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Tuesday, January 26, 2010

A simple style rotation model

Recently one of the more frequent commentators on this site quoted George Soros at The Big Picture blog (thanks Keith):

In other words, the path to profit is to spot a trend early, jump on it and then jump off before it totally blows up. This makes absolute sense and I can illustrate the effectiveness of such models by applying it to the NASDAQ Bubble of the late 1990’s and its aftermath.

Style rotation with trend following models
I have written about trend following models before and the NASDAQ Bubble example is an ideal application of this class of models. First, I formed a relative performance ratio of the Russell 1000 Growth Index against the Russell 1000 Value Index and apply the following rules:

Buy Russell 1000 Growth Ratio > 50 day MA > 200 day MA (Growth signal)
Buy Russell 1000 Value Ratio < 50 day MA < 200 day MA (Value signal)
Buy Russell 1000 All other conditions (Neutral signal) The above chart illustrates how the model has performed in the last 18 months. The down arrows are the “buy Value” signals; the up arrows are the “buy Growth” signals and the circles are the neutral signals.

The chart below shows the performance of the style rotation model compared to a buy and hold Russell 1000 Index for the period from December 1997 to December 2009. A buy and hold strategy of holding the Russell 1000 had a total return of 3.2% from 1997 to 2009, compared to 1.7% for the Russell 1000 Growth Index and 3.9% for the Value Index. The style rotation model’s return was 6.4% over the same period, an outperformance of 3.2%, and it had a lower risk (standard deviation of return of 21.5%) compared to the Russell 1000 (21.7%). The next chart shows the relative performance line of the style timing model compared to the Russell 1000. The model successfully navigated the extremely tricky Technology boom and bust period by switching between Value and Growth. Since then, it has had a long record of positive relative returns. It should be noted that the magnitude of relative performance was not as large since 2001 because the lower magnitude of relative returns between growth and value US large capitalization stocks. Spotting the next investment bubble?
In summary, this is a proof of concept of using trend following models to spot long and medium dated trends and manias.

This model was intentionally not optimized as I used the commonly used 50-day and 200-day moving averages to prove my point about the use of trend following models. In addition, there are no trading costs in the simulation, which led to annual turnover of about 16 times a year. Slowing turnover down to about 1.5 times a year cut the alpha of 3.2% by about 1%, indicating that this model can be implemented as part of an investment process.

Trend following models have been around for a long time. The best known is probably The Dow Theory. My Inflation-Deflation Timer model is also based on trend following principles. The idea is to spot a bandwagon forming and jump on it as more and more investors pile on. The sell signal comes when momentum begins to falter.

Maybe we can use it to spot and profit from the next investment bubble!
at 12:44 AM 1 comments Labels: Style rotation, trend following


A counter-trend rally led by Financials?

The massive selloff seen last week broke a number of key support levels and it now appears that the bears are now in control of the stock market. In the short run, the market is now short-term oversold and poised for a rally.

The spark for a rally may come from a re-assessment of the Obama proposals to limit banking activity. Simon Johnson's post Is the "Volcker rule" more than a marketing slogan? suggests that the Obama proposals may be more sizzle than steak. Go and read it in full.

Now that the bears appear to have gained the upper hand and have an (over)valuation tailwind at their backs, my inner trader tells me to wait for the oversold bounce before taking significant short positions in this market.
at 12:41 AM 0 comments Labels: investment banking, sentiment analysis


Glass-Steagall 3.0?

The stock market has been spooked by Obama’s Volcker plan to limit banking activities. Moreover, there have been trial balloons floated regarding the reinstatement of the Glass-Steagall Act, legislation that separated commercial and investment banking activities.

Time for Glass-Steagall 3.0?
Is that enough?

Any legislation overseeing financial activities should have the following purposes:

I have a modest proposal that will meet most of those multi-purpose objectives. Let’s call it Glass-Steagall 3.0. I start with the old Canadian model, where financial institutions were broken up into four distinct categories: banking, trust, insurance and investment banking and companies that were in one business were not allowed to be any other. This effectively breaks up large financial conglomerates and reduces their size and therefore their TBTF risk. If you agree with Paul Volcker’s contention that the greatest financial innovation has been the ATM, then breaking up financial conglomerates should not reduce value because of the removal of “synergy”.

Add to that, implement my proposal for bringing back the partnership investment bank, or at very least, do not allow investment banks to be publicly traded. If an investment bank were to be a privately owned limited liability corporation, most of the personal net worth of management is likely tied up in the illiquid shares of the company. Such an arrangement focuses the mind on risk management, not short-term profits.

Nothing is perfect
This plan isn’t perfect. It wouldn’t have prevented AIG from imploding. On the other hand, if investment banks had greater risk controls in place, the size of the mortgage market wouldn’t have gotten to the size that it did. Consequently, the size of the AIG book wouldn’t have grown to the gargantuan size that it did and the spillover effect into the investment banking system could have been contained.

Another drawback is that the small size may hamper the ability of some of the smaller financial institutions to compete effectively. Stanley Hartt, who was Canada’s Deputy Finance Minister (the most senior bureaucrat in the “apolitical” civil service), commented that Canada dismantled the four pillars approach to financial regulation because it found that there were a number of small regional bank failures because they were too small and had an overly undiversified asset base to compete effectively.

Pick your poison
There is a classic line from the original Star Trek series:

Spock: The guilty party has his choice-- death by electrocution, death by gas, death by phaser, death by hanging...
(see sequence from about 3:55 below)

Would you like a financial system that bends like a willow tree with the wind (Glass Steagall 3.0)? Or would you like one that is strong but brittle (the current system)?

Personally, I would prefer to live with small bank failures, i.e. a system that fails in small pieces but gracefully, than to a large monolithic one that is brittle and breaks without warning.

Pick your poison. Death by electrocution, gas, phaser...
at 12:43 AM 1 comments Labels: financials

Thursday, January 21, 2010

American Dream or Fugue?

Recently Barry Ritholz at Big Picture posted a video of George Carlin’s comment about the plight of the middle class and the illusion of the American Dream.

American Illusion?
I had posted before about this populist issue in Political stability and the middle class. The problem is that the American Dream of unlimited opportunity is that, a dream. I had also previously highlighted an OECD study showing that the United States has a high level of inequality combined with low intergenerational social mobility: While high inequality, as measured by Gini coefficients, is not in of itself a bad thing. The evidence of low intergenerational social mobility creates a class structure which will ultimately lead to a society’s downfall. After all, if anyone can’t succeed in America just by trying hard, what do you have? An old boys’ club? Economic ossification?

I recently came across a couple of papers that further confirms the low intergenerational mobility effect:

Get ready for an era of commodity inflation
Under the current circumstances, the most immediate macro-economic effect of rising inequality is likely to be an era of commodity price inflation in the US. Steve Randy Waldman, who blogs at Interfluidity, explains [emphasis mine]:

Follow the money. Whether an economy generates asset price inflation or consumer price inflation depends on the details of to whom cash flows. In particular, cash flows to the relatively wealthy lead to asset price inflation, while cash-flows to the relatively poor lead to consumer price inflation.

Why? In Keynesian terms, poorer people have a higher marginal propensity to consume. The relatively poor include people who are cash-flow constrained — that is they cannot purchase what they wish to purchase for lack of green, so their marginal dollar gets immediately applied to the shopping list. Also, poorer people may be different, there may be a correlation between poverty and disorganization, lack of impulse control, inability to defer gratification etc. Think of Greg Mankiw’s Spenders/Savers model.

At best, the US is becoming another Argentina. At worst, it risks a populist backlash, growing social unrest and a possible uprising that could turn the country upside down. In such a case, the elites can party now, but longer term they will have trouble staying alive to enjoy their wealth.

at 1:08 AM 1 comments Labels: commodities, Economic history, Economics, inflation

Monday, January 18, 2010

When quants fail

I am sometimes asked why I am so anti-quant. That's because there are many circumstances when quantitative analysis fails. I can cite two examples off the top of my head. The problems shown in the first example can be managed, but the second instance highlights a more serious problem with quantitative analysis and modeling in general.

The trees or the forest?
Avner Mandelman wrote a commentary about a company he analyzed. Everything seemed fine at first and from his description. The numbers would pass any quant screen or model:

It sounded promising, so first I checked out management. None had a criminal record, spats with former investors, or bitter divorces pending.

Next I read the filings. The auditor was reputable, the lawyers good, the footnotes few, revenue recognition plain, inventories slim, patent disputes nil, and debt non-existent.

What of the technology? I asked an engineer I knew to check it out for me - it was fine.

So I called management and arranged to meet the chief executive officer, the chief financial officer and the marketing guy. All seemed smart, hardworking, and honest.

Yet an investment in the stock would have fallen apart because of a flaw in the company’s business model. For the full details of the story, read more about it here.

The moral of this story is that any good fundamental analyst is looking at the trees, but the good quantitative analyst is better at looking at the forest. The former will beat the latter on a stock story virtually every time. That’s why quants size their stock bets accordingly to diversify away stock specific risk (residual risk in geek-speak) in the models so that what is left is largely a model bet. Accordingly, a typical quant stock portfolio will have 150-200 holdings, whereas a fundamentally driven one will have far fewer.

These principles are encapsulated in Grinold’s Law of Active Management. I would warn, however, that the application of Grinold's Law has subtle nuances that good quants should be aware of (see my previous comment here).

What about model assumptions?
The other risk for quants is that their models are just plain wrong. As Kid Dynamite puts it in his post: “It's not a crime to have more information than the guy on the other side of the trade/bet”.

He went ont to illustrate his point with his interview that he once had with Susquehanna [emphasis mine]:

The typical profile of a “top” fresh quant is one with a Ph.D. out of a top school. People like that are left-brained smart and book smart. The problem is that they tend not to be Street Smart but investing and trading are behavioral in nature. Therein lies the problem. These kinds of misalignments in skill sets can lead to catastrophic failure if there is no adult supervision. I wrote before that:

The greatest quant failure occurred in the 1960s and it was caused by Robert McNamara and the “whiz kids” in their conduct of the Vietnam War. They incorrectly framed the problem and focused on the wrong metrics. The results scarred an entire generation and altered American foreign policy ever since. As an example, you can find an analysis of differing analysis of a battle of the Vietnam war here at Fabius Maximus' blog.

To answer the original question of why I am so anti-quant, I'm not. There are circumstances when quantitative analysis fails. The unfortunate thing is that many in the profession don't recognize those limitations. There is an article in the New York Times entitled Do you have the 'right stuff' to be a doctor? It goes on to say that personality matters in medicine, a profession that is similar to being a quant, which requires someone not only be book-smart but cognitive-smart.

Great investors not only understand models, but they internalize models and know when and when not to use them. Great quants should do that too.
at 12:59 AM 6 comments Labels: quantitative analysis

Thursday, January 14, 2010

The Chinese giveth...

Earlier this week, the People’s Bank of China signaled that it was tightening monetary policy. Many market observers attributed the move as a response to the apparent real estate and asset bubbles forming in China.

But is China that intent on restraining asset bubbles?

At about the same time, the government announced that it moving to allow greater leverage for stock market players:

The government said it had approved, “in principle,” the creation of stock index futures, trading on margin and short selling, investment tools that are commonly used in New York, Chicago, London and many other financial markets, according to Xinhua, China’s state run news agency.

Is this just a case of poor policy coordination? Or something else?

For the intermediate term (3-5 years), I believe that the Chinese growth story remains intact. Tom Friedman is right: Never short a country with $2 trillion in foreign currency reserves (at least for the time being.)
at 8:24 AM 2 comments Labels: China

Tuesday, January 12, 2010

Incentive mis-alignment on Wall Street

I see that Barry Ritholtz at Big Picture sees my point about the mis-alignment of incentives on Wall Street, but he hasn't taken the next leap about my suggestion to bring back the partnership investment bank:

I always found it an amazing coincidence that none of the private partnerships got into any trouble. Coincidence? Perhaps not — from page 136, Bailout Nation:

More importantly, banks started adopting the “eat what you kill” compensation systems. The bonus structure, replete with short-term financial incentives, began to dominate banks. Throw in monthly performance fees and annual stock option incentives, and you end up with a skewed business model suddenly embracing quicker trading profits.

“This had an enormous impact upon the ways investment banks approached business generation and risk management. Like many public companies, they became increasingly short-term focused. “Making the quarter,” in Street parlance, meant pulling out all the stops to hit your quarterly profit figures, by any means necessary. Incentives became misaligned with shareholders’ interests, as risky short-term performance was rewarded with huge bonuses. Not surprisingly, this worked to the detriment of long-term sustainability.

But short-termism was only part of the equation. Of greater concern was how these firms’ internal risk management changed. Unlike in public corporations, partners are personally liable for the acts of any of the members of the partnership. If any one of a firm’s partners or employees loses a trillion dollars, every last partner is on the hook for that money.

Putting a supertax on banker bonuses will not solve the problem. The problem is the lack of incentives to pay attention to risk management. Partnership structures will do that.

Has anyone noticed that partnerships, such as lawyers and accoutants, rarely blow up? Even if they did, e.g. Arthur Anderson, they didn't bring down the system?
at 5:13 AM 3 comments Labels: investment banking

Asset inflation, here we come!

I see that central bankers really haven’t figured out this “bubble” thing. The deputy governor of the Bank of Canada recently stated that the Bank of Canada won't raise interest rates to cool housing:

“Some observers – those who see a housing bubble forming – have said that since low interest rates have stimulated housing market activity, the Bank should now raise interest rates to dampen that activity,” deputy governor Timothy Lane wrote in a speech delivered by an adviser on his behalf in Edmonton. “But that poses a problem.”


Those who fear a bubble worry that many people are taking advantage of cheap money to buy homes they wouldn't be able to afford once rates rise, leading ultimately to a crash in prices.

Mr. Lane said the bank understands the concern, but it uses its lending rate to keep inflation in check for the whole economy and the housing market is “only one of several factors” that influence inflation.


Instead, he said, the government could increase capital requirements for lending institutions, adjust loan-to-value ratios and change the terms and conditions required to obtain mandatory mortgage insurance.

[He]e said. “Ultimately, it is the Minister of Finance who is responsible for the sound stewardship of the financial system.”

Lane’s remarks are reminiscent of Ben Bernanke’s speech at the AEA in which he absolved the Fed’s role in the last bubble. This has prompted comments such this one, the Fed missed this bubble, will it see a new one?

Central bankers seem to stuck with the concept of inflation as it existed in the 1970’s, where a vicious feedback loop created a self-reinforcing cycle of inflation. In my previous post what kind of inflation? I believe that this next round of inflation is likely to show up as asset inflation, which primarily manifests itself in commodity prices.

What party?
If the role of central bankers is to take away the punch bowl just as the party gets going, the Bank of Canada has now abdicated that responsibility to the party's host (the government). By contrast, Bernanke's response has been "what party?"

at 1:55 AM 1 comments Labels: Economics, federal reserve, inflation

Monday, January 11, 2010

The 2009 Inflation-Deflation Timer model update

As I went through the year-end discussions over the holiday season, it struck me that the inflation-deflation question remains stuck in a lot of peoples’ minds. As examples, Zero Hedge pointed out this paper by Brait Capital Management, and recent instances of the inflation vs. deflation debates continue here and here.

In the meantime, my Inflation-Deflation Timer model has remained at an inflation reading since July 2009. The table below shows the returns of the Inflation-Deflation Timer model compared to other asset classes. All returns are denominated in Canadian Dollars. (click for a bigger picture)

The returns for the Inflation-Deflation Timer model was a very respectable 18.1% in 2009, which is roughly in line with a 60/40 balanced fund benchmark during normal periods but it performed best during recent deflationary crisis periods. Model signals
The chart below shows the returns and “signals” of the Inflation-Deflation Timer model of the last couple of years. The grey zones show periods when an "inflation" signal was in flashing, the pink zones indicate a "deflation" signal and the white zones indicate a neutral signal.

As the chart indicates, the Inflation-Deflation Timer model was able to successfully navigate through difficult asset deflation periods. The model protected earlier gains by switching to the default-free U.S. Treasury long bonds during the asset deflation periods. In 2009, when the model indicated inflation, the model moved to riskier assets, namely equities and commodities further advancing the model’s performance. 
at 12:30 AM 5 comments Labels: deflation, Economics, inflation, trend following

Friday, January 8, 2010

Watch the tape for signs of direction

As 2010 opened, the stock market averages have crept to marginal new highs. Scott Grannis at Calafia Beach Pundit has pointed out that there are some real signs of a recovery. Examples include:

Is all right with things in the world and are stocks poised to continue their rally?

The bear case
Just when you thought that it might be safe to go back in the water (even after the immense recovery in the markets since March), there is bad news on the ticker:

Longer term, John Hussman is warning about another round of credit troubles that await the US financial system:

From the standpoint of the financial markets, we can anticipate an increase in mortgage delinquencies in the coming months if only from the combination of high unemployment, high loan-to-value ratios, and a gradual movement into the heaviest portion of reset schedule on Alt-A and Option-Arm mortgages written at the peak of the housing bubble. That this will result in true credit losses is virtually certain. Whether or not this leads to fresh reported credit losses depends on how much latitude regulators allow in maintaining current (substantially written-up) values for securities that are not delivering the underlying cash flows.

What we do know is that stocks are overvalued even on the basis of normalized earnings, to an extent that exceeds nearly every pre-1995 level except 1929. Intermediate term conditions are strenuously overbought, investors (with advisory sentiment now down to 15.6% bearishness) are clearly overbullish, and interest rate trends are pushing higher. This situation does not always resolve itself into market declines, and indeed, given that market internals remain reasonably firm, we may continue to observe marginal new highs for some amount of time. But the statistical regularity from overvalued, overbought, overbullish, rising yield environments is one of steep, abrupt market losses generally within a period of about 10-12 weeks.

Stay tactical
In this kind of high-risk environment, it's important to stay tactical and watch the tape. How the market reacts to news such as the items mentioned, as well as the NFP report, will set the short-term tone for market direction.
at 12:09 AM 0 comments Labels: China, equity markets, federal reserve, financials, sentiment analysis


Is the Fed contributing to instability?

In this fragile economy, one of the sources of stability should be the central bank. Paradoxically, mixed messages coming out of the Federal Reserve have contributed to the uncertainty.

Uncertainty about QE
The December 16, 2009 FOMC statement suggested that the Fed was prepared to ease off on quantitative easing [emphasis mine]:

Now we get the news that they are prepared to re-enter the MBS market later in 2010? What’s going on? Did some earth shattering event occur between the December FOMC and today?

No clarity on the Plunge Protection Team question
In addition, consider my last post alluding to the presence of the Plunge Protection Team, or PPT. Over at Cunning Realist, he blogged about a question from Senator Jim Bunning to Ben Bernanke:

Before the financial crisis there was a widespread sense, especially on Wall Street trading desks, that the stock market was strangely resilient. This encouraged excessive risk-taking in various types of assets. Do you have direct or indirect knowledge of the Federal Reserve or any government entity or proxy ever intervening to support the stock market (or any individual stock) via futures or in any other way? If yes, who decides the timing of such intervention and with what criteria? How is it funded? Which Wall Street firm handles the orders, and who sees them before they are executed?

He went on to complain about the Fed Chairman’s non-answer, or incomplete answer:

The Federal Reserve has not intervened to provide support to the stock market or individual stocks by trading in futures or any other financial instrument. I have no knowledge of any other U.S. government entity providing such support.

Bernanke's answer was incomplete because he ignored the word "proxy," an important part of the question.

I have never been a big fan of conspiracy theories, largely because they generally don’t make sense. In the case of PPT, governments are known to intervene in a variety of markets, such as FX and the bond market. Why would they want to keep intervention in the stock market a secret?

If they were propping up the stock market (or the currency), wouldn’t they get a bigger bang for the buck if they let it be known that they were intervening?

The story of PPT intervention doesn’t make sense. Stock market leadership has been narrowing in the large caps. If the Fed or some other government agency was directly or indirectly buying S&P 500 futures, why is the Dow Jones Industrials outperforming the S&P 500?

Despite my reservations about the PPT story, it is nevertheless disturbing that Chairman Bernanke can’t give a straight answer to a question about government intervention in the equity market. He is experienced enough to know that the markets parse every nuance of his statement so his incomplete answer can’t be an accident.

All these actions point to either a Fed that is rudderless, indecisive, beset by internal bickering or plain doesn’t know what to do. In these uncertain times, any of these conditions at a major central bank is downright scary.
at 12:16 AM 4 comments Labels: federal reserve

Monday, January 4, 2010

In lieu of a 2010 market forecast

This is the season for year ahead forecasts, but I hate doing forecasts so I won’t be doing one [*]. (BTW, I recently did an interview here that largely outlines my views for 2010.)

I believe that equities remain overvalued and overbought, but overvalued markets can stay overbought for a long time. Over at ZeroHedge, which seems to have a slight predilection for conspiracy theories, quotes Charles Biderman of Trim Tabs on the possibility of government intervention in the stock market:

While the evidence is consistent with government intervention, I have no idea whether the Plunge Protection Team (PPT) has been active in the market and I don’t care to guess.

Teaching you how to fish
Given the current backdrop, the downside risks are likely to be much higher than upside rewards. My inner trader tells me to wait for signs of technical breakdowns before either more defensive or aggressively committing funds to the short side of the market.

Giving my readers a market forecast is like giving someone a fish. As the saying goes, if you teach someone how to fish…

(they’ll want to buy a boat.)

[*] If tied to an anthill, I would bravely forecast that the S&P 500 is likely to trade between 500 and 2000 in the coming year.
at 12:15 AM 0 comments Labels: equity markets, federal reserve

Friday, January 1, 2010

Two more steps towards Argentina

Several months ago I wrote a piece called Going south to Argentina, where I described the process where the United States and Argentina parted paths as promising emerging market economies about a century ago. However, much of the malaise that has plagued Argentina is now showing up in America today.

What happened to "inalienable rights"?
Recently I saw two more steps that America is taking down the road to Argentina. Yves Smith at Naked Capitalism writes:

Reader Walter passed along this distressing sighting from Chris Floyd’s blog. American civil liberties were gutted last week, and the media failed to take note of it.

The development? [The Supreme Court has ruled that i]f the president or one of his subordinates declares someone to be an “enemy combatant” (the 21st century version of “enemy of the state”) he is denied any protection of the law. So any trouble-maker (which means anyone) can be whisked away, incarcerated, tortured, “disappeared,” you name it.

Preconditions for a Dirty War?
This Supreme Court ruling sets up the preconditions for a Dirty War that Argentina saw in the late 1970s and early 1980s, where government forces made suspected left-wing guerrillas and their sympathizers “disappear”. Just as the repeal of the Glass-Steagall did not result in immediate consequences, I don’t believe that we will see the effects of this ruling overnight but the long term effects are potentially disastrous.

This ruling tramples on the Constitution and one of the most powerful symbols of America. Just understand this - that Constitution was paid for by blood, not only of the Founding Fathers, but by every American soldier. Every G.I. that ever enlisted swore an oath, not to the president of the day, but to the Constitution of the United States.

Remember the U.S. soldiers who fell at Omaha Beach?

…and at Pearl Harbor?

IMHO, this Supreme Court ruling tramples on their graves. More importantly, it sets up the preconditions for an Argentina-style "Dirty War" that represses the population.

Addendum: An alert reader emailed me to note that the Supreme Court did not rule that the president can declare anyone an enemy combatant, but declined to hear an appeal from a lower court on that issue (which is judicially a very different matter). While the ruling (or non-ruling) nevertheless has far reaching implications, it isn't as bad as I initially thought.

Selling off the family silver to pay the bills
Equally disturbing was Robert Shiller’s trial balloon about selling GDP-linked bonds. His proposal represents the sale of the equity of the country which involves participation in economic growth, as opposed to the debt which involves no participation in growth.

Shiller’s proposal is an echo from a past era of what happens when empires get desperate. Consider what historian Niall Ferguson had to say about the financial difficulties of the Ottoman empire about a century ago [emphasis mine]:


In Disraeli's day, the debt crisis turned out to have political as well as financial implications, presaging a reduction not just in income but also in sovereignty.

In the case of Egypt, what began with asset sales continued with the creation of a foreign commission to manage the public debt, the installation of an "international" government and finally, in 1882, to British military intervention and the country's transformation into a de facto colony. In the case of Turkey, the debt crisis was followed by the sultan's abdication and Russian military intervention, which dealt a lethal blow to the Ottoman position in the Balkans.

Given that backdrop, analysis that showing that the US needs to roll over $3.4T in debt over the next four years must be a huge concern, not only for investors but for the political stability of America and the world.

[Sigh...] sometimes you can’t save the world, you can only save yourself.
at 12:18 AM 4 comments Labels: Development Economics, Economic history, emerging markets, politics
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