10 o’clock check in

Where to begin today? We’re a little late on the uptake because so much is new and so much is old.

The dollar continues its downward spiral with Singapore joining the rest of the world against the USD and Bernanke’s campaign for inflation. The currency wars are raging, and I’m not sure if winning is good.

Meanwhile, August trade balance is at -$46.3 billion – worse than expected. Assuming it doesn’t get revised even lower, it will still have a negative impact on GDP revisions for Q3. At the same time, the China bashing continues in Washington (as if that’s the problem).

PPI came in a 0.4%. We have been discussing the duality of the market – inflation in expenses, deflation in wealth. Well, food and energy were the main drivers of the increase. Sans those, and PPI was only 0.1%. That being said, most people don’t exclude energy and food prices from their monthly bills, so the average person is feeling it in their pocketbook.

Jobless claims came in at 462K (up from 445K), and the prior number was revised higher (no surprise).

On the other side of sanity, Paul Krugman discusses the need to increase QE by $8-$10 Trillion, while on the same day, the St. Louis Fed comes out with a report on why QE is bound to fail. It’s a mad world.

Capital Structure Mispricings

I expect capital structure arbitrage/mispricings to be more prevalent with ZIRP. As investors try to gauge how to price risk-free return in this environment, many models of efficient markets become skewed by market realities and provide the nimble with opportunities. This one is courtesy of ZeroHedge:

the mispricing of tail risk as represented by equity and credit derivatives in BP at the time when the company’s bankruptcy seemed like a sure thing. Due to a major skew resulting from a huge imbalance in implied vol, a perfectly hedged trade which saw the selling of equity vol through near terms puts, coupled with the purchase of default protection via 6 month CDS, would have yielded a 158% annualized return at trade unwind 3 months later. In other words, which it is difficult to generalize, it appears that in times of dramatic risk, equity derivatives tend to overprice fat tail risk, while default protection is underpriced. Such capital structure arbitrage trades will become increasingly more profitable as the Fed-created drift between equity and credit accelerates, and as vol pricing allows phenomenal arbitrage opportunities.

Read the full article here.

The challenge, of course, is that these can only be implemented by sophisticated institutions and not available for anyone else.

Dangers of Indexing – This is important for money managers

There has been a lot of debate recently about the death of stock pickers, usually in conjunction with some discussion on high correlation, lower factor predictive abilities, etc. and at the same time, there has been an obvious growth in the use of index investing styles. I have tried to show different reasons why notifications of our death are premature, but a recent paper from the NBER has made me more optimistic about stock-pickers chances of success than I have recently been. For starters, a simple comparison of RSP (equal-weighted index) and SPY (market-cap-weighted index) shows that the average stock in the S&P 500 tends to outperform the index, leaving room for stock pickers over the index. For a quick chart, click here.

If that doesn’t satisfy you – because it didn’t satisfy me either – here’s a more thorough and interesting report (from FT.com):

A new paper from the National Bureau of Economic Research by Jeffrey Wurgler, Nomura professor of finance at New York University, discusses the potentially overlooked perils of indexing…

In terms of the effects, he finds:

On average, stocks that have been added to the S&P between 1990 and 2005 have increased almost nine percent around the event, with the effect generally growing over time with Index fund assets. 6 Stocks deleted from the Index have tumbled by even more. Given that mechanical indexers must trade 8.7% of shares outstanding in short order, and an even higher percentage in terms of the free float, not to mention the significant buying associated with benchmarked active management—this price jump is easy to understand and, perhaps, impressively modest.

——

If a one-time inclusion effect of a few percentage points were the end of the story, then the overall impact of indexing on prices would be modest. But the inclusion effect is just the beginning. The return pattern of the newly-included S&P 500 member changes magically and quickly. It begins to move more closely with its 499 new neighbors and less closely with the rest of the market. It is as if it has joined a new school of fish.

Figure 2 (right) illustrates the phenomenon. It is worth repeating that this pattern is occurring in some of the largest and most liquid stocks in the world.7

In essence, he argues that the liquidity and market capitalisation of the stock becomes increasingly irrelevant once it becomes a member of a major index…

As he explains:

The net flows into index-linked products are both large and not perfectly correlated with other investors’ trades. Indexers and index-product users are by definition pursuing different strategies from those of the more active investor. They are less interested in keeping close track of the relative valuations of index and non-index shares. Some are index arbitrageurs or basis traders who care only about price parity between index derivatives and the underlying stock portfolio. The upshot is that over time, the index members can slowly drift away from the rest of the market, a phenomenon I will call “detachment.”

Consequently, Wurgler says this detachment may lead to a significant price premium for S&P 500 Index members.

He also cites a paper by Morck and Yang from 2001 which matched stocks within indices as closely as possible to a stock outside the index, with compatability defined in terms of size and industry.

The comparative valuations showed that S&P membership drove up a price premium in the order of 40 per cent.

Which leads him to conclude:

…the evidence is that stock prices are increasingly a function not just of fundamentals but also of the happenstance of index membership. This drives many of the negative consequences noted below.

As for those negative consequences, those are:

1) Bubbles and crashes.

The S&P 500 Index’s visibility and the easy access to ETFs and Index funds facilitate a high sensitivity of flows to returns.

—

Index membership also affects high-frequency risks, and may encourage trading activity that exacerbates those risks. Dramatic examples include the crash of October 19, 1987 and the intraday “flash crash” of May 6, 2010. SEC investigations have centered on S&P 500 derivatives in both cases.

2) A confused risk-return relationship.

Whereas the basic proposition of asset pricing theory is the positive relationship between risk and expected return, he says in stock markets, the proposition is incorrect:

High risk stocks have, on average, delivered lower returns than low risk stocks in both U.S. markets and those around the world.

—-

A $1 investment in a low beta portfolio in 1968 grows to $60.46 by 2008, while the same investment in a high beta portfolio yields $3.77. The high beta portfolio actually has a negative real return; the 2008 portfolio adjusted for inflation is worth 64 cents. Restricting to larger cap stocks doesn’t significantly change the qualitative picture.

And this he says is because the basic problem is that managers benchmarked against a simple index will tend to favour high beta stocks – because the index is actually already outperforming versus the fundamentals.

In other words, for a manager benchmarked against the market portfolio, a stock with an alpha of 2% can be a candidate for underweighting. A similar argument shows that such a manager is also incentivized to overweight a low or negative alpha, high beta stock, unless the alpha is extremely negative.

For the full article, click here.

This should come as good news for stock pickers, but also might provide some interesting fodder for new tests, particularly low-latency equity long-short strategies.

GS catching up on our conversations on demographics

We’ve often discussed demographics as a critical long (very long) term indicator – and, by the way, the message ain’t good. Goldman is finally catching up on the conversation. The main idea is that by looking at demographics, both on a national and world level, we can anticipate major trends in spending, real estate, and price pressures. For years, the developed world has known that it is facing a declining demographic profile brought on declining fertility rates and just the sheer size of the baby boomer generation. The emerging markets, meanwhile (except for China), maintained a younger average age, higher fertility rates, etc. Additionally, the savings profile in the emerging markets has helped sustain the overspending of baby boomers – and that was at the time when baby boomers were in a position to save on their own if they so chose, which they didn’t.

And now, the baby boomers are entering a phase of declining savings, and are facing structural challenges that will need to be financed. Goldman starts to analyze them. Here are the main highlights:

• Demographics are a major determinant of long-term current account trends.
• Countries with a high proportion of ‘prime savers’ (those aged between 35 and 69) are more likely to run current account surpluses.
• We show how demographic shifts have influenced global current account trends in the past 30 years, and what they imply for the next 20 years and beyond.
• We have seen some rebalancing from the extremes in 2008 but the process is not yet complete.
• Demographic shifts point to a cleaner split between emerging markets (mostly in surplus) and developed markets (mostly in deficit) in the future than is evident in the current, more complicated picture.
• Emerging markets (EM) could continue to lend to developed markets (DM) on average.
• Demographic forces may help keep global real rates low.
• The development of EM capital markets may be important in offsetting demographic pressures for capital flows from the EM to the DM world.

For the full article, click here.

From the Fed: Future Recession Risks

Future Recession Risks

by Travis J. Berge and Oscar Jorda

An unstable economic environment has rekindled talk of a double-dip recession. The Conference Board’s Leading Economic Index provides data for predicting the probability of a recession but is limited by the weight assigned to its indicators and the varying efficacy of those indicators over different time horizons. Statistical experiments with LEI data can mitigate these limitations and suggest that a recessionary relapse is a significant possibility sometime in the next two years.

For the full paper, click here.

There’s nothing more to say. The Fed is starting to recognize that risks remain to the downside. It supports the view that rates will be kept low for the foreseeable future.

Behavioral Portfolio Theory

In a new paper, Hoffmann, Shefrin, and Pennings explore the differences amongst investors in terms of preferences, individual biases, and goals.

Abstract:
Existing studies on individual investors’ decision-making often rely on observable socio-demographic variables to proxy for underlying psychological processes that drive investment choices. Doing so implicitly ignores the latent heterogeneity amongst investors in terms of their preferences and beliefs that form the underlying drivers of their behavior. To gain a better understanding of the relations among individual investors’ decision-making, the processes leading to these decisions, and investment performance, this paper analyzes how systematic differences in investors’ investment objectives and strategies impact the portfolios they select and the returns they earn. Based on recent findings from behavioral finance we develop hypotheses which are tested using a combination of transaction and survey data involving a large sample of online brokerage clients. In line with our expectations, we find that investors driven by objectives related to speculation have higher aspirations and turnover, take more risk, judge themselves to be more advanced, and underperform relative to investors driven by the need to build a financial buffer or save for retirement. Somewhat to our surprise, we find that investors who rely on fundamental analysis have higher aspirations and turnover, take more risks, are more overconfident, and outperform investors who rely on technical analysis. Our findings provide support for the behavioral approach to portfolio theory and shed new light on the traditional approach to portfolio theory.

The authors go on to answer the following:

Our investigation into the role of individual differences focuses on the following questions:
How do investors differ from each other in respect to the type of information upon which they
rely to develop their strategies? How do investors differ from each other in respect to their
general investing objectives and risk attitudes? To what extent do differences among investors
impact the composition of their portfolios, trading activity, and investment performance?

For the full paper, click here.

Fascinating reading for anyone interested in behavioral finance and economics, decision making processes, etc. Additionally, the paper cites numerous studies on the topics, which should serve as a valuable resource in and of itself.

Books, books, and more books

I’m often asked for book recommendations by both investors and traders. In the past, I used to tailor some of these recommendations based on the particular situation, but more recently, I decided to start compiling a list that will hopefully continue to grow. It’s by no means exhaustive, and quite honestly, I read  a lot of books that aren’t worthwhile and are repetitive. But here are some books to start us off with…

Must read from Jeremy Grantham

As always, Grantham brings an astute, experienced eye to a host of global issues, from the risks of global warming to the burdens placed on our working population to the financial sector zero-sum games. This series of essays, summer readings, are a must. Click here to download all six essays.

Global inflation revisited – IMF working paper

Since the inflation vs. deflation debate rages, I want to bring a new IMF working paper by Joseph Crowley to your attention, which highlights a possible decoupling of inflation trends. On a personal level, I think there has been some decoupling on the inflation front on a relatively short term basis, however, I anticipate that there will be a re-coupling in the next few years as asset prices drive down inflationary pressure. On a longer term basis, emerging markets can face higher inflation pressures as limited domestic resources, tighter currency controls, unstable politics, etc. could provide fodder for inflation.

From the paper:

Abstract:
Inflation followed a strikingly uniform pattern in all countries of the Middle East, North Africa, and Central Asia during the period 1996-2009, falling until about 2000 and then rising. International fuel prices do not help explain this pattern. This conclusion is robust even when different cross sections of countries are tested or when different regression variables are included. The pattern of inflation is explained mainly by past inflation, the strength of the US dollar, US inflation, and—depending on the subset of countries analyzed—monetary and exchange rate policies and nonfuel commodity prices.

The paper goes on to point out some key findings:

Inflation is driven by many factors, and the interest and exchange rate policies that
central banks implement, the money supply growth that they allow, and the exchange rate
regimes that constrain them are ultimately the most important. In the MENACA region,
central bank policy decisions clearly bear significant responsibility for the reemergence of
inflation. Many countries (particularly in the Maghreb) have failed to increase nominal
interest rates in the face of increasing inflation, largely because of the constraints of official
or unofficial pegs to the US dollar. Others, including in the GCC, have increased rates in
spite of the peg, but not enough to keep up with inflation. Often the key policy decision has
been to maintain adherence to an official or unofficial peg.

But the reemergence of inflation around the world was so uniform that it is hard to
attribute it entirely to shifts in the policies of individual central banks. Meanwhile, there were
striking developments in certain global variables, particularly during the period following
2000, and it would be logical to consider global factors in any study of inflation.

Global factors may have a significant impact on inflation and this impact may have
increased in importance in recent years. Borio and Filardo (2007) argue that global factors
are important and since the 1990s have become increasingly important in determining
inflation, even replacing domestic factors in some cases. Rogoff (2004) argues that
globalization, by increasing competition, has changed the shape of the Phillips curve, making
the inflation-output tradeoff less favorable to policymakers who might be willing to accept
higher inflation in return for higher output. Other authors have similarly argued that greater
openness reduces the benefits of unanticipated monetary expansion (Romer 1993) or
otherwise has effects that make narrowing output gaps more costly in inflation terms (Razin
2004). Chen (2004) finds that openness had a downward influence on prices in the EU during 1988-2000. D’Agostino (2007) finds evidence that US inflation is more closely related to global liquidity than to US liquidity. Ball (2006), however, disputes these claims. He provides evidence that the Phillips curve has changed shape, but in the wrong direction to
support the conclusions that are drawn. He also provides evidence that US inflation is not
dependent on output in other countries.

It is hard not to notice that the comeback in inflation coincided with a sharp increase
in food and energy prices, and it is tempting to infer that these increases in commodity prices
drove the resurgence in inflation. The IMF’s April 2008 Regional Economic Outlook (REO)
for Latin America noted that “Rising domestic food prices, reflecting both sharp increases in
world commodity prices and some local supply disruptions, have been widely viewed as a
key element in the uptick in inflation.” In a cross regional paper on inflation in emerging and
developing countries, Habermeier, et al (2009) concluded that the main causes of the increase in inflation were demand pressures and commodity prices, and that the initial impact of commodity price increases was followed by second-round effects. The Economist magazine indicated in May 2008 that a main cause of higher world inflation was higher food and oil prices.

The conclusion that recent inflation has been driven by commodity prices could lead
to the hope that the recent softening in energy and food prices will bring with it reduced
inflationary pressure. The decline in the value of the US dollar has also been tied to
commodity prices and to world inflation, and this raises the possibility that the recent
strengthening of the US dollar could also reduce world inflation. In the case of the MENACA
region, the benefits of lower commodity prices may be limited. A stronger dollar may have a
more important impact.

For the full article, click here.

Which experts?

I’ve been struggling to piece together a picture of “expert” opinions, and find myself more worried that ever – mostly because the areas of agreement and disagreement point to some stark realities.

Let’s start with some numbers. Cash levels are hovering near all time lows (as measured since 1968) of 3.6%:

(Source click here)

Certainly, expert investors in the form of mutual fund managers are putting cash to work. That might be a result of low yields on cash or inflationary leanings; regardless, it leaves less cash to put to work in the future.

In terms of sentiment, here’s a good summary of all the different survey’s out there, but at best they’re not confirming anything. Click here for the full picture. Here’s just one example from the article last week:

Investors Intelligence
A similar shift took place in the sentiment survey of newsletter editors by ChartCraft. This week’s II shows a slight decrease in bulls (38.5%) and a slight increase in bears (31.9%). That brings the spread between the two camps to the smallest gap since February. As well, the bull/bear ratio is now 1.21:1 lower than at the end of the February correction, when the bull/bear ratio stood at 1.30:1.

So far, nothing alarming, nor surprising. But I also like to see what some “old timers” are doing. (They aren’t old, they’ve just been involved in the markets longer than the average mutual fund manager at Fidelity.) These guys have been around for so long that they don’t really have to care what anyone else says and they’ve already established themselves as contrarians. Surveying these guys is pretty scary. Jeremy Grantham at GMO sounds bullish when he writes that he expects stocks to deliver low single digit returns over the next 7 years. There’s Gary Shilling, who’s shorting stocks and expects a return to cycle lows (mid-600′s on the S&P). There’s Robert Prechter of Elliott Wave fame, who’s predicting a 90% slide on the Dow. What about David Rosenberg? Richard Russell? In 2005, Richard Rainwater spoke to Fortune magazine about his view of the future. Five years later, the underlying conditions aren’t better. Rainwater set up a working self-sustaining farm for the coming of scarcity in resources and food. If a guy with $2.5 billion is worried about access to food, maybe everyone should be worried.

As we all work towards understanding different markets and predicting probabilities, expected returns, etc. it’s worth noting that quite a few of the top investors are in agreement. While the might disagree on inflation or deflation, direction of gold and commodities, or ways to implement their views, similar themes keep reappearing – stocks are overvalued, price instability is coming in some form (deflation or inflation) which should cause a contraction in multiples, we need to delever on all levels (personal and governmental), etc. This is not to sound alarmist in any way. As long time readers know, based on valuations I am very concerned about the near to medium term performance of equities. These investors have actually made me rethink some of my own inputs and reanalyze whether my 50% (order of magnitude) decline in equities is too optimistic. Interestingly, I haven’t found any old-timers who are extremely bullish, and while some may look at that as a counter-indicator, I think sometimes it’s worth heeding the advice of experienced practitioners.

Food for thought for anyone utilizing sentiment indicators or trying to understand intra- and inter- market behavior for predicting expected returns.

Update on q-ratio

As readers already know, I use the q-ratio (aka Tobin’s q) for insight into the general market levels: The signs ain’t good. With the Flow of Funds report coming out June 10th (for the 1st quarter), the q-ratio was standing at >1. It’s historical average is 0.65. That implies a >35% decrease from here, which implies an S&P 500 level of 724. That’s just to approach fair value; however, we all know that these mean reverting series tend to overshoot, in the case to the downside.

For the full Flow of Funds data, click here. The applicable table is B.102 on page 105.

Non-financial companies, including both quoted and unquoted, were 62% overvalued according to q at 31st March 2010, when the S&P 500 index was 1169. Adjusting for the subsequent decline to 1087 (10th June, 2010), the overvaluation had fallen to 50%. Revisions to data had little impact on q, with downward revision to net worth for Q4 2009 of 2.9% being offset by a downward revision to the market value of non-financial equities of 2.1%. Net worth for Q1 2010 fell slightly as equity buy-backs exceeded profit retentions.

The listed companies in the S&P 500 index, which include financials, were 58% overvalued at 31st March 2010, according to our calculations for CAPE, based on the data from Professor Robert Shiller’s website. Adjusting for the subsequent decline to 1087 (10th June, 2010), the overvaluation had fallen 46%. (It should be noted that we use geometric rather than arithmetic means in our calculations.)

For a bit further discussion (and the source of the chart and quote) click here.

Where is money made?

There is so much daily noise in the market, that sometimes its easy to lose sight of the big pictures and trends taking place right under our noses. Earlier today, I wrote about Alvin Toffler and the waves of transformation. For me, there is a connection between “the waves” and money flows. In each of Toffler’s waves, money flowed to the new wave, only to create bubbles, financial collapses, debt spirals (up and down), yet often the older industries were left as significant beneficiaries of the new advancements. As a quick example, agricultural productivity was able to soar after the industrial revolution introduced new tools, transportation, materials, etc.

As an investor, I’ve been thinking that Toffler’s waves had (have? His book, The Third Wave, was written in 1980) vast implications if one was able to invest in them. Instead of just thinking in terms of technological or developmental “waves”, I think we should also consider the waves of money flows around us. In my mind there are 3 big waves occurring and money will be made by individuals, firms, and countries that can place themselves strategically.

The first transfer-wave is between developed to developing countries. Wealth is invariably being transferred and the gaps in quality of life will eventually close. For developed nations, it will probably mean a slowing of the rate of increase in quality of life, while for developing nations it will mean an exponential growth. Without discussing whether this is good or bad for any individual group, the companies that can take advantage of these shifts, both in terms of manufacturing and distribution, will win.

The second transfer-wave is between old and young. Baby boomers were not a US phenomenon. The Western world is facing an aging population that will at first require assistance, then slowly be forced (by nature) to transfer its wealth to a new generation. Again, those countries and companies that understand this demographic shift will win. As an example, countries able to attract and retain young talent, or encourage their populations to grow faster than others, etc. will benefit in the long term. A classic counter-example is Japan, with it’s fast-aging population, low birth rates, and relatively closed borders.

The third transfer-wave is from men to women. While it’s occurring more quickly in the developed nations, developing nations will face it as well. “The postindustrial economy is indifferent to men’s size and strength. The attributes that are most valuable today—social intelligence, open communication, the ability to sit still and focus—are, at a minimum, not predominantly male. In fact, the opposite may be true.” This was from The Atlantic which is running a cover story on this specific topic and is a must read (click here for the full article).

None of these transfer-waves are bad nor good – they are obvious and necessary. The key, as investors, is to understand the dynamics involved, evaluate the opportunities and pitfalls, and translate these trends into investable themes and ideas. That’s what we’ll be referencing in the upcoming weeks, months, and years, as we try to understand the implications for households, companies, and countries.

Size of the global yen carry trade

I don’t like the yen. The demographics are awful, with an aging population, 200%+ debt to GDP, and virtually zero percent interest rates make for an awful combination. Yet, it’s gotten stronger throughout the crisis, both against the dollar and the euro. We’ve discussed that this is a result of the yen carry trade being unwound globally, and that once this unwind is done, the yen will be a victim to the infamous arbitrarily defined “wolfpack”. So the question for investors is whether we can measure the carry trade, watch it unwind, and predict when the base of support for the yen will end.

In a recent paper by Stephen Cecchetti, Ingo Fender and Patrick McGuire, they try to do just that. You can download the entire paper here or read the summary from ft.com here. The measure is not perfect, and the timing of the reporting for BIS statistics makes it an extremely difficult factor to implement, but the direction is the right one as we sort through the current crisis.

Hugh Hendry’s Eclectica Fund Letter

This is a must read for investors. Hugh Hendry is one of a handful of fund managers that I believe actually get it: it’s not about style or asset class, it’s about finding undervalued opportunities around the globe.

His letter details why he’s pessimistic on Japan, and is therefore NOT shorting the yen. Pessimistic on China because THEY ARE COMMUNISTS (my emphasis) and you cannot trust a totalitarian regime – a point I’ve often made on these pages. He sees (hyper)inflation coming, but first deflation – I tend to agree. And, oh yeah, he’s buying corn – we’ve discussed ag here recently (although I believe that exposure through financial instruments might be tested in the near future as liquidation of ALL financial assets takes hold).

For the full letter, click here.

Exploring Infinity

For anyone who loves numbers, math, theory, and the connections between everything, check out this article:

Excerpt from: The Hilbert Hotel

In late February I received an e-mail message from a reader named Kim Forbes.  Her six-year-old son Ben had asked her a math question she couldn’t answer, and she was hoping I could help:

Today is the 100th day of school. He was very excited and told me everything he knows about the number 100, including that 100 was an even number. He then told me that 101 was an odd number and 1 million was an even number, etc.  He then paused and asked: “Is infinity even or odd?”

I explained that infinity is neither even nor odd.  It’s not a number in the usual sense, and it doesn’t obey the rules of arithmetic.  All sorts of contradictions would follow if it did.  For instance, “if infinity were odd, 2 times infinity would be even.  But both are infinity!  So the whole idea of odd and even does not make sense for infinity.”

Kim replied:

Thank you.  Ben was satisfied with that answer and kind of likes the idea that infinity is big enough to be both odd and even.

Although something got garbled in translation (infinity is neither odd nor even, not both), Ben’s rendering hints at a larger truth.  Infinity can be mind-boggling.

But then Steven Strogatz goes on to explain some of the contradictions of infinity. It is an infinitely interesting topic.