Black Swan

I continue to think about black swans – not the movie. It’s a bit of a tautology to say that we can only identify them in hindsight, that is, we can only tell that an unexpected event will happen AFTER we’re caught off guard. The corollary to that is if we’re caught off guard, then it must have been a black swan event. I think investors and market participants often use that as an excuse. Continuing with that line of thinking, then, the implications for the pundit, writer, or talking head (or anyone not actively making decisions) is to try to mention as many possible events or outcomes as possible. Then, when one hits, the non-decision-maker can always say that he predicted it. In that light, prognosticators have a distinct motivation to talk about the possible, without thinking of the probable.

In contrast, decision makers often base their decisions on the probable. At its root, most institutional money managers don’t want to take any career risk, and “no one gets fired for buying IBM” (although, these days, maybe they get fired for buying HPQ). The idea behind this mentality is one of momentum, namely what’s happened in the recent past is likely to continue.

The last group – I guess you might know where this is going – looks at expected return. This last group are number crunchers at heart. I hope I fall into this camp more often than not. This group relies on SUMPRODUCT. The idea behind this group’s thinking is that you need to know both the possible outcomes AND the probability of each outcome. The expected return crowd is comfortable making appropriately sized investments given the expected outcome, recognizing full well that the expected outcome will deviate from the actual outcome in any given turn BY DEFINITION. The key for this group is that there is always a possibility that they/we don’t anticipate; except, you can anticipate the unanticipated by making an “other” category. This other category will now be factored in and will only be limited by the assumptions you input into it. Other, remember, can go in both direction. In essence, it’s a haircut. The more investors lump into the other category, the smaller they should trade.

I happen to have a lot of things in my “other” category. I worry about the weather. I think about terrorism. I think about supply shocks in every commodity imaginable. I think new technologies will revolutionize the way we live. And on and on. The implication is that I invest more conservatively than I would without my “other” category. I think a lot of people I speak to invest bigger than they should. Great when your PNL is going up. Hurts more on the way down. How big should you invest? Well, it probably depends how many things you think should be lumped into your “other” category.

In anticipation of the rebuttal, I’ll provide it myself… Fear, and especially fear of the unknown, can lead to inactivity. You might decide that so many things are unknown and in the “other” category, that your positions become miniscule, or even non-existent. In that scenario, you should also be afraid of inaction and indecision, and weigh that option. Against the risk of loss through action. You’ll probably find that inaction is worse.

In that light, our decision to hold cash, while simultaneously holding securities that would benefit from inflation might seem at odds. It is. It’s part of our inflation barbell strategy, namely in our analysis, inflation will EITHER increase or decrease, we’re just not sure yet which one. The one thing we’re pretty confident in, though, is that it won’t stay here very long. Food for thought as we move forward in our tactical allocation research.

Relevant ETFs: XLU, CROP, GLD, TBT

More on moving averages

I’ve read a couple of pieces about the markets breaking below their 50 DMA, but why do people only write about it when it confirms their thinking? I’m referring, of course, to the fact that those same people aren’t writing about the fact that USD index is breaking above it’s 50 DMA. It’s probably because they wrote about the end of the USD just a few short days ago.

IWM and moving averages

The past few days have certainly provided some new data points. The IWM is below it’s 50 DMA, and I’m sure if it finally breaks, technicians will point to this fact. Except that it broke through the average in early March also, only to give a false signal.

The flip side, is that I’m pretty bearish on equities, so I tend to view these signals with a confirmatory bias. Regardless of one’s reasoning, being long here doesn’t seem prudent.

And just another note on moving averages…In a new study of utilizing momentum strategies, Isakov and Marti showed that signals have more predictive value the longer out one looks, meaning, utilizing moving averages for short-term market timing doesn’t work as well as using the to identify larger trends. At that point, technical and fundamental analysis seems to overlap. Here’s the abstract:

This article extends the literature on the profitability of technical analysis in three directions. First, we investigate the performance of complex trading rules based on moving averages over longer horizons than those usually considered. The different trading rules are simulated on daily prices of the S&P 500 index over the period 1990 to 2008 and we find that trading rules are more profitable when signals are generated over longer horizons. Second, we analyse if financial leverage can improve the profitability of the different strategies. It appears to be the case when leverage is achieved with debt. Third, we propose a new test of market timing that assesses whether a trading strategy is able to generate signals corresponding to longer market phases. According to this test, the signals generated by the complex rules investigated in this article coincide strongly with bull and bear markets.

But back to expectations…The markets are finally showing signs of recognition that the Fed-induced rally might be in jeopardy. China’s growth is finally being questioned, as we have done many-a-time here. And the euro is no longer being heralded as the new USD alternative. So maybe the technicals and fundamentals aren’t that far off now.

Relevant ETFs: IWM, RWM

Hiding places…

In today’s overvalued market, there are no “safe” hiding places. Let’s just give a quick rundown:

• Equities – depending on your measuring stick, fairly valued to overvalued by 60%. I’m in the latter camp.
• Treasuries – except for the most extreme set of conditions, yields are at extreme lows with no fiscal/monetary support. Do you really want to be on the other side of Bill Gross?
• Commodities – maybe they’re in a long term bull, certainly Grantham’s missive 2 weeks ago was convincing, but with their moves come big speculative players.
• Precious metals – getting out of silver allowed me to sleep at night, even as we missed the last few dollars. Certainly happy we switched into GDX and XLU. That being said, I doubt that utilities can lead the market higher.
• Currencies – zero sum game, so be careful.

What we’re left with are some high conviction long term investments (DXJ, for example) and then relative performers (XLU, NLR, KOL for example). Others, meanwhile, have been long term holdings that are finally at the point of paying off (TBT, YCS). I am keeping a close eye on IWM as the leader down:

If I had to point to the single most important area of research its determining the high conviction long term investments and the price at which they’ll be worthwhile. An example is India. While we have not had exposure for the past 3 years, there are many more vehicles available for investing and the long term story has only gotten stronger. That being said, the case for global equities is weaker and the difficulty for investors to hedge currency risks are challenging. Here’s the chart (weekly):

There’s a long way down if things go the way I anticipate and world currencies flow back to their respective homes. These are the types of opportunities we want to keep on the screen for when they become so low priced that we just can’t stay away – for now we can.

Relevant ETFs: NLR, KOL, TBT, YCS, EUO, SLV, EPI, IWM, RWM, XLU, DXJ

Demographics

A few days ago, Mark Hulbert wrote a piece on MarketWatch.com that caught my attention: USA Will be Especially Youthful in 2020. I often write about demographics as one of the more predictable and powerful, yet least utilized, factors, and I was sure that by now, this research would have been picked up by more analysts. It hasn’t.

A quick summary: Hulbert points to research by Ned Davis Research that the proportion of children under the age of 15 will rise by 2020 to levels unmatched by any other developed nation except Ireland. Aside from being a long, long-term positive for Ireland, this will give the US distinct advantages in the future. But, and it’s a big BUT, this is a very long term demographic shift. What are the implications?

For starters, the immediate implications are to know that investors tend to not account for changes that are more than 5 years out, so this won’t be factored in by most investors for at least 3-5 years. Addressing just this issue, Hulbert writes:

Entitled “Attention, Demographics, and the Stock Market,” the study found that the market systematically does not take into account the consequences of demographic trends that are more than five years into the future — even when those consequences are quite predictable. (The study’s authors are Stefano DellaVigna, an associate professor of economics at University of California at Berkeley, and Joshua M. Pollet, an associate professor of finance at Michigan State University. Click here for a copy of the study .)

Another of the professors’ findings shows just how much is at stake: On average historically, they found, whenever demographic trends predicted a one-percentage-point increase in demand for an industry’s goods or services, its profits that year were 5% to 10% higher.

So even though 2020 seems like an awfully long way off, the rewards will be great for those who begin now to anticipate what the world will look like then.

The rewards for thinking and planning ahead will be great. The TradersNarrative blog picked up on Hulbert’s analysis and provided the following analysis:

A chart of the ratio of those middle-aged and those young has an unbelievably good track record for predicting the price earnings ratio of the stock market. And since the vast majority of the total return from the stock market comes from price earnings expansion, this provides us with a very good guide for future stock market returns. Of course, this is a long term and macro guide. It is not suitable for navigating the short-term gyrations of the market.

Here is a chart from a research paper written by Favero, Gozluklu and Tamoni illustrating the relationship between stock market returns and the MY ratio:

Source: Demographic Trends, the Dividend/Price Ratio and the Predictability of Long-Run Stock Market Returns

This would lead one to assume that the bear market has a few more years to go, with wild swings the norm. Additionally, it means that the areas most vulnerable might be luxury retail, high end restaurants, and large mcmansions. It’s also a long term benefit to companies geared towards the under 15 year crowd – from educational games, video games, and your local jungle gym manufacturer. For now, it confirms for me place I want to stay away from (luxury and “wants”) and places where I want to look for solid foundations in demand (“needs”).

Relevant ETFs: XRT, RTH, XLY, VCR, IYC, SZK

Silver down 10%

It was down even more and is even recovering as I write this – could be nothing more than a blip on low volume, could be something more. Interesting to note that gold is stable.

Meanwhile, fears of Chinese slowdown are making their way through the rumor mills.

Yen is down a bit, but Nikkei is up nicely.

More to come…

Anybody out there watching VIX?

The VIX is down 7%. Yes, that right – 7%. Am I the only one strangely attracted to assets AFTER they fall off a cliff? I just can’t seem to tear my eyes away from the dollar and volatility. Sure it can go lower. For years, I received ads for programs claiming a sharpe ratio of 12, that were just option selling programs. Picking up nickels. Then, one day – poof! The papers said it was unpredictable. The pundits called it a thousand year flood that happens once every 3 years. Etc. You know the story. So, yes, the VIX can go down to 9. Maybe even lower. But, can it stay there? Absolutely not. This is starting to be the opportunity to buy vol, through options tends to be the most direct, or even some ETF products. I’m not stepping in yet, but this is the type of opportunity I prefer than to continue to play in the silver pits.

Relevant ETFs: VXX, VXN, SLV, UUP

Quick note

Check out the dollar index. In a somewhat counterintuitive effect the USD shot up. A combination of factors, but in the end, when investors don’t want to hold financial assets and prefer cash, you have the observed impact. Rising yields here are NOT inflationary. Rising gold is NOT inflationary. They are signs of a debt deflation era that has a long way to run.

ETF Industry Red Flag – IMPORTANT!!

I use ETF’s all the time. I use them to gain exposure on the long and short side. I have been both surprised and impressed by the speed and breadth of development. I have also voiced a gut concern that such rapid development and asset flows may be harbingers of danger, but at the time, the plain vanilla ETF structures seemed pretty stable, and while not without flaws, represented a better alternative than mutual funds for many investors.

Over the past few days, the Financial Stability Board published a report of recent trends in the ETF industry. While I haven’t heard about the report in most major news outlets nor financial blogs, at least FT.com published it. Here are a couple of highlights:

…the nature of the product structures themselves and the huge conflicts of interest that arise from the providers’ synthetic, vertically integrated models. It is here that the FSB report really stands out, since it is the only regulatory note to date which really focuses on the innate conflicts of interest. It also hints pretty overtly at the real motivation for the creation of many of these products. Namely; cheap access to collateral and funding — although we’d add that at many banks ‘position recycling’ also plays a large part.

But overall, it’s true — you plain vanilla ETF investors, who naively take these products at face value, are more than likely funding banks. (Hint, they tend to trade on margin while you’re giving up 100 per cent of your cash to let them hedge on your behalf. Unless you’re shorting the ETFs, of course — which is what the smart-money, namely hedge funds, almost exclusively use ETFs for.)

These articles are a must read:

• Part I: http://ftalphaville.ft.com/blog/2011/04/13/544396/do-banks-see-etfs-as-inexpensive-funding-for-illiquid-securities-part-i/
• Part II: http://ftalphaville.ft.com/blog/2011/04/13/544596/do-banks-see-etfs-as-inexpensive-funding-for-illiquid-securities-part-ii/
• Follow-up warning from IMF: http://ftalphaville.ft.com/blog/2011/04/13/545351/now-the-imf-is-warning-about-etfs/

The last one is especially critical of new synthetic replication techniques.

These warning are likely to go unheeded both because of limited alternatives, liquidity needs, and false sense of security, however, investors in these products and their advisors should understand the underlying risk in the implementation vehicles, and make the appropriate considerations.

Vive la vérité . . . Vive la volatilité

For months I have been frustrated and surprised by the action of the markets in the face of continued turmoil. In different contexts, I’ve used terms such as disconnected or bifurcated where there seems to be a total discontinuity between the facts and the market actions. I now have a new term: The Negative Volatility Regime.

In a new report from Artemis Capital, Christopher Cole outlines the current environment by focusing on volatility. After my own heart, he starts with behavioral finance and defines the normalcy bias:

Normalcy Bias and Crisis: A quirk of the human condition is for the mind to desire normalcy so intensely as to consciously or subconsciously disregard knowledge that is disruptive to a pre-conditioned reality. This phenomenon is an important part of crisis management and market psychology. The consequence of a normalcy bias is that warning signs of a potential crisis go unnoticed or are interpreted optimistically. When a crisis occurs people are so overwhelmed by events inconsistent with a desired reality they lose their ability to make decisions. Researchers believe when the mind encounters an entirely new experience or event it attempts to match that reality to relevant experiences from the past. If there are no matching experiences the mind enters into a kind of feedback loop resulting in passivity. This lack of action as a response to risk is called negative panic1 and it culminates in a dangerous inability to act assertively in crisis. In essence, the psyche struggles to come to terms with what is really happening. Paralysis follows.

He then goes on to discuss how the normalcy bias can lead investors to ignore looming threats, which in turn can lead to “a cancellation of short-term volatility risk premium that should otherwise exist.” This new Negative Volatility Regime is defined by:

1. Large declines in spot volatility: The past nine months have shown an unusually high number of large declines in spot volatility (realized and implied) that are of a much higher magnitude and length than what has been observed historically. As a result of these large declines the VIX index and short-term realized volatility are below historic averages;
2. Abnormally steep volatility curve: The manifestation of an abnormally steep volatility curve (as a % of spot volatility) with a linear shape that more closely resembles a glacial cliff as opposed to the more traditional desert plateau (see chart);
3. Underperformance of Variance Hedges: Low volatility-of-volatility on the back of the variance term-structure results in the underperformance of out-of-the-money options and variance as a hedge against market declines;
4. High Volatility Skew: High levels of volatility skew for far out-of-the-money options showing increased likelihood of large declines in equity prices.

The article has a detailed discussion and great graphs representing the shape of the volatility structure. The full report can be accessed at: Artemis Q1 2011_Is Volatility Broken. (It is posted with permission.)

S&P 500 sectors

This is an interesting tidbit: the S&P 500 is up 4.64% YTD. Guess how many sectors are outperforming and leading the way? Average. Makes you think have are below half are above, right? Wrong. Only 2 sectors are outperforming: energy and industrials. Everything else is lagging. Good for us for being overweight energy, but not a healthy sign in the medium term.

Performance Data

(as of 28-Mar-2011 )

Source: http://www.standardandpoors.com/indices/sp-500/en/us/?indexId=spusa-500-usduf–p-us-l–

Of note…

Case/Shiller numbers came out, and they aren’t pretty.

From WSJ.com:

The S&P/Case-Shiller Composite 20-city home price index, a broad gauge of U.S. home prices, posted a 1% drop in January from a month earlier and fell 3.1% from a year earlier, as the housing market faced a new round of trouble.

Nineteen of 20 cities in the index posted month-to-month declines in November — just Washington, D.C. notched an increase. On a seasonally adjusted basis, which aims to take into account the slower winter selling season, eight cities — Atlanta, Boston, Cleveland, Dallas, Denver, Las Vegas, Los Angeles and Washington — posted monthly increases.

Going deeper, it’s sad to note that the only metro area seeing increases is D.C. considering the fact that those increases are being funded by taxpayers paying for increased government spending. A minor detail, I guess, in the grand scheme of things.

On a different note, consumer confidence fell from 72 to 63.4. I don’t really follow this number in a meaningful way. Not because I don’t think consumer sentiment is important, it’s just that I don’t find it to be a useful data point to use for any investment decision. It has wide swings, doesn’t anticipate turns, and is always related to the previous month, which is too short a period for me to integrate. On the other hand, it’s a great tool to show confirmation bias (if you’re feeling lousy and it comes in weak, you’ll give it more credence than if it comes in strong). So I guess it’s at least noteworthy.

Meanwhile, in a story that has gotten virtually no press, Syria’s Assad is “accepting” the governments resignation. Hmmm. Not sure how that works, but I guess Assad figured he’d try to sacrifice the government in order to maintain his own power. We’ll see if he’s able to hold on.

Lastly, Greece and Portugal are getting downgraded left a right, yet the euro is holding up better than I anticipated. History will write the reasoning behind these moves, but in the meantime, even if the euro doesn’t decline, I can’t see it having too much appreciation. I continue to view the risk to the downside.

China’s property bubble

This is from Australia’s SBS Dateline: http://www.sbs.com.au/dateline/story/watch/id/601007/n/China-s-Ghost-Cities. The numbers mentioned are not new to readers, since we’ve spoken about the 64 million empty apartments as a rough estimate before. What is interesting is that the knowledge of China’s GDP inflation is becoming more mainstream. And again I ask, what will happen to materials when China’s bubble bursts?

Deflation probabilities’ uptick

This is from the Atlanta Fed:

March 24, 2011
Longer-term deflation probabilities move up slightly

Prices of Treasury Inflation-Protected Securities (TIPS) with similar maturity dates in 2015 can be used to measure probabilities of a net decline in the consumer price index over the five-year period starting in early 2010. One measure of the deflation probability was11 percent on March 23, up slightly from10 percent a week earlier. An alternative lower bound on this deflation probability ticked up from 0 percent on March 16 to 1 percent on March 23.

Link is here.

This is a very short time frame and can fluctuate easily (as you can see from the time series). That being said, it’s tough for the probability of deflation to get any lower, which to me says that it might be a good time to check out www.intrade.com or, if you’re an investor, just find who are the winners and losers from deflation materializing. It just needs to materialize more than the market expects for it to make a significant impact.

Relevant ETFs: TLT, VNQ, RWR, REK, GLD, SLV, XLF

Is everything a currency play now?

Last weekend Barron’s ran their BUY JAPAN cover. I won’t go over the details, except to say that after the earthquake and fear took over, Japan was an even bigger buying opportunity and we told our readers to add or initiate positions. Except for one small difference. Barron’s kept going over Japan in absolute terms. As inherently value-biased investors, we like to think in terms of valuation, cashflows, etc. Then on top of that layer of analysis is the layer of management strength, moats, whatever. On all those levels, Japanese firms also have potential. Here’s the kicker, though, the government of Japan is emphatically working to devalue their currency, even more so after the disaster struck, injecting billions of dollars to provide liquidity, stimulus, etc. For a US-based investor, if you invest in Japan you take on an additional layer of risk that most value investors aren’t equipped to analyze: currency risk. In this scenario, if a US based investor bought a Japanese firm’s shares and those shares appreciated by 1% and the currency lost 1%, the investor would be no better off.Currency moves can also exaggerate an investment (shares up 1%, currency up 1%, investor now sees 2% gains).

Now, for the past few years the yen has gotten stronger, and hit an all-time high right after the earthquake. So an investor in Japan through the traditional ETF, EWJ, is buying a low priced equity investment and buying a high priced currency investment by purchasing yen exposure. To make a long story short, Barron’s may have been right that Japanese equities are cheap, but only when one accounts for the currency. The easy way to solve that is to buy the equities, short the yen, or in this day of ETF variety, buy DXJ and not EWJ. For the record, we are long DXJ.

But this is really only one example where currencies can drive the investment, and recently it seems as if the volatility in currencies has reached such a degree that currencies are driving the money flows in different asset classes. Equities may no longer be as forward looking so much as reacting to the forward looking currency markets.

If that is indeed the case, then how should investors be thinking about currencies in light of their other investments? I think that what we’re seeing is that finally, after years of asset allocation dominating discussions, and index tracking error dominating the investment industry, we are entering into a world where EVERYTHING is relative. By this I mean that we need to start talking about each investment relative to all other investments. Namely, any asset class will not need to be discussed relative to the currency it’s being bought in, relative to other asset classes in that AND different currencies, and on and on and on. The investment universe is now that much more complicated. I can now buy energy and instead of being denominated in USD, I can denominate it in gold, or to take it to the extreme, I can denominate it in healthcare stocks, or mortgage REITs. Investors in this environment need to think critically about with “currency” will outperform, where the definition of currency is now fungible. The new innovations in the financial sphere have been more dramatic than some realize. Re-packaging debt isn’t the new innovation. The new innovation is the ability to buy and sell and short assets globally in a way that was never before imagined. It has made currencies both more important, and less. It has given a new meaning to the concept of “barter” if I can sell my REIT holdings to buy your energy holdings to hedge against my increasing gas prices – all happening without the physical exchange of any traditional currency.

In this new environment, investors that don’t analyze relative valuations will be missing a key ingredient to long-term success.