Sunday, September 28, 2008

This bailout is destined to end in tears

As of the time of this writing, the Emergency Economic Stabilization Act of 2008 is scheduled to be introduced in House of Representative on Monday September 29th. As I had no special insights on the bailout, I have so far avoided commenting on the situation.

Was foreign pressure the REAL reason for the bailout?
However, there is something that not many have talked about that makes me compelled to speak up. While some have pointed to the breakdown in the credit markets as the compelling reason for a bailout, there is gathering evidence that the US authorities succumbed to Chinese pressure to “make them whole”, so to speak, on China’s investments in US paper. The Washington Post recently reported [emphasis mine]:
As U.S. officials were deciding in August whether to take over Fannie Mae and Freddie Mac, the Treasury Department held informal talks with officials from the People's Bank of China, the country's central bank. At that time, investors in Fannie Mae and Freddie Mac in China were dramatically reducing their holdings. The U.S. side told China that a cash infusion was in the works; China said that it expected the U.S. government to "do whatever is necessary" to protect the investments.

As an indication of further pressures, China also signaled that it could shift away from USD assets. Given the size of the US current account deficit, a buyer’s strike of USD paper would send long rates soaring and the economy would nosedive into a serious recession, if not another Depression. In that case, the US authorities may have caved into Chinese pressure and chosen to bailout Agency paper.

Two unpalatable choices
To finance the bailout, the United States has two choices. It can either monetize the debt or go to its lenders, hat in hand, to finance the bailout at whatever terms it can get. As any first year economics student can tell you, any monetization of debt of this size would be inflationary. If it chooses the latter path, the Washington Post article reported that:
Ibuki, the Finance Minister, said Friday that Japan would consider funding the International Monetary Fund or other international lending agencies to help with bad debt.
IMF mandated adjustments have always been very painful. Whatever path is taken, this bailout is destined to end in tears.

Thursday, September 25, 2008

Sorcerer’s apprentices at work

As the financial meltdown began with overly aggressive lending and securitization techniques, all on the back of faulty quantitative models, it would be useful to re-examine the foundations of quantitative finance.

Emmanuel Derman, in a paper entitled The Boy's Guide to Pricing & Hedging, wrote that “[o]ver the years I’ve seen a few too many fresh graduates who, on being asked why one believes that one can obtain a credible value for an option, reply that it’s because of Girsanov’s theorem.”

Falling in love with the technology
The above comments from the students reminds me of the process of learning to drive. When I first learned to drive, we began with theory such as the rules of the road, e.g. when to signal, etc. I then proceeded to a simulator and then into a car. In my first hour in the car, all I was expected to do was to drive straight. No one expected me to merge or change three lanes and head for an exit in 60 mph freeway traffic.

To be sure, there were technological aids. As examples, crumple zones and air bags of various designs helped to mitigate the effects of a crash. As well, borrowing from the aircraft cockpits, fancy systems such as cockpit management systems and HUD (heads up displays) helped the driver with his situational awareness.

Somewhere along the way, we fell in love with the technology. Would you put your son or daughter in a school bus driven by a ten-year-old, no matter what kind of cockpit management systems, collision avoidance and mitigation systems and other technology it has?

Imagine the following ad:
BUS DRIVER WANTED: Looking for a recent graduate from a top driving school; must be in the top 20% of class. Familiarity with safety management systems, cockpit management systems…

What is quantitative finance?
Derman wrote that:

To begin with, you must distinguish between price and value. Price is what you pay to acquire a security; value is what it is worth. The price is fair when it is equal to the value.

He summarized quantitative finance as

If you want to know the value of a security, use the price of another security that’s as similar to it as possible. All the rest is modeling. Go and build.

He then added[emphasis are mine]:

Models are only models, toy-like descriptions of idealized worlds. Simple models envisage a simple future; more sophisticated models incorporate a more complex set of future scenarios that can better approximate actual markets. But no mathematical model will capture the intricacies of human psychology. If you listen to the models’ siren song for too long, you may end up on the rocks or in the whirlpool.

Adult supervision needed
The guild of sorcerer’s apprentices took over Wall Street with the acquiescence of the Powers That Be. Where else could you come out of grad school and work as a derivatives trader [see above ad] for 300K plus a year? The results are now clear.

Quantitative models tend to work well at the micro level, such as trading strategies and some forms of risk analysis. However, they can experience catastrophic failure at the level of capturing system wide risks and dynamics. For that, you need adult supervision.

Monday, September 22, 2008

Relief rally but no convincing bottom

It is said that you don't make money from the stories on the front page but from the stories that move from page 10 to the front page.

What's on the front page?
If this is the weekend then it must be time for another rescue...Bear Stearns, Fannie, Freddie, Merrill, Lehman, AIG, WaMu, short sale prohibitions and now the Morgan Stanley, Goldman Sachs reorganizations as well as the $700b bailout.

The Japanification of America continues and the market melted up this week in response to short-term government “fixes”. Notwithstanding the outrages that others have expressed over the government’s intervention, China also signaled that its line of credit has limits.

Page 10 items that I am focused on
While all the headlines are fascinating, it is equally important not to allow them to distract you. The equity market was oversold and certainly due for a relief rally. The VIX Index spiked to 41.97 on Wednesday, which is sufficiently high for a short-term bottom. The most important "tell" of a short-term bottom has been the telephone calls and emails that I received in the past week from people that I hadn't heard from in some time - they all wanted to hear what I thought of the market.

While the panic last week likely marked a the start of a short-term rally, I don’t believe that the bottom has been put into place for this Bear Market for the following reasons:

  • Technical: the leadership in this rally is all wrong. Moreover, sentiment was not sufficiently bearish enough for this to be anything but a short-term relief rally.
  • Monetary: Money supply growth remains anemic.
  • Fiscal: The market hasn't discounted the likely fiscal drag on the economy that is coming next year.

Wrong leadership in this rally
I have pointed out before that true rising from the ashes Phoenix bottoms tend to be led by large cap stocks. In the two days of this rally, the small cap Russell 2000 (+11.2%) beat the large cap S&P 500(+8.4%).

Sentiment isn't sufficiently bearish
The AAII sentiment survey of individual investors shows that while investor sentiment was bearish (contrarian bullish) going into this rally. However, readings were nowhere close to bearish extremes. Mark Hulbert’s analysis led him to the same conclusion: relief rally, yes, market bottom, probably not.

Money supply isn’t growing
No matter how you define it, money supply growth has been anemic. Macro and TAA quants know that money supply growth is correlated with equity market returns. The premise is really simple. You throw money into the system, some of it make it into the stock market in the short term and the market goes up.

The chart below from the St. Louis Fed shows MZM updated to 19 Sep 2008. Despite the Bear, Fannie, Freddie and AIG bailouts of the recent past, the narrowly defined MZM money supply isn’t growing at all. Using a different metric, the broadly (reconstructed) M3 growth has also been falling off a cliff.

Here is a puzzle. If there has been all these bailouts but no growth in the monetary base, where is it coming from? Brad Setser’s analysis suggests that it is coming from foreign central banks and sovereign funds. There is anecdotal evidence of foreign central banks lending in US Dollars. In writing about the massive intervention last Thursday, Reuters reported that:

In Europe, there were signs that the stress was easing. The cost of borrowing dollars overnight fell back towards the Fed's 2 percent target, and three-month borrowing costs slid. The Bank of England offered [USD] $40 billion to banks, but only half of it was taken up.

Recession watch
John Hussman wrote that the market consensus hasn’t quite accepted that we are in a recession:
I'll emphasize again that at the point we do observe sufficient evidence for investors to concede recession, the potential downside could be abrupt, leaving little opportunity to make defensive changes after the fact.

A pre-condition for making a market bottom is the recognition that the economy is in a recession. Despite all the indicators, the market consensus doesn't seem to quite want to concede that reality yet. A good indicator of sufficiently bearish sentiment occurs when commentators start to talk about a double-dip slowdown. Right now, I have not even seen the “double-dip” term in the vocabulary of the economic bears like Nouriel Robini and David Rosenberg.

Likely fiscal drag on the economy in 2009 and 2010
The likely catalyst for talk about a double-dip will be the realization a) America is in a recession; and b) that there will likely be further fiscal drag on the economy in 2009 and 2010. The United States is going to see a presidential election in less than two months but I have not seen anyone discuss this: The propensity of new presidents is to take any economic pain early in his term (and blame his predecessor) so that he can have a solid base for re-election.

A likely scenario will be the new president, whoever he is, will assume office and be shocked! (shocked, I say!) to find the cupboard is bare and be forced to raise taxes as a result. The Washington Post has a good summary of McCain and Obama’s tax proposals. Obama’s stated net tax rate is roughly neutral for the general population (doubtful). As for John McCain, despite his stated policy to lower taxes rates, Greg Mankiw posted an analysis that shows the market believes that the likelihood of a tax increase under a McCain Administration is 74%.

Equities would sell off on the prospect of a tax increase and the resultant fiscal drag. That selloff could possibly set up the market bottom of this Bear.

Wednesday, September 17, 2008

Heebner pukes his positions

For the uninitiated, the term to puke indicates to flatten a position, usually the result of a stop loss.
I have written about Ken Heebner before – that he is a manager who runs a high turnover, high concentration portfolio with a good long-term track record. Heebner had a hot hand for the first half of 2008 in managing the CGM Focus Fund (CGMFX). The defining characteristic of the fund for 2008 had been its long commodity-short financials exposure – until now.

Using the techniques shown in the sidebar titled Reverse engineering a manager's macro exposures, I updated my estimates of Heebner’s sector bets.

Surprise! Surprise!

Heebner is selling his off-the-charts overweight in commodity sectors (Energy, Materials):

He is also neutralizing his off-the-charts underweight position in financials:

Is this part of the risk control process?
Maybe he is demonstrating that he has a risk control process, particularly with the news that Heebner is starting a hedge fund. The chart below shows the performance of CGM Focus and the S&P 500 on a YTD basis. After an incredible first half 2008, CGM Focus gave up about 29% from June 2008 for a return that is roughly in line with the S&P 500.

Or maybe it’s not just hitting a stop loss, more on that in a future post…

Postscript: As an aside, my “smart fund” sample remains overweight the commodity sectors and underweight financials (see this and this).

Sunday, September 14, 2008

Everybody’s a genius in a bull market…

In the last bear market after the popping of the Tech bubble, hedge funds held their own and exhibited positive and uncorrelated returns to other asset classes. This time, hedge fund returns have been far more correlated with equities.

A recent NY Times article states that HFR reports that the average hedge fund is down 4% YTD. Other figures available to me show YTD returns to be closer to 5%. The negative returns are not just attributable to the positive correlations to the S&P 500. The credit crunch has hit hedge funds too as prime brokers reduce risk:
It is now 5 to 10 percent more expensive for hedge funds to borrow from banks than it was a year ago, and banks are increasingly hesitant to lend to hedge funds for long periods.

Investor reactions have been predictable:

"I think we’re seeing what these hedge fund managers really, truly are,” said Robert Discolo, head of hedge fund strategies for A.I.G. Investments, an asset manager within the insurance giant A.I.G. “And some of them really can’t make money in a difficult environment."

In reaction, some hedge funds are reported to be reducing leverage. Others are cutting fees (subscription required) to try and retain assets.

The shakeout is truly in progress. It remains to be seen how the hedge fund business model survives.

Thursday, September 11, 2008

Factor diversification = Living to fight another day

In the past I have met a number of quants who have forgotten the value of diversification. This attitude is especially prevalent among those who work at funds that happen to be showing superior returns at the time. The blowup at Ospraie illustrates the importance of factor diversification in model building (not to mention risk control and position sizing).

Timing commodity equities – an example
As Ospraie invested in the commodity equity space, I show an example below of the components of a long-only timing model as applied to a commodity equity index. The black line shows the cumulative returns of the index from 1995.

Value works - but not all the time
The blue line shows the returns of a timing model based mainly on value principles. The underlying model is not a classic value model but one modified by market signals. The problem with classic value is that it tends to be too early – early to buy and early to sell. One way of mitigating that problem is to combine it with some forward looking signal, e.g. estimate revision or relative strength, so that the model doesn’t buy just because it’s cheap, it buys when it’s cheap and fundamentals have stopped moving down.

This modified value model delivered returns that were roughly in line with the index over the 1995-2008 period but with lower volatility. It avoid much of the negative returns in the 1997-99 period but lagged when the benchmark started to rise in 2004.

Momentum works but it’s volatile
Momentum and trend following models can solve the problem of missing a significant uptrend in the benchmark. The red line shows the cumulative return of a momentum model as applied to the commodity equity index.

The momentum model also avoided much of the drawdowns that the value avoided in 1997-99. It was also above to participate in the rise in the index from 2003 onwards. Overall, it outperformed the value model probably because the test period in question was mainly a bull market. However, returns were more volatile than the value model. Moreover, the momentum model suffered a drawdown in this current downturn whereas the value model was flat for this period.

How to diversify and how not to diversify
The correlation of the excess returns of the two models is 0.69. Even with a relatively high correlation coefficient we can observe a diversification effect. The green line shows the cumulative returns of a modified value and momentum model, which outperforms the index and either the value or momentum model alone. Volatility is lower than the momentum model indicating superior risk-adjusted returns.

When do you zig and when do you zag?
This diversification exercise assumes fixed equal weights between the value and momentum models. What if an investor was short term oriented and allocated the weights according to recent performance? This could easily happen in a hedge fund with a value manager and momentum manager: “We manage risk and allocate capital according to the returns of our strategies”. The chart below shows the returns of a weighting scheme that adapts according to the recent returns of the two investment approaches. While adaptive weighting does outperform the benchmark, it does not outperform the fixed weighting scheme.

There are some lessons for quants in all this:

  • Diversify so that you can live to fight another day
  • If you can't forecast which model does best, don’t forecast and stay at a neutral (fixed) weight

Monday, September 8, 2008

Watch smart funds on their long bond position

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

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

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

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

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

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

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

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

Thursday, September 4, 2008

Smart funds: Still early in the inflation trade

I have written about smart mutual funds and reversed engineered their macro exposures before. One of the benefits of such an exercise is to formulate a longer term macro scenario and examine it for internal consistency and to see if I am comfortable with the general thesis. In looking at smart funds today, their macro exposures can be summarized as follows:
  • Still believers in the Inflation Trade;
  • Still underweight Financials; and
  • Long the US long bond!

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

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

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

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

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

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

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