Archive for the ‘Business Cycle’ Category

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Is Buy and Hold Dead?

Tuesday, June 8th, 2010

 After reading a recent debate, I decided to chime in with my own thoughts on the matter. Somehow the discussion of buy and hold evoked the typical academic responses of markets being efficient and so forth.

A few comments on ‘efficiency’

Market efficiency implies that all information is assimilated into the current market price, and therefore there is no possibility that you can buy assets cheap, to then sell high, because if it was truly cheap, the market would quickly jump in to buy the security, thus bidding up the price, eliminating the opportunity. Fantastic, but is it logical? This is similar to the University of Chicago line of thinking that if there was a $20 bill on the floor, it must be fake because someone would have picked it up by now. We all know that there is a very high possibility that short term inefficiencies exist. The quant funds have all but proven it: DE Shaw, Medallion, AQR Capital are all funds that trade in liquid equity markets but arbitrage short term opportunities. A hedge fund expert wittingly referred to these funds as “excess liquidity providers”.  My favorite response to anyone who says that markets are efficient is: “that is a self fulfilling prophecy” …

The Buy and Hold Debate

Buy and Hold is an “asset allocation policy” … it basically implies that the strategic asset allocation it the best guess as to what will be the best performing allocation over the investment horizon (typically 1+ years). If you do not think buy and hold works, that means you adjust the strategic asset allocation (ie shift equity weightings up and down over time) and make tactical trades (short term opportunities that present themselves in the market) to add alpha.  Dynamic asset alllocation therefore, is saying that “buy and hold” doesnt work (ie “Buy and Hope” …. :-) .  Time varying asset allocation emphasizes that dynamically switching the asset allocation you can minimize the downside of bear markets, overweight markets that are rallying, etc. It is the holy grail of money management: “equity like returns with bond like risk”. 

Due to the increased difficulty in cranking out decent returns, it is even more important to “think dynamically”.

Performance of a 70% stocks, 30% bonds Portfolio

The chart below shows how difficult money management has been. A portfolio of 70% stocks and 30% bonds (note we are using the MSCI US Stocks Index, total return, for stocks, and the Salomon Brothers US Treasury Index, for bonds) performed as follows:

  • +16.6% per year from 1985-1999, with a standard deviation of 10.9%, compared with…
  • +1.8% per year from 2000-2010, with a standard deviation of 11.1% 

This is a huge drop in annualized values in an aggressive Equity portfolio (far below the risk free rate of return), with an elevated level of risk. The return to risk ratio was nearly 9x higher from 1985 – 19999 versus the past ten years.

Returns by Market (80s and 90s versus 2000s)

 

 There was a huge drop in asset class returns between the two periods. further strengthenting the case for a more dynamic approach to asset allocation in the 2000s. Even bonds have fared substantially worse in the past decade than the prior 15 years. 

Returns by Asset Class (80s and 90s versus 2000s)

Another asset class focused way to see the same data …

Efficient Frontier Comparison

This secular shift in returns between the different decades has produced a notable response to the buy and hold, academic oriented crowd: a notable downward push to the efficient frontier. Interpretations of the efficient frontier are as varied as how people like their eggs in the morning.  Some think it is useful, others useless, some think it is a good framework, others think it is a good tool for clients to see and not much else. Regardless, it is a mathematical approximation as to the “best, most efficient portfolios using return and covariance measures”.  Utilizing expected returns from these different periods, the following two, vastly different efficient frontiers were produced.

Conclusion

This is slicing the past thirty years into two periods, one when the business environment was booming and capital markets surged, and the other when the world suffered two disastrous bear markets and a global mini-Depression. Buy and Hold is a methodology that worked “before” and it is unlikely that it will work in the future.  After the carnage in 2008 and 2009, portfolio managers have lowered their expectations. With the world economy still unstable and risky, investors have accepted this fact, and our view is that asset allocation has to be more imaginative and dynamic.

 

 

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Economy versus Politics

Tuesday, June 8th, 2010

We wrote earlier that the steady state for the economy is being reached.  Profit growth is still the base case.  What could offset this strong profitability? It seems far fetched that the declining Euro will put a huge dent in US profitability, given that approximately 18-20% of US revenues are from the eurozone.  What are some potential catalysts?

  1. tax increases by state / local governments
  2. collapse in the EUR to below parity
  3. aggressive tightening in China or Europe (for different reasons!)
  4. policy mistake in the US

It is clear that the economy is chugging along, and that some of the biggest risks are how the markets will punish policy mistakes.  It reminds us of a quote from Schumpeter:

“As a doctor is unable to predict whether his patient will be run down by a motor car, so the economist is unable to predict in a situation in which so many political motor cars run about …”

- “Depressions, Can We Learn from Past Experience?”, Schumpeter, 1934

 

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Economic Expansion Outpacing Money Supply Growth

Monday, June 7th, 2010

This is an interesting graph.

Top Chart: Rolling 12 month returns on the S&P 500

Bottom Chart: Monetary Supply (M2) divided by Industrial Production (IP)

 

The bottom chart is meant to imply if money supply growth is outpacing industrial production. In other words, when this index spikes (as it did in 2002 and in 2009) this means that the monetary supply is increasing due to Federal Reserve actions and this is not finding its way into the real economy. We take the decline both in both instances to represent when money growth found its way into the real economy and industrial production “caught up” with policy actions.

We think this is a positive for markets. Clearly the original impulse response (12 month return on the S&P was over 40%) is over. Now markets are in Act II, and clearly recent news from the European debt crisis imply we are in for a mid cycle slowdown. A slowdown does not imply the market and economic recovery is over. As was evident in 2003, markets rallied like crazy from their bottom, formed a stable base that finally gave way to a new bull market.

Economic fundamentals and the corporate profit picture points to a healthy recovery, even though recent market action would imply the opposite. What is going on in Greece is not pretty, and it could easily cascade to less important economies (Hungary) as well as more important economies (Spain). Just like a household that is having trouble paying its debts should not take on more debt to be able to pay its interest payments, global central banks should not throw more debt at a problem caused by too much debt.

 

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Keeping an eye on the indicators

Tuesday, May 18th, 2010

As we mentioned back here in our post on the direction of the stock market over the upcoming months, it is important to track the indicators.  Long story short, they have turned a bit ugly.  To paraphrase one of the true brightest and best:

“Put your ears to the railroad tracks. Prices move first, and fundamentals come second.”

This tells you that though reports are confirming that fundamentals are sound …

  • M&A, Capex, share buybacks, dividend increases have been running at historically low levels and are just beginning to rise
  • Corporates are lean, and richer in cash than they have been in decades
  • Profit margins are approaching all time highs, only a year after the “Great Recession”

… the market is sending a different signal:

  • Dr Copper and Dr Crude are both down about 17% (through today, May 18)
  • S&P was spooked into its largest intra day loss since 1987, and is now down about 7% from April 26
  • Yield curve (10s / 3Ms) has flattened by about 50 bps from nearly 380 bps to 330.

Where to from here? The Greek drama reflects a broader sovereign crisis that took us by surprise with respect to how quickly it cascaded into a crisis.  Greece was one of the weaker guys in the pack, but its amazing to us how Ireland has a deficit of -14.7%, compared with Greece’s deficit of -12.2% and little mention is made in the press of their situation. True, the total indebtedness of Greece is higher, at 124.9% of GDP compared with Ireland’s 82.9%.

And thats not all.  A massive oil spill, looming uncertainty over financial reform, civil lawsuits against the investment banks, etc.

Difficult times indeed. However we think the market is going to trade lower over the next few months. This is not to say the rally has been officially delayed, but these are major headwinds that have reminded the market that volatility is always around the corner. It is very easy to say that this has spooked a bunch of investors who have been cautiously adding to their exposure and are now reminded of the awful 2nd half of 2008.

Sincerely,

The Covert Analytics Team

 

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Quantification Can Create the Illusion of Precision

Thursday, May 6th, 2010

At Covert Analytics our dynamic asset allocation models are based on risk indexes which portfolio managers build to evaluate the risk inherent in a market. But this quantitative indicator may create a false illusion as to the true risk of any market. Today was an example of this.

The past few weeks showed an amazing resurgence in seemingly black-swan type risks. First an Icelandic ash volcano that paralyzed European travel, a massive oil spill in the Gulf of Mexico, the “smartest guys in the room” aka Goldman Sachs getting hit with civil fraud charges by the S.E.C. and now out of nowhere a -9% selloff intraday on the US stock market. It was the biggest intraday selloff in percentage points since 1987.

Today showed us that financial markets are fickle. Sentiment and risk perception often swing abruptly. Greece’s economy is small, at EUR 254 billion, particularly in an economic bloc that is nearly EUR 9 trillion or 35x its size. The Greek problem has the potential to develop into a full blown epidemic, threatening the entire European economy.

The political tension is rising: elections in the UK today with a change in leadership from Labour to Conservatives, Germany’s elections in North Rhine – Westphalia, etc. A Greece bailout is very unpopular, but so is preempting a global financial crisis. Whereas some rumors have indicated that Greece has consulted with Lazard to examine a restructuring, other rumors have hinted at G-7 coordination today (May 7) to contain the crisis.

A simple punchline is that a Greek debt default or restructuring is inevitable. Even in the event of restructuring the result is the same.  Looking back to the 1930s the Creditanstalt bank default occurred in 1931, sparking a global banking crisis, but the great crash of the Great Depression occurred 2 years before in 1929.

Regardless on the view of whether Greece will be bailed out it is difficult to envision an environment where this will be beneficial for the Euro. This is not to say that a breakup of the EUR is in order. But, countries now including the ECB will be inclined to transition into quantitative easing, ie print their currencies.

Own gold as a hedge. Stocks are a good buy given that this event will definitely leave in place accommodative monetary policy. We dont think an all out default of Greece or a disintegration of the Euro bloc will occur. If we are right, stocks will rocket from current levels with renewed stimuli and a refocusing on economic fundamentals.

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Speculation on Future Stock Market Direction

Monday, April 12th, 2010

I am of the opinion that the stock market still has some legs in this rally. As you can see in the chart below looking at month end numbers for the S&P, you can see a very similar co-movement between the current cycle (“the Great Recovery”) and the mid-70s bear market (“Oil Crisis”).

 
Note: “Great Recovery” till April 12, 2010, using monthly numbers. The Oil Crisis is from December 1974 – December 1976.

Clearly at Covert Analytics we espouse a cross asset class, global approach to investing. In other words the decision to invest in stocks is not only based on how risky the US market is, but also, how risky is it compared to other markets, how risky is it compared to bonds, etc.  Clearly at this point in the cycle, with the S&P up over 70% (factoring in daily prices), it is hard to have an “all-in” approach to stocks. But I am still very optimistic at this point of the cycle, regardless of how much little upside is displayed by historical comparisons like mine above.

I do not think the market is likely to reverse direction. Clearly the tendency after a deep downturn has been to underestimate the efficacy of economic and monetary policy as well as the resilience of the business sector. It is very in vogue these days to speak of the new normal and how this means boring corporate profitability and a market with limited upside.  What if everyone is wrong? What if we are facing a stronger than expected stock market environment?

If you look at historical stock market cycles, the average cyclical bear market has been followed by at least two years of positive returns.  Of course we acknowledge that 2009 was a strong recovery year, and there are many risks out there. However, lets look at some market indicators to see how they are pricing in the recovery.

  • Dr Copper / Oil  are up sharply. Crude is only a couple percentage points away from its 52 week high, and Copper is signalling a very strong demand for the commodity.
  • Yield curve is still very steep. Strongly positive sloping yield curves (steep) imply an upcoming economic recovery. The difference between the 10 year and 3 mo money market yields across the G7 are very high (353 bps in the US, 344 bps in the UK, 260 bps in Euro-zone, 327 bps in Canada, 322 bps in New Zealand, etc).
  • Still low interest rates. Recent studies by Siegel have implied that low risk free rates encourage risk taking and thus higher multiples of earnings.
  • Accomodative monetary policy.  Federal Reserve bank is sitting tight at current levels, and so is the ECB / BoE / BoJ, etc. Only select commodity currency countries are in hiking mode (Australia).
  • Junk spreads continue to compress. Single B spreads were 629 bps as of December 2009 and have compressed to 598 bps.

I guess our conclusion is the following, as long as short rates stay at zero, there is a high propensity for economic growth to accelerate, and for the stock market rally to continue.

Sincerely,

The Covert Analytics Team

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Suggestion for CALPERS

Friday, March 19th, 2010

We agree with the Wall Street Journal article, implying that serious investors need to rethink asset allocation. It goes without saying that an asset allocation strategy “works” over the long run, but that doesnt help navigate through ferocious bear markets.

“In their research, managers came across Denmark’s ATP fund. In 2008, that $112 billion pension fund moved from allocating investments based on asset type to what drives risk, a spokesman confirms. For example, it put private and public equities into one category called corporate earnings, which usually perform badly during economic downturns.”

That is exactly how Covert Analytics suggests portfolio managers manage portfolios! Allocating investments based on what drives risk? That is the exact definition of what our platform is trying to achieve!!!

Suggestion: CALPERS can fire all their employees (except 2), hedge funds, advisors. Maintain one employee to manage their Covert Analytics subscription and other employee to execute trades! Problem solved.

Here is the link to the WSJ article

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Some need-to-know tidbits on market timing

Tuesday, March 2nd, 2010

We grew up in the ‘hood.  The “hood” of academic circles.  Our formative years in money management were spent surrounded by brilliant academics, a few literally with Nobel Prizes, a few more PhDs, and a bunch of graduates from Wharton / Kellogg etc.  This should be a great start, you would say? It actually wasn’t.

Quoting Warren …
In retrospect, we all learned a bunch. What I would sarcastically say is that we learned what not to think.  In our defense, even Warren Buffett said at his 2009 annual shareholders meeting that if he taught a course on investing, the first thing he would do is unteach the “efficient market hypothesis”!

Cross-Check
The problem was we were building a new type of money management firm, based more on index-investing (since you could not outperform the index) rather than blindly allocating to managers. The problem with that approach was still that you needed an asset allocation approach to “beat the business cycle”. The “Chicago boys” thought this was a waste of time, markets were efficient, you could not outsmart them, etc.  This greatly upset the other half of us, who wanted eventually to run our own hedge funds and were insulted at this death knell to our future careers.

Our focus has always been on using quantitative techniques to identify when investment opportunities offer the most probable profit. Thus why we developed Covert Analytics. We were frustrated that some basic tools were not commercially available for portfolio managers, money managers, investment management firms, asset allocators, family offices, whatever label you want to give them.

Fast forward to Covert Analytics
Our platform is not a market timing software.  Our software is about identifying when forces are in place to propel asset markets further, or when valuations, monetary conditions, etc are so stretched that a price collapse is likely in the medium term.

What the Research Says
We realize how important the confidence our clients place in us is. Our entire premise is that asset allocation is the most important decision a money manager has to make. More important than security selection, more important than the aggregate effect of tactical trades, etc. Here are some studies we recently evaluated and their conclusion on market timing.

  • The Clairvoyant Investor Not Much Better Off
    Sharpe (1975) imagined an investor who had two assets to choose from: US Stocks and Cash, and invested with perfect accuracy in the “higher returning asset” plus transaction costs.  The results were rather disappointing: Perfect Timing resulted in a 15.3% annual return versus 12.8% for Buy and Hold, an outperformance of 2.5% annually.  This did include however pretty high transaction costs.
  • Missing the 10 Best? Invest in Cash
    Jeffrey (1984) did an analysis on comparing perfect accuracy with horrible accuracy, but the most interesting conclusion we thought was this: If the 10 best performing stock market years out of his study are missed, then the resulting return is equivalent to a cash return.
  • Out for Best 7%, Return of 0%
    Chandy and Reichenstein (1993) came to a similar conclusion as Jeffrey: using monthly data since 1926, they concluded that if an investor missed the best 7% of monthly returns, then the remaining 93% of the months provide a 0% return.

Clearly market timing is  a tough task. We believe that with our approach, and a wide variety of assets, outperforming the market in a systematic way is achievable.  What this research proves is the following: forecasting bull markets is just as important (actually more important) than forecasting bear markets over the long run.

BTRheT

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Principle versus Practice: Forecasting the Market

Friday, February 5th, 2010

Forecasting the stock market is never an easy task.  The principle behind a bull market are simple enough: if valuations are attractive, liquidity is plentiful and the earnings outlook is favorable, then it is reasonable to expect the market to rise.  In practice though, it is not always that simple.

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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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