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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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Posted in Business Cycle, Stocks | 2 Comments »

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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Posted in Asset Allocation, Business Cycle, Dynamic Rebalancing, Our Approach, Stocks | No Comments »

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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Posted in Asset Allocation, Business Cycle, Dynamic Rebalancing, Our Approach | No Comments »

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 »

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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Posted in Business Cycle, Illiquid Assets, Market Talk, Our Approach | No Comments »

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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Trends in the Investment Management Industry: ETFs

Tuesday, January 5th, 2010
This graph is a depiction of how the investment management industry has evolved since the 1980s. Whats most obvious is that the dominance held by traditional funds (ie mutual funds) is being replaced by the index funds or passive investment approach.  Also note the growing importance of alternatives.  By alternatives we mean the alternative invesmtment management industry (specifically hedge funds, private equity etc).  Under index funds we lump the growing asset classes devoted to commodities (including Crude, Gold, Silver, Agriculturals, etc).

Evolution of the Asset Management Industry

We think most investment advisors should abandon the desire to bringing the “best” in the investment management industry into their client portfolios.  Time after time, we have seen mutual fund managers with stellar “alpha” capability get destroyed on a absolute and relative basis (Bill Miller of Legg Mason and Richard Pzena of the Pzena Value Fund are some examples).  What about hedge funds? They never do any harm right? Wrong.  Forgetting for a moment the obvious disasters like Madoff, there have been a string of “high-flying, hot shot” hedge fund managers that blew up rather spectacularly. 

Some “meltdowns” to note of in the hedge fund world: Polygon Global, Platinum Grove, and Amaranth … which were forced to wind down after horrendous performance. A slew of other hedge fund disasters are “restructuring” their funds, something which to me sounds like changing around the terms so they can start charging egregious performance fees given they are years away from hitting their old “high water marks”. 

Regardless, the range of investment options via low cost index funds is growing at a steady rate. For those eager to implement asset allocation strategies across various stages of the business cycle, futures or index funds are the way to go.

The Covert Analytics Team

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