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.

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

 

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.

You are always left wondering: how the hell can I assess whether the manager will outperform the market over the investment horizon (say a year or so). Does it even matter if the market is down 20% over the subsequent year?

Security selection is the part of the portfolio management process that is vital, and we historically were of the opinion that why complicate things? Throwing in a slew of more variables to analyze makes the process that more complicated. Let’s say conservatively when looking at 10 equity markets globally, along with 4 bond markets, plus commodities, you closely evaluate 5 indicators per market:

As you can imagine, this in and of itself is plenty of variables to

But now you throw in fund managers into the equation. Here is where it gets complicated. Client gives you, Advisor, the money, and you can either allocate directly to “markets” or invest in managers, that then invest in the markets.

Unfortunately we think there are so many negatives involved in this process, that it is never worth it. Let’s start with some key facts:

• 75% of all funds underperform “the benchmark” net of fees
• Clients pay you and then you are implicitly paying the manager *double layer of fees!*
• Manager screening is another significant challenge for any advisory firm
• Historical returns and wonderful pitchbooks are no indications of future returns

We think the model an investment advisor should proceed with is a combination of an asset manager (bottom up security selection + top down macro views) plus the investment advisor (matching capital market views to client-specific situations, ie portfolio allocations).

Friday May 7 – day after Flash crash trade, SPX opens at 1126 and closes at 1,110

Monday May 10 – market opens at 1,160

Thursday May 13 – market trades at its intra-week high of 1,175, closes down 1.4% that day from the peak

Friday May 14 – market sells off again, with heavy selling pressure at the open

Monday May 17 – big selloff intraday with a huge recovery rally

Tuesday May 17 – the week’s bear market begins, with a strong open and a  decline of 2.5% that day …

Thursday May 19 – already down to 1,086 (almost at the “Flash Crash” lows). Market is down 7.5% since the peak on the 13th

Markets are in untested waters. I would like to give a great quote from Larry Hite, one of the premier systematic investors of our times:

“Two basic rules: 1) if you don’t bet, you can’t win, and 2) if you lose all your chips, you can’t bet.”

Keep that principle in mind. Why do we say untested waters? Because sovereign risk is an ugly situation for markets to face, because it isnt about corporate profitability, it isnt about market sentiment, it is about global macro panic. It is about the potential for a new global crisis …

Trade safely,

The Covert Analytics Team

“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

We cannot help but identify with another market leader, albeit in consumer electronics. And this is how we see ourselves:

Apple redefined consumer electronics, and we hope to redefine asset allocation. Our aim is not to be the most intelligent group of software developers and market practitioners, but instead the most easy to use product, that delivers the most benefits, and is one part of your business that is a stress reliever, and not a stress provider.

Sincerely,

The Covert Analytics Team

The recent black swans that have dominated the news have caused understandable fright among many investors and coinciding with that is a rise in apprehension among their money managers. Why is this? Because recent events are a reminder that the raging bull since March 2009 will finally be met with a formidable adversary: volatility. Vol is back. The past few weeks have brought about known risks: sovereign default risk, investor panic, wild currency swings and unknown risks such as the BP oil spill, Iceland’s volcanic ash, the US intra day market crash, etc.

There has never been a better time for an approach like ours. We think that the key differentiating factor of our software is that it was built by market practitioners, and not under the cozy umbrella of academia. A good analogy of this is being street smart versus books smart. Though the books smart guy may have the better degree and vocabulary, the one that is going to get you through the tough part of town safely is the street smart guy.

Covert Analytics is the streets smart guy. To borrow a saying from Eastern philosophy, “the best defense is a good offense”, and this is precisely what we aim to provide our clients. Our clients, again, are fancy hedge fund managers and simple fee based money managers in Ohio. The punchline we give potential clients is, for sure our market modelling is not the black box solution to solve your portfolio management process issues, but we are however a software that will help you (the money manager) sleep better at night.

The diagram below displays what we call the “Four Cornerstones of Portfolio Management” … as you will note we believe Covert Analytics touches each aspect of this four cornerstone approach.

1) Client Profile – this is set forth by our users when they specify the “focus” of the portfolio along with the target range. As you will note this is a no frills approach to “client specification” … as a bunch of other less relevant details can be included, however we think any advisor will agree these are the key questions to answer.

2) Asset Allocation – any user of our approach will benefit from the Covert Technique to asset allocation, by which markets are selected, quantitative risk indicators are built per market and a dynamic asset allocation (fully backtest-able) mode is constructed.

3) Security Selection – typically this would include a fund manager screening tool, however since our model allocates  to stock and bond markets along with commodity baskets, we would urge clients to view markets the same way. Top priority is picking the market and a distant second (on the priority list) is finding the vehicle.

4) Rebalancing & Monitoring – Covert Analytics emphasizes constant rebalancing as new data is incorporated into your model. The monitoring service allows you to keep a better eye on your models and the portfolios based on those models.

We hope you will see why we think our software is a great offense for any portfolio management, investment advisory or hedge fund shop. Please contact us if you have any questions.

Sincerely,

The Covert Analytics Team

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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.