Tag: finance

“The Pain Trade Is Always Down In The End”

Volatility-selling activity is continuing to drive the short-term performance of the S&P. Starved for yield, Ice Farm Capital's Michael Green explains that investors are selling volatility against their equity positions – and likely feeling their greatest risk is an upside move that takes them out of their underlying position. Against this, however, Green warns, the volatility selling is leaving them much longer than desired on a sharp down move.  While current FOMO (fear of missing out) dominates, it’s important to remember that the pain trade is ALWAYS down.

As an aside, we note that the underlying trends of volatility-selling or buying minimum volatility ETFs, in some systematic belief that herding into this strategy will reduce risk. As Green details…

The flaws in human emotion and bias are often cited for reasons to embrace “passive” or systematic investing.  Unfortunately, unless the allocation is truly passive (meaning ALL securities in equal proportion to their existence) as I have discussed over the last few weeks, it simply becomes another form of active speculation – this time around driven by a one-time decision by someone embedded in an ETF machine rather than the thoughtful attempts by a highly skilled analyst.  “Allocate to solar?  Which solar?  Let’s pick the large and liquid names at the creation of the index and embed them through a modified cap weighted index.”

 

Welcome to rank speculation by ETF.

 

I’m currently working through the math (which I assure you is as exciting as it sounds) to measure the impact of flows into non-mkt cap weighted type ETFs, one that is capturing attention is the USMV ETF, the iShares Minimum Vol ETF:

 

 

Having attracted nearly $14B of investment, this has been a phenomenal return vehicle… barring of course that poor sucker who sold down 40% on August 24, 2015…

 

And that’s the core of the math… because as a growing algorithmic (not passive) vehicle allocates increasing quantities of capital to the “lowest” vol equities, it is introducing an endogenous risk of volatility associated with the inclusion in the ETF. 

 

Historical modeling cannot identify this risk, because it never existed in history before!  Welcome to the machine!

So with systemic fragility building (via ETF allocations to low vol stocks), the potential downside from considerably "longer" than desired exposure, is clearer in less "manipulated" markets, like the R2000 where a pattern very similar to 2007 is playing out and markets remain far from highs. 

The R2000, especially the R2000 Growth is simply a H&S top that is mirroring the 2007/8 action.  If correct (and as noted, it’s not complete), then target is 500 on RTY which would make a lot of sense:

 

Or put another way…

 

This would suggest the S&P around 900 which also makes a ton of sense from a price pattern and valuation standpoint – remember, as Green explains, as Boomers are forced to de-risk their portfolios, we should expect single digit P/E ratios in this decade just as we had them in the 1950s.

Against reported EPS of $86.30 for the S&P500 (not the $107 “before all the bad stuff” nonsense), the S&P is currently trading at 24x… a move to 900 would take it 11x.  That’s the multiple we had in 2011…

 

As IceFarm's Michael Green concludes: "I think I’m right, but hope I’m wrong."

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Citi On Yellen’s Speech: “What She Did Not Say Is Dovish”

Yellen is still speaking in Philadelphia, but the attempts to set narrative and the market’s own “reaction function” to what the Fed is saying are already taking place, case in point, Citi’s Steven Englander who moments ago wrote that “Yellen expresses optimism throughout the speech but she doesn’t repeat her guidance from less than two weeks ago that a rate hike would be forthcoming  “in coming months.”

 Englander says that this on net is slightly dovish. “There is no timetable and the pluses are very vague. Unless the sky is falling in there is no way that she can express pessimism — would be self-defeating, so you take it as a given that she will sound optimistic on hitting targets in long-term. The vagueness on the timing of hikes is what is striking.”

As Citi’s Aerin Williams notes, “the market has been quite jumpy on Yellen speech. EURUSD made a quick look below 1.1330 as initial headlines read hawkish to the market but has since recovered to 1.1360/70. In G10, its been one of the most volatile.”

USDJPY has been less volatile – seeing a move towards 107.60 and now trading 107.17.

 

The cooldown is likely appropriate if one takes the guidance of CitiFX Head Strategist Steven Englander. What Yellen did not say in this speech can be taken dovish, in his opinion.

We expect that stocks will promptly regain their recent highs, because while the recently hawkish Fed was clearly bullish for stocks, a dovish Fed – as Citi now defines it – is even more bullish for stocks.

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Confused “Dovish-Hawk” Yellen Sends Stocks, Dollar, & Bond Yields Lower

Shrugging off the weakness in jobs as ‘transitory’ one can’t help but get a hawkish feeling from Yellen’s speech, but it appears the FX market disagrees (as the US Dollar is leaking lower). Bond yields are also fading back lower and so are stocks… Once again Fed communications policy wins – baffle e’m with bullshit.

 

 

Bonds and Bullion are bid as the USD slides with stocks…

 

Confused? Then ‘Mission Accomplished’.

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Does Iran Have The Upper Hand In OPEC Oil War

Submitted by Rakesh Upadhyay via OilPrice.com,

Traditional rivals, Saudi Arabia and Iran, continue to fight to prove their supremacy in OPEC. Neither gives up an opportunity to hurt the other, whenever and wherever they can, and oil seems to be their favourite playground.

With Saudi Arabia scuttling any chances of a production freeze in Doha in April, Iran has followed suit by thwarting attempts by Saudi Arabia to introduce a production ceiling on OPEC production in Thursday’s meeting held in Vienna.

Iran, which is close to its pre-sanction levels of production, had earlier agreed to discuss being part of any production freeze after it reached its desired output. However, in yesterday’s meeting, Iran refused to adhere to any production ceiling, which led to OPEC abandoning the idea.

Iran has been a dark horse since the lifting of sanctions, increasing its market share quickly to the surprise of many investors.

Iran has resorted to offering large discounts to its Asian customers, undercutting the Saudi and Iraqi prices to levels not seen since 2007-2008 in order to regain their market share, reports Reuters.

Iran shipped 2.3 million b/d in April 2016, the highest level since 2012. These figures are 15 percent higher than the International Energy Agency (IEA) forecast. Iran has been successful in its strategy until now, but increasing its market share further might prove difficult.

Meanwhile, Saudi Arabia is attempting to cement its market share in the wake of this increased production from Iran and Iraq. Though Saudi Arabia is attempting to transition away from being an oil-dependent economy, its transformation depends on the successful listing of Saudi Aramco.

As part of its preparation for the listing, Aramco is gaining market share and improving its efficiency, according to its chief executive, Amin Nasser.

"We are preserving our market share, which continues to increase year-on-year," he said in the interview. "This year, as last year, it is increasing. Our market share is picking up," he added, without giving figures, reports Reuters.

Ian Bremmer, the president of political risk consultancy Eurasia Group, told Reuters that the Saudi’s were planning to increase production by close to 1 million b/d after speaking with executives and a member of the Saudi ruling family.

The struggle for supremacy between the two nations doesn’t show any signs of abating, and there is no clear winner in this showdown.

Though Saudi Arabia has large reserves, it is burning them at a fast rate. On the other hand, experts believe that the Iranian economy is better equipped to withstand lower oil prices because its economy is more diversified and has an educated and hardworking population.

Emad Mostaque, a strategist with the London-based research consultancy Ecstrat, echoed a similar view. He said that Iran is better equipped to cope with the long-term upheaval because it is less dependent on oil than Saudi Arabia, having raised more through general taxation than through oil duties last year, reports Fortune.

The fight between the two for supremacy in the Middle East region is unlikely to end anytime soon. Currently, supply outages to the tune of 3.5 million b/d are supporting the oil prices by creating a balance between demand and supply.

Once Nigeria, Libya, and Canada resume pumping at their normal levels, the effects of the struggle between Iran and Saudi Arabia will be felt. If both increase production, the world will be awash with oil, pulling prices back to the mid $30/barrel levels.

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It Takes a Village to Maintain a Dangerous Financial System

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Injustice anywhere is a threat to justice everywhere. We are caught in an inescapable network of mutuality, tied in a single garment of destiny. Whatever affects one directly, affects all indirectly.

We know through painful experience that freedom is never voluntarily given by the oppressor; it must be demanded by the oppressed.

The answer lies in the fact that there are two types of laws: just and unjust. I would be the first to advocate obeying just laws. One has not only a legal but a moral responsibility to obey just laws. Conversely, one has a moral responsibility to disobey unjust laws. I would agree with St. Augustine that “an unjust law is no law at all.”

We should never forget that everything Adolf Hitler did in Germany was “legal” and everything the Hungarian freedom fighters did in Hungary was “illegal.” It was “illegal” to aid and comfort a Jew in Hitler’s Germany. Even so, I am sure that, had I lived in Germany at the time, I would have aided and comforted my Jewish brothers.

– From the post: Martin Luther King: “Everything Adolf Hitler did in Germany was Legal”

Last month, Anat R.Admati, the George G.C. Parker Professor of Finance and Economics at Stanford University’s Graduate School of Business, published a very important working paper titled, It Takes a Village to Maintain a Dangerous Financial System. At 26 pages, it’s a bit longer than what you might leisurely read in the course of your daily activities, but I strongly suggest you take the time. Of course, if you don’t have the time, I’ve provided some key excerpts for you below.

Despite deconstructing an intentionally complicated subject, the paper was both an enjoyable read and easily understandable. Additionally, the range of issues she successfully covered in such an short piece was nothing short of heroic.

I knew it would be good after reading the abstract…

Abstract: I discuss the motivations and actions (or inaction) of individuals in the financial system, governments, central banks, academia and the media that collectively contribute to the persistence of a dangerous and distorted financial system and inadequate, poorly designed regulations. Reassurances that regulators are doing their best to protect the public are false. The underlying problem is a powerful mix of distorted incentives, ignorance, confusion, and lack of accountability. Willful blindness seems to play a role in flawed claims by the system’s enablers that obscure reality and muddle the policy debate. 

continue reading

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Why portfolio theory is wrong

[Editor’s note: This letter was penned by Tim Price, London-based wealth manager and author of Price Value International.]

“Suffice it to say that volatility and risk are not the same thing, but that for reasons which remain obscure most of the investment world chooses to treat them as if they are. The only one that makes any sense at all is that the mathematicians who came to dominate the financial world from the 1950s onwards were desperate for something they could calculate, and the variance of past periodic returns seemed like the best candidate.”
– Guy Fraser-Sampson, ‘Intelligent Investing’

Some people in finance have a sniffy attitude towards academics, writes Buttonwood in the latest Economist magazine. For good reasons, we might add. (Why are academics so bitchy ? Because the stakes are so low. And as Jerry Pournelle observed, you won’t learn much about capitalism at university, and you shouldn’t expect to. Capitalism is a matter of risks and rewards, and a tenured professor doesn’t have much to do with either.) So far, academia’s biggest contributions to finance have been Modern Portfolio Theory, the Capital Asset Pricing Model (CAPM) and the Efficient Market Hypothesis. With contributions like that, who needs asinine overly simplified wrong models ?

From the get-go, Buttonwood’s piece (‘Risk and the stock market’) launches from a dubious platform:

“Risk is linked to reward; it is virtually the first lesson one learns about finance. Safe assets pay low returns; if you want higher returns, you have to risk your capital.”

But QE has subverted the relationships between supposed safety, returns and risks. As Jeremy Siegel points out,

“You have never lost money in stocks over any 20-year period, but you have wiped out half your portfolio in bonds [after inflation]. So which is the riskier asset?”

Today, for example, all German government bonds out as far as 9 years to maturity carry a negative yield. Anybody buying them and holding them until redemption is guaranteed to lose money, even before inflation. Safe? Or extremely hazardous?

And as Berkshire Hathaway’s Charlie Munger points out, using volatility as a measure of risk is madness. Risk, for Berkshire and for ourselves, is either the risk of permanent loss of capital or the risk of inadequate return.

So it is hardly surprising that two papers in the Journal of Portfolio Management find fault with financial theory. The first, ‘Risk Neglect in Equity Markets’, by Malcolm Baker of the Harvard Business School, found that – as conventionally defined – more risk led to lower returns, not higher ones. Baker took two portfolios from 1967. One consisted of the 30% of US stocks with the lowest beta (volatility relative to the market as a whole), the other of the 30% of US stocks with the highest beta.

By the end of the study, $1 invested in the high beta portfolio had grown to $18. But $1 invested in the (less risky) low beta portfolio had grown to $190. You could drive a truck through the difference in compound returns, which equates to some 5.5% a year. Not only is the low beta portfolio the stand-out performer in returns, it also displays lower volatility and its maximum drawdown (peak to trough loss) is 35% versus 75% for the high beta portfolio.

Baker’s study is not alone. In ‘What Works on Wall Street’, James O’Shaughnessy selected the 50 most expensive stocks in the US stock market on the basis of a variety of metrics (price / sales; price / cashflow; price / book, and price / earnings), together with the 50 cheapest stocks using the same metrics. Each portfolio of 50 stocks was rebalanced annually to ensure that the focus on outright expensiveness and cheapness remained consistent over time. The results are shown below.

Value of $10,000 invested in various value strategies, over 52 years

What works on Wall Street

Source: ‘What Works on Wall Street’ by James P. O’Shaughnessy

Financial theory would have suggested that the ‘expensive’ portfolio enjoyed higher returns. O’Shaughnessy’s study, like Baker’s, showed exactly the opposite.

Take price / book. The ‘growth’ portfolio, which had a starting value of $10,000, ended up after 52 years being worth $267,147. But the demonstrably cheaper ‘value’ portfolio, with the same starting value, ended up being worth over $22 million.

Perhaps value trumps growth. (We clearly believe so, which is why we established a global fund of unconstrained value managers.) Perhaps financial theory is wrong.

The second paper cited by Buttonwood examined the role of tracker funds – cheap, passive market-tracking vehicles. The index-tracker owes its existence to the validity of the Efficient Market Hypothesis – the theory that active managers cannot beat the market over time. One problem with trackers is that they are dumb. They “dilute the purpose of the stock market, which is to allocate capital to the most attractive companies”. Another problem with trackers is that they are dangerous. Firstly, they cause herding, as trackers collectively buy or sell the market’s respective winners and losers. Secondly, they offer no escape route for the investor in the event of a market sell-off. The market-tracking investor is destined to go down exactly in line with the market. This is a particular problem if stock markets are currently priced above their fair value, which certainly appears to be the case for the S&P 500, which stands roughly 60% above its long term fair value, according to Robert Shiller’s cylically adjusted p/e ratio, or CAPE.

The third problem with trackers is that the Efficient Market Hypothesis is wrong. Warren Buffett made the same observation when he wrote about the Superinvestors of Graham and Doddsville in his appendix to Ben Graham’s reissued ‘The Intelligent Investor’ in 1984. There is a class of managers that has meaningfully outperformed the market over many years, whilst simultaneously taking on less risk, because everything they buy offers a ‘margin of safety’ by comparison to more expensive (and therefore riskier) stocks. They are called value investors and we are extremely happy to be invested right alongside them.

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Janet Yellen Explains How The Fed Will Keep What’s Left Of Its Credibility In June – Live Feed

Will she or won't she? With an increasing number of market participants entirely confused by the Fed's utterly failed communications policy – as it constantly changes its focus from one meeting to another – Janet Yellen's speech today on the economic outlook and monetary policy at the World Affairs Council of Philadelphia seems critical just one week out from a supposedly "live" June meeting (who market-implied rate-hike odds are now just 4%).

Credibility crushed…

 

Live Feed (Yellen is due to speak at 1230ET, followed by a Q&A)…

 

With the narrative that a Fed rate-hike reflexively proves the economy is strong, how does Yellen justify a confidence-inspiring rate-hike following Friday's jobs data and today's collapse in The Fed's own labor market indicator?

 

Of course stocks don't care… good news is good news (confirms Fed narrative), and bad news is better news (enables Fed to stay lower for longer) – until it's not.

 

Little bit of weakness heading into Yellen.

Her full comments:

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Bill Clinton’s Brother Arrested For Drunk Driving In California

The last thing Hillary Clinton needs a day before the California primary is a stark reminer of the “clan’s” tendency for mischief outside of the White House. Which is why the latest news that Roger Clinton, Bill’s brother, has been arrested – and in Southern California at that – for drunk driving, may have come at the worst possible moment for the Democratic presidential candidate, for whom winning the Golden State is a matter of urgency. 

According to The Hill, Clinton, former President Bill Clinton’s brother and Democratic presidential front-runner Hillary Clinton’s brother-in-law, was arrested late Sunday for a DUI, according to TMZ, two days before California’s critical primary.

Law enforcement sources told TMZ Roger Clinton was booked for DUI just after 8 p.m. in Redondo Beach, Calif. He reportedly refused blood alcohol testing, and currently remains in police custody with his bail set at $15,000. TMZ on Monday reported that it is unclear whether Roger Clinton, was also arrested for DUI in 2001, would be able to vote in Tuesday’s primary.

Just before leaving office in January 2001, Bill Clinton pardoned Roger Clinton, who was sentenced to two years in prison after pleading guilty in 1985 to conspiring to distribute cocaine.

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JPM Still Hates The Market Rally: Here Are Its Reasons

In the past month, not a day has passed without some major sellside firm (yes, that also now includes traditional bull Goldman Sachs) releasing its bearish take on deteriorating fundamentals, and urging clients to not only not buy the rally but sell into it (and as both retail and “smart money” flows indicate, this advice ha been heeded). Today it’s JPM’s turn. In the latest note is out of JPM’s Mislav Matejka, the equity strategist presents five reasons why “upside for stocks is limited” due to numerous reasons but mostly because “global activity momentum is failing to pick up.”

Here are his five reasons not to chase the rally in the short-term:

Equities have seen very large outflows for a number of weeks now, vs bonds which have enjoyed significant inflows.

This could be interpreted as a positive, as one could say that equities appear underowned, vs bonds which might be overowned. US EPS revisions have managed to stay in positive territory for the last 3 weeks. Given these and the fact that stocks have been consolidating the Feb/March gains for two months now, the question is should one look for another leg higher, such as the 10-15% tradeable rally we called for on 15th Feb? Our view is that risk-reward is not attractive for equities, as:

  1. Activity remains sluggish. The latest business expectations reading within US services PMI is the lowest on record. The latest output read