Turning beta into alpha

Joe Weisenthal over at Clusterstock recently reported that quants have become beta chasers:

In a survey of quant investors done by BofA/ML, the number of respondents who say that beta is a key factor in their stock screens, has surged overtime, from less than 20% in the mid 90s to over 70% now.

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

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


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



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

Time to sell? Roach turns bullish on China

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

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

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

Which part of Goldman is right?

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

At the same time, Goldman is forecasting for an economic slowdown in China:

Our new GDP estimates show a significant slowdown in 2Q11 to 8.0% qoq (significantly below trend), then recovering towards trend in 3Q11 at 9.0% and returning to trend in 4Q11 at 9.3%. This is both a sharper and more extended slowdown than we had previously forecast.

How can Goldman Sachs be oil and commodity bullish when China consumes 25-50% of many key commodities?

Izabella Kaminska at FT Alphaville points out some analysis from Simon Hunt of Simon Hunt Strategic Services which suggests that rising copper demand seen in China is the result of re-stocking and not final demand, which remains weak:

What is now being seen is that fabricators who have been operating on a hand to mouth basis, now seeing prices having fallen by $1000+ , are replenishing those inventories. It is not a signal that actual production of semis, i.e material going into furnaces has improved. On the contrary, I expect to be told that business is pretty weak.

Who is right? Which part of Goldman Sachs is right? Are they all right?

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

On the fence, watching for an Apocalypse

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

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

The bull case

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

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

The bear case

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

A place to hide

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

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

The bears in control

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

I beg to differ.

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

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

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

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

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

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

Ursa Major or Ursa Minor?

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

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

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

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

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

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

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

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

Take a ride on my demographic train

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

Now, I see that others have jumped on the story. Mark Hulbert has highlighted some analysis from Ned Davis Research indicating that American age demographics will be more youthful than China's by 2020. Hulbert pointed to a paper that concluded that investors don't pay much attention to demographics, even though age demographics is highly predictable and such trends exploitable by investors. Here is the abstract [emphasis added]:

Do investors pay enough attention to long-term fundamentals? We consider the case of demographic information. Cohort size fluctuations produce forecastable demand changes for age-sensitive sectors, such as toys, bicycles, beer, life insurance, and nursing homes. These demand changes are predictable once a specific cohort is born. We use lagged consumption and demographic data to forecast future consumption demand growth induced by changes in age structure. We find that demand forecasts predict profitability by industry. Moreover, forecasted demand changes 5 to 10 years in the future predict annual industry stock returns. One additional percentage point of annualized demand growth due to demographics predicts a 5 to 10 percentage point increase in annual abnormal industry stock returns. However, forecasted demand changes over shorter horizons do not predict stock returns. The predictability results are more substantial for industries with higher barriers to entry and with more pronounced age patterns in consumption. A trading strategy exploiting demographic information earns an annualized risk-adjusted return of 5 to 7 percent. We present a model of underreaction to information about the distant future that is consistent with the findings.

My conclusion has been equity markets are likely to go sideways until the end of this decade. I wrote that:

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

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

Sell in May?

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

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


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

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


Macro risks everywhere
I am concerned that the market is acting vulnerably during a period of heightened macro risk. There are three major sources of macro risk:

• Europe: As I write this, Greek 2-year debt is sporting an eye-popping yield north of 25%. These stratospheric levels reflect market fears that bond holders will have to take a significant haircut on Greek debt, which would be a devastating blow to the already fragile European banking system. If Greece re-structures, then it could very well take down Spain - which may be too large for the EU to rescue.
• China: The PBoC has signaled that it will take further steps to cool its superheated economy and there are "no limit to how far it can raise the reserve requirement". Already, there are signs that its property bubble is being deflated. Recent reports indicate that Chinese property developer profits are falling and their debt is approaching $1T in a climate of rising inventory.
• US default: The political horse-trading over the debt ceiling continues to be worrisome. A default by the US Treasury would send shockwaves all around the globe and it would be the financial equivalent of the comet that hit the Earth and created the Gulf of Mexico in prehistoric times.

The current market environment is likely to resolve itself with a plain vanilla 5-10% correction. However, if any of these macro risks were to manifest themselves during that pullback, the downside has the potential to extend itself to 40-50%.

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


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

Where's diversification when you need it?

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

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

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

In the future, it would make more sense to divide the world by risk. If an investment is not prone to the same risks as the others you already hold, then buying it will reduce your overall risk. If it is subject to exactly the same risk, then buying it is pointless, even if it is in a different asset class or country. Rather than balance between stocks and bonds, for example, it might be better to balance the risks of inflation and deflation, which both affect stocks and bonds. Diversification itself is as good an idea as ever. You should not put all your eggs in one basket. But in the globalized world, you can put your egg into a different country an still find that it is in the same basket.

EDHEC said the same thing, but in a slightly different way. (Note that my Timer Model is a dynamic asset allocation model) [emphasis added]:

The postmodern quantitative techniques suggested as extensions of mean-variance analysis, however, exploit diversification as a general method. Although diversification is most effective in extracting risk premia over reasonably long investment horizons and is a key component of sound risk management, it is ill-suited for loss control in severe market downturns. Hedging and insurance are better suited for loss control over short horizons. In particular, dynamic asset allocation techniques deal efficiently with general loss constraints because they preserve access to the upside. Diversification is still very useful in these strategies, as the performance of well-diversified building blocks helps finance the cost of insurance strategies.

When do you want risk control the most? During "normal" periods when diversification dampens volatility and returns? Or during extreme crisis events when standard diversification techniques break down?

Comparing private and government compensation

There is an assumption in many quarters of society that virtually any form of government is inherently bad. Private enterprise and the free markets can do things much better. Consider this essay entitled If Supermarkets were like Public Schools, as one of many examples. Donald Boudreaux lays out the scenario:

Suppose that groceries were supplied in the same way as K-12 education. Residents of each county would pay taxes on their properties. Nearly half of those tax revenues would then be spent by government officials to build and operate supermarkets. Each family would be assigned to a particular supermarket according to its home address. And each family would get its weekly allotment of groceries—"for free"—from its neighborhood public supermarket.

No family would be permitted to get groceries from a public supermarket outside of its district. Fortunately, though, thanks to a Supreme Court decision, families would be free to shop at private supermarkets that charge directly for the groceries they offer. Private-supermarket families, however, would receive no reductions in their property taxes.

He went on to assert that private enterprise, or the free market, could deliver those services much better [emphasis added]:

Being largely protected from consumer choice, almost all public supermarkets would be worse than private ones. In poor counties the quality of public supermarkets would be downright abysmal. Poor people—entitled in principle to excellent supermarkets—would in fact suffer unusually poor supermarket quality.

If the free market is the superior choice in virtually all instances, then incentivizing workers by their output, as well as a business friendly tax policy, is the correct solution. Nowhere else can this attitude be found than the gargantuan compensation packages found on Wall Street.
 
The Epicurean Dealmaker has a more nuanced interpretation of banker compensation. He explains that investment banks are networks that can be rented by clients. The investment bankers and traders are also valuable in and of themselves:

Clearly, a proprietary trader or an M&A banker is more powerful and effective if he or she works at a great platform with outstanding network resources, like Goldman Sachs. He or she can do more, bigger, and more profitable deals because of it. But Goldman Sachs itself is more powerful and more valuable to its clients because they have that person (and his or her network(s)) in place. To the question, "Who is more valuable, the banker or the platform?," the answer is always "Both." Take one away from the other, and both are diminished.

So discussions like this one, where an individual who arranged a massively profitable trade for his bank expects far more compensation than the bank wants or is likely to give him, are an annual staple of my industry. Clearly the trader could not have done such a trade without the capital and resources of his employer, so a huge bonus is not merited. But the bank has incentives to make him happy, too, lest he leave with the special knowledge or relationships he employed or developed in that trade to replicate it—and the accompanying profits—at a competitor. Investment banker compensation is always comprised of some portion of reward for business won and profits made plus an option on potential future business and profits from that same banker. This insight helps explain the fact, puzzling to most outside the industry, that investment bankers can get paid tons of money even when they or their firms lose it: they are being paid for future potential results.

So if you accept the principle that someone makes a zillion for the bank, he deserves a reasonable cut of the profit (with definition of the term "reasonable" subject to later discussion).


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

Now think about the jubilation over the death of Osama bin Laden and the adoration of the anonymous SEAL team that executed the raid. Now think about these questions:

• Why is there all this adoration over a bunch of people who work for the federal government?
• There was a $25 million reward for OBL, why didn't that get results earlier?
• Would we have seen better or faster results if these civil servants had been incentivized properly (perhaps to give a three or six sigma effort)? Should this SEAL team, along with the numerous intelligence analysts involved in the operation be incentivized with multi-million dollar Wall Street bonuses?

People do things not just because of greed. Greed is a powerful motivator, but it isn't everything.

Upcoming conferences

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


Pacific Northwest Economic Conference: Fixing Global Finance

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


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

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

Cheap way to get Aussie exposure

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


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

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

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

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

Is Bernanke more brilliant than we ever conceived?

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

Nick Rowe, writing at Worthwhile Canadian Initiative, inadvertently laid out Bernanke's nefarious scenario. First, he wrote:

There's a general principle in economics: first you eat the free lunches; then you look at the hard trade-offs. Functional Finance says "first eat the free lunches". The Long Run Government Budget Constraint says "then look at the hard trade-offs".

Everyone likes a free lunch. The Washington Post reported that in a poll, Americans would like to cut the budget deficit, but they oppose entitlement, defense and across-the-board tax increases cuts.

The survey finds that Americans prefer to keep Medicare just the way it is. Most also oppose cuts in Medicaid and the defense budget. More than half say they are against small, across-the-board tax increases combined with modest reductions in Medicare and Social Security benefits. Only President Obama’s call to raise tax rates on the wealthiest Americans enjoys solid support.

In other words, they want a free lunch. (Consider, for example, this more realistic assessment of the budget from former Reagan budget director David Stockman where he blames both sides of the aisle.) Rowe postulated that there are certain circumstances where the American People could have their free lunch:

Suppose, just suppose, that if you kept on doing what you were planning to do, you never had to worry about inflation. Not now, not in the future, not ever. Because Aggregate Demand was too low now, and was projected to be too low forever. So you are not worried about inflation. Instead you are worried about deflation. And you were a government that could print your own money. What would you do?

You would print money and spend it. Or print money and use it to finance tax cuts. And you would keep on doing it, more and more, until you got to the point where you did start to worry about inflation. You first eat all the free lunches.

When the US Dollar is the de facto reserve currency of the global economy, there is a free lunch of sorts. But what about the consequences? Rowe has an answer to that as well, given that the global economy collapsed in 2008 and remains very fragile [emphasis added]:

Suppose inflation isn't a problem right now, because Aggregate Demand is currently too low. Does that mean the government should print money and spend it? Not necessarily. Print money yes, but instead of spending it on goods, or on tax cuts, it might be better to use it to buy back some interest-paying government bonds. Because even though inflation isn't a problem right now, it may be a problem some time in the future. So you can buy the money back in future, by re-issuing the bonds (and save on interest in the meantime) without having to raise future taxes or cut future spending.

Isn't that what the Fed is doing, in its own way, with QE2. Okay, it's not retiring government debt but putting the paper on the Fed's balance sheet. Nevertheless, the Treasury can now finance new debt at lower rates because Aggregate Demand is so weak.

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



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

2011 growth surprise & 2012 growth bust?

Now that the FOMC meeting and Bernanke's first press conference is over, one of the questions that has been nagging at me is whether the Fed might over-react to the recent bout of economic growth.

More importantly, is the growth self-sustaining?


Cash for clunkers on steroids
I came upon an intriguing point of view from Lombard Street Research (LSR). I have been very impressed by these folks as top-down forecasters for their non-consensus out-of-the-box thinking. The most memorable, for me, was their call after the Tech Bust to watch China as a source of global growth when few forecasters were even thinking about the Middle Kingdom.

In their Review published February 28, 2011, LSR voiced concerns that a provision for 100% deduction of capital spending in 2011 would pull capex forward from 2012 and create the illusion of growth (sort of a cash for clunkers program on steroids). In addition, the corporate cash that would flow into capex in 2011 would reduce liquidity and end the stock market rally [emphasis added]:

[T]he chief danger is a large boost to 2011 business capital spending arising from 100% first-year depreciation this year only, and then, with its end-year withdrawal, a very sharp downswing in 2012. This Review posits the chance that 2% of 2012 GDP could be brought forward into 2011 to gain the tax break, and that its bunching at end-year could boost GDP growth to 7% in 2011 Q4 from 2010 Q4. But the loss of that spending in 2012 would doubly reduce cap-ex next year, maybe causing recession. In addition, the build-up of accelerated cap-ex this summer could remove much of the cash flow surplus that businesses are currently pouring into financial markets, at the same time as the end of QE2 takes away the current $100 billion/ month of Fed inflows. This liquidity squeeze would end the stock market recovery.

This LSR analysis is highly intriguing. Indeed Mr. Market seems to have recognized the capex story. The ratio of Industrial stocks, the sector where most of the capital equipment companies are, are in a well-defined uptrend relative to the market.

What if the Fed overreacts?
What nags at me is the Fed reaction. What if the Fed interprets this growth spurt as a self-sustaining recovery and ends ZIRP prematurely? The resulting tightening effects would start to bite in 2012 and coincide with the capital spending slowdown.


Market volatility ahead
If the capital markets look ahead 6-12 months, it would start to anticipate a growth slowdown starting about 3Q, which is also the timeframe for the end of QE2 and discussions about the end of ZIRP. I am already seeing worrisome negative divergences in the market, which should concern the bulls. My inner trader believes that there is still some limited upside to stocks, which he wants to stick around for. One of the important "tells" would be to watch for a downturn in the relative performance of the Industrials to the market shown in the chart above. My inner investor, on the other hand, is preparing for the storm to come. Its magnitude is unknown because it is highly policy dependent.

Fasten your seat belts!

What happens after QE2?

As the markets hold their collective breaths and wait for the FOMC April 27 statement and subsequent Bernanke press conference, it seems that the end of QE2 is baked into the cake. The question is more one of what happens to ZIRP?

I thought I would add my 2 cents worth to the implications of end of QE2. It is evident that one of the purposes of QE2 is to push up the prices of risky assets. John Hussman has complained repeatedly about the effects of this Federal Reserve policy [emphasis added]:

In our view, quantitative easing has been a reckless policy, not only because it has fueled what Dallas Fed president Richard Fisher calls "extraordinary speculative activity," but because aside from a burst of short-term optimism, the historical evidence is clear that fluctuations in stock prices have very little impact on real spending (the so-called wealth effect is on the order of 0.03-0.05% for every 1% change in stock prices). People consume off of perceived permanent income, not off of fluctuations in the prices of volatile assets. Now, it's true that QE2 has probably been good for a fraction of 1% in additional GDP, which should be sustained over a period of a year or two, and though we haven't observed real activity or actual industrial production that matches the optimism of survey-based measures such as the ISM indices, it's clear that some pent-up demand was released. Still, the links between monetary base expansion, stock values, and GDP growth are tenuous at best. The most predictable outcome was commodity hoarding, where our expectations have been fully realized, with awful consequences for the world's poor, not to mention for geopolitical stability.  

As regular readers know, I use the Inflation Deflation Timer Model, which depends on commodity prices as the canaries in the coal mine of global growth and asset inflationary expectations, to time the risk-on vs. risk-off trade. Russ Winter pointed out that there has been a close correlation between the expansion of the Fed balance sheet and commodity prices.

With the end of QE2 in sight, Winter asked, "When does the meltup switch into a full-fledged meltdown of the global economy? "

Regardless, John Hussman added that the fate of QE2 is irrelevant as the program is nearly complete anyhow:

The next FOMC meeting is on April 26-27. While there has been some debate on whether the Fed might decide at that meeting to terminate the policy of QE2 early, that debate is actually moot. By the time the Fed meets later this month, QE2 will already be at least 85% complete.

I am already seeing disturbing signs of negative divergence in the stock market. Although commodity prices, which are my principal indicator, haven't keeled over yet, the combination of bearish signals from my secondary indicators and the prospect of the end of the Fed's QE2 purchases are setting the climate for substantial downside in asset prices.

A Peak Oil warning

I haven't written about Peak Oil for a while, but the blogger Early Warning recently warned about peaking Saudi oil production. I summarize his concerns here (get full details if you click on the above link):

• A sharp production decline in March, combined with
• A sharp increase in well counts in February and March;
• The Manifa project, which had been put on the shelf, has been restarted; and
• Reports of a new paper by a senior Saudi oil official that oil production will not rise in the next five years.

Other bloggers have commented on the Saudi production puzzle. Jeff Rubin asked on April 13, 2011: Where is Saudi's excess capacity when you need it?

In early March, I wrote a Qwest for Returns essay entitled Is Saudi oil production peaking? I pointed to the often cited US diplomatic cables from Wikileaks. Moreover, the blogger Satellite o'er the desert used Google Earth imagery found that the latest Haradah III development reached its production target using 60% more wells than originally projected.

In the words of the late Matt Simmons, when Saudi production peaks, so will the world.

That's why, despite my near term reservations about the markets, where an economic downturn would be devastating for commodity prices, I remain a long-term oil and commodity bull.

Batteries not included

Here in these pages, I have been a believer that the free market works but one of the pre-conditions of that form of market efficiency is full disclosure. So it was with a shock that I found this article from the Ottawa Citizen that revealed that Canada's purchase of the F-35 fighter jets does not include an engine:

The multi-million dollar F-35 stealth fighter that the Conservatives want to purchase comes with all the accoutrements of a high-tech aircraft — everything, that is, except an engine.


The government will be required to provide engines for the 65 planes to be delivered by U.S. manufacturer Lockheed Martin, according to newly released Defence Department documents.

Why, in the middle of an election, that the opposition parties haven't jumped all over this story is a mystery to me.

No time to be a hero

The market melted down Monday and melted up Wednesday. What to make of this market action?

I have some good news and bad news for the bulls. The good news is that commodity prices, which is used by my Inflation Deflation Timer Model to measure global growth and inflationary expectations, remains in an uptrend and is therefore is at an "inflation" reading. Given this signal, my inner trader remains bullish on the "risk on" trade.

Secondary indicators bearish
The bad news is my secondary indicators are not confirming the bullish signal. As an example, one of my favorite measures of risk appetite - the ratio of Consumer Discretionary stocks to Consumer Staple stocks, has rolled over indicating that investor risk aversion appears to be ascendant.

Loss of market leadership a concern
This chart shows a pattern of a broken relative uptrend and a downward channel indicating a relative downtrend has begun. The same pattern can be found in a number of market leaders. Consider the chart of Goldman Sachs, for example.

Other market leaders such as Google look positively sick.

To add to my concern, while oil prices as measured by WTI are now above $110, the Dow Jones Transportation Average is not behaving well. The Transports staged a false breakout and is now mired at minor support despite the general market strength Wednesday.

These conditions have made my inner investor extremely cautious and he has already left the bull's party. My inner trader believes in the adage that "tops are made by a process". He is staying at the party for another drink but he is standing at the door (just in case) and relying on the Timer Model to give him the signal to leave.

Macro volatility ahead

As the market holds its breath in anticipation of the results of the upcoming FOMC meeting and various Fed luminaries voiced concerns about rising inflation, it seems that QE3 is dead and there is a risk to the Fed's zero interest rate policy (ZIRP).

Notwithstanding Friday's headline CPI showed itself to be up 2.7% in the last twelve months, inflationary hysteria was further fanned when CNBC featured a story that showed the calculation, by Stadowstats.com, of CPI using the method used in 1980 to be an astounding 9.8%.

How will the Fed perceived inflation? I have no idea.

Given that the latest Beige Book shows an improving economy, the consensus seems to be that QE3 is off the table for now and ZIRP is threatened. The ECB, which does not have the dual mandate of the Federal Reserve, is already starting to tighten monetary policy despite the risks to the eurozone periphery.


Outlook is highly policy dependent
Meanwhile, the IMF warned that the US will have the largest fiscal deficit in the developed world and should take steps to deal with the problem now:

The U.S. is set to have the largest budget deficit among major developed economies and should narrow it now rather than face tough adjustments in the next two years, the International Monetary Fund said.

The U.S. shortfall will reach 10.8 percent of gross domestic product this year, ahead of Japan and the U.K., the Washington-based agency said in a report released today. It estimates that President Barack Obama will need to cut the deficit by 5 percentage points of GDP in the next two fiscal years, the largest adjustment in “at least half a century,” to meet his pledge of halving it by the end of his four-year term.

Throw in the bickering and horse trading over the debt ceiling - and future macro conditions are highly policy dependent. Needless to say, any fiscal tightening in the face of a fragile recovery could be deadly for the economy and markets.
 
I wrote in November 2008, at the height of the meltdown, that conditions were highly policy dependent and that there are no investment models for all seasons. It seems that nothing has changed.
 
Investors need to be prepared to weather this volatility, whether it is the use of tactical asset allocation such as the Inflation Deflation Timer Model, risk budgeting, or simply to raise some cash in order to keep some powder dry in preparation for better investment opportunities should the markets hit an air pocket.

How quants think

Quants aren't like most of us because they think in ways that are counterintuitive. Recently, Cliff Asness explained quantitative investing by comparing the portfolio construction styles of quants and fundamentally oriented investors (or "quals"):

A qual digs very deeply into potential investments, but he can only do that with so many stocks, so he needs to have a relatively high level of conviction that he is right, since he's going to hold a pretty concentrated portfolio, say 10 or 20 stocks ... A qual needs to be careful about not making mistakes--one bad mistake in a 10-stock portfolio can get ugly!" He continued: "A quant, on the other hand, has the ability to study thousands of stocks at once, and thus can hold much more broadly diversified portfolios. Because quants hold so many stocks, ones that are even slightly misvalued may still make sense ... If you can find 500 stocks to bet on where each has a 51 percent chance of beating the market, then through diversification, the odds of your overall portfolio start to look pretty good.

Asness was really re-stating Richard Grinold's Fundamental Law of Active Management which states, in effect, that you should size an investment bet according to the size of your "edge".


How much should you hold of a stock ranked "sell"?
Consider, for example, a large cap stock (e.g. Apple) that is ranked "sell" comprising of 12% of the weight of the benchmark (a revised NASDAQ 100). How much of it should you hold?

For a fundamental investor who strenuously researches the company, the answer is a zero weight. For a quant who holds a large number of positions in his portfolio and depends on a statistical edge in stock picking, the answer is likely a non-zero weight, equal to the index weight (12%) less the size of the bet (probably between 1.5% and 3%). In the latter case of the quantitative investor, the correct answer is likely between 9.0% and 10.5%.


Remember your investment philosphy
Although there are some practical problems with the application of Grinold's Fundamental Law, the lesson still holds: bet according to the size of your edge.

For investment managers, this means that you should remember your marketing material when you construct a portfolio. Recall that investment managers are usually evaluated on the 4Ps:

• Philosophy: What is your edge in the market?
• Process: How do you implement your edge in the market?
• Performance
• People

What is your edge and how do you implement it?