Friday, August 29, 2008

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

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

Another example of political peaking occurred in April 2008, where

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

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

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

Thursday, August 28, 2008

Why you can’t stop bubbles

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

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

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

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

Monday, August 25, 2008

A modest proposal (for hedge fund investors)

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

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

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

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

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

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

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

What this post was not:
  • A call for hedge fund investors to gaming: I am well aware that the gaming industry is economically sensitive and cyclical. These are obvious limitations to the gaming industry.
  • A call to buy gaming stocks: See comment above about the gaming industry. However, do think about the cash flows of the business because when you engage in direct investment you need a long-term horizon, much like the lockups that you see in the hedge fund industry.

to have to explain my jokes...

Wednesday, August 20, 2008

Crude oil close to a bottom

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

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

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

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

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

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

Monday, August 18, 2008

Gold correction has further to run

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

Not so fast!

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

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

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

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

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

Friday, August 15, 2008

Time to cover housing shorts

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

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

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

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

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

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

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

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

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

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

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

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

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

Tuesday, August 12, 2008

Algo trading – too much of a good thing?

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

That has all changed.

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

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

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

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

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

Friday, August 8, 2008

More constructive on crude oil (correction)

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

More constructive on crude oil

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

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

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

Peak Oil Concepts

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

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

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

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

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

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

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

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

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

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

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

Tuesday, August 5, 2008

Is Value just a big bet on Financials?

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

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

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

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