Search This Blog

Monday, July 26, 2010

A World of Correlation Doesn't Mean Diversification Isn't Important...Or That Stockpickers are Going to Do Better

John Authers, like most of the FT commentators is an intellectual force to be reckoned with something that can't be said for too many commentators in the major US financial publications. Yet in this article on the increased correlation among equities around the world I think he overstates the case a bit.

Investors face a world of correlation
By John Authers
Published: July 23 2010 23:13 | Last updated: July 23 2010 23:37
The world trades in unison. Many bright people spend many long hours pondering which stocks, sectors or countries to buy but, of late, it scarcely seems to matter.
You can see this phenomenon clearly at the national level.... US, Europe and Japan have performed, in dollar terms, since the financial crisis began to break out in February 2007. There have been wide differences in the way their economies have responded over those years but, at any one time, if you know how any one of those regions is performing you have a great steer for how the others will move.
The same is true, with a twist, for emerging markets. Unsurprisingly, they have been more volatile than developed markets. But, with the brief exception of a few months in late 2008, they have also consistently moved in the same direction as the developed world.
Perhaps more startlingly, correlations are even increasing at the level of individual stocks. This week, the Financial Times reported that the correlation between individual US stocks is now higher than it was in the aftermath of the Lehman Brothers debacle, when virtually all stocks were simultaneously marked down. Correlation between the biggest European stocks is also almost perfect.
As for the popular distinction between value investors, who look for companies that are cheap relative to their fundamentals, and growth investors, who try to pick companies when their earnings are in a growth spurt, there are again no distinctions of late. Value and growth indices have constantly moved in the same direction and scarcely diverged.
Of course the above is correct: equity markets move in tandem and increasingly so. But that is not the same as it not making much different which equity classes are held . Here are the one year returns for several equity asset classes
emerging markets 15.7%
eafe (developed) 5.4%
US total mkt   14.3%
US large cap  13.8%(value 14.6% growth 13.1%)
us small cap   19.2% (value 20.7% growth 17.8%)

Looking at the above there is no doubt that investing in any equity asset class would have put you into equities moving in the same direction. But to argue that it doesn't matter where one invests geographically or in terms of market cap or even style is not at all accurate. Hence Auther's conclusion is not fully correct

This has discomfiting implications. Painstaking work crunching through balance sheets appears to be beside the point. Rather, the job now is to spot the direction of the market and buy on that basis, without bothering to pick stocks. Getting the macro picture of the markets right is all that matters.
There has long been evidence (and debate) to argue that the likelihood of consistent success in picking individual stocks is quite low. In point of fact the evidence that the "painstaking work" of crunching numbers ever yielded profits is quite thin,

 Spotting the direction of the macro market would indeed be a valuable skill although again few seem to be able to consistently time the market.

So perhaps its not such a bad thing to abandon hope of stock picking and market timing success, But it might make sense in an equity allocation to stray from a simple cap weighted indexing strategy. Such a strategy overweights large high p/e stocks and underweights the holdings of stocks of developing countries relative to their current and future shares of world GDP. Thus some version of a tilt towards small and value stocks and a tilt towards emerging market stocks relative to their weighting in market cap based indices is justified.

Authers points out reasons for this increased correlation

First, the “good” reasons. Companies are getting bigger and more truly international.
Second, there are good reasons for the macro to dominate the micro. The great chastening of 2008 showed investors that a financial crisis can gobble up all the differences between companies..
His most interesting point(below) regards the feedback loop that exists in financial markets (a factor missing in the academic models of finance) George Soros calls in "reflexivity" and the way new financial instruments are not just part of the financial markets but they actually change them what Richard Booksataber refers to in his great book of the same title as Demons of Our Own Design:

  • Investors lose faith in the ability of managers to pick individual stocks and move to low cost etfs
  • Volume in exchanges tilts towards the etfs rather than the individual stocks
  • The indices start to drive individual stocks rather than vice versa
  • Profitable stock picking becomes even more difficult as macro factors drive the markets.
  • Professional traders and active individual investors move from trading individual stocks to taking macro views through etfs on broad markets or sectors
  • Add in the factor of leveraged trades and derivatives on the indices which exacerbates the volatility and momentum trading.

the tail now wags the dog. Indices of stocks drive the prices of individual stocks

Authers writes:

But high correlations are not just a symptom of the extreme uncertainty that naturally follows an extreme event. The way the markets behave has been driven by the way investors invest.
Passive index funds have grown to take a greater share of investors’ money over the past few decades. In the past decade, these funds have increasingly done business in the form of exchange-traded funds, which can be traded on exchanges on a minute-by-minute basis.
There are good reasons for this, as index funds carry low costs. The problem is that as ETFs account for a greater share of each day’s turnover, so they become more critical in setting the price. If there are big sales of an ETF, it does not sell the stocks that seem most overvalued; it sells stocks in proportion to the index. Hence stocks tend to rise and fall together.
Macro factors should dominate at present but not to this extent. The more investors behave on the assumption that the macro is all that matters, the more it tends to be true – and the greater the risks that stock prices get out of kilter. If the market ever calms down, the indiscriminate way investors now allocate their money should create a killing for those who pick their stocks carefully.

Authers conclusion imo falls into the "hope springs eternal " argument I see no reason to believe that stock pickers are no more likely to consistently beat the indices in the future than they have in the past.

Thursday, July 22, 2010

Can You Make Money Using Behavioral Finance ?

I am a big fan of behavioral finance. I think it is an essential antidote to the rigid efficient/rational market thesis. The whole debate is outlined brilliantly and without a single equation in Justin Fox's book The Myth of the Rational Market. In my work as an advisor and in my personal investing it is extremely useful to use the insights of the approach that incorporates psychology into investing in performing "behavioral therapy" on my clients and myself to prevent the well known traps that investors fall inot which are so well described by Daniel Kahneman and those that followed in his footsteps.

On the other hand I have great sympathy for those that have criticized behavioral finance as having many interesting 'stories" but no overarching theory. As a correlate they point out that behavioral finance doesnt identify any particular anomalies that can be systematically exploited for a profit. The market may not be rational, it may be subject to bubbles and busts where price is not equal to value. But it remains what is called 'weak form efficient" there are no systematic ways to consistently bear the market.

In light of that I found this article from the FT about a fund that is trying to put the insights of behavioral finance to work in an investing strategy quite interesting. My bolds, my comments in blue.

Decoding the psychology of trading

By James Mackintosh
Published: July 16 2010 20:28 | Last updated: July 16 2010 20:28
Before you even started reading this article, it had already been electronically scanned and its language examined by dozens of computers at hedge funds and investment banks.
At MarketPsy Capital in Santa Monica, California, remote servers will have rated how positive or negative it is on the economy and checked for emotional content on thousands of companies. Finding nothing useful, the computers will then move on.
From the tens of thousands of newspaper articles, blogs, corporate presentations and Twitter messages being analysed every day, MarketPsy builds a picture of investor feelings about 6,000 companies. When emotions are running high, the hedge fund steps in and trades.
MarketPsy is tiny by hedge fund standards, but it is at the cutting edge of behavioural finance, the intellectual offspring of psychology and economics.
Like others focused on behaviour, MarketPsy has long since discarded the idea that investors are rational, and tries instead to judge exactly how irrational they are. The answer is simple to explain, if hard to implement: two standard deviations of moves in its measures of emotion is a strong trading signal. When people are deeply gloomy about a stock, it is time to buy; when they are raving about its brilliance, sell....

Anybody who does behavioural finance will tell you they buy when people are overly pessimistic [and so the price is low],
 I would disagree with this. As is mentioned in the article below those that believe in behavioral finance believes that markets overshoot and that there is a momentum factor in the market. That momentum factor has been well documented in academic research. It is also a basic element of technical analysis, long dismissed by academics but now given more respect by some of them including the well respected Andrew Lo of MIT. When a technical analyst is trading based on a price crossing the 200 day moving average he is trading based on momentum. And whether the  technician explicitly acknowledges it or not believe in momentum in markets is part of behavioral finance.

Not surprisingly the use of behavioral finance has a mixed reccord in creating alpha:

The strategy worked beautifully through the crisis, returning about 45 per cent in its first 12 months, and 30 per cent last year. This year it has lost money, after getting caught the wrong side of short squeezes in biotech companies (as a result it no longer trades biotech, with Dr Peterson concluding there is too much insider information in the sector).
I have the sneaking suspicion that in the future there will be another type of stock that doesn't peform as hoped and another post facto reason, After all was it that there is too much insider information on biotech stocks as a group or was there something unique to biotech stocks in 2010 or to a couple of individual biotech stocks that created particularly large losses.
Furthermore it already seems that whatever "alpha" existed related to the behavioral strategy is extremely difficult to catch on an ongoing basis:
More seriously, the number of trading ideas has shrunk 40 per cent, as day traders give up and chatter on web sites plunges. “There’s probably emotional exhaustion,” Dr Peterson says. “The people who are still trading are a lot more savvy than they used to be.”
Still, the public has woken up to the failure of the efficient market hypothesis, and behavioural finance is an obvious beneficiary....
It is results such as this that have persuaded the biggest names in investing that they need to pay close attention to the theories behind market psychology.
Mohamed El-Erian, co-chief executive of Pimco, one of the world’s largest fund managers, reels off technical terms from the language of behavioural finance to explain market moves,....
Pimco uses behavioural explanations to help understand markets, and also as a structure to try to avoid being caught up in the type of irrational investing the academics have documented.
Yet behavioural finance has plenty of critics. It doesn’t, they note, provide an intellectual framework for its findings. Even Prof Ariely agrees that “behavioural economics is a collection of facts, not a complete theory”.

Here is the crux of the paradox of integrating behavioral finance into aninvesting strategy:
For investors, many fund managers who use behavioural approaches end up with much the same bets as traditional “value” or “momentum” managers, who exploit anomalies in markets identified decades ago.
Christopher Blum, chief investment officer for behavioural finance at JPMorgan, the US bank, admits that there may be overlap in trades driven by psychology and those driven by value or momentum. The difference is that behavioural finance investors understand why their trades work, he says. “Behavioural finance is really an explanation of why markets behave the way they do and why they are inefficient.”......
Andrew Feldstein, chief executive of BlueMountain Capital, a New York hedge fund, agrees. “When you can explain [price distortions] in terms of psychology it gives you much more comfort in taking advantage of opportunities,” he says.
Of course, followers of traditional academic finance also had an explanation, at least for the outperformance of value stocks, those that have been beaten down in price: they are higher risk, and so provide higher returns.
 The above summarizes the intellectual debate brilliantly. Researchers led by Eugene Fama and Ken French for years have presented data related to the outperformance of  value and especially small value stocks. Despite the fact that many of the traditional risk measures did not show these stocks to be riskier Fama a hard core efficient markets proponent insisted that other risk factors accounted for the outperformace. Withoug reconstructing the entire debate others argued the anomaly was due to behavioral factos. In a more recent paper Fama has reluctantly acknowledged that not all market participants may be profit mazimizers hence price my deviate from value in some stocks. (Justin Fox goes through all of this material extremely well)

 As I noted academics have long noted a short term momentum factor in stocks which could not be explained other than by incorporating concepts of behavioral finance.

The fact that we know that value strategies can be profitable and that there is a momentum factor creates the paradox that we know a priori how difficult it is to make money based on behavioral finance.

  • The insight with regard to markets overshooting that leads to profitability of value strategies. Would lead the behavioral trader to sell stocks that have had large increases in price relative to earnings or book value and sell those that have fallen in price.

  • The existence of momentum means that stocks can continue to be "over" or "under" valued for significant periods of time. As Keynes noted "the market can be wrong longer than you can hold onto your position". Of course once leverage and shorting is involved this is particularly true. And momentum can turn extremely quickly there is no consistent way to exploit the momentum factor.
The proof of the difficulty of profiting from these factors can be seen in the wide swings in profitability of hedge funds which make consistent use of momentum and shorting of "overvalued " trades.

So as a firm believer in behavioral finance how do I use it in my investment management process ?

  •  I do find the evidence of a long term outperformance of value stocks. Rather than trying to pick value stocks or managers however I make use of etfs based on a value strategy giving a value "tilt" to a portfolio.
  • Markets are subject to bubbles and busts even if they can't easily be predicted. The instruments available to "buy volatility" like the VXX and VXZ etns can be incorporated into a portfolio to hedge against this.
  • Pointing out to myself and my clients when we are falling into the well known behavioral finance pitfalls can be as important to investment success as any other factor.
I would certainly agree with this (below) the fund management industry has found a new buzzword ("absolute return" is so 2008). No doubt we will soon see the marketing blitz of behavioral finance funds with fat fees. My advice would be to buy some cheap value etfs instead

One thing behavioural finance academics did not have to discover was that the finance industry jumps on any new trend. So it should be no surprise that many fund managers have been rebranding their business as based on the discipline. “It has been co-opted as a marketing gimmick,” Dr Peterson laments. That behaviour, at least, was entirely predictable.

Goldman Gets Hit By The Black Swan As It Shorts Volatility

Seems that in at least one case Goldman's clients were savvier than their market maker.Clients took on the equivalent of the black swan trade (that can be done with the volatility etns) apparently buying volatility directly from Goldman with over the counter derivatives. Instead of hedging Goldman apparently sat on the short volatility created by the client trades.

 From the WSJ: (my bold)

...When the financial markets are topsy-turvy, Goldman Sachs Group Inc. has a knack for finding a way to profit from the turbulence. That didn't happen in the second quarter.
Goldman reported an 82% profit tumble, hurt by a surprisingly steep decline in revenue that included a wrong-way bet on the stock market's volatility. The New York company didn't disclose the size of the loss, which occurred in its equity-derivatives business and is an unusually large blunder given Goldman's reputation for prudent risk management....
... the firm made a costly decision not to completely hedge bets made by customers that the market's volatility would rise during the second quarter. "We were directionally wrong," Mr. Viniar said.
Asked whether Goldman itself made a mistake in the firm's view of turbulence in the market, Mr. Viniar responded that Goldman "didn't hedge it fast enough."
One managing director on the stock-derivatives desk that is responsible for the losses recently left Goldman, and other employees in the unit are considering leaving, according to people familiar with the situation. The departed managing director was a salesman. Goldman declined to comment.
Earnings for Goldman Sachs slid 82% in the second quarter, socked by its settlement with the SEC and the U.K.'s payroll tax. Paul Vigna, Neal Lipschutz and Bob O'Brien discuss. Also, John Bussey discusses why the Senate is poised to extend unemployment benefits for 2.5 million Americans after three previous attempts failed to gain sufficient Senate support.
As a result of the losses, "the most striking shortfall on the revenue line was equities trading, 

Thursday, July 15, 2010

The Little Guy Seems Always to Chase the Mkt

I often hear that the market is "rigged' against the individual investor. It seems more likely to me (and anyone that has studied behavioral finance) that the major thing that "rigs" investment markets against the individual is the one that the investor can see in the mirror.

From the WSJ

For the week ended July 7, ICI reported stock funds had outflows of $4.23 billion, compared with $216 million a week earlier. U.S. stocks had $4.12 billion withdrawn and $112 million was withdrawn from foreign funds.
Bond funds took in $6.02 billion, compared with $3.49 billion the previous week, said ICI. Taxable funds had inflows of $5.04 billion, while municipal funds added $979 million

S&P 500 return form the beginning of the week cited (jun 30) till July 14 +6.5%
Aggregate bond index (etf AGG) return for that week = 0

S&P 500 return form the end of the week cited (jul 7) till July 14 +3.3%
Aggregate bond index (etf AGG) return for that week = 0

one month chart for the bond aggreate index

one month chart for the  sp  500 (spy)

at least for this period the major outflows from stocks came at the bottom and the money that flowed into bonds has done nothing.

buy high sell low based on emotion and ;looking into the rearview mirror  is it really a "rigged market" that is the major enemy to individual investors ? or as shakespeare said "the fault methinks lies within"?

Monday, July 12, 2010

I Thought hedge Fund Managers Were The Guys Who Did intensive Research to Find Inefficiencies and Undiscovered Opportunities For Their Strategies and Profits...

.....instead it looks like many of them are joining into what has to be the most crowded trade in many years. And  many are later to the party than the most unsophisticated individuals who have been getting their strategic investing advice from advertisers on Glenn Beck and talk radio advertisers.

It seems that rather than depending on fundamental or quantitative research many hedge fund managers are content to simply ride momentum. Given the hedge fundies propensity for high leverage the potential for a crowded trade like this to trade down with a venegance if/when the market reverses the hedge funds once again are hardly hedged at all but simply taking large leveraged positions.

The FT reports  on the hedge fund rush into gold (my bolds and my comments in blue)

Hedge funds look for a golden edge

By Sam Jones and Jack Farchy
Published: July 9 2010 19:10 | Last updated: July 9 2010 19:10
Not so long ago, hedge funds would send their most junior analysts to the seminars that bullion bankers hosted.
Gold, for much of the past two decades, was the ultimate dreary asset – of interest only to central bankers and miners.
Now those same bankers are struggling to find time in their diaries to fit in many of the hedge fund industry’s biggest players.
In mid-town New York, funds that employ barely 100 staff are finding themselves with gold holdings larger than those of some developed nations.
Paulson & Co, one of the world’s most successful hedge fund managers, denominates a third of its $33bn of assets under management in a share class bolstered by huge positions in the gold market.
In fact, gold is the firm’s largest single position.hedge managers are becoming increasingly bullish about the precious metal. They are drawn to gold’s traditional status as a store of value in crises. 

Look at the gld chart aqt the top of the page doesn't it appear to any observer that it is rather late to become "increasingly bullish" . And are they really drawn to gold because of analysis of the economics are simply being afraid of missing the party ?

This expectation of further prices rises (gold has increased four-fold since 2002) is based in part on the view that bullion provides a hedge against a rise in inflation.
Some fund managers believe a sharp jump in inflation is unavoidable as a result of central banks’ monetary easing policies, which have, in effect pumped more money into the economy.
Historically, they say, the correlation between gold and inflation is hard to ignore.
Over the past half century, the gold price has tracked the amount of money in the world – measured broadly in terms of “M2” monetary supply – fairly accurately, peaking at times of inflation, such as the mid-1970s and early 1980s.
The hedge funds argue that the recent swelling of the monetary base will translate into a spike in monetary supply. When it does, gold prices will fo

I have pointed out the flaws in the above arguments several times:

1. the message of the market coming from the bond market is for anything but inflation in fact deflation is the forecast. The 10 yr treasury is at 3.07% and with the ten year tip yield at 1.21% the implied inflation forecase is 1.86%. Surely a more direct way to play a view on higher inflation is to short the long end of the treasury yield curve and/or to short tips, 

2. Although I am far from a Friedmanite on many issues it is inconsistent adopt monetarism ala Friedman ("inflation is primarily a monetary phenomenon" ) without at least paying attention to Friedman's entire approach relating increases in money supply to inflation. If the money supply is increased but economic activity doesnt increase and the velocity of money doesnt increase there is no or little potential for inflation. The central bank is effectively "pushing on a string"

I found this quote from Samuelson (on wikipedia of course) which well describes the current situation. In order to get to inflation one would even have to get past the point of weak demand into a situation of excess demand/inadequate supply and inflation, Seems to me that seems a minimal risk for the foreseeable future.

In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. “You can lead a horse to water, but you can’t make him drink.” You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs.

 at least some analysts like those above at lease are seeing a yellow light

“The number of funds who are exposed to gold has increased massively in the last three or four years,” says Philip Klapwijk, executive chairman of GFMS, a precious metals consultancy......
Many analysts agree that gold is likely to set fresh nominal all-time highs in the coming months. But they also see the weight of investment in the metal as a warning signal.

Mr Klapwijk says the rush to invest in the metal is not irrational. The motivation is fear about the debasement of paper currencies and of a panic in markets fuelled by any worsening in the eurozone debt crisis. But he also says that gold currently has “elements of a bubble”.

It seems to me the rush into gold both by individuals and supposedly sophisticate investors is not based on sophisticated economic analysis but has one simple rationale: trying to ride momentum

more evidence of the unsophisticated analysis (rationalization) leading to gold bullishness is evidenced from what should be one of the most sophisticated sources in the world:

Jeffrey Currie, head of commodities research at Goldman Sachs, points to a strong historical inverse relationship between gold prices and real interest rates. The time to sell, he says, will be when the economy returns to normal.
“It’s pretty simple. Just stay long until real rates rise, likely driven by central banks taking liquidity out of the system.”

 Why, if what could bet directly on real rates rising either by going short long term bonds or tips would one enter into a trade that has already factored in high guture inflation. Real rates go up long term bonds and tip prices go down it is a almost a certainty (for tips it is an identity real rates up tip prices down, The logical trade is in the bonds. That is truly" pretty simple"

Put me in the camp of the skeptics below.

“Don’t forget, gold is also a commodity with supply and demand fundamentals that can come into play,” says Mr Klapwijk.
Some managers are all to aware of the distinction, and view with derision the bets of their colleagues in a market they know little about.
“The problem is that people see it [gold] as both a commodity and a refuge,” said the manager of one London-based macro hedge fund. “It is not really a liquid instrument and there’s a danger that the market is being cornered.”
Paulson &;Co remains optimistic that the trade is not crowded(!!!). In a presentation to potential investors, salesmen from the firm point out that gold ETF holdings amount to $78.3bn,a fraction of the $2,849bn held by US money market funds. The implication is that, with massive unconventional monetary easing under way, gold will become the ultimate store of value.
All of the above in my view is addition evidence that hedge fund managers are often merely high risk leveraged momentum players. As a consequence at times they may have outsized gains.....and losses. Which leads me to (again ) conclude that on a risk adjusted and fee adjusted basis hedge funds are not a particularly attractive "alternative".

Thursday, July 8, 2010

Looks Like The Black Swan Trade is Getting Crowded

It's been  months (first time was in april) since I first wrote about using volatility etns as a hedge against extremely turbulent markets. It seems that investing in these instruments has become quite fashionable as reported by Jason Zweig in the WSJ: (my comments in blue and my bolds)

Hazardous Waters: Should Investors Bet on Rising Risk?