.

Peak Oil Concepts

Peak Oil mitigation: 9 women can’t have a baby in 1 month
Hirsch’s conclusion was that the US needs to invest in alternative technologies now, because mitigation technologies take time. Put it another way: nine women can’t have a baby in one month – no matter how hard they tried.

If we are indeed facing Peak Oil in the immediate future then the secular trend for energy prices is up and will continue to rise until a combination of alternative energy and conservation measures kick in. This bull would have a long way to go.


Global cooling?
What I am writing here may be sacrilege to some people. The popular consensus about Global Warming is that the Earth is undergoing a warming period caused by the effects of industrialization. However, there is another view that global warming is caused by solar activity – sunspots and solar winds.

Currently, the forecast for the latest solar cycle is that it’s late. Such extended cycles have been associated with cooling periods such as the Little Ice Age experienced a few hundred years ago. Indeed, there have been reports that there is more ice in the Arctic (yes – it’s only one data point) and there has been some hand wringing among the scientists about the timing of the solar cycle.

Is this theory about solar activity correct? I have no idea. I do have allow for the possibility that it is a valid one and should the Earth enter a cooling period, this would be bullish for energy demand and result in higher energy prices.

Heebner still bullish on Energy
In s post back in early June comparing Bill Miller and Ken Heebner, I noted that Ken Heebner had a hot hand largely because of his overweight position in resources and underweight position in Financials. Moreover, Heebner does not hesitate to turn over his portfolio if he thinks that it is positioned improperly.

The chart below shows the Heebner’s latest imputed position in the Energy sector. Despite the recent rally in Financials and the air pocket hit by Energy, Heebner may have trimmed back some of his Energy overweight and is now adding back to his position.



You have to respect Heebner's views given his record.


Investor sentiment is bearish
Finally, in the short term, investor sentiment on crude has retreated to levels that warrants taking a less bearish stance. While oil prices may not rocket up from these levels, these readings do suggest a period of stabilization or consolidation in price.

A nervous bull on oil
Given that oil prices have retreated about $30 from their peak, I believe that the near-term upside and downside price risks are far more balanced and would be inclined to be more constructive on the oil price. Does that mean that it can’t go down any more? Of course not, there remain substantial risks to buying here. However, if you are playing the odds then the probabilities are now tilting more in favor of the bulls.

Addendum: The chart estimating the CGM Focus position in Energy has been corrected as the previous x-axis was incorrect. Apologies for any inconvenience.

Is Value just a big bet on Financials?

Recently, the relative performance of Value vs. Growth seems to be driven mainly by the relative performance of Financials.

The chart below shows the relative weights of the Value and Growth indices in the large cap (Russell 1000 Value and Growth), mid cap (Russell Mid-cap Value and Growth) and small cap (Russell 2000 Value and Growth) indices. As you can see, the Value indices have consistent large overweight in Financials across all market cap bands when compared to the Growth indices. By contrast, the Growth indices are overweight Health Care or Technology, depending on when it’s a large cap (Technology) or small cap (Health Care) index.

Given the recent problems that the Financials have had, it’s not surprising that Value has become tilted towards the sector. In this environment, relative returns are becoming dominated by one big bet on Financials.

Investors in Value funds may want to check their fund if that’s the big bet they want to make.

Many headwinds for this market rally

You can tell a lot about a market by the way it reacts to news. Merrill Lynch’s announcement of more writedowns and capital raising, ten days after its quarterly earnings report, should have been a shocker to the market. The stock opened down but closed up strongly on the day. This suggests to me that this oversold rally in the Financials has more to go in the very short term.

Yet I am under no illusions that this is a bear market rally. A bear market serves to shake out the excesses of the last boom. In the medium term, I continue to be concerned that the shakeout and adjustment process is nowhere near complete.


Interest rates are rising
The chart below shows the yield on 10-year Treasuries, which has risen since the market began to rally. Mortgage rates have been rising in along with the 10-year yield (see comments here and here) and such a development can’t be good for the beleaguered housing market.

An old-fashioned credit crunch
In typical recessions, lenders pull in their horns and tighten up their lending standards. When done to excess these actions result in a credit crunch, which the IMF is now warning about and is also being reported elsewhere in the press. The Fed has already in place a new alphabet soup acronyms of emergency lending facilities, how much more can it do?

More importantly, what will a credit crunch do to the real economy?


Longer term imbalances remain
Brad Setser also pointed out that many of the long-term imbalances, which a recession should correct, are unresolved. US savings rates have stopped falling but remain low.

In mortgage lending, he writes that the US government is becoming the lender of last resort:

Mortgage lending hasn’t even collapsed. Demand for “private” mortgage-backed securities has disappeared. But the Agencies stepped in and bought mortgages both for their own book and for the mortgage-backed securities that they guaranteed.

Enjoy the ride but trade with tight stops
In the short term, the fact that the market rose on bad news from Merrill Lynch is bullish. However, many of the problems remain unresolved and we will likely see further adjustments that will affect the real economy. In the medium term, this can’t be a bullish sign for US equities.

Don't confuse correlation with causality

One of the first things that I learned as a quant is “don’t confuse correlation with causality”. Unless there is a direct relationship (e.g. interest rates go up, bond prices go down), statistical correlations don’t necessarily hold up.


Correlations move around
The folks at Bespoke have an interesting study showing the correlations of different asset classes and sectors over two time frames, one longer and one shorter. In the short term, S&P 500 sectors have become slightly more correlated with each other. The Yen has become more correlated with virtually all assets while Treasuries have become less correlated.

The lesson of this study is: asset correlations move around. In this case, U.S. Treasuries have become a much better diversifier to U.S. equities in the short run. Which correlations should an investor rely on when building a portfolio?


Understand the fundamental case
My inner quant tells me to ignore the short term figures as the time frame is too short to matter. My inner fundamental investor tells me to figure out why the correlations are moving around. In fact, there may be a perverse causal relationship at work with asset classes that show negative correlations. Here are some examples:

• EAFE (1980s) – International equities were sold as diversifiers as they exhibited low correlation to US equities. Money moved in and eventually correlations rose.
• Emerging markets (1990s) – Emerging markets were sold as diversifiers to US and international equities. Even during periods of stress, their correlations were historically low. Money moved in and correlations rose.
• Hedge funds (starting about 2000) – Hedge fund returns were uncorrelated to equities, especially during the post-Tech Bubble bear market. Money moved in…

The secret of Warren Buffett’s success

Years ago I was asked what kept us from being Warren Buffett. My reply was "how Buffett picked stocks was fairly well-known. The problem was the inability of managers to tolerate excessive tracking error." This was quant-speak for "portfolio managers spent too much time building benchmark hugging portfolios for business reasons".

There has been much written about how Warren Buffett picks stock. Jeff Matthews had a great series of posts on this topic:

• If you can’t write an essay describing ‘why I’m going to buy the entire company at the current valuation,’ you have no business buying 100 shares of stock
• They have a great intuitive sense of how to value companies
• It’s not just about hurdle rates, etc. and the math has to work
• They leave their companies alone post-acquisition

It's not just about picking stocks
One of the effects of Buffett’s approach is that he won’t buy companies whose businesses he doesn’t understand or he deems “too difficult to run”. As a result, the portfolio will contain very few companies in certain industries, such as Technology. As any good quant can tell you, a lot of return risk can be explained by industry weightings and such a lopsided portfolio will have returns that are very different from the S&P 500.

I have written before that running a portfolio is a lot more than picking stocks, which people have focused on for Buffett. It’s also about benchmarking, portfolio construction and trading.


Warren has a plan - and sticks to it
Could the secret of Warren Buffett’s success be the way he benchmarks himself? Indeed there is some evidence of that as this study shows that despite Berkshire's vaunted investment results, its Sharpe ratio is only 0.64.

In many cases, Berkshire Hathaway buys the whole company and seems to only consider the value of that cash flow stream at purchase time. Buffett et al seems to care less about the value of the company in the marketplace after its purchase. After all, the value of Berkshire Hathaway’s unlisted subsidiaries are not reported anywhere nor can they reported since there is no publicly listed value for these companies. After BRK acquires them, they only get valued by the market based of their aggregate cash flows, asset values, etc.

Could Berkshire's investment policy be just a form of Economic Value Added (EVA), as popularized by Stern Stewart & Co? Under the EVA analytical framework, your objective in running a company is to make sure the returns on your investments are above the cost of your funding. Since Berkshire buys and doesn't sell, its investment policy seems to be consistent with the concepts of EVA: buy cheaply and never mind what the market thinks in the interim because you are managing through the economic cycle.

You can build your own Berkshire Hathaway
You may argue that “Warren Buffett has the means to buy the whole company, but I don’t. I don’t have the luxury of doing the same thing.”

It can be done. I once worked with a taxable family trust that held an equity portfolio with many positions with very low cost basis (and therefore large capital gains liability if the position were to be sold). The objective of the trust was to provide its current beneficiaries with an income stream while preserving the inflation adjusted value of the capital for future generations.

The trustees decided to focus the portfolio on holding dividend paying stocks with good growth prospects. They created a synthetic benchmark based on the dividend growth metrics to measure the portfolio’s performance. Returns were measured on an after-tax basis. The hurdle rate for selling a stock with an embedded capital gain therefore was higher than normal because of the higher after-tax cost of replacing the dividend stream.

As the portfolio manager for one of the trust’s portfolios, I found myself in the unusual situation of apologizing every time the market went up, even if the portfolio had outperformed: “Sorry, we made money for you this quarter (but that means that we can’t re-balance the portfolio and sell anything without taking the capital gains hit)”. Conversely, market declines were welcome because it afforded an opportunity to harvest some capital losses so that the portfolio could be re-balanced on a tax-efficient basis.


Know yourself, be disciplined and march to your own drumbeat
The story of this trust is an example of an investor knowing his objectives and sticking to them. In this case, the trust knew its objective and created its own benchmark. The trustees focused on dividends and their growth rates (just as Berkshire Hathaway focuses on cash flows and their growth). What the market pays for those investments in the interim was mostly noise that could be ignored.

If you know yourself and can be disciplined in the same way, you can do the same.

Was that THE BOTTOM?

The market action this week showed the classic signs of investor capitulation. The most important sign was the enormous volume seen in XLF. My trading desk sources reported huge buying interest in XLF on Wednesday and Thursday, indicating that there was real institutional money buying the Financials – a sign that these stocks may have seen an intermediate bottom.


Phoenix not rising yet
Despite these bullish indications, I don’t think that this marked THE BOTTOM for the S&P 500 this cycle. I may live to regret this but I am not buying the low-priced, near bankrupt Phoenix stock basket that I described here and here.


Sentiment indicators are bullish
Sentiment certainly got very bearish. Short term sentiment indicators such as AAII got to bearish extremes, which is contrarian bullish. As mentioned previously, high volume market action in the Financials, the most troubled sector of the market, was consistent with capitulation. We also have the news that superbear David Tice is selling his firm, another contrarian bullish indicator.


Low expectations going into Earnings Season
We are also going into Earnings Season with low expectations. Bespoke Investment Group reported on Thursday morning that with 11% of the S&P 500 reporting, the beat rate is 72%. What is most surprising is 34% of the reporting companies have been in the Financials sector, which has been the most challenged of companies in the market. (These statistics are pre-MSFT, MER, GOOG reports after the close Thursday).


Valuations are constructive
As I mentioned before, one of my personal rules of thumb is to look for the investment banks to trade at 1x book value. The stock prices of Merrill Lynch (MER) and Morgan Stanley (MS) did touch their stated book value this week. However, there are well documented problems as to what book really is for a bank and MER reported a $4.6b loss after the close Thursday, which took book value down further.


But long-term sentiment isn't bearish enough
In many ways this has been a classic cycle like the ones we saw in the 1960s, 1970s and 1980s. For the market to bottom, we need some recognition that we are in a recession. This poll is showing that sentiment is getting to near that point but it isn’t quite there yet. Even Europe is weakening and soon there may be nowhere to hide.


Wait for late cycle stocks to weaken
In a classic cycle, the late cycle resource stocks collapse as economic growth slows and inflationary expectations fall. While the near term corrective action in oil prices represent a start, resource stock investors need to feel more pain before this cycle is over. These charts from Bespoke Investment Group show the relative strengths of the different sectors within the S&P 500. While Energy and Materials have weakened, the action in the last two days is barely a blip in the overall trend and that trend needs to be in serious reversal before we can see an overall bottom in the market.


Wrong leadership in the rally
Another important indicator that this is not THE BOTTOM: in past bottoms, we saw large caps lead the way (see chart here). In the last two days of the rally, the small cap Russell 2000 has been the leadership. I would theorize that with an important market bottom institutions jump in with both feet and buy the most liquid part of the market. To put the relative liquidity of the stock market in context, the top 20% of the S&P 500 by market cap represents roughly two-thirds of the weight of the index. If you had a large amount, say $10-20 billion, to put into the market while everyone else is buying, what would you buy?


A bear market rally
After considering all of the evidence, what are we left with?

This has the feel of a bear market rally, which can see the S&P 500 move up 10-20% before the bear market resumes. No doubt there will be volatility as we go through Earning Season but the path of least resistance is up. Enjoy the ride and see this as an opportunity to lighten up your long positions.

Is Size the answer for the hedge fund industry?

I received a number of responses from my post hedge fund shakeout continues that suggests that the current trend of size and consolidation seems to be the answer for the hedge fund industry. Indeed, the WSJ (subscription required) reported:

By the end of last year, 87% of all the money in the business was handled by funds managing $1 billion or more, and 60% was held by managers sitting on $5 billion or more. The dominance by the largest funds has been accelerating: In the past two months alone, the world’s largest public hedge-fund company, Man Group PLC, increased assets by $4 billion, to $78.5 billion.

Size is not a panacea
There are a number of problems with this approach by hedge fund investors. Firstly, while larger funds may be better positioned to weather downturns, a look at the hedge fund implode-o-meter shows large funds are not immune to blow ups.

In addition, as hedge funds gain in size, their capacity constraints will begin to kick in and the opportunity for alpha can diminish.


Fix the business model
The hedge fund industry doesn’t offer a good value proposition. Fees are too high and returns are getting commoditized. I wrote in the past that Bridgewater Associates reported that many hedge fund strategies could be replicated by simple passive strategies. For example, emerging market hedge funds could be replicated using a 50% weight in emerging market bonds and 50% emerging market equities – all without the high costs. Already, there is a mutual fund starting up to replicate hedge fund returns using ETFs (see announcement here).

Warren Buffett reported made a bet that the S&P 500 would beat any hedge fund of funds picked by the other bettor over a 10 year period. He believes that the high fee structure embedded in hedge funds would overcome any alpha generated.

Hedge funds used to be highly differentiated investment vehicles. Returns were good and un-correlated to other asset classes. You didn’t mind paying 2% and 20% or more for the likes of Soros or Tiger. Today, the returns are being commoditized. Size, which confers the benefit of economies of scale, is not an answer. The industry needs to fix its business model and value proposition.

$100 oil before $150, but $200 before $50

I previously pointed out that the Bank Credit Analyst, or BCA, wrote that “emerging markets will be key to timing a slowdown in oil [and other commodity] demand”. Today, we see signs of slowdown in many emerging markets. Vietnam is a disaster. India is slowing down and problems are becoming more evident (see comments here and here).


China slowing?
Risks are also increasing in China. BCA also summarized the risks the China well here and the Economist wrote about China’s macro risks here. Recently Stratfor summarized the risks to the Chinese economy well in the following commentary (emphasis mine):

Ruling China has always been a difficult prospect, as the country is riven with urban-rural and coastal-interior splits. But while the Olympics were supposed to have been a celebration of China's "arrival" as a modern state, they are instead serving as a showcase for all the ways in which China falls short. But dealing with these issues — entrenched corruption, financial dysfunction, (unapproved) regional autonomy, unaffordable energy subsidies — is difficult for Beijing in the weeks leading up to the Olympics because, under the glare of international spotlights, it can no longer use the tried-and-true tools of an authoritarian state. The result is a string of patchwork fixes that highlight China's weaknesses, making the Asian giant vulnerable to any foreign power with an interest in demonstrating that the emperor is less than fully clothed. Not exactly the global celebration that Beijing intended when it bid for the
Olympics all those years ago.

In China, the chickens may be coming home to roost. Recently we saw that China’s June trade surplus declined $21.3b, compared to an expected $22.0b. While one data point does not make a slowdown, it does point to a trend of slowing growth, which would be negative for commodity prices.


Emerging market slowdown is commodity bearish
Some commodity prices are starting to show the strain and may be starting an intermediate term correction. Demand destruction is already being seen in oil and petroleum products.


Be prepared for volatility
Is it all over for the commodity bulls? I was asked that question recently and my answer was “expect $100 oil before $150 oil, but expect oil to hit $200 before $50.”

We remain in a hard asset cycle and the long-term fundamentals for commodity remain intact. However, investors need to be prepared for commodity corrections, which can be nasty and violent. The chart below shows the price action of the Continuous Commodity Index, which the old equal weighted CRB index before CRB went to a liquidity weighting. The index has moved up tremendously in the last few years and the bull trend can still remain intact should we see a 20% correction.

Idiot’s market neutral fund: A mid-year report card

I first wrote about construction of the idiot’s market neutral fund here and I further addressed the controversy of why the technique may work here. A mid-year update of this hypothetical fund shows that estimated YTD returns to June 30 was 3.5%. This is ahead of the HFRX Equity Market Neutral Index of 2.3% for the same period. Other investable hedge fund equity market neutral indices (e.g. Dow Jones Equity Market Neutral at 1.5%) show even worse performance than HFRX.


Smart funds remain defensive
The idiot’s market neutral fund’s alpha is mainly derived from the market positions of a group of smart funds. The question in many investors' mind must be what are the smart funds doing now?

The orientation of smart funds hasn’t changed significantly since my last update in late April. Smart funds continue to be more defensive. The managers of these funds seem to believe that the worst may not be over for the US economy.

As the chart below shows, smart fund market beta shows that they are defensively positioned. By contrast, the consensus funds, a group of funds run by the largest mutual fund complexes have market betas roughly in line with the S&P 500:

Smart funds continue to be underweight Financials, while consensus funds are slightly overweight:

…and smart funds are roughly market weight Consumer Cyclicals, while consensus funds are overweight:

A LT demographic headwind for the US$

What if we had a time machine that could tell you how the world markets and economies are going to behave? We do – it’s called demographics. While this time machine won’t tell you the winner of the Super Bowl in 2015, it will tell us a lot about the probable behavior of world economies, consumer behavior and investment and saving preferences.

We all know about the Baby Boomers in America. The appearance of this cohort has dramatically affected American consumer and investment behavior for the last half of the 20th Century and will do so into the 21st Century.

There are other “baby boom” that have occurred around the world. Japan is the oldest. It had a baby boom whose demographic peak preceded the US one by about ten years. The US, Canada, Australia and New Zealand had a post WW-II baby boom all about the same time. The EU also had one, albeit with lower intensity, that lagged the US boom by about ten years.


Poole’s projections for Japan
With that in mind, we can roughly forecast what America will look like by looking at Japan and lag it by ten years. William Poole, the former president of the St. Louis Fed, gave a paper in 2005 analyzing the probable demographic effects on the Japanese economy. He argued that with her aging population, Japan’s trade balance will slide inexorably into the red (see graphs here). Left unsaid is the pressure on the Yen as Japan’s current account deteriorates.

Japan is known to have a very high savings rate. With American savings rates so low and the US current account in severe deficit, what will be the probable path of the US Dollar once this demographic storm hits?


China saves the world, but…
Laurence Kotlikoff is an academic that has written extensively on demographics and their effects on the economy. In a 2005 paper entitled Will China eat our lunch or take us to dinner? he wrote that all is not lost because China can save the world:

If successive cohorts of Chinese continue to save like current cohorts, if the Chinese government can restrain growth in expenditures, and if Chinese technology and education levels ultimately catch up with those of the West and Japan, the model’s long run looks much brighter. China eventually becomes the world’s saver and, thereby, the developed world’s savoir [sic] with respect to its long-run supply of capital and long-run general equilibrium prospects. And, rather than seeing the real wage per unit of human capital fall, the West and Japan see it rise by one fifth percent by 2030 and by three fifths by 2100. These wage increases are over and above those associated with technical progress, which we model as increasing the human capital endowments of successive cohorts.

However, this doesn’t mean that the developed world is out of the woods:

On the other hand, our findings about the developed world’s fiscal condition are quite troubling. Even under the most favorable macroeconomic scenario, tax rates will rise dramatically over time in the developed world to pay baby boomers their government-promised pension and health benefits. As Argentina has so recently shown, countries can grow quite well for years even with unsustainable fiscal policies. But if they wait too long to address those policies, the financial markets will do it for them, with often quite ruinous consequences.

How ruinous are the consequences for the US? Here are some current options that he suggests:

- 70% increase in personal and corporate income taxes;
- 109% hike in payroll taxes;
- 91% cut in federal discretionary spending; or
- 45% cut in Social Security and Medicare benefits.

While you ponder those questions - Happy 4th of July!