MarketDNA Blog - 4Q 2009 Review

Year 2009 has ended; modern society did not end, capitalism is still standing – at least nominally – and the banking system is still nowhere near a true resolution of its role and responsibilities after “the beginning of the end” started over a year ago.

2009 was a strange year; dubbed “the Great Recession” this economic period which has followed the excesses of the past decade resulted in a magma of monetary and fiscal interventionism, superficial stabilization of the financial system, historically large unemployment and more confusion on the future of our economic model.

Capitalism survived but only nominally as central bank intervention – albeit mostly unavoidable – corrupted the true price discovery process of most asset classes. The law of unintended consequences is already at work and those who actively engage in financial activities – whether virtually by trading or on the ground by building businesses – have already felt the winds of change. Markets do not move as they used to and micro and macro economic dynamics do not interact as business schools have taught us for decades. Political divining is now more important than ever as an element of decision-making and so is subtle understanding of monetary policy. If the last 25 years were the poster child of aggressive entrepreneurship, the next 25 – or at least the next 10 – will probably require superior coziness with government and its modus operandi.

But what does all this mean for the future of investing? How should we position ourselves and where should our chips land? I believe that the fluidity of the situation requires flexibility, diversification of asset classes and strategies and much work toward aligning your interests with governments. More specifically, I believe, asset class timing must be part of the process and alpha driven strategies should be the core of every portfolio. 2010 may bring about the kind of environment where investors should be prepared for constant cross-currents and no defined trends. Equities may still do fine as a result of liquidity pressures and by benefiting form potential pockets of re-surging globalization but I see their action collared. If in the nineties we learned to trade the “Greenspan put,” this new dawn may bring about the “Bernanke collar.” Unless global GDP growth wildly exceeds the expected 4% rate, it is difficult to imagine significant multiple expansion therefore capping more price upside. On the other hand, stocks are not as expensive as they have been for most of the last 15 years and they should benefit, in case of sudden economic dislocation, by the generosity of global central banks which understand very well the role of confidence in perpetuating the system. Volatility is hovering around its 15 year moving average (as measured by the VIX) indicating neither panic nor complacency within an historical perspective. Diversified high yield portfolios still seem to make sense in a world where yields are very compressed; MLPs and fixed income closed end funds still bring value to the table but timing and risk control are still forefront issues. The spread of MLPs as an asset class versus the 10 year Treasuries has now fallen below 400 basis points and also on a case by case basis and on quarterly schedule, spreads are at low levels indicating short-term caution. The key term is short-term; on that level most studies I have been looking at are flashing caution for equities in general: corporate insiders sales, smart/dumb money spreads, stock/bond ratios, options indicators. Mid January could present us with a tradable correction. A more pronounced two way trading than the V shaped momentum driven environment typical of 2009,would play well for alpha strategies and would allow for options strategies like ours to outperform the benchmarks.

The elephant in the room could be the US Dollar. The greenback has showed an inverse correlation with equities for much of this decade as part of the liquidity/leverage boom bust cycle. The degree of bearishness on the USD reached significant levels in the last quarter of the year and eventually resulted in a strong rebound; at this point a lot of USD bearishness has been corrected and the outlook for next year depends on many variables. The bearish argument resides on the idea of massive FED money printing and large fiscal deficits; while I cannot argue against this idea, I would caution on the timing of it. As of now the FED has not actually printed much money and most of its intervention was either done thru electronic adjustments and stabilization types of credit facilities; most of the liquidity injected is just sitting on banks balance sheets and it is very short term in nature. Should that liquidity be channeled into the real economy and multiplied by our fractional system then the inflation worry would grossly materialize. This scenario may be one to two years away and it is subject to many variables. In this case, the USD would suffer and equities could increase in nominal values. On the other hand, I think a more likely scenario in the intermediate term is a continuation of the deleveraging of private sector balance sheets; this would entail a stronger USD and possibly sagging equities. I feel a stronger Dollar is in the cards also because of its relative position versus the Euro; while we have significant issues to work thru in our effort to stabilize our economic cycle, I believe Euroland has higher sovereign risk (Spain, Greece, Italy, Baltic States) and more structural and political restrictions to maneuver.

What the USD may do in the next twelve months has repercussions on commodities as well. If the USD gets stronger, there would be less pressure on commodities (priced in Dollars globally) to re-adjust upward. However, if all global currencies accelerate the new trend of competitive devaluation, then commodities and gold especially will continue to benefit from investment flows. Political divining and close monetary policy scrutiny will be paramount in dealing with this unfolding issue.

In conclusion, I would like to take a moment to thank all of our clients that believed in our strategies, risk management and unbiased analysis. At Cervino Capital Management LLC we strive every day (and almost every night considering our different shifts) to be the best money managers and we relentlessly push the boundaries of our talent in the never ending quest for alpha.

Beta(ful) Market Hypotheses

In my many years as a derivative trader and hedge fund manager, I forged a solid and long lasting relationship with risk. Like a beautiful but dangerous woman, risk permeated my professional life—a constant courtship leading me to many attempts at fully understanding its mysterious ways… a never ending effort!

The theoretical foundations of risk analysis were laid in business school where I diligently learned of Alpha and Beta, Random Walks and Efficient Market Hypotheses (EMH). These theories were elegant and pure, like a fresh mantle of snow they seem to perfectly cover all market uncertainties and provided a boost of confidence to a young man ready to leave his mark in Wall Street.

Yet, the one reason why I was fascinated by the markets was the mesmerizing and intellectually challenging example of hedge fund manager extraordinaire George Soros. His book “The Alchemy of Finance” seemed to directly contradict EMH and his track record seemed to be damning evidence. Nevertheless, one of my first large successes came from the application of the bell curve to index returns for an option strategy. It worked like a charm in the roaring late nineties.

This initial success aside, every night I could not shake off that feeling of disconnect from theory to practice. Yogi Berra once said: “In theory there is no difference between theory and practice, in practice there is.” Indeed, while the trading model was successful, the distribution of returns seemed way out of line with even a fat tail distribution. Adding to my discomfort it was the clear pattern of price dependency upon past changes (the H factor as Mandelbrot defines it) versus the theory of price randomness.

In 1999 and in 2000 we witnessed a ridiculous bubble in internet and technology stocks and a consequent blow up—a dynamic that really should not have happened in the EMH universe. During 1999 I had decided to tweak my model and added heavy behavioral components. I think such changes saved me from terminal disaster in 2001, 2002 and more recently 2008.

In spite of evidence of misleading logic and cracks in the foundation behind the concepts of Beta and EMH, the theories are still wildly popular among academics. Academic politics and group thinking may be the cause; after all, almost every economist in the country is one way or the other on the Federal Reserve payroll for example. Yet Beta and EMH are now under attack not only by behavioralists but by mathematicians as well. Benoit Mandelbrot, one of the most influential mathematicians of our times, is again very vocal—he started his critique 40 years ago and was derided by the mainstream---against these alluring but ultimately deceiving theories. Paul Wilmott also has been active in his criticism.

The idea that equity returns are random and therefore should be expected to fall in line with Gaussian distribution models is a bizarre conceptual starting point. While many natural events follow such distribution, why would something like investment returns follow a statistical order? Aren’t stocks prices the result of fear and greed? Aren’t financial markets the making of highly emotional beings? Isn’t information asymmetry a major issue in financial markets? If anything, a clean statistical distribution should have been a last resort explanation for price formation rather then a starting point.

The real world does not move neatly—markets are messy and simple mathematical relationships cannot capture reality. Equity prices can be explained by more logical (yet less statistical) structural and behavioral relationships. The Capital Asset Pricing Model armed with the false fortitude of the bell curve, reduces everything to one variable, Beta, to explain risk. Does one variable for a system as complex as financial markets make sense?

The buy and hold theory forced stocks in people’s portfolios even when valuations were clearly off on the assumption of a consistent equity risk premium. This dynamic snowballed into the commercial explosion of beta-driven portfolios and unhooked Wall Street from any effort to produce intelligent analysis. Portfolio management reduced its legal liabilities and turned the large majority of the asset management universe into a huge marketing machine sucking in money flows which perpetuated the fallacy.

Beta is dead, long live Beta! Or perhaps it never existed. Maybe Beta was just a mirage of an industry looking for order and economies of scale. In the end, however, investment returns were proven to be influenced not by statistical distributions but by real issues.

Financial markets are highly reflexive as George Soros pointed out 25 years ago, and as a result, equity prices are dependent on the past. Momentum is a constant component of price formation. Also, the structural dynamics of the money management business are clearly heavy influences in stock prices—the heavy hand of relative performance among money managers and the problem of career and business risk are two of the most important influences in the process of pricing investments. Tax issues and the changing regulatory environment are certainly more important drivers of prices than the Gaussian distribution. Not to mention social contagion, feedback loops, and of course changing technology.

The smart money manager must rely on a much more sophisticated framework than just the bell curve. I like to approach my investments following a 4 level framework, and ex hedge fund manager turned media entrepreneur Todd Harrison follows a similar approach:

- Structural overview. An analysis of the political, regulatory and technological environment.
- Fundamental overview. Valuation analysis like Cyclically Adjusted Price/Earnings ratios and others.
- Technical market make-up. Momentum, mean reversion, support and resistance, volatility.
- Sentiment overview. A comprehensive behavioral analysis.

Comprehension of financial markets and the risks they inherently breed is a never ending process. As elegant as Beta and EMH were they were clearly not the answer.



Sources:

Benoit Mandelbrot, The (Mis)behavior of Markets, Basic Books, New York, 2004

James Montier, Insight: Efficient Markets Theory Is Dead, Financial Times, June 24, 2009

George Soros, The Alchemy of Finance, Wiley and Sons, 1994

MarketDNA September 25th, 2009

This week the market finally finds some resistance at new relative highs (1080), a level consistent with last year’s October breakdown. Whether this is the beginning of the much awaited correction it is way too early to say; the bears have been faked out so many times this year that I feel it will not be so easy to break the upside fever.



I have been reluctant to increase long exposure for a couple of months as valuations seemed to get more and more disconnected with reality. David Rosenberg quoted a few interesting stats on FT yesterday on market valuations: an unprecedented 8 point p/e ratio expansion in the last six months of rally which made the SP the most expensive in seven years – 26 times operating earnings and 160 times reported profits. Rosenberg goes on mentioning some history: every time the p/e ratio on trailing earnings goes above 25, the average total return after a year is a negative 0.3% and a median negative 6.2%.



The bulls argue that after a deep recession GDP grows north of 6%, even 7%, and stocks now are pricing forward 12 month growth of only 4%. Frankly I think 2% next year will be a blessing (which coincidentally is what the corporate bond market is pricing) which would put the SP500 at 850, maybe 900 at best. In any case, there are so many cross-currents that forecasting forward EPS is more uncertain than usual which does not warrant a huge multiple expansion. The other perma-bulls who constantly quote low inflation and interest rates as major elements explaining p/e expansion must have missed the last 24 months of economic history and what those low levels really mean.



All this considered, this year highs should not be pierced significantly, if at all, but, again, I am not so convinced the correction will be hard and scary as performance anxiety, huge levels of cash and good ol’ greed will probably lead the show into year end. 2010? I fear a whole other story. Perhaps 2010 will usher back two way trading and alpha driven money managers will be useful again (I know I know I am spinning my story…).



Another potential scenario for 2010 is a continuation of the major rally as a nominal increase in price will be met by a constant devaluation of the dollar, abysmal monetary policy by the FED and a rally in gold. This plays contrary to my idea that USA is now spelled Japan and our own deflationary cycle is only getting started. Marc Faber and a few other managers I respect are out there building portfolios around this scenario.



In currencies, I think the Euro is overvalued but it does have a tendency of finishing the year strong so I would like to buy any substantial pull-back into November for an EOY rally. The Yen is getting stronger, seemingly on Japanese corporations profits repatriation, and if that is indeed true, it should be a very fleeting move. I cannot make any intelligent case for the Yen getting stronger.

Disclaimer:

The above writing is not intended as a trading or investing recommendation

The Danger with High Frequency Trading

The Danger with High Frequency Trading

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MarketDNA Blog September 3rd, 2009

The telegraphed day of reckoning has finally arrived and many commodity ETFs (ETNs) are now finding themselves in the regulatory line of fire.

I have been on the record with my MBA students and with many of my colleagues in the investment business for quite some time on the multitude of problems associated with commodity ETFs and now it seems corrective actions are being taken.

Just recently UNG, the ETF which attempts to track nat gas futures performance, was subject to massive price distortions. UNG built a premium in its price versus its NAV of as much as 20% due large inflows of money; these inflows reflected investors’ bottom fishing but UNG was suddenly unable to expand its position due to an abrupt fear of breaching position limits in the futures pit. When an ETF cannot deliver on its strategy for regulatory fear, the model is pretty much broken.

Along the same lines, today we hear Deutsche Bank will close down its leverage long oil ETF due to similar concerns. D Bank is not having a very good streak as its agricultural commodity ETF was also stripped of its exemption on speculative limits in the correspondent futures markets and therefore will find it more arduous to continue with the same business model.

Since their inception, I have been a great advocate of ETFs in general but commodity ETF specifically were always ridden with issues. From a regulatory point of view, these were hybrid products, which were backed by derivatives and yet traded like securities avoiding proper scrutiny. By using futures to manufacture tracking performance for the equity investor, they were also inherently leveraged bypassing leverage restrictions normally applied to equity products (this is an issue with index ETFs as well and not only with commodity related products).

Commodity ETFs, furthermore were practically built on the wrong assumption of permanently long only products with obvious price distortion ramifications in markets like commodities built for hedging purposes. Commodities have really no beta because they are consumable, transformable and perishable asset. Frankly, I am beginning to think that the concept of beta is one massively flawed idea in every market…but this is material for another blog. The idea that equity investors should passively include this asset class indiscriminately in their portfolios was another one of those brilliant, self-serving ideas of Wall Street – always driven by the never ending search for a way to needlessly repackage risk and earn fees. If an equity investor feels the need to incorporate inflation hedging in his/her portfolio or seeks an edge in overweighting the commodity sector, there are already plenty of proper choices: TIPS, Commodity Stocks, Gold etc.

Commodity trading is just that: trading, exploitation of anomalies, price arbitrage and it should be approached in that way. Futures traders, CTAs, hedgers are the natural players in this game; ETFs…not so much.

From a strategic perspective, it is reasonable to expect a potential dull period in commodities as these ETFs may be forced to close or downsize for quite some time.

Welcome to a New Normal in commodities as well?

High Frequency Trading: The Rise of the Machines

High Frequency Trading: The Rise of the Machines

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Market DNA blog August 21, 2009

1025 Breakout or Fake-out?

A 55% run up in prices since the March lows require some attention and analysis; most striking is not only the magnitude of the rally but the almost total absence of retracements and volatility. 50% plus rallies off significant bottoms are not uncommon, see Japan, US 1930s and the NASDAQ in 2000 after the first bust; however, they rarely are jumping boards for additional huge run-ups. 2003 was a clear and close exception but that recovery in the real economy, reflected by stock prices, was being artificially inflated at the cost we all are now paying. Could this occur again? That is the hope of the Fed, Government and bankers. Unfortunately this time around it is a little more tricky as they are fighting a tectonic shift in attitudes: economic agents de-leveraging will continue unabated regardless of monetary injections. That is why the monetary base (controlled by the Fed) has been increasing dramatically just to keep the money supply (eventually determined by the banking system and consumers) basically flat. In other words, economic activity will remain subdued and mostly in life support thanks to constant government action until the deleveraging cycle is complete and a new technology will spark the next boom. Unemployment will remain high for years and add to the headwinds of recovery.

In this situation it is hard to understand multiples expansion in equities. As I wrote previously, equities seem attractive below 700 (on the SP500) and even below 800 but seem rather pricey above 950. At a normalized EPS level of $60 for next year and a fair multiple of 15, we have a fair market value at 900. Expand that multiple to 20 and you have 1200 and a very speculative situation.

1200 also seems to be a potential liquidity target; this morning I twittered a few bits from MF Global and their predictions based on taking the money market funds back to trend-line (a decrease of about $400 bln) and the SP500 reaction to such an occurrence and their model predicts 1200, on liquidity only.

I can’t read much in this summer doped market action; while HFT agendas meet PPT guidelines most measures, fundamental and technical, call for dangerous waters ahead. Everyone expects the ides of September to bring the much awaited correction, just in line with the historical negativity of autumn trading; however, this pervasive certainty makes me uncomfortable, in spite of my bearish bias. Market perversion would dictate multiple failed attempts to get short in September followed by another unexpected speculative rally into November and just when everyone takes out the celebratory eggnog glasses, a bear raid will make everyone feel like the Grinch stole Xmas again.

Tight stops, risk management and size management are still your best friends out there.

Disclaimer:

The above writing is not intended as a trading or investing recommendation