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Thursday, January 27, 2011

as expected

see previous (jan 13 post)

wsj Jan 27'

Gold Slumps to Four Month Low

wsj jan 25

ETF Investors Slowed Gold Investments in 2010 

and first of many stories of this type large medium and small:

wsj  jan 26

Small Gold Trader Makes Big Splash

Daniel Shak's Aggressive Bet Grabbed Sizable Chunk of Contracts, But Prices Fell and Wager Went Bad

Thursday, January 13, 2011

Food Riots, Increased Fear of Inflation , Sovereign Debt Crisis and Continued Currency Crisis...But Why Isn't Gold Going Up ?

Looking on a global basis it would seem that the world is far closer to the gloom and doom scenario of the gold bugs that at any time in the last 2 years (or more)

  • Surging prices in the commodities that fuel actual inflation: oil, food, and base metals.
  • As a consequence food related riots and demonstrations in the thrid world: so far India, Bangladesh,Algeria and Tunisia(top photo)
  • High inflation in Brazil (8%) and elsewhere in Latin America due to strong currency and high commodity prices.go
  • Sovereign debt crisis in Europe currently focused on Portugal .
  • As a consequence of that debt crisis a weakening trend for the Euro.

Yet just as these crises are identifying gold has barely budged while other commodities have surged. Below th is a chart for the last three months (click to enlarge for gld (gold in green) +1%, FXE (euro etf red)-5.9%,USO (oil etf black) +7.8%,DBA(agriculture blue)+11%.,DBB(base metals yellow)

Why is this happening ?

The Gold rally hasn't really been based on economic analysis. Those with an economics bent can't see a rationale for owning gold: it neither has any actual use (other than jewelry) and doesnt pay interest. The only rationale for holding it is the prospect of being able to sell it to someone else at a higher price.

On the other hand the commodites that actually have something to do with real economic activity (food, base metals and energy) are responding to real economic forces be they growth in the developing world or short term events that cause shortages such as weather. Doubtless once these get moving based on fundamentals a momentum factor kicks in here as well, But unlike gold there is an economic rationale.

The "analysis" that spurred the price rise were more a mantra than an analysis. Gold has historically been a poor inflation hedge. The rest of the rationale for gold rested on a provincial analysis of the conditions only in the United States but looked at globally they seem pretty thin. A readoned analysis would show they argue far more for holding other commodities as well as that paper money  hated by gold bugs...the US dollar than for holding gold.

  • Basic commodities are a far small part of US consumers outlays and thus inflation than in the rest of the world, labor costand housing s are a far bigger components of inflation and they are not going up any time soon.
  • If one is looking for apocalyptic  political instability with riors in the streets  it is  already happening in Europe and the third world if such instability leads to a flight to gold why wouldnt riots in Greece, France and Britain cause that to happen.
  • The US certainly faces a long term crisis because of tis debt but that criisis is at a far more advanced stage in Europe. Shouldn't such a debt crisis lead to european purchases of gold ?
  • Because of the European debt crisis the Euro is undergoing weakness. If the rationale response to a crisis with a major currency is to sell the paper currency and buy gold why is the money flowing from the dollar and other paper currencies instead.
  • With the prospect of the US economy strengthening US interest rates have moved up a bit making the marginal cost of holding gold a bit higher. Looking around the world that cost is even higher. Money has been flowing into Brazil where 7% interest rates and an appreciating currency make holding gold not such an attractive proposition. In a global economy all of these are alternatives.
Looking at the above developments and the lack of movement in gold it's hard not to conclude that in the final analysis the gold rally has been a pure momentum play. In other words once things got going Gold kept going up because it was going up and more and more people bought for that reason far more than any "analysis" of gold's fundamentals.

There definitely is a momentum factor in markets particularly commodity markets (there certainly is some of that, along with fundamentals driving the other commodities) we also know that such momentum plays are pretty ugly especially for those not nimble enough to get in and out early. One would expect that will be the case for retail investors.

Once the momentum slows even without sharp declines the "fast money" of professional commodity players will move out and into the commodities that seem to have momemntum. After all why hold gold if sugar,copper,oil and even stocks have upward momentum all of these are traded in the futures markets by professional commodities traders. The retail investor looking at gold as a binary buy/sell decision will likely hang on longer suffering more pain on the way down.

The FT reports

But investors are stoking the commodities bull run with some big bets. Money flows into commodities have been huge. Barclays Capital estimates $60bn was injected into commodities in 2010. Some observers believe speculative trading has sent prices to excessively high levels, making a sharp recoil likely should the fragile economic optimism fade.
Figures from the Commodity Futures Trading Commission, the US regulator, reveal very bullish bets among money managers such as hedge funds.
In late December they owned a record net “long”, or buying, position in crude oil futures and options on the New York Mercantile Exchange. In September the same types of traders held record net longs in corn.
As well as hedge funds analysing global economic trends, money managers include trend followers who use computer programs to ride market momentum and “high-frequency” traders who move in and out of positions in microseconds. Electronic traders helped send volumes last year in energy, metals and agricultural commodities at the CME, the largest US futures exchange, to a record.

Could we be on the verge of that dreaded point in the gold market when the music stops and everyone runs for the door at the same time ? It could well be.

(I can't wait to see the comments on this one)

Monday, January 10, 2011

Spending Time Readin Those Beginning of The Year Market Forecasts ? Even the Forecasters Tell You Not to Bother

A great article on market forecasts in the NYT reviewing their terrible track record, and the many reasons why it's near impossible to forecast the market. The article notes that the forecast consensus for 2008 was for a strong market. Most entertaining to me is that some of the best known names in market forecasting say that their forecasts are basically useless:

But how much credence should we place in forecasts like these?
Byron R. Wien, the veteran strategist who has been issuing market forecasts for decades and is now vice chairman at Blackstone Advisory Services, says the quick answer is this: Don’t take these forecasts too seriously, and don’t view them as the literal truth.

but my favorite quote from the article is the following:

Aaron Gurwitz, the chief investment officer at Barclays Wealth. “I don’t think market forecasts provide very useful information,” he says.
Instead, he focuses on asset allocation and on expected returns, volatility and correlations of specific asset classes over long periods. “I would really like my friends and neighbors to stop asking me whether I think the market is going up or down,” he says. “Investment strategy is the practice of decision-making under uncertainty,” he says, and it’s not wise to act as though the future is anything but uncertain.

Good advice, but even the above is difficult to do. Historic correlations are proving less and less to be useful as a guide to the future as the cross correlation of asset classes --a fancy way of saying the extent to which all classes of equities move together--- has increased over time. The past may not give much of a guide not only to forecasting market direction but also to correlations, Just another reason why investing strategy is decision making under uncertainty. Also another reason not to market time  and stock pick and  instead to have a globally diversified portfolio including stocks, bonds and commodities composed of low cos index instruments.

Wednesday, January 5, 2011

A Better Market for Active Fund Managers in 2011...or an Even Worse One

A WSJ blog reports on research from (surprise) Merrill Lynch that the future will be better for active managers than it was last year:

Active Managers in 2011: A Wheat/Chaff Moment?

December’s 6.5% melt-up on the S&P 500 caught a lot of investors by surprise, not least of which were active managers. According to numbers put out by Bank of America-Merrill Lynch yesterday, 39% of actively-managed funds beat the market in December — not bad, but lower than the 44% that beat in November.

A fortune report on the merrill reseach notes it was one of the worst year's ever for active managers

Entering December, a quarter of funds were running ahead of their benchmark indexes, Subramanian writes Tuesday in a note to clients. But another dismal month, with fewer than half of managers beating their bogies, took that number down to a dismal 20% by year-end.
yet amazingly the merrill research report argues:

With a new year upon us, and the economic recovery back on track (fingers crossed), this may be the moment to separate the wheat from the chaff, as far as active stock pickers go. With stock clustering starting to wane, good companies will likely be freer to rise on their own fundamental strengths — and weak companies more likely to fall on their inherent weaknesses. In BAML’s parlance, then, this is the year stock pickers “make a comeback,”
indeed hope springs eternal

The evidence for the above is pretty slim as it is based on a small decrease in correlation between stocks of late (and the active managers didn't have much better success during that period). In fact, the longer trend: the growth of  high speed intra day trading  and the growth of etfs which means at a minimum a high correlation of stocks within industries if not the overall market, argues the cross correlation of stocks will continue.And this can only mean a more difficult market for active managers going forward rather than a better one.

Seems whatever the short term decline in correlation the long term trend is clear. From cnbc website

Investing Dying as Computer Trading, ETFs & Dark Pools Proliferate

There's an old Wall Street adage meant to inspire investors that goes "it's not a stock market, but a market of stocks." Consider that dead.
Computer trading, dark pools and exchange-traded funds are dominating market action on a daily basis, statistics show, killing the buy and hold philosophy still attempted by many professional and retail investors alike. Everything moves up or down together at a speed faster than which a normal person can react, traders said.
High frequency trading accounts for 70 percent of market volume on a daily basis, according to several traders' estimates.
The theory that buy-and-hold was the superior way to ensure gains over the long term, has been ditched completely in favor of technology," said Alan Newman, author of the monthly newsletter. "HFT promises gains are best provided by holding periods measuring as few as microseconds, possibly a few minutes, or at worst, a few hours."

While individual investors must cede the intraday profits to the high speed traders, in my view it doesn't necessarily mean that a long term well diversified global portfolio suffers from these trends, After all if stocks are more correlated holding a broad basket for the long term should still be a viable strategy with lower fees and lower taxing helong the results.

.After all during an earlier period specialists, floor traders and institutional trading desks  in a slower trade environment profited from the daily trading flow (otherwise a seat on an exchange wouldn't have been a  valuable asset) Indivdual investors didnt get a piece of those profits either. So the more things change the more they stay the same: market makers extract a profit from providing liquidity.

In fact the argument below argues for etf portfolios rather than stock picking:

The problem is only made worst by the proliferation of exchange-traded funds, traders said. The vehicles, which make trading a group of stocks as easy as buying and selling an individual security, passed the $1 trillion in assets mark at the end of last year, according to BlackRock. This is probably why all ten sectors of the S&;P 500 finished in the black for two consecutive years, something that's only happened one other time since 1960, according to Bespoke Investment Group.
If the above has occurred for 2 consecutive years, why would there be any evidence to expect a "stock pickers" maket going forward. After all the growth of high speed trading and etfs in accelerating, not slowing.

This frustrating trend  for stock pickers is doubtless behind the latest "product" from the mutual fund industry: "alternative strategy, go anywhere funds."From the WSJ

In 2010, a growing number of companies offering actively managed mutual funds finally began to get creative in their efforts to halt the erosion of their business caused by low-cost, index-tracking exchange-traded funds....
The alternative funds are actively managed, too, but they aim to invest and perform differently from funds that hold standard investments like stocks or bonds or cash. Alternative funds may hold uncommon assets or use particular strategies that historically haven't moved in lock step with plain-vanilla investments. For instance, many of the alternative stock funds buy some shares in hopes they will rise, while also placing bets that other shares will fall in price.....
The fund companies have had success in marketing:
Investors seem to like the idea. The funds have taken in more than $22 billion in the past year, Morningstar says....
and they have been marketing them for good reason (for them):
One big reason the fund companies like alternative funds: They can charge much higher fees than they do for traditional funds because of the more complicated strategies, which can include sophisticated derivatives. The average management fee on alternative stock funds is 1.04%, compared with 0.62% on actively managed funds holding big-company U.S. stocks, according to Morningstar.
Of course etfs on broad market categories can be purchased with even lower low as .10%

The likelihood these funds will be better will perform better for investors than they do for the fund companies seems slim. If it is difficult to beat the market picking individual stocks I'm not sure it would be more difficult "going anywhere". Furthermore if the long term trend is for higher correlation across stocks in particular industries it would seem a particularly environment for the strategy of " "paired stocks" matching longs and shorts. Add in the higher fees and the hurdles to beat the indexed portfolio seems even higher.

And even the recent divergence among US stocks hardly argues for stock picking. Small stocks have diverged from large stocks recently, but a well diversified etf portfolio would have benedfited from this, without being dependent on individual stock selection

At the end of last year, something strange happened. After tracking the S&P 500 for most of 2010, the Russell 2000 Index, made up of many small companies with very different characteristics and merits, broke away in the final three months to double the gains of large cap benchmark for the year.
"Small cap outperformance in the last quarter is a very good sign this trend is ending," said Joshua Brown, money manager and author of The Reformed Broker blog. "Winners and losers are starting to separate themselves after a year of the whole risk-on (buy anything), risk off (sell everything) of the last year."
Of course, you could have just bought the iShares Russell 200 Index ETF (NYSEArca:IWM - News) in September.(or simply held them as part of a diversified portfolio all year benefiting when large and small stocks moved together and capturing the small stock outperformance.)

Monday, January 3, 2011

Report Card on The Black Swan Hedge

Even with the strong stock market this year, the rise of optimism and consequent sharp decline in the VIX, a hedged portfolio composed of vxx and vxz dragged down only moderately even this year.performance this year. The vxx was particularly hard hit as the contango really generated a big hit. My rough calculation is that a mix of vxx and vxz equal took down a diversified portfolio of "risk assets" (global stocks and some commodities) by around 2%.

For a portfolio composed of 95% sp 500 2.5% vxx and vxz the portfolio total return was 12.1% vs 15.1% for 100% sp 500. And the portfolio volatility was reduced from sp 500's 18% to 15.1% for the hedged portfolio. In other words in a bad year for the hedge (strong underlying market, decline in implied volatility=vix) the hedged portfolio performed exactly as one would expect: lower return and lower volatility vs 100% stocks unhedged, (chart below)

I would venture to guess that many people that tried to time the market, particularly those that moved to medium or longer term bonds suffered   a bigger drag on performance. A 20% AGG aggregate bond index /85% sp 500 portfolio would have returned 13.3% with 14% volatility. Not a big improvement considering the volatility hedged portfolio has better risk/reward characteristics should bonds continue to reverse or if stocks sold off sharply.

Looking at an alternative "black swan " edge in the options I still would go for the vxx/vxz. A 10% out of the money (110 strike with the sp 500 at 1257.64 closed the year at  25.20 which would be 2% for six months and remember unlike the volatility etns this has a high probability of expiring at zero in fact according to option pricing theory a 50% chance of expiring worthless.

So I would say the report card for the vxx/vxz hedge in a particularly bad year was a low B. A higher proportion of vxz to vxx  rather than equal weight going forward And of course those that initiate the hedge now are buying into very low vix levels, not to say they cant go lower.

Some of the new volatility related products which have various mechanisms that could moderate the impact of the contango in the futures are intriguing and worth examining later.