Archive for January, 2010

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The Covert Analytics Trinity

Saturday, January 30th, 2010

These are three integral components of the Covert Analytics approach, what we call our Trinity!

Here is a description of these components:

Gut feeling: We believe that the best money managers have a certain amount of experience, that translates into a “gut feeling” of the market. A deeper sense as to what drives the market’s up and down moves that does not vacillate depending on what the headlines say is causing markets to gyrate. It always amuses us when we see Bloomberg headlines that explain that “the market is up today because of X” and then subsequent day to see the market down and to have a headline that reads “X continues to disappoint, thus leading the market lower”. Gut feeling allows you to over write the noise. It allows you to have a grasp of what the market is going to do, how you will react if it unfolds and how you will manage your risk if it does not.

Systematic approach: This term refers to having a disciplined approach to investing, usually applied to ’systematic hedge funds’. A systematic hedge fund is a concept that explains the investment style of the fund, where a system is in place to trade markets irregardless of the hedge fund manager’s input. The opposite of this is a discretionary approach, ie one where the hedge fund manager makes all investment calls for the fund on an “ad hoc basis”. We do not advocate that any investment advisor adopt a black box style approach to investing, which is what the majority of systematic hedge funds employ. What we strongly advocate however is that having a systematic approach which helps you maintain a framework across booms and busts, across bull markets and bear markets, will help you achieve greater returns over the long run by avoiding common pitfalls of investor emotions.

Global macro focus: Again this is a hedge fund term, but really applies more on the markets traded than anything else. The best global macro hedge fund managers (Paul Tudor Jones of Tudor Investment Corp, or Bruce Kovner of Caxton Associates) make the majority of their investment calls on broad market moves (ie where is the S&P going, how Crude, Gold is going to trade, where the Euro is headed) and typically abstain from “I like Dell over Microsoft” type calls. It is an emphasis on global capital flows and making money on stock, bond and commodity markets across the world. They benefit from the fact that usually “there is a bull market somewhere”. So not only is this a regional de-emphasis (ie go global), it is a security type definition as well (broad market indexes).

Covert Analytics is a software platform that was developed to allow investment advisors combine these three key paradigms into one successful money management platform. Our asset allocation software was designed to allow you to combine your gut feeling, with a systematic approach (that you custom tailor), and to have a global macro focus (rather than just simply allocating to US stocks, US bonds, and Cash).

The Covert Analytics Team

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US Stock Market Outlook

Wednesday, January 27th, 2010
 
The S&P 500 today had a shakeout in response to the Federal Reserve announcement.  It has since made a great rally (not shown on the graph!!!).

S&P 500 Intraday

 Regardless of the noise today – please note the 5% correction we have had over the past two weeks. This coincided with earnings season.  It is interesting that 3/4 of the companies that have reported earnings beat estimates, according to Bloomberg.  If you look at an average 4Q earnings report, it is typical to see a 8-10% increase in revenue y-o-y but a nearly 20% gain in earnings.  Shows that companies are being run very efficiently; Gavekal says they are being run even more efficiently than sovereigns!

S&P 500 Intraday for past 15 days

The trend from March 2009 seems still well in place. It is clear the pace of stock gains has moderated since about November, and we are having another 5 % selloff. In the graph below there are arrows indicating the 5% corrections that have occurred since the rally began.  In other words, no need to cry wolf yet.  Markets are trading reasonably well and we believe they are in great shape.  In other words, any further weakness in the broad market would be seen as a short term buying opportunity for those investors who have not entered or have a lower than target allocation.

S7P 500 past 12 months

 

On a similar note, we acknowledge the many tailwinds that are facing investors … they include ( this is a non exclusive list compiled by us ):

  

And the case for the bulls is as follows:

Bulls ...

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Great chart by PIMCO: “Ring of Fire”

Tuesday, January 26th, 2010
 

There is no need to throw out another rambling dialogue over indebtedness and the sovereign risk that is or is not priced into markets.  Regardless, this chart shows an interesting “Venn Diagram” of the groupings of nations as measured by their deficit (as a percent of GDP) plotted against their federal indebtedness.  We have discussed in recent posts Japan, and the nearly 200% of GDP tsunamai of debt they have hanging over their heads.  But PIMCO intelligently groups Japan and some Western nations into a Ring of Fire. 

 

These include: US, UK, Spain, France, Italy, Ireland, Greece and Japan: 

PIMCO: Ring of Fire

 The general justification for the fiscal deficits central banks have run were that it was necessary at the time, and that the private sector would eventually replace the government’s money. PIMCO put it this way: 

“the global private sector is now expected by some to detox and resume a normal cyclical schedule where animal spirits and the willingness to take risk move front and center.” 

That has yet to take shape.  We have long felt that what what will turn this recovery into a “sustainable” economic recovery will be if this return of animal spirits ensues.  PIMCO says the following: 

“But there is a problem. While corporations may be heading in that direction due to steep yield curves and government check writing that have partially repaired their balance sheets, their consumer customers remain fully levered and undercapitalized with little hope of escaping rehab as long as unemployment and underemployment remain at 10-20% levels worldwide.” 

PIMCO then goes on to discuss Reinhart / Rogoff who put together a seminal study called “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”. Link is included below.  We saw Carmen Reinhart speak at the Inter American Development Bank presentation in Miami a few years ago. She is a stunning academic, with forceful thoughts and words to be heeded. Her study almost implied that over the long run, no governments pay off their debt! Very interesting read, and though long I strongly suggest you read it. 

The important point to remember about the historical analysis of financial crises is that “the starting point is important”.  The following table shows the gross level of public and private debt (measured as a percent of GDP).  The results are impressive - and scary considering the precarious situation of the US, UK and Japan. 

Total Debt as a % of GDP

The next chart shows the total indebtedness (as a group) of advanced (red) versus developing (blue) countries. One can see why the emerging markets escaped from the financial crisis relatively unscathed.  Their financial markets performance was another story. 

Developed versus Developing

Bill Gross and PIMCO continue to put out their monthly Investment Outlook for free. It is available to the worldwide financial community, giving you rare, FREE, access to one of the preeminent thinkers on investment strategy.

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Posted in Asset Allocation, Business Cycle, Market Talk, Tracking Smart Money | 1 Comment »

Great quote from a NY hedgie

Wednesday, January 20th, 2010
Was speaking to a NY based event driven hedge fund manager yesterday, and he had a great quote:

“Investing is 70% instinct, and 30% homework”

This is no small time hedgie either. He is the founding partner of a $2 billion event driven hedge fund. Reminds us of a great quote from one of our favorite investors, Marc Faber:

“Investing has a lot to do with common sense and personal observations”

We built Covert Analytics to allow investment advisors and portfolio managers to input their views across global capital markets. The framework we initially conceptualized would allow investors to apply a logical methodology to evaluate a varied group of assets, and to see how this methodology would have worked historically.

Here is how we see our platform “mixing” with our great quote:

Your views, our platform

Covert Analytics is a platform, that combined with your views, produces information that helps drive your portfolio management process

Our plaftorm + Your Views = Input for your PM Process

Our platform is not a black box which tells you how to allocate. Our software allows you to input market specific views without the traditional academic mumbo jumbo of forecasting market returns or standard deviations, but instead allows you to build and combine indicators which are consistent with your views. Our proprietary backtest methodology allows you to evaluate how your asset allocation model performs historically, factoring in the portfolio guidelines you set forth, and proposes a recommended asset allocation.

Covert Analytics is a platform which allows you to build dynamic, quantitative asset allocation models that are driven by your expertise, and your views. We are glad our hedgie friend said that, because we could not have agreed more!

The Covert Analytics Team

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Kyle Bass (Hayman Advisors) Discussing Japan

Wednesday, January 20th, 2010

I am a huge fan both of Kyle Bass (of Hayman Advisors) and of the blog titled “Global Economic Analysis” …

About Kyle Bass
A great outside the box thinker. His hedge fund is based in Texas and though I am not familiar with the size of his fund or performance before their “grandslam” short of subprime in 2007-2008, this is one hedge fund I would give serious thought to.   Please read our previous posts on hedge funds and other illiquid assets to see our general view on hedge funds, which is reluctantly skeptical.

About Global Economic Analysis
I am a loyal reader to a handful of blogs, and Mr. Shedlock’s GEA blog is one of them.  I would recommend this blog to anyone interested in the markets.  His insight is right on point, and he finds away to bring the best of financial information to his readers without a perpetual bombardment of data, news links, etc.

Please see Kyle’s video and the helpful script provided by Mish at the link below:

Click here for link

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Start asking the right questions

Friday, January 15th, 2010

As an investment advisor you are primarily responsible for 1) having a view on the markets and 2) how to position your portfolios (given their unique constraints) according to those views.  Too often more attention is paid to the vehicles used to implement those decisions. In other words, rather than spending the bulk of your time deciding how much to allocate to Equities, you spend the bulk of your time picking Equity fund managers.

The article below is a perfect example of this.  Though it is a good article, from the Financial Times Fund Management section, it should not be groundbreaking news to investment advisors. It should be met with a shrug of the shoulders.

The wrong question still has a good answer!

Too often outperforming Equity managers still cost portfolios to suffer substantial drawdowns in a bear market. Too often the best bond fund outperforms its benchmark by 300 bps annually during a market cycle that saw Equities double.  You see where this is going? Start asking the right questions:

In general, here is our view …

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Peaks and troughs in the Chinese stock market

Thursday, January 14th, 2010
 

We wanted to evaluate the peaks and troughs in the Chinese Shanghai A share stock index and see how they compared with the US benchmark (S&P 500).  The Shanghai index defines how a “high octane” market performs.  What we did was look at all the major peaks and troughs in the SHASHR index and see for the exact same period how the US market performed.  We were surprised by the results. 

Keep in mind that what occurred during the past 15 years (pay attention to timing):

  1. On a total return basis the US equity market had no negative returning years in the 90s.  The Shanghai market on a calendar year basis was down -21% in 1994 and -14$ in 1995.  The major bottom however occurred in July 1994. 
  2. The LTCM crisis and Russia default in 1998 was a blip on the screen in the long term bull market of this period.
  3. The US officially entered into recession in 2001, but the TMT bubble burst in March 2000.  After declining nearly 50% the US equity market bottomed out in March 2003 (October 2002 had a false bottom!) and began a multi year bull market till the end of 2007. 
  4. The financial crisis was a multi year event but most major Equity markets peaked in October 2007.  The US equity market had a false bottom in late 2008 then had a mini rally til the lows were retested in March 2009 (where the major bottom was formed).

China versus the US (local currency) The first major market correction from 2001 through 2005 coincidede with a positive return in the US market. The next bull market run from 2005-2007 in Shanghai was met with a modest +30% return in the US market - note it already had a huge runup. The financial crisis and subsequent market recovery showed a very similar tune. Taking a step back for a second, we wondered how Brazil performed during these times: Brazil, US and China ..... local currency

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Is China or US the new Japan?

Thursday, January 14th, 2010
 Reading an article yesterday in the FT discussing the problems that still plague Japan after their meltdown since the early 1990s led us to some interesting analysis.  The question posed was: is the most similar comparison between US and Japan post bubble, or China and Japan pre bubble?

Market commentators are often referencing how the US will face a Japanese style deflationary bust given the over indebtedness of the economy (government and individuals) and the deleveraging that will occur. A credit fueled bubble propelled Japanese assets to dizzying heights in the 80s. A similar, primarily-US, credit fueled bubble propelled assets across the world to new highs.  The retrenchment that occurred in Japan led to two decades of lethargic performance, in both the markets and economy.  The Nikkei is still 75% below its 1980s peak.

We often hear comparisons to how the US is in the unfamiliar process of deleveraging.  That after excessive credit growth for decades a retrenchment is uncomfortable, but 100% necessary.  Nomura here describes this as a “balance sheet recession” and is what happened in Japan :

“According to Mr Koo of Nomura, an economy in which the overindebted devote their efforts to paying down debt has the following three characteristics: the supply of credit and bank money stops growing, not because banks do not wish to lend, but because companies and households do not want to borrow; conventional monetary policy is largely ineffective; and the desire of the private sector to improve balance sheets makes the government emerge as borrower of last resort. As a result, all efforts at “normalising” monetary and fiscal policy fails, until the private sector’s balance-sheet adjustment is over.”

This would seem to be counter to what is occurring.  Companies are in better shape than ever and only in a doomsday scenario do you see the largest consumer market in the world, reverting to Japanese – style saving characteristics.  We for one think govermnent action to date has done one very important thing: restore Mr. Market’s confidence. Back to Japan for a second, Martin Wolf, whom we respect thoroughly describes the root problem of Japan’s weak economy for the past two decades on the corporate sector:

“My own view is that the underlying structural problem has been the combination of excessive corporate savings (retained earnings) and diminished investment opportunities, once catch-up growth was over.”

And here is where Mr. Wolf makes an interesting conclusion: could it be that China is facing a similar bubble risk like Japan was in the 80s?

“Yet Japan’s experience also has a lesson for quite a different economy. It indicates that when very fast growth begins to slow in a catch-up economy with very high corporate savings and comparably high fixed investment, demand may well prove extremely difficult to manage. This is particularly true if the deliberate promotion of credit growth and asset price bubbles has been part of the mechanism used to sustain demand. And who needs to learn this vital lesson now? The answer is: China.”

Please click here to read the full article.

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Market Technicals

Wednesday, January 13th, 2010

One of the best contrarian indicators we know of is the % deviation from the 200 day moving average.  Its intuitive and reliable.  The simple explanation is as follows: an extreme deviation from the moving average signals an over bought or over sold condition. 

% deviation - measure the shaded area!

Many people look simply at whether the current price is moving above or below the moving average.  But in a low volatile environment by default the price indexes will essentially hug the moving average and thus provide little insight.  At market extremes however you will see a strong deviation from the moving average.

Current indicator readings

Its clear that the EM countries are indicating some frothiness.  Brazil is up 139% since its lows in March … this bull market is well advanced and it seems that adding money to EM is a bit “after the fact” performance chasing and is not a good place to bet your portfolio dollars.

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How we view market risk

Friday, January 8th, 2010

Risk is alot like rain, and your asset allocation is alot like an umbrella.  Your portfolio (you) always seem to get wet on your feet and the bottom part of your legs, right? Thats because the part of your body most exposed to the rain is your “risk assets” such as Equities and Commodities. These are the more volatile assets which though they have the best chance of giving your portfolio a substantial boost are also the most exposed when “the bear comes a-knocking”. The dry, upper part of your body? Thats the Bonds and Cash in your portfolio. Much more protected from the rain and thus less susceptible to market swings.

Risk and the Umbrella

 Covert Analytics aims to be your bigger umbrella! 

Covert Analytics = less risk

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