Why gold bulls shouldn't buy gold stocks

In light of the recent stories of hedge funds piling into gold and gold related plays (see this and this), I am still shaking my head over the fact that investors were buying gold stocks instead of gold and other inflation hedge vehicles.

Maybe the purchase of gold stocks was justified by the analysis of the history of the PHLX Gold & Silver Index (XAU) to gold ratio, which is near all-time lows:

Perhaps it was bullish calls on gold stocks like this. Maybe it was the Fed's bombshell announcement last week, which whacked the USD and sent gold and other commodities soaring.

Maybe it was analysis like this, which recalled the degree of leverage that gold stocks have enjoyed over bullion.


Gold stock leverage to bullion is falling
The trouble is, gold stocks aren’t just a simple leveraged play on the gold price.

As I pointed out before, a gold company could be simplistically thought of as a call option on the price of gold, with the strike price being the cost of production. My analysis also showed that most senior gold producers were raising production costs by mining lower grades of ore. Gold mining shares consequently did not perform as expected because of earnings disappointment.

Moreover, as the gold price has risen from about $260/oz. in 2000 to over $1,000/oz. seen this year, the leverage of gold stocks to gold has diminished as a result of the rise. The scatterplot below, which charts the monthly change in the Gold Bugs Index (HUI) against the monthly change in gold, illustrates my point. I split the sample in two: when gold was below $500 and when it was above $500. As you can see, the degree of leverage shown by the period when gold was above $500 is lower than the period when gold was below $500.

(click on chart for larger picture)

The chart below also tells the same story by showing leverage of HUI to gold in a different way, where

Leverage = % monthly change in HUI / % monthly change in gold

The average leverage of HUI to gold has been falling more or less steadily as gold prices has risen.

It’s all rather simple once you think about it. If you hold an at-the-money call on gold, which is roughly what an investor did with gold stocks in 2000, the option's leverage to gold is relatively high. As the gold price advanced, the call option got deeper and deeper in the money and the degree of leverage declined.


Gold stocks are not a good alternative to gold
Once you throw in other considerations such as political risk (e.g. wars, etc.), operational risk (fires, floods, strikes) and developmental risk (such as the Galore Creek fiasco), are gold stocks really worthwhile investment vehicles? More importantly, if commodity inflation does surface with a vengeance, then we will likely see negative surprises in the form of increased mining costs stemming from rising material and energy prices, which will squeeze gold mining margins.

Of course, it depends on why you are buying gold. If the gold holding is a hedge against disaster, then some physical gold in the form of coins and bullion may be better choices.

If you are looking for a pure inflation hedge, then perhaps inflation-linked bonds, gold ETFs like GLD, or a closed end fund like Central Fund of Canada (CEF), could be your vehicle.

If you are looking for a leveraged play on gold, then you may want to look at silver (the metal, not the silver stocks), which is traditionally thought of as a leveraged play on gold. Another alternative could be the purchase long-dated options on gold bullion for investors.

Buy gold stocks? The fact is, they are overly erratic and unpredictable vehicles as to be effective leveraged plays on gold bullion.

How to spot THE BOTTOM

Was that the real thing? Is this the new bull?

Just as the consensus was forming that the rally from the lows last week was the start of a bear market rally (example here), the Fed announced that it invented another tool to throw money at the financial system by buying U.S. Treasury bonds at the long end of the yield curve. The announcement sparked off a stock market rally that took the S&P 500 to an interim resistance level of 800.


What now?
What’s more, Merrill Lynch’s institutional survey shows increasing levels of bullishness among fund managers. If they start to put money back into the market, the funds flow could easily raise the S&P 500 by 100 points or more in fairly short order.

Is this the start of a new bull?

This has been a market of maximum frustration for many traders. While the consensus has been that we are witnessing a bear market rally, I would not be surprised that if the market powered itself upward and then fell back but does not test the bottom made last week, as expected by many technicians. Instead it bottoms at 5-10% above those levels, faking everyone out again.


Stealth bottom?
My base case is a “stealth bottom” as called for by Bill Luby at VIX and More and other analysts. Instead of a dramatic high volume capitulation V-shaped bottom, we could very see a bottom marked by an attitude of “I don’t want to hear anymore about stocks”:

[P]ast bottoms were more often than not distinguished by investor disgust, exhaustion and apathy. Having been burned for so long by the bear markets that preceded those bottoms, investors resolved never, ever, to trust the market again. By the time the market did finally bottom, therefore, there were relatively few investors who were even interested enough to take notice.

What to watch for
The fact is, I have no idea of whether we have seen the bottom of the market for this Bear. I tend to agree with Jeremy Grantham that equities look attractive right now. Long-term investors should have a long-term plan, which includes being fully weighted in equities (possibly on a dollar-cost average basis) at current levels. As an investor, you will find it very hard to catch the exact bottom but the likelihood of regret in 3-5 years is low if you bought into stocks in 2009.

For traders who are willing to bear tactical risks and want to spot THE BOTTOM, here is a list of what I am watching for (in addition to Barry Ritholtz’s list):

Sentiment: I would like to see sentiment measures, such as the AAII bull/bear ratio, approach new lows while the market makes a higher low (and forming a positive divergence).

Phoenix list composition: The latest list of Phoenix stocks numbered 58 names. Of the stocks on that list, about 25, or 43%, were in sideways basing formations. I would like to see that percentage of Phoenix stocks in basing mode increase to at least 60% before I could be confident that a bottom is truly in place.

Better market action from the financials: The chart below shows the relative performance of the KBW Banking Index (BKX) and S&P Homebuilder SPDRs against the S&P 500. Since the market is so focused on the troubles experienced by the banks right now, I would like to see some basing action from the banks and financials, much like the formation shown by the homebuilding stocks.

Market valuing gold stocks on cash flow, not assets

Mystery solved!

In a recent post entitled Gold stock mystery, I had wondered that with the price of gold bullion nearing all-time highs, why were gold stocks underperforming?

The main basis for my analysis was an option-based model for gold mining companies, where a gold mine could be modeled as a series of call options on gold, with the strike price being the cost of production.


Production costs are rising
The option-based model showed that gold stocks should be near all-time highs and enjoying superior leverage to gold, except for one small detail...

Back in 2006 when I started modeling the gold mining stocks, the cash cost of production was around $250/oz. Now company guidance shows that they are mostly north of $400/oz., as shown in this chart from a recent Goldcorp presentation to investors:


The reason why gold stocks are underperforming bullion is because higher production costs are depressing the value of the expected future cash flows.


Mining lower grade ore
Why did production costs rise? When I examined the past annual reports of the senior gold miners, it became evident that the industry has adopted a policy of mining lower grade ore in order to better preserve and extend the lives of their mines given the elevated price of gold. In all cases where the company reported the figures, the grade extracted has gone down. This is consistent with the observation by one analyst who commented that while cost per oz. has risen, cost per tonne of ore has remained relatively flat in the last few years.


Mr. Market is paying for cash flow, not asset value
If that is the explanation for gold stock underperformance, how do we make of the market’s reaction?

Are gold stocks cheap relative to bullion? If the market is only paying attention to cash flow (which is what it's doing right now) and not asset value, then the current practice of voluntarily raising production costs to extend mine life and optimize asset value is a great disappointment to investors. On the other hand, if an investor is willing to take the contrarian view that he is buying cheap assets then the group represents great value.


Gold stocks may not be necessarily that cheap
My view comes down somewhere in the middle. Over the course of an economic cycle, investors do not value companies on asset value until we get into the later phase of the cycle, when inflationary expectations are high. However, if gold and gold mining stocks are to be viewed as inflation hedges then we have to be cautious that if runaway inflation rears its ugly head, then gold mining and production costs will rise because of higher commodity prices (e.g. energy, metals, etc.) The rise in production cost may serve to counteract the higher leverage that investors may have come to expect from gold mining stocks compared to bullion.

In that case, gold stocks may not necessarily be such great bargains after all. An investor could be better off in just holding bullion, or a long dated deep-in-the-money call option on gold if he wants a leveraged inflation hedge vehicle.

Is Cuomo just piling on Merrill?

In the news earlier in the week, New York attorney general Andrew Cuomo accused Merrill of misleading Congress about bonuses:

Merrill Lynch & Co may have misled Congress in representing last November that it planned to pay out bonuses at year end, when in fact it decided to accelerate those payouts, New York Attorney General Andrew Cuomo said on Wednesday.

He added that [emphasis mine]:

The attorney general also said Merrill traders may have delayed taking hefty losses late last year until after the company decided to pay out $3.62 billion of overall bonuses.

I qualify these remarks with the disclosure that I worked at Merrill’s research department until early 2007 and I don’t personally know any of the people involved.

There are ways of showing a profit and temporarily hiding losses in complex derivative books but Cuomo’s accusations of traders manipulating their own P&L for to boost their own bonuses is a serious charge. It is certainly possible given this characterization of investment bankers, the obscene bonuses paid before the BofA takeover and how risk is managed at investment banks. I believe that the business model of Wall Street i-banks needs reform, but for Cuomo to level these charges without substantiation seems like a case of politically piling on to me.

We need specifics, Mr. Cuomo. Who? When? What did they do?

Phoenix strategy update

It seems that I am not the only one highlighting a Phoenix strategy these days. Mebane Faber wrote that John Templeton sucessfully implemented a Phoenix-like strategy in 1939. As well, Standard Life is offering a Phoenix themed fund for UK investors.

Further to my last Phoenix strategy update of Feb 24, the latest update of the Phoenix screen shows the number of stocks passing the screen jumping from 48 stocks to 58 stocks this week. As a reminder, the Phoenix stock screen consists of the the following criteria:

• Stock price between $1 and $5 (low-priced stocks)
• Down at least 80% from a year ago (beaten up)
• Market cap of $100 million or more (were once "real" companies)
• Net insider buying in the last six months (some downside protection from insider activity)

As Faber points out in his post, some of the charts that passed his screen are truly nauseating. For example, Citigroup (C) remains in a downtrend despite the huge rally yesterday.

I would prefer to look for stocks like Liz Claiborne (LIZ) that shows more of a bottoming pattern:

To reiterate, I don’t believe that it’s time to buy into a Phoenix strategy yet, but the number and the composition the Phoenix list bears watching.

Gold stock mystery

Further to my last post Bullish signs for the inflation trade, I would also like to point out that Warren Buffett, in the latest Berkshire Hathaway letter to shareholders, also indicated that inflation is likely the effect of the macro policy response to the financial crisis [emphasis mine]:

This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.

Why are gold stocks underperforming?
The most obvious way to hedge against inflation and rising inflationary expectations is with gold and gold equities. However, gold stocks are not performing up to their potential in light of the relatively buoyant market for bullion.

The chart below shows the monthly ratio of the PHLX Gold & Silver Index (XAU) to the London PM gold fix. I also linked the Amex Gold Bugs Index (HUI) to the XAU price series to show the difference between HUI and XAU. While HUI has outperformed XAU, both gold stock indices have been lagging the price of bullion in the past few years. More importantly, gold stocks have not shown the same upside potential as they have in the past relative to gold.

Analysts have advanced several interpretations of the relationship as shown by gold stock to gold ratio. The simplest explanation is that gold equities are cheap relative to bullion and that they should be bought now.


Loss of leverage and speculative appeal?
Another possible explanation is that as gold prices advanced, gold stocks have lost much of their speculative appeal as levered vehicles to play the rise of the yellow metal.

When gold prices were $300 an ounce about a decade ago and production costs of the senior miners were in the $200-250 range, gold stocks were in effect call options on gold with a strike price in the $200-250 area. As gold prices rose, gold equities became deep in the money options and their leverage to gold declined. Speculators who wanted to play the rise in the gold price lost interest, especially with the introduction of very liquid gold ETFs around the world.


Synthetic gold stock is still undervalued
While the loss of leverage thesis does hold some water, the numbers don’t make sense. About a year ago I wrote a posting on a synthetic gold mining stock model that I built in 2006 using a series of gold call options. When I revisit that synthetic gold mining stock valuation today, the synthetic still looks very cheap.

To briefly summarize the model: Conceptually a mine can be thought of as a series of call options on the underlying commodity, with the exercise price as the cost of production. If the commodity price falls below the cost of production, the mine operator has the option to either close or mothball the mine until prices improve. I created a synthetic gold stock by building a model based on these principles. Key features of the model are:

• A series of eight deep-in-the-money call options on the price of gold, with terms of 1, 2, 3 … 8 years, which models a mine with an eight year life, a common estimate of long-lived gold mines;
• An exercise price equal to cash production cost of $250, rising each year by the current inflation rate. ($250 appeared to be a common estimate of cash costs for existing gold stocks in 2006);
• Equal amount of gold mined each year; and
• The position is rolled forward once a year at a cost of 1.5%.

The chart below shows the value of the synthetic compared to the gold equity index. The valuations started to diverge in early 2007 and the gap has been steadily widening since.


The chart below, which shows the difference in valuation between the synthetic and actual gold stocks, indicates that the discount of gold equities to the synthetic is near all-time lows:

Why the discount?
The prolonged valuation gap is a mystery to me. To be sure, there are differences between the model behind the synthetic and actual gold stocks, but I believe the difference are relatively minor in magnitude:

• Gold mining companies have exploration upside, operational risk (strikes, fires, etc.) and political risk, which the synthetic gold stock does not;
• Gold mining companies may hedge the gold price with forward sales and other derivatives (but most don’t these days other than for the purposes to lock in a price to develop a new property);
• Actual gold mines can somewhat manage the cost of production by high-grading when gold prices are low and mining a lower grade of ore when prices are high. The synthetic gold stock’s assumed cost is inflexible.
• Many ore bodies do not yield only gold, but other byproducts (e.g. silver, copper, etc.) The synthetic assumes that the mine only produces gold.
• The synthetic model only describes the asset side of the balance sheet for gold companies. If the company is financed with debt then the behavior of the equities would be different from the one forecast by the synthetic (but most gold miners don't have a lot of debt).

Some questions to ponder:

• Are gold stocks just cheap relative to bullion? If so, why the prolonged mis-pricing?
• Is there a conceptual error behind the synthetic gold model? Does the market just not think about gold stocks this way?
• Could a PE fund buy out a gold producers or mine and use the synthetic model to arbitrage the difference in value?
• Are production costs spiraling out of control at gold miners that investors are discounting the prices of their equities?
• Have gold mining companies, as a group, not re-invested their cash flows in a way that has enhanced shareholder value and therefore investors are marking down their share prices?
• Has the stock market been so beaten up that gold stocks are underperforming their potential? (This explanation doesn't make sense as the discount began in early 2007, well before the market break.)

I would be especially interested to hear any response from mining analysts. You can either respond directly in the comment section of email me at cam at hbhinvestments dot com.

Bullish signs for the inflation trade

As the world waits for China of “will they or won’t they stimulate more”, there are increasingly bullish data points that line up for the inflation trade everywhere.


We hate you guys
The elephant in the room is how the U.S. and the rest of the world pay for all this fiscal stimulus. The most obvious path is to print money. Despite China’s enormous reserves, China can’t hold up the world but is getting increasingly frustrated with it:

Even at the elite level, the sense of frustration occasionally bubbles over. "We hate you guys," Luo Ping, a director-general at the China Banking Regulatory Commission (CBRC), complained last week on a visit to New York. "Once you start issuing $1-$2 trillion . . . we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do."

The path of least resistance seems to be resorting to the printing presses, but with Eastern Europe in trouble, the difficulties with the USD will not likely show up in the foreign exchange market, but the commodity market.


Commodities recovering
A look at the Continuous Commodity Index, which is the continuation of the old CRB Index before its re-balancing in 2005 to give greater weight to the more liquid energy complex, shows that commodities prices appear to be stabilizing as a whole. The Baltic Dry Index is also giving the same message of stabilization.

Despite the underperformance of the energy sector relative to other commodities, I indicated before that energy stocks aren’t giving up their relative leadership in the market, indicating that the sector may lead this market up in the next cycle.


SWFs and strategic buyers moving into the market
Some sovereign wealth funds have indicated that they are likely to move more into commodities. Strategic buyers are also moving into commodity suppliers to take advantage of these depressed prices. Consider these stories:

China buying “stuff”, more here
Total buying into Canada’s oil sands
Japanese buyers taking a strategic interest in Uranium One

While the presence of strategic buyers do not usually mark the bottom of a market, it does indicate that these users see value in commodities at current levels.


Gold above $1000
Gold prices also recently topped $1000, but have pulled back to about the $900 level. Interestingly, both gold and the USD have been rising in unison - a highly unusual situation as they have historically had an inverse relationship. This is explained by the fact that both are regarded as safe havens in times of financial stress – and the world is certainly stressed right now.

Despite the rise of gold, I hold to my view that while gold is a good barometer of inflationary expectations and financial stress levels, I prefer the energy complex as an inflationary hedge because of its greater liquidity and depth of market. In short, there isn’t enough gold around in the world to hedge away our troubles from a policy viewpoint:

What about gold? That one’s easy: it’s estimated that all the physical gold in the world that’s ever been produced amounts to roughly 140,000 tons (worth about $4.5 trillion dollars using $1,000 an ounce). About 75% of that is either in coins or jewelry… not available to China, or to any other government.

The new gold available each year is miniscule: about 2,600 tons (almost $83 billion dollars worth) of new gold is being mined and refined annually, increasing the total supply by 2% per year.

The Minority Report
Should we put on the inflation trade?

My answer is a qualified yes for investors with a 3-5 year time horizon. However, there are still troubling signs that deflation may be the greater problem and must be overcome.

We would also not overlook Richard Koo’s hypothesis that inflation may not be a problem despite all this fiscal and monetary stimulus. His contention is that as long as government spending and investment replaces private spending and investment, because households are in a saving and balance sheet repair mode, then inflation should not be a problem.

Investors in the inflation trade need to watch closely for signs of inflation as economic recovery takes hold in the coming quarters.

I didn't make these rules!

I would like to thank everyone who gave me the feedback on my post In defense of the mutual fund manager, both online and by email.


What’s handcuffing the fund manager?
Pity the poor fund manager. Not only can he not even beat plain vanilla index funds, now a study shows that fund managers are bad market timers. What is handcuffing the fund manager?

The problems that the fund manager faces can be separated into the four categories:

• Alpha generation is hard
• Turning good investment ideas into investment performance is hard
• The System really doesn’t like people who think “outside the box”
• Mis-aligned incentives

Alpha generation is hard: A case of low signal-to-noise ratio

Henry Kaufman, in the Wall Street Journal, recently wrote that:

Why do our computers work so well -- except when we use them to manage derivatives and hedge funds? The answer lies in methodology. In science and technology, we rely on the scientific method: experimental design with dependent and independent variables and with reproducible results.

Economists and financial experts like to fancy themselves as exact scientists as well. Back in the 1960s, when we landed on the moon, economists emulated the terminology of Space Age navigation. They spoke of "midcourse corrections" and of bringing in the economy for a "soft landing." Since then, quantification and modeling have only grown thicker in the economics profession, where econometricians and other "quants" employ complicated analytical techniques and mathematical formulas.

Investing isn’t engineering. Good investment professionals and quants understand that we work in a business that has a low signal-to-noise ratio. It isn’t physics. You can’t repeat experiments. Investment returns depend on human behavior, which is fickle and depend on people’s hopes and fears.

As an illustration of how difficult investing is, a study shows that the Sharpe ratio of legendary investors like Buffett, Robertson and Soros don’t significantly top 1.1. Who of us, as mere mortals, can hope to top those kinds of results?


Turning good investment ideas into investment results is hard!
Even if you a good investment idea, putting it together into a portfolio, or what quants call the task of alpha transference, is not easy. Peter Schiff had the right grand idea, but his implementation was lacking. He was not alone as many others were in the same boat.

How sure are you of your idea? How much do you want to bet on it? How do you manage risk (your client’s risk, your business risk and your career risk)?

When do you trade? How do you time your trade? If you are a large fund, how do you move in and out of a position without leaving footprints in the market?

If things didn’t work out, what happened? Did your selection techniques fail? Did your risk control fail? Did all parts of your investment process work together or were they fighting each other?

These are all issues that a fund managers need to address and face.


Do we really want people who think “outside the box”?
We all like to see innovative thinkers. We laud people who think “outside the box”. The reality is that society and organizations really don’t want people to think too far outside the box.

Frankly, people who do that are mavericks. It’s hard to manage mavericks. They tell their superiors to FOAD (the last two stand for “And Die”). A frequent theme seen in Hollywood movies is the rebel who defies the system and win. How many rebels have you actually seen in real life do that?

One example of a maverick who won was Colonel John Boyd. He spearheaded the design of important U.S. fighter planes and had a strong influence in U.S. military thinking over the years. However, the system doesn’t like rebels. My question is: "If he was so great, why did he retire in 1975 a colonel? Why didn’t he have some stars on his shoulders?" (Imagine someone with the stature of a Myron Scholes retiring after a long career at an investment bank with the rank of a junior director and you get the idea.)

The System is not built to accommodate rebels. It certainly does not reward them.

Here in Vancouver, there has been a long-standing tradition among the engineering students at the local university to engage in creative hijinks and pranks. Years ago, they stole the Speaker’s Chair from the provincial parliament. I recall one instance when a number of student engineers managed to steal the emergency lights from a police car. At one level, these are creative activities that should be encouraged. At another level, they are anti-social and disruptive and people who engage in such destructive behavior should be punished. Recently, a story emerged that some engineering students got caught trying to suspend a car from a bridge. Some of them may get charged. Criminal records may be involved and possibly future careers may be destroyed.

In defense of the System, we can’t let every rebel and maverick run wild. Should mavericks like the Unabomber be made a hero? What about the perpetrators of the Oklahoma City bombings? What about the member of the Red Brigade? Baader-Meinhof gang? Weatherman underground?


A case of mis-aligned incentives
Tom Brakke, who writes the blog Research Puzzle, correctly pointed out that fund managers at actively unconnected to investors. In other words, there is a severe case of mis-aligned incentives.

The current paradigm is: asset allocation accounts for most of an investor’s risk and return, followed (in equity-land) by country allocation, sector allocation, along with style (value/growth), sector and market cap. As a result, we allocate by these style boxes: international, emerging markets, domestic equities, large/small cap, value/growth, etc. Fund managers are expected to stay within their mandate and remain fully invested. Their job is to beat their style benchmark (e.g. large cap growth).

There are funds that are permitted to be opportunistic and rotate between asset classes but those funds are relatively rare (e.g. Hussman Funds). While every few years or so, there have been calls to reform the fund management industry, I don’t see any looming competitive threats that will compelling a drastic re-thinking of this investment paradigm. A few years ago, hedge funds might have posed a serious threat had they been able to generate pure alpha, but it turns out that what hedge funds mostly deliver are different forms of beta, which in aggregate are not worthy of their 2 and 20 fee structures.

I didn’t make these rules. Until something radical happens to challenge the business model of fund management, we are stuck with the current paradigm.


Addendum: Barry Ritholz at Big Picture has an interesting post about conflicts of interest and mis-aligned interest at the asset allocation level for individual investors.

China's Golden Rule?

Recently there has been a cacophony of calls for stockholders and bond holders of zombie financials to take their lumps as part of an overall reorganization plan. Instead of injecting more government money so that these institutions could maintain their zombie status. John Hussman’s comments are a good example of this school of thought [emphasis mine]:

Take a look at Citibank's balance sheet as of the third quarter of 2008. The company had about $2 trillion in assets, versus about $132 billion in shareholder equity, for a gross leverage ratio of about 16-to-1. That's not a comfortable figure, because it indicates that a decline of about 6% in those assets would wipe out Citibank's equity and make the bank technically insolvent. Unfortunately, we saw credit default spreads screaming higher last week, while the bank's stock dropped below $2 a share, so evidently the market is deeply concerned about the possible immediacy of that outcome.

But keep looking at the liability side of Citibank's balance sheet. There is over $360 billion in long-term debt to the company's bondholders, and another $200 billion in shorter term borrowings. None of that is customer money. That puts the total capital available to absorb losses at $132 + $360 + $200 = $692 billion, which is about 35% of the $2 trillion in assets carried by Citibank. That's a huge cushion for customers, who are unlikely to lose even if Citibank becomes insolvent. Should that occur, the proper response of government will not be to defend Citi's bondholders at taxpayer expense, but rather, to take Citi into receivership, wipe out the shareholders and most of the bondholders, and sell the assets along with the liabilities to customers to another institution…

Simply put, institutions that are insolvent and would only avoid continued insolvency by large and continued infusions of taxpayer funds should be allowed to “fail” through the process of government receivership. It is wrong to squander the taxes of ordinary citizens and put a burden of indebtedness on our children in order to protect the bondholders of careless and poorly-managed financial institutions.

Ahhh, if economic policy is only so simple.

A recent article reports that China’s holdings of U.S. corporate debt may be hampering efforts to reorganize and/or nationalize banks. Rachel Ziemba, an analyst for RGE Monitor, estimates that China’s banks and investment funds holds close to $160b in U.S. corporate debt, much of which is concentrated in financials.


Could the U.S. relationship with China be the stumbling block?
I had written before that throughout this crisis, the attitude of China has been that it expects the U.S. government to insulate China from losses. The Chinese attitude to business has typically been based on long-term relationships. Part of the give and take of a relationship is to not let your business partner down.

We cannot know what has happened behind closed doors, but given the soothing sounds emerging from Hillary Clinton’s recent visit to China, could efforts to reorganize the U.S. financial system be hampered by U.S. efforts to maintain a friendly Sino-American relationship? The aforementioned article went on to speculates that “the Obama administration may be waiting for China to reduce its exposure to the debt of the latest U.S. financial institutions found lying near death’s door before it nationalizes them.”

As the saying goes, he with the gold makes the rules. China has the gold…

Phoenix rising: Day 1 update

Nice rally yesterday! Unfortunately, yesterday's market action confirms my previous suspicions that this is a bear market rally and not a rally off THE BOTTOM.

I have commented before that true bottoms that are conducive to the Phoenix effect tend to be initially led by large caps and not small caps. Yesteday saw the small cap Russell 2000 lead the large cap S&P 500 with a return of 4.5% to 4.0%. Bespoke also reported that the best performers in yesterday's rally were smaller and beaten up stocks.

Enjoy the ride but keep tight trailing stops.

Sign of the times

When states like California are starved for revenue, they'll try to get it any way they can.

Phoenix rising?

With the US equity market averages either probing or breaking down through their November lows, is it time to buy Phoenix stocks? Others have picked up on that theme, with the latest being a Minyanville article on buying beaten up stocks.

With that in mind, I screened the US market for stocks with the following characteristics:

• Stock price between $1 and $5 (low-priced stocks)
• Down at least 80% from a year ago (beaten up)
• Market cap of $100 million or more (were once "real" companies)
• Net insider buying in the last six months (some downside protection from insider activity)

This screen gives us a list of low-priced stocks of Phoenix candidates. The $100 million market cap gives us some assurance that it was once a substantial company. The net insider activity gives signals that company fundamentals are less likely to completely fall apart. The screen, which showed a count of 30 stocks that passed the criteria a week ago, jumped to 48 names when it ran after the close on Monday 23 Feb 2009:

Affymetrix Inc (AFFX), Aircastle Ltd (AYR), Amkor Technology Inc (AMKR), ATP Oil & Gas Corp (ATPG), Bank of America Corp (BAC), BGC Partners Inc (BGCP), Boyd Gaming Corp (BYD), CapitalSource Inc (CSE), CB Richard Ellis Group Inc (CBG), CBL & Associates Properties Inc (CBL), Century Aluminum Co (CENX), Cenveo Inc (CVO), Citigroup Inc (C), Colonial Properties Trust (CLP), Conseco Inc (CNO), Delta Petroleum Corp (DPTR), Developers Diversified Realty Corp (DDR), Fifth Third Bancorp (FITB), First Industrial Realty Trust Inc (FR), Gannett Co Inc (GCI), Genworth Financial Inc (GNW), GFI Group Inc (GFIG), Global Industries Ltd (GLBL), Great Atlantic & Pacific Tea Co (GAP), Helix Energy Solutions Group Inc (HLX), Hercules Offshore Inc (HERO), Huntsman Corp (HUN), Insight Enterprises Inc (NSIT), ION Geophysical Corp (IO), Janus Capital Group Inc (JNS), Liz Claiborne Inc (LIZ), Marshall & Ilsley Corp (MI), MF Global Ltd (MF), MGIC Investment Corp (MTG), MGM Mirage (MGM), PAETEC Holding Corp (PAET), Patriot Coal Corp (PCX), Pennsylvania Real Estate Investment Trus (PEI), Popular Inc (BPOP), Protective Life Corp (PL), Quiksilver Inc (ZQK), Regions Financial Corp (RF), Reliant Energy Inc (RRI), Saks Inc (SKS), Sunstone Hotel Investors Inc (SHO), Tetra Technologies Inc (TTI), Wyndham Worldwide Corp (WYN) and XL Capital Ltd (XL).

I find it interesting that given the recent news on the weekend, both Citigroup (C) and Bank of America (BAC) are Phoenix candidates with positive insider activity, though insiders bought Citigroup earlier at substantially higher prices.

Phoenix: the bull case
Is it time to buy? Here is the bull case, based mainly on sentiment readings:

European pension funds are throwing in the towel and reducing equity weightings.
Brokerage firms are awash in cash.
The magazine cover indicator, always a good contrarian indicator, is flashing positive.
Bullish sentiment among individual investors is falling.


Phoenix: the bear case
Nevertheless, there are some troubling indicators out there:

CEOs aren’t buying their own stock.
AAII sentiment readings, while bearish (contrarian bullish), aren’t at bearish extremes. The chart below shows the bull and bear sentiment ratio from AAII. Note that while the market has fallen, sentiment readings aren’t as bearish as they were in November – a bearish divergence. By contrast, extreme bearish sentiment was in evidence when the market tested its 2002 lows in 2003.

Not oversold enough: Some of the proprietary overbought/oversold indicators that I watch (not shown) are not at oversold extremes.

Commitment of Traders data is leaning bearish: The latest weekly Commitment of Traders report, large speculators are net long S&P 500 futures with readings near (contrarian bearish) extremes. While they are net short NASDAQ 100 futures, readings are neutral.


Get long for a punt?
Putting this all together, my interpretation of the big picture suggests that isn't THE BOTTOM. Any rally from these levels is still a bear market rally.

While I wouldn’t recommend it, speculators could try to get long a basket of Phoenix stocks for a punt. If you do, then I would suggest that you manage risk with some tight stops in place so that the trade doesn’t totally fall apart on you.

Needless to say, this is an extremely high risk/high reward trade. This post is by no means a recommendation to buy Phoenix stocks. You are on your own on this one.

In defense of mutual fund managers

Last week there was a flurry of posts in the blogosphere about how dumb mutual fund managers are. Michael Stokes of MarketSci kicked off the discussion with I Just Don’t Get It (the Failure of Mutual Funds to Think Outside the Box). It was followed by other supportive posts such as the one by Damian at Skill Analytics.

I would like to address the very real points raised by these bloggers. Most of the complaints fall into two categories. The main one goes something like this: “I’ve got a great system, why can’t Wall Street recognize me?” In both these cases, the writers identify themselves as “quants” and blame the bottom-up fundamental stock picking mindset as mental barriers to superior mutual fund performance.

The second complaint is voiced more indirectly. If there are great quantitative systems or thinkers around, why can’t the average mutual fund outperform?


Would you go to a pizza joint for sushi?
There are a number of misconceptions at work here. These writers fail to understand that asset management is a business. More importantly, they fail to understand what mutual fund managers are selling.

Investors use mutual funds as building blocks in their portfolios. Allocate 60% to stocks, 40% to bonds. Within the stock portfolio, allocate this much to large caps, that much to small caps. Maybe if you have a great growth manager, then offset it with a value manager, etc.

Style drift is death to mutual fund marketing. Investors don’t like surprises. If you bought a fund that was labeled as a mid-term government bond fund, what would your reaction be if you found it stuffed full of emerging market bonds? What is the mutual fund manager’s business risk if the emerging markets blew up?

Do you go to a pizza restaurant and order sushi? Mutual fund managers are acting rationally. They are delivering what their customer wants. Straying from their mandate is the equivalent of offering sushi at a pizza joint. While bloggers such as Stokes, who work mainly on market timing models, have some very interesting ideas. Unfortunately for him, many of their ideas don’t fit in the mutual fund “boxes”.


He’s just not that into you
There is admittedly a cultural divide between fundamental stock pickers and quants. I have experienced that all my professional life. The job interview described by Damian, a quant, by a fundamental stock picker was an example of that divide.

Accept it. He’s just that into you.

I would take exception, however, to some of the points raised in his post.

Reliance on a single approach: Not all fund managers are fundamental stock pickers. There are many quant firms out there. One example of prominent name who has been in the news a lot recently is Jeremy Grantham of GMO.

Strategy Scaling Requirement: Damian admits that “many of the quantitative strategies that people put forward on the net (including my own) simply won’t scale to the size of a $1b fund.” If a strategy isn’t very scalable, isn’t its commercial value limited?

Fully invested: See my previous comment about ordering sushi at pizza joints. Mutual funds are there to provide an investor exposure to an asset class. Unless you style yourself as a market timing fund or an absolute value fund, then not being fully invested all the time is style drift.

100 stocks or more = Indexing: As a quant, he should know better than that. If I were to hold an equal weighted portfolio of the top 100 stocks in the S&P 500, the forecast tracking error, according to most risk models, would easily be in the 3-5% range. (Note that tracking error is defined as the forecast one-standard deviation return difference between a portfolio and its benchmark).


If you're so smart, start a hedge fund
I have also done a lot of interesting work as a quant during my life. You can find some examples here and here – and they only scratch the surface of my thinking. Most notably, some of my models didn’t blow up in August 2007 when many equity quant funds melted down, indicating a crowded trade. I recognize that in many cases, the chemistry just isn’t right.

If people who complain about mutual funds believe that they have a real alpha, then the answer is simple: go start a hedge fund! Hedge funds are supposed to be the embodiment of pure alpha.

Oops! We know how that turned out for a lot of people.

In reality, there is a lot more to portfolio management that knowing what to buy and sell. The case of Peter Schiff is a recent example but he is not alone. That’s why I am working on my book project.

Amateurs pick stocks, sectors, markets, time markets, etc. Professionals manage portfolios.

A trader's view of fundamental indexing

As fundamental indexing has gained a foothold in the consciousness of investors, there have been critiques of the theoretical underpinnings of the concept. Today, I would like to offer a trader’s view of fundamental indexing.


How fundamental indexing works
Here is how fundamental indexing works. Instead of weighting a portfolio by market capitalization, you weight it by some fundamental measure (e.g. sales, book value, etc.). In practice, fundamental indices are weighted by a combination of fundamental factors, rather than a single factor, in order to increase stability.

There is an important difference between cap weighted indices and fundamentally weighted indices. Cap weighted indices are far more passive. In the absence of membership changes and changes in shares outstanding because of buybacks or new issues, a cap weighted index portfolio requires no trading or portfolio rebalancing, other than the periodic re-investment of dividends.

By contrast, fundamental indices need to be periodically re-weighted and rebalanced. As stock prices move over time, the actual weight in a fundamentally weighted portfolio will deviate from the target fundamental weight. In practice, the rebalancing occurs annually.


The perils of rebalancing
Years ago, I was involved in the management of an international equity portfolio benchmarked to a GDP weighted EAFE index. The GDP weighting was conceptually appealing to investors at the time because Japan was such a large weight in the cap-weighted EAFE index. Virtually no manager was at cap weight in the EAFE portfolio because it would leave the portfolio with too much country specific risk. In practice, problems occurred on an annual basis when MSCI rebalanced the GDP-weighted EAFE index to its GDP weight. Japan’s weight in the index would typically move overnight by 5-10%. Such huge swings in the benchmark made it very difficult for an active, never mind passive, manager to run the portfolio.


An invitation for front-running
Any trader will tell you that the worst place to be as a trader is when the rest of the world knows what you have to do – and you have to do it despite that knowledge. This foreknowledge exacerbated the effects of the market crash of 1987 as market makers knew the portfolio insurers/program traders needed to sell more stocks as the market moved down. It also played a part in the sinking of Long Term Capital Management. The Street knew LTCM’s book. They knew the firm was in trouble. Arbs were front-running the firm’s positions, which worsened their losses.

As fundamental indexing gains in popularity, arbitrageurs, hedge funds and position traders can estimate the amount of rebalancing that will need to be done by the fundamental indexers – and front run them. This form of front running is not illegal, just smart trading, and it will serve to reduce the returns to fundamental indexing.

Investing in semi-passive investment strategies such as fundamental indexing is a game of inches. As fundamental indexing becomes more popular, rebalancing and implementation costs could easily take away any gains from the underlying investment concept.

Deep value plays

As S&P 500 earnings have started their collapse (see articles here and here), there has been a debate about whether this market constitutes good value. From a bottom up basis, however, I am seeing values that I haven’t seen in a long time.


Screening on net-net working capital
Using the free data from the Yahoo! finance website, I wrote a program that screened an investment universe that is roughly equivalent to the Russell 3000 members. The test is: stocks that trade below net-net working capital (current assets less all liabilities and preferred) and has positive trailing 12 month earnings. The net-net working capital requirement is a classic Ben Graham deep value criteria. The earnings test represents an additional margin of safety of corporate viability.

I got 39 names. Even if I threw out the microcaps (market cap below $100 million), I still got 13 stocks that passed the test:

Adaptec Inc (ADPT), Cynosure Inc (CYNO), Fuqi International Inc (FUQI), Horsehead Holding Corp (ZINC), Ingram Micro Inc (IM), Movado Group Inc (MOV), Olympic Steel Inc (ZEUS), PC Connection Inc (PCCC), Shoe Carnival Inc (SCVL), Skechers U.S.A. Inc (SKX), Tech Data Corp (TECD), Tecumseh Products Co (TECUA) and Volt Information Sciences Inc (VOL).

Stocks trading below net cash
Using the more restrictive criteria of non-financial stocks trading below net cash (cash less short and long term debt) and that are earnings positive, I got three names:

Adaptec Inc (ADPT), AuthenTec Inc (AUTH) and Cutera Inc (CUTR).

Two of the three trading below net cash are Technology stocks. This is confirmed by a recent story stating that many Tech companies are sitting on large cash hordes.

On a slightly unrelated note, a recent paper by Dino Palazzo shows that shares of companies with large amounts of cash exhibited higher returns.


Value in this market
I would disagree with those who say that there isn’t value in this market. There are good fundamental values to be found for investors who are willing to dig around and these screens support my contention that the downside risk to this market is limited.


Disclaimer: The caveat to these lists is that they represent a starting point for further research and you should not blindly go out and buy them without further investigation.

Don’t let the sorcerer’s apprentices hijack this model

As I perused my latest edition of the Financial Analysts Journal, two interesting articles came to light. The first entitled Estimating Operational Risk for Hedge Funds, detailed a quantitative scoring methodology for hedge fund operational due diligence:



The authors found high return volatility and high levels of conflict of interest at hedge funds may lead to problems, such as fraud and fund failure. Even though the authors noted that “a quantitative model can never fully replace human judgment”, no doubt some sorcerer’s apprentice will formalize some version of this into a quantitative score, much like the Altman Z, and it will go into wide usage for OPDD.

I don’t know about you, but I would not like to entrust my money to a manager of a corporate bond fund who bases his decisions mainly on the Altman Z score.

This hedge fund operational risk model is an extremely useful model as a first cut at due diligence, but it is not a substitute for clear thinking. Most importantly, if the inputs to a model are known, the score can be gamed and manipulated by unscrupulous users.

Interestingly, the same edition of the FAJ had an article called Models, by Emanuel Derman, where he echoes my feelings on quant models:

Financial models are therefore best regarded as a collection of mathematically consistent, parallel “thought universes,” each of which will always be far too simple to resemble the real financial world, but whose exploration as a whole can nevertheless provide valuable insight.

Quants need to learn to be more empirical
The mortgage meltdown was caused by the blind application of dubious models by quants who didn't know any better. I hope that the financial world has learned its lesson.

Don’t let the sorcerer’s apprentices hijack this hedge fund due diligence model. Otherwise this will get out of control and lead to another meltdown a few years from now.

Which standard to judge Peter Schiff?

Given the recent controversy about Peter Schiff’s recommendations, I thought that it is useful to explore the framework that investors should judge his record, or anyone else's record for that matter.


A framework for analysis
Investment processes vary from portfolio manager to portfolio manager, but this is a basic outline of what an investment process looks like:

Selection: What do you buy and sell?
Portfolio construction: How much do you buy and sell (in a risk controlled fashion)?
Trading: Pulling the trigger, or when and how do you buy and sell it?
Review and control: Did you do everything (all of the above) right?

We spend most of our time thinking about the first step of the investment process of what to buy and sell. Brokerage analysts do that every day. In addition, there are various services that try to emulate the buys and sells of other investors such as Gurufocus and Mebane Faber’s alphaclone.


Two standards to judge Schiff, or any other advisor
Given our natural intense focus on selection, it is natural to judge an investment advisor on the quality of his picks and opinions. By that standard, his opinions weren’t too bad. He did call the economy's decline correctly and it was a great call. He was, however, wrong on the decoupling thesis and the emerging market/commodity play.

There is a second much tougher standard to judge Schiff – as a portfolio manager. A portfolio manager is held to not just the first step of the investment process (what to buy and sell) but on all parts of the process based on his overall performance. By that standard, Schiff failed dismally. As I understand it, he overstayed his welcome in the commodity and emerging market trade and performance suffered as a result.

(Incidentally, my opinions are similar to Schiff but the positions in my own portfolio were stopped out in the decline. That is why I don’t represent this blog as investment advice. I know nothing about your preferences. I don’t always tell you when to sell, because I don’t know your risk appetite. I don’t tell you how much to buy and sell. If you really wanted all of the above you would be paying me and we would have a real business relationship.)


What do you do after you’ve decided on what to buy & sell?
This is a cautionary story for investors. Beyond the buy and sell decision, they need to pay attention to all the other stuff of putting together a portfolio. That is the reason why I have felt a need to explore this topic in my book project, What do you do after you’ve decided to buy and sell? [*]

For example, if an advisor recommends a buy on Citigroup, is that a bet on the specifics of the stock or the financial services sector? That’s also why I spent a lot of time on portfolio characteristics (example here, here and here).


[*] If any reader in the publishing industry would like to take this further or if you know of anyone in the publishing industry who would like to take this further please contact me at cam at hbhinvestments dot com.

Breakout or fake-out?

Technicians characterize triangular patterns as a “coiled spring”. Triangles represent consolidation and indecision. Breakouts from triangles are considered significant as they tend to forecast the next major direction of the underlying index or stock.

As I write this, the non-farm payroll figure came in slightly worse than expected but the market rallied anyhow. More importantly for technicians, the S&P 500 staged an upside breakout from a triangular pattern.


A similar breakout can also be seen in the broader NYSE Composite:


The NASDAQ 100, which had been the leadership recently, is also staging a good old-fashioned upside breakout:



This bear market rally is for traders only
At these levels, valuations look reasonable, even by Warren Buffett’s standards. I have blogged before that we are seeing signs of healing in the markets. Is this the start of a new bull?

Not so fast.

Mark Hulbert reports that newsletter writer sentiment seems to be too bullish.

Bear markets take price and time to resolve. We have seen the price move but it needs more time. This is probably still a bear market rally. We are likely still in a basing/consolidation/trading range period until this summer. The S&P 500 has seen resistance at the 900-920 level and it will likely pause there again in this rally before come back down to test the old lows set in November 2008.

A new hedge fund business model

As hedge fund returns continue to disappoint, there has been a cacophony of voices calling for changes in approach to investment in hedge funds and for reform in the industry. Some are pure marketing hype, while others do have some value. Here are some a couple of notable examples (and my reactions):


Hedge funds as alternative beta instruments
Lars Jaeger suggested that investors should view hedge funds as sources of alternative beta, which I take to mean that they are diversifying. He went on to indicate that investor should take a macroeconomic based approach to managing these hedge fund betas as a way of adding alpha to the overall portfolio.

I blogged some time ago that a Bridgewater study showed that hedge fund strategies have definite return patterns. For example, emerging market hedge fund returns could largely be replicated by a portfolio of 50% emerging market stocks and 50% emerging market bonds. If hedge fund strategies have betas, why not structure their incentive fee to their passive benchmark? In the case of an emerging market hedge fund, pay 20% of the outperformance against a 50/50 emerging market stock/bond benchmark, rather than an absolute return benchmark?


Longer lockups and different incentive structure
Another suggestion is for a longer lockup but the incentive fee doesn’t get paid out until the end of the lockup. In this case, there is a three year lockup in the fund, but the incentive fee doesn’t get calculated and paid out until the end of the three years.

I think that this is a good idea. It takes away some of the short term-ism that exists among hedge fund managers. Having worked at a fund with quarterly incentive payouts, I personally experienced the mentality that there are only four important dates in the year – the quarter end dates.


Heads I win, tails I walk away
One of the problems with the hedge fund industry is the asymmetric nature of the return incentives. Heads I win. Tails I walk away. If the fund return suffers and the unit value falls significantly below the high-water mark, the manager’s incentive to run the fund diminishes. The temptation to close the fund, walk away and start afresh grows as the fund returns get more negative.

Here are my suggestions for structuring a hedge fund in a way that is fair to the investor:

Benchmark: Benchmark the fund’s returns to the strategy proxy (see above example of the emerging market fund). When I moved from the long-only asset management world to the hedge fund world, I was shocked to see that there was a recognition that different strategies had return betas but incentive fees were not calculated in excess of the beta of the fund. Intermediaries were already pigeonholing hedge funds into different strategy groups (e.g. convertible arbitrage, global macro, etc.), so that was not a problem. Why are investors paying alpha fees for beta?

If a fund can truly demonstrate that it has an undiversified alpha that is uncorrelated to any of the other hedge fund strategy benchmarks, then by all means structure the incentive fee to a cash benchmark.

Incentive fees: Make the manager truly eat their own cooking. Instead of paying an incentive fee in cash, pay it in units of the fund, with a lockup. For example, a fund could pay an incentive fee of 20% of a return in excess of a benchmark. The manager would then be required to reinvest the incentive fee back into the fund, with a three-year lockup. That way, the manager would have strong incentives for risk control and blowups would hurt his own wallet a lot more.

Additionally, the fund could be structured with a longer lockup with an incentive fee payout at the end of the lockup.


People respond to incentives
The problem so far has been the incentives in the financial markets have been wrongly structured. A lot of people made a lot of money without adding a lot of value, or added value short-term by increasing risk longer term. I have suggested before that making the reward system symmetric in investment banks could solve a lot of the structural problems on Wall Street.

We can use the same approach to fix the hedge fund industry too.

Don’t panic: Real-time data points to stabilization

When I have done fundamental research in the past, I focused on the company’s strategy and its drivers of profitability and growth. When I expand my investment universe to thousands of companies using quantitative techniques, I used multi-factor models based on the usual suspects: value, growth, momentum, sentiment, signals (e.g. insider activity, buybacks, etc.)

When I do top-down analysis, my philosophy differs from many other researchers in the field. During these times when economists bicker about the stimulus package, it’s important to keep in mind that 2009 will be the year when the economic crisis fully migrates from Wall Street to Main Street. The headlines will get a lot worse before it gets better.

Particularly during periods like this, economic statistics are not very useful because they are mainly backward looking. For top-down analysis, I prefer to rely on real-time market signals.


Don’t panic
The real time data is constructive for the economic outlook. The equities of two leading industries that I watch closely, homebuilding and temp agencies, are showing signs of stabilization.

Homebuilders appear to be trying to put in a bottom compared to the market. I also put together a composite of the stock of Staffing and Temp Agencies and compared their performance relative to the S&P 500. As the chart below shows, this group has broken out of a relative downtrend. More importantly, this group doesn’t seem to be totally falling apart despite the dire headlines hitting the mainstream media. The chart indicates that the group has only retreated to a relative support zone dating back from 2003-5.




Bad news already discounted?
Another important sign to watch is how the market reacts to bad news. A case in point, the outlook for Tech earnings looks terrible, but the chart below shows the NASDAQ 100 outperforming the S&P 500. Is most of the bad news in the market already?

It’s so bad it’s good
The psychology is terrible. It is so terrible that the blooger VIX and More is reporting a buy signal from his global volatility index.

We seem to be entering a “bad news is good news” phase for the market. In fact, there are indications that there is an inverse long-term relationship between employment and equity returns.

I believe that as long as we don’t see an ugly surprise like protectionism rear its ugly head, most of the bad news is in the equity market and the downside is limited at current levels.