Saturday, December 9, 2006

November 2006 Review and a Volatile World


Our eleventh month of trading ended up strongly with a positive return of 1.77%, our best monthly number since inception as a result of some well-timed trades in the currencies. We like to think this bodes well for the holiday season and hopefully none of our clients’ children will be left without presents due to poor performance!

Jokes aside, market conditions and perceptions continue to diverge from the reality embedded in the economic data that is doled out each week. At the very least the data picture is mixed with the ISM Manufacturing number, released on December 1st, unexpectedly shrinking for the first time in more than three years, while the ISM Non-Manufacturing report, released December 5th and which reflects activity in the service sector, showing evidence that US economic growth was not slowing.

The various business news outlets are also emitting conflicting interpretations on economic data. Take a look at on November 29th and the spin is decidedly favorable. In an article entitled “Better Than It Seemed,” the author writes positively “Fed Chairman Ben Bernanke may be on to something. A day after he indicated the U.S. economy was stronger than investors appeared to think, government data arrived to support his argument.” This is posited on the same day Bloomberg reports that “The U.S. economy may head into 2007 in weaker-than-expected shape after reports showed October new-home sales fell for the first time in three months and stockpiles at companies jumped last quarter.”

Who is right? I guess it depends if you are looking at the stock market or the bond market, or how deep you want to dive below the headline numbers to get at the economic undercurrent. Either way, in our opinion more and more evidence seems to validate our long held idea of a substantial slowdown (that is, recession) in 2007. At the very least it would seem to indicate a cyclical peak in corporate earnings. Not only are economic statistics pointing in that direction but it would seem that even the inside corporate players, the ones supposedly with the best knowledge of future profitability of their corporations, are also beginning to be heavy sellers.

In the meantime, world headlines are filled with negative stories: a civil war brewing in Iraq (at least according to one channel I watch), ever growing current account deficit financed by China and oil exporters, and continued rumblings about the supply of energy from Russia. Yet in this volatile and risky world investors in the equity markets will point to soaring oil prices and a nuclear test by North Korea as “exogenous events” which the markets have barely responded, and then blithely focus their attention on mega mergers and private equity acquisitions that are taking place.

The result is that S&P 500 options have only priced in a 1% move up or down over the next month. Yet, markets have never been good at spotting and pricing political risks and at some point expectations of low volatility will turn out to be wrong.

I would argue that the massive complacency of market players, measured by one of the lowest level of volatility (VIX) in more than 10 years, is certainly misplaced. The bond market seems a bit more worried about future growth and so are forex players who have pushed the dollars to new lows for the year. Gold is following a proven inverse correlation to the greenback as it becomes more apparent that no matter who is going to be right, the bullish pro-growth camp or the bearish recessionary club, that should be negative for the currency of the world (USD) and a solid, yellow hedge (gold) may be in order. Certainly the Chinese, the Arabs and the Russians (when they are not too busy poisoning or shooting anyone who doesn’t see it their way) have all indicated a desire to diversify their foreign reserves away from the dollar.

Should a recession indeed occur next year and possibly weaken crude oil and other energy sources, I would view such a price break as a great opportunity to accumulate serious positions. After all, over the long term the world demand of more and more of a commodity of which there is less and less of is normally a characteristic of a buyer’s market… at least until we find out how to use anti-matter like they do on Star Trek.

Overall my investment tactics don’t change: look for cracks in the thesis of the majority, use common sense, diversify your plays.


-Davide Accomazzo, Managing Director

Thursday, December 7, 2006

The Lore and Legend of the Bulls and Bears

“Nothing is more admirable than the fortitude with which millionaires tolerate the disadvantages of their wealth.”
— Rex Stout, Mystery Novelist (1886-1975)

After gold was discovered at Sutter’s Mill in California, instant wealth was for the taking and all across America men made the decision to go west. Many sought and some found fortune in a camp called Hangtown, which at that time rivaled San Francisco.

Among the diversions sought by the miners on a Sunday afternoon was the bullfight that had long been a part of California’s development under Mexican rule. The bullfight, which had been introduced to Spain by the Moors in the 11th century, was brought to Mexico by the Spanish and was part of the fiesta held regularly at the mission-presidio complexes established between 1536 and 1832. The Mexicans added a wrinkle of their own by arranging fights between Spanish bulls, first brought to the new world by Columbus, and the native grizzly bear that roamed the California coast.

The Spanish longhorn cattle were brought to Mexico in quantity in 1521 and virtually ran wild until Texas became a state in 1845. The longhorn had a keenly developed sense of survival and often encountered the grizzly in the wild.

The game that entertained the miners in Hangtown was to chain a 1,000-pound grizzly to a huge stake in the middle of an arena and then turn the bull into the same arena. The fights were short and violent with the bull sometimes winning by impaling the bear, but mostly the bear won by meeting the charge between the horns and using his enormous paws to wrestle the 1,500-pound bull down to the ground, often breaking its neck in the process.

Since the gold discoveries created a flood of trading in mining shares, both in San Francisco and New York the terms “bull” and “bear” were introduced in the investment jargon to describe opponents in setting market direction. The analogy had been used before by the Spanish writer Don José de la Vega in 1688, but the active Civil War markets established the terms for all time.

The first person to be called a bear or bull was Jacob Little, who made his mark by introducing short selling in the panic of 1837. He made and lost four fortunes in the years that preceded the Civil War and was dubbed “The Little Bear” by fellow traders. One time he escaped a corner in Erie Railroad by buying convertible bonds that had been sold in England, unbeknown to the bulls, and he converted the bonds to cover his short position.

The two combatants that focused the terms for all time were the bear, Daniel Drew, and the bull, Cornelius Vanderbilt. The analogy fit perfectly the gigantic struggles between these two titans that went on for 30 years over steamboats and railroads.

Vanderbilt was as straightforward and optimistic as a bull, while Drew was devious, without scruples, and always trying to wrestle the market lower. These two bumped heads continually with a fight over Harlem Railroad during the Civil War producing a typical encounter.

Vanderbilt had been accumulating shares of the road for a number of years and introduced improvements to the line. Uncle Daniel was attracted when the stock started to move and joined in the buying to give the price an artificial boost from $8 to $100. He then cooperated with the politician “Boss” Tweed to mount a massive bear attack on the road. They went heavily short the stock, and Tweed used his influence to get Harlem’s right-of-way rescinded.

Vanderbilt let them “operate” until the stock dropped to $72. They had sold 137,000 shares, even though only 110,000 shares were outstanding. Vanderbilt then began soaking up the shares held by others and advanced the price to $179, forcing the bears to terms with the Commodore.

But then Drew attacked again, selling the stock down to $100 before Vanderbilt began to squeeze again. He raised the price to $285 and offered to settle again. Drew, hat in hand, pleaded with the Commodore and was finally excused with a $500,000 loss.

Vanderbilt advised Drew, “After this, never sell what you haven’t got, Dannie.” Which prompted Dan’l to compose his famous couplet, “He who sells what isn’t his’n, must buy it back or go to prison.”

In the gold camps, the bear defeated the bull in most fair fights. On Wall Street, the smart money follows the bull. Daniel Drew died broke, unable even to fulfill pledges to his church (he was short there too!), while Commodore Vanderbilt left his son William a fortune of $80 million——the only son he didn't disowned because he was as ruthless in business as his father and the one Cornelius believed capable of maintaining the business empire.

- Mack Frankfurter, Managing Director

Saturday, November 4, 2006

October 2006 Review and the Perfect Storm


The often difficult month of October brought unseasonably favorable weather for the stock market, but treacherous waters for our Diversified Options Strategy program. The good news is that our risk management worked as expected in the face of what we could call the perfect storm of breakout markets and imploding volatility.

The bad news is that for October 2006 our Diversified Options Strategy returned just +0.01% resulting in a year-to-date return of 7.93%. Meanwhile, the S&P 500 Index (GSPC) returned a strong 3.15% for the month and is up 10.39% year-to-date. The Barclay CTA Index is reporting +0.32% for October as of this writing and is up 0.94% on the year. Please refer to our website at for the most recent performance numbers on our investment programs.

Whereas the Dow Jones Industrial Average (an index consisting of just 30 stocks, albeit the largest and most widely held public companies in the U.S.) was engaged in a relentless march to new highs and increasing enthusiasm on the part of investors in the stock market, our diversified approach had to deal with a number of challenging positions that found unexpected correlations and unfortunately worked against us.

Our Diversified Options Strategy is designed to be an absolute return program and is engineered to generate consistent risk adjusted returns regardless of market conditions; however, there are occasional anomalies, like unusually protracted moves mismatched by higher or lower than usual volatility, which may create difficulties.

We are proponents of diversification and think investors should have as a cornerstone of their investments a well-diversified portfolio with a mix of asset classes. The last time the DJIA and S&P 500 had this kind of uptrend slope and momentum for this long of duration was in 2003 when the market bounced off the bottom of the 2000-2002 bear market. Exposure to stocks in the DJIA during the last three months would certainly have benefited overall portfolio performance. Then again, the context is that this index has been a laggard over the past six-seven years and is only now breaking out to new highs.

While past performance is not necessarily indicative of future results, a comparison of our performance to date reveals a track record that has a low correlation to the stock market. It is well recognized that combining investments that exhibit low or negative correlations result in a more efficient portfolio, which in turn offers the highest expected return for a given amount of risk.

As to the recent strong performance in the stock market the conditions could best be described as a “melt up,” but early on the bull run began as a stealth rally. Since before the May/June correction market participants have been debating soft versus hard landing. The bond market seems to point to a not-so-soft landing as indicated by the inverted yield curve. But with the benefit of hindsight, it is easy to see that the soft landing scenario has overruled thinking in the equity markets. In essence the markets have had a classical response to the shift in Fed policy with respect to putting a hold (for the time being) on the federal funds rate.

The evolving situation was backed up by an exceptionally strong earnings season, and cash flow coming in from the sidelines. This circumstance combined with lower oil prices underpinned the institutional-led rally in the “Dogs of the Dow.” Michael Driscoll, director of listed trading at Bear Stearns said it well, “You hate to sound cliché, but this is the generals leading the troops—the big Dow uglies lead the charge and set new highs and the rest of the market plays catch-up.” More in depth research reveals that the rally was largely confined to index-related stocks, a phenomenon that in our opinion will likely persist with the increasing popularity of ETFs.

By the time we got into October, sentiment indicators reflected overbought conditions and underlying distribution with higher highs on lower volumes.

The late stages of the bull run was marked by short covering rallies probably instigated by the plethora of covered call writing closed-end funds that were launched in the last couple of years. Meaningless end of day spikes became significant fulcrums for the next day’s trading. Additional derivatives related pressure to the upside was responsible for adding more fuel to the bullish fire, not to mention the struggle of underperforming money managers trying to keep up with the indices this year (Xmas bonuses anyone?!?). All the while, sentiment revisited the irrational exuberance of 1990s as reflected by the cheering section for DOW 12000 flashing across CNBC’s screen every few minutes.

A stat that's been making the rounds is the rather amazing fact that the S&P 500 has gone more than 70 days without a 1% decline. In fact, over the past 56 years the S&P has managed only six times to duck through both September and October without a 1% daily drop. The consequence was a narrowing trend channel and a considerable decline in volatility during a period which historically has a deserved reputation for being volatile.

Invariably, it is when markets hit these types of extremes that it is most important to have included in your investment portfolio other alternative approaches that are contrarian in strategy and help hedge portfolio gains.

The Diversified Options Strategy program deals with different markets and even multiple positions in the same market in terms of direction and time horizons. Because options provide a great deal of flexibility, we can establish multi-dimensional strategies such as positions that allow us to be short term bearish while being long term bullish for example. In so doing our approach does a generally good job of smoothening out volatility in day-to-day performance.

For this reason it is unlikely for our program to suffer greatly when any one bet may turn out to be wrong. However, there are instances when multiple markets may exhibit unforeseen correlations which in concert act against our existing positions. The situation can be aggravated by low volatility levels that are historically atypical, as implied volatility is central to any option program.

It is in such periods that our diversified approach using options may not work as well and the flexibility of our program is put to test.

We entered the month of October with routine spreads on the S&P 500 which carried higher gamma on the short call side. In more simplistic terms, while we had long positions we were also a little more aggressive on the short side. Earlier in the month we felt the upside move in the S&P 500 had reached record levels and the probabilities of at least a digestion of the recent gains were higher than a continuation of such gains.

Unfortunately for us, the S&P 500 continued sailing higher forcing us to reset our shorts at higher levels in accordance with our risk management rules. Simultaneously, we booked our profits on the long side but the uncontested up-move of the market also had the effect of pushing the VIX (the premium paid by option buyers) to extremely low levels making it unattractive from a risk-reward point of view to take new positions on the put side.

We eventually did hedge our shorts by selling some December put premium and we let some long November calls run with the bulls.

While we were fighting the strong directional move in the equity market we also had to manage a volatility explosion in the corn market. We bet correctly on the direction of this commodity (up); but while we were long March 2007 calls, we played as a hedge the short side on the December 2006 contract. Seasonally this was the correct move; lower prices normally occur in the midst of the harvest and this was going to be the second or third largest crop in US history. Unexpectedly an unprecedented move for this time of the year was sparked by a drought in Australia which affected wheat and by reflection U.S. corn. The parabolic move that ensued made our spread go out of line and we had to cover. To put this move into further perspective, the 22.1% move in December Corn in the month of Ocotber was the biggest single month jump in last 32 years.

As if these two moves–statistically very rare by historical standards–were not enough, we've been struggling with long crude oil positions which is in the midst of forming a base after a 20% plus correction. Long and intermediate term we feel the odds are surely in favor of higher prices but in the short term the battle is still undecided.

So there you have it. While the stock market was enjoying balmy weather, we were hit with storm clouds. In the end, however, we came out of it still on the upside with a one basis point return—the slightest of gains.

You may now understand why we think that the way our strategy worked in the face of these rare crosscurrents is a silver lining.

My business partner and I often find ourselves in meetings being asked the question of how we think we would do in extreme situations. While perfect storms can always be perfected by future ones, we think our Diversified Options Strategy program now has a strong point of reference to answer that question.

When we designed this trading strategy we ran stress-test calculations. We allowed for far greater havoc in our simulations—expect the unexpected, prepare for the worse. This past month real world tested our approach under strenuous circumstances. Having sailed through this storm, I feel very positive about our methodology going forward.

As far as our predictive views on the markets, I still expect the U.S. economy to hit a recession next year, yet believe oil prices will stay high relative to its average price over the last ten years. I also believe that the correction in the housing market has only just started and will have a negative impact on our economy just as it was a positive influence when real estate was booming.


-Davide Accomazzo, Managing Director

Friday, November 3, 2006

What Ever Happened to the Loyal Opposition

“Politics is the art of looking for trouble, finding it whether it exists or not, diagnosing it incorrectly, and applying the wrong remedy.”
— Sir Ernest Benn (Publisher, 1875-1954)

As I write this, there are only four days left until the mid-term election—it cannot come soon enough.

And so, with some trepidation, and despite our blog’s focus on economic and investment concerns, I am allowed, this once, at the risk of alienating certain readers, to banter in political discourse and comment on that which should not be discussed amongst friends.

Let me begin by first addressing the pollsters and ideologues who feel it necessary to categorize Species Americana Voter and box us into political affiliations and “liberal” or “conservative” leanings—I recently reregistered for “Other” writing in the Whig Party.

[The Whig Party existed from 1832 to 1856, and was formed to oppose the policies of President Andrew Jackson and the Democratic Party. In particular, the Whigs supported the supremacy of Congress over the Executive Branch and favored a program of modernization and economic development.]

This is just another way of saying I’m an Independent without inadvertently becoming associated with the American Independent Party, a party with a specific platform I do not entirely agree with.

But seriously, I’m in total agreement with Will Rogers when he said: “The more you read and observe about this politics thing, you got to admit that each party is worse than the other. The one that’s out always looks the best.”

And so there you have it; per chance you may even agree: something is rotten in the state of U.S. politics, as it seems all has become fair play with our representatives’ desire to win at any cost. That cost is getting very, very expensive, and I’m not just talking dollars.

Spreading hatred and lies about one’s opponent has become a routine and accepted part of running for office. According to, a respected website that reviews the accuracy of ads, this year stands out for the sheer volume of personal assaults.

No wonder some of the most intelligent and capable people in our country don’t want anything to do with politics.

Watch CNN, MSNBC and FOX regularly, and you cannot but admire the skill of punditry that permeates dialogue on all issues and even non-issues. Hyperbolic, distorted and divisive rhetoric is the rule along with blatant bias in anchors’ “reporting.” Guests with the loudest retort are implicitly declared the debate winner, notwithstanding any obvious hypocrisy in a particular “expert’s” positioning of “truth.”

Sure, it makes for good TV. But the next thing you know Rolling Stone is declaring Comedy Central’s Jon Stewart and Steven Colbert America’s most trusted “news anchors,” as a reprieve from the likes of FOX’s Sean Hannity and Bill O’Reilly, whose self-declared authority on everything under the sun conjures up a McCarthy-era redux of mistrust toward our fellow Americans.

Yet this malady of cynicism is not particular to our times. Davy Crockett (1786-1836) is quoted as saying “There ain’t no ticks like poly-ticks. Bloodsuckers all.”

Fact is, I’m mad as hell and I’m not going to take it anymore.

What we need is a return to the center. We need to quiet the shrillness emanating from the vocal minority and replace it with intelligence, moderation and mutual respect.

Unfortunately, the current trend in American politics is not encouraging in this regard.

A French economist by the name of Frederic Bastiat once suggested that when social policies turn out to be harmful to the citizenry, it is because politicians often react to problems that they can see, without any regard for the unforeseen consequences of their solutions to those problems.

Mark Twain also had a thesis about politicians and wryly wrote circa 1882 “Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”

No doubt both Twain’s and Bastiat’s sentiments apply to the 109th session of Congress.

Regardless of the outcome in the House or Senate races, there are many serious issues that need to be addressed. The biggest dirty little secret everyone in Washington knows is the budget deficit.

Politicians don’t like to talk about the nation’s long-term fiscal prospects—the subject is complicated and it reveals serious problems and offers no easy solutions. This is not a partisan issue. But the problem is tied to the country’s three big entitlement programs: Social Security, Medicaid and Medicare. At the same time, the burgeoning cost of the war in Iraq is not helping matters.

Fortunately for us there are true patriots like David M. Walker, head of the Government Accountability Office (GAO), which makes him the nation’s accountant-in-chief. Walker’s job is not in jeopardy if he tells the truth (he is serving a 15 year term ending in 2013), and what he has to say is scary.

Washington has dug itself a fiscal black hole. Combine that with the “demographic tsunami” that will come as the baby boom generation begins retiring with the recklessness of borrowing money from foreign lenders (such as China) to pay for the operation of the U.S. government, and you’ve got a recipe for disaster. Not facing this issue, squarely and honestly, will irreparably damage our great country for future generations to come.

Given the current climate I have little hope anything meaningful will be accomplished in the next two years unless the rhetoric is toned down and replaced by sensible dialogue between those with contrasting positions. Worse would be another session of Congress that kowtows to the President and legislates without transparent and meaningful debate.

Luckily, voting anti-incumbent is a great American tradition. The focus should be on electing politicians who are willing to work more than three days a week and forge bipartisan solutions, not engage in endless fund raising and political upmanship.

However the election manifests itself, given the current state of affairs, what we need most is new leadership in Congress and a return to principles of mutual respect.

Long live the loyal opposition!

- Mack Frankfurter, Managing Director

Wednesday, October 4, 2006

September 2006 Review and Buying the Bull


Our Diversified Options Strategy program for September 2006 returned a positive 0.77% resulting in a year-to-date return of 7.92%. The S&P 500 Index (GSPC) returned 2.46% adding to the gains from the prior month and is up 7.02% year-to-date. Meanwhile, the Barclay CTA Index is down as of this writing with a return of -0.20% for September; for the year the CTA Index is up only 0.64%. Please refer to our website at for the most recent performance statistics on our investment programs.

BUY BUY BUY!!!! The Wall Street trumpets and the airwaves of CNBC are at work again. The meaningless Dow is at historical highs and the S&P 500 is up 10% in practically a straight line since the lows of June. Volatility is again MIA as market players perceive the total absence of potential threats to this picture perfect situation.

Not to be cynical but the indices rallying so strongly in the name of suddenly “defeated inflation” and the much vaunted “soft landing” scenario seems naïve at best. Aficionados of this blog know well my tirades on how inflation is dramatically underestimated by official statistics. Again I will point out the rise in most of your daily living expenses and monthly bills…

For the bulls out there: yes, I acknowledge the rather significant decrease in oil prices, but I have to wonder on the timing given that on July 12th Goldman Sachs revised their benchmark commodity index (GSCI) from 8.45% dollar weighting in unleaded gas to 2.30%. This little noticed event forced hedge funds and institutions tracking the GSCI to sell 75% of their gasoline positions in order to conform to the reconstituted index. Mmmm... Goldman Sachs... Treasury Secretary Paulson... Elections anyone?

But seriously, the key question regarding oil is what will be the average price range going forward. Are oil prices settling into a much lower range or is this just a trading correction? Considering that some short term problems may indeed have been resolved, a re-pricing of the commodity may be justified. But then again, the ongoing imbalances of this depleting resource in the face of projected long term rising global demand supports my thinking that this current “re-pricing” is just temporary.

Another interesting fact is that soft landings in the history of this country have only been achieved once, in 1994, under much better structural contingencies. My fear of a potential “bull trap” seems to be justified by the “technicals” of this market. The rise is narrow and is concentrated in a few index related names. New highs have been hard to come by and the CNBC cheerleading thermometer is rising too far too fast. I suspect a lot of seasonal players and retail investors were caught on the wrong side of the fence after Labor Day and the oil drop added fuel, excuse my punt, to the fire.

Only time will tell if my thesis is correct.

As far as the other markets, gold seems to be searching for a floor and I believe it will have problems flying high until the dollar starts weakening again. I am not in the camp calling for the destruction of the dollar and the fiat money system but I do think gold should eventually benefit from a reallocation of foreign central banks’ reserves. This is a long term theory and I’m reminded of what J. M. Keynes once said: “In the long run we are all dead.” So in light of such wisdom we will continue to play the currencies (gold included) on a very short term and very technical basis.

It’s a short missive from the trenches this month but I am sure you would like me more engaged managing your hard earned money than fueling my vanity with these scripts.

I rest my case. Until next time...


-Davide Accomazzo, Managing Director

Options: A Three Dimensional Chess Game

"Could we look into the head of a Chess player, we should see there a whole world of feelings, images, ideas, emotion and passion"
— Alfred Binet (French Physiologist, 1857-1911)

One of my favorite pastimes is playing chess, which unfortunately I have not had the time to indulge as of late. To experience the full brunt and emotional psychology of the game try a five minute speed match against a chess hustler in Washington Square Park, NYC. Unless you’re rated 1800+ you will likely walk away feeling beat-up.

Don’t believe me? Bobby Fischer, the only US-born chess player ever to win the World Chess Championship, once said “Chess is like war on a board. The object is to crush the opponent's mind.” Even more revealing is what he said during a Dick Cavett interview, “I like the moment when I break a man's ego.”

For the uninitiated the inner nature of this multidimensional game is nicely explained by David Norwood in his book Chess and Education:

“It is often supposed that, apart from their ‘extraordinary powers of memory,’ expert players have phenomenal powers of calculation. The beginner believes that experts can calculate dozens of moves ahead and he will lose to them only because he cannot calculate ahead so far. Yet this is utter nonsense. From my own experience I can say that grandmasters do not do an inordinate amount of calculating. Tests, notably de Groot’s experiments, support me in this claim. If anything, grandmasters often consider fewer alternatives; they tend not to look at as many possible moves as weaker players do. And so, perversely, chess skill often seems to reflect the ability to avoid calculations. It is, in truth, not clear that chess is a game of calculation. Of course there are times when intense calculation is called for, and often the master is better at dealing with these situations than the amateur. No wonder, he has had more practice than the amateur, but all the same his innate calculating ability need not be any greater. Most of the time it is something quite different that is required, something akin to ‘understanding’ or ‘insight.’”

Interestingly, the analytical yet intuitive nature of chess and trading is very similar, and many great traders happen to also be fanatical chess players. In fact, the introspective process is so alike that Norwood’s description could have been written about trading.

The psychological aspect of trading is something that serious investors should spend time studying. Generally, investors have three choices when trading an asset directly:

(1) stay out of the market
(2) buy and “go long”
(3) sell and “go short”

Once either “long” or “short” the next decision becomes whether to stay in the position or get out; technically this is known as “liquidating the long” or “covering the short.”

The confluence of investor agendas results in historical market prices which can be tracked by charts. Anyone who has looked at charts can easily recognize markets that trend up or down versus markets that move sideways within a range. Charts are great tools, but don't forget they look backwards. As the regulators regularly remind us “past performance is not necessarily indicative of future results.”

From an emotional perspective such tactical investment alternatives, seemingly simple trading decisions, present an array of contexts. Remaining un-invested is neutral, but psychologically the trader is thinking in terms of greed or fear: “Should I stay out or get in? Is the reward worth the risk? What if I buy it here and it goes lower? Is it too expensive? What if I wait for it to go lower before buying?”

Common sense wisdom says “buy low, sell high,” but how many investors feel more comfortable “buying high, selling higher?” Unfortunately, most of the time we end up buying high and selling low, emotionally trapped by the “come back to breakeven before selling” curse. Chartists call this "resistance" because investors sell at these levels, while "support" levels exist because there are no more sellers as investors are willing to hold until a better price.

Purchasing an asset is the easy part; alas most investors don’t think about an exit strategy. The “trend is your friend until the trend ends,” but how far should you let a stock “run” before you sell it? How would you feel if you sold it but then it goes up further? What if it was higher, but now lower… Would you wait until it goes back up? What if it doesn’t go back up? What if it goes lower still? At what point would you feel forced to sell?

Thomas Huxley, known as "Darwin's Bulldog" (1825-1895), once quipped that “The chessboard is the World, the pieces are the phenomena of the Universe, the rules of the game are what we call the laws of Nature and the player on the other side is hidden from us.” The same sentiment could easily be applied to trading.

As you can see, there are many emotional dimensions to just buying and selling an asset. And when a trader has the sophistication to “go short” the thought process doubles.

This psychology underpins every day decisions/actions of markets participants. Quite a few books analyze the phenomena such as the 1841 classic “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay. Successful investors learn to discipline their emotions and act contrarian to natural tendencies.

Yet when all is said and done, for most investors the choice is simple: stay out of the market, go long at a certain price, go short at a certain price, or get out at a certain price (liquidate the long or cover the short). As with chess there is vast complexity behind such decisions, but in the final analysis the rules to game are simple.

Not so with derivative trading! If directly trading an asset is like playing chess, then as my business partner likes to say “option trading is a three dimensional chess game.”

An option is a contract whereby one party (the holder or buyer) has the right, but not the obligation, to exercise the contract (the option) on or before a future date (the exercise date or expiry). The other party (the writer or seller) has the obligation to honor the specified feature of the contract. Since the option gives the buyer a right and the seller an obligation, the buyer pays a premium for such right.

Because options are indirectly related to the underlying asset and have many more components for an investor to consider, the result is an unlimited variety of ways to structure trading strategies as compared to just buying or selling the asset.

● First, options are a wasting asset and therefore have a time component. If not "in-the-money" at expiration, they're worthless.

● Second, part of their value is determined by the relationship of the underlying asset’s price versus the option’s “strike price.” The degree of correlation between the pricing of the asset and option is a function of the distance between the asset price and strike price.

● Third and fourth, there are multiple options representing different strikes prices—this is called an "option series"; further, there are multiple expiration dates for each option series.

● Fifth, their price, while related to the underlying asset’s price, is also tangentially influence by the underlying asset’s volatility.

● Sixth, double up all of the points above because there are two basic types of options: “calls” which give the holder the right to purchase the asset at a certain price, and “puts” which give the holder the right to sell the asset at a certain price.

● Seventh, double up everything again because option traders can either be purchasers of options or sellers (“writers”) of options.

So how do all this option background work together in forming three dimensional trading strategies?

Suppose the S&P 500 is trading in a narrow sideways range and volatility is extremely low. Bullish and bearish sentiment is equal and you think that the market is going to breakout either to the upside or downside—but your not sure which way.

If you were trading the Spyder (ETF contract that is linked to the S&P 500 index) you could either go long and hope the market goes up, go short and hope the market goes down, or stay out of the market all together. Limiting yourself to three choices could be frustrating.

But with options you could purchase both a call and a put at the same time. Since your cost is limited to the premium of the option you have limited downside either way if the market rallies or crashes. But if the market does breakout to the upside or downside you will be positioned to take advantage of that move. The key is that you don’t have to be right on the direction—your betting both ways at once.

Now buying options can be expensive, so how do you pay for the right to be a holder?

Let’s say that in the above scenario you think the market is going to go up or down, not in the next month, but maybe three months from now. You could “write” options (both calls and puts) with a nearer expiration date to help pay the cost for purchasing options (both calls and puts) with a later expiration date.

With this situation you’ve got four different positions operating at the same time on the same underlying S&P 500 index. Each of these positions will increase and decrease in value differently depending on the price action of the underlying S&P 500 index.

The above two option strategies are just a sampling of the position combinations that can be created with options, thereby expanding a trader’s tactical repertoire exponentially.

But take note, because of the volatile nature of markets, the purchase and granting of options may involve a high degree of risk. Option transactions are not suitable for many members of the public. Such transactions should be entered into only by persons who understand the nature and extent of their rights and obligations, and of the risks involved in option transactions.

As you can imagine the variety of trading strategies that options offer are limitless and multidimensional. It is that variety that attracted Cervino Capital Management to develop its Diversified Options Strategy. For more information this investment program, visit our website at

- Mack Frankfurter, Managing Director

Wednesday, September 6, 2006

August 2006 Review and Shifting Norms


As we conclude August 2006 our Diversified Option Strategy program returned a positive 1.51% resulting in a year-to-date return of 7.10%. The S&P 500 Index (GSPC) returned 2.13% finally overcoming the negative sentiment leftover from May and is up 4.45% year-to-date. For comparison, the Barclay CTA Index is positive 0.32% as of this writing and up 1.20% for the year. Please refer to our website at for the most recent performance statistics on our investment programs.

It seemed appropriate at this time to take a step back and analyze the state of the “hedge fund” industry, the changes that have taken place over the past fifty years and opportunities that are still available to us, participants in the alternative investment arena.

We were recently invited to be guest speakers at an international business class at UCLA. The topic of our presentation was “Cultural Crosscurrents within the Financial Services Industry.” Our thesis, applied across various economic case studies, was that norms within society have been progressively influenced by the rapid pace of globalization, resulting in macro-level transformation of the financial industry’s values and its institutions. Which ever way resulting cultural values and norms shift, astute players seek to arbitrage anomalies between local business practices versus innovations in global products/services, regulatory jurisdictions and price parity.

Such arbitrage is fast taking place in the alternative investments segment of the financial services industry as an increasingly competitive environment has subjected practitioners and their respective strategies to the unrelenting march of market efficiency. Over the past fifteen years hedge funds have become widely accepted by investors and institutionalized. By doing so, many sophisticated and previously successful investment strategies have effectively become victims to the hedge funds industry’s success.

The raison d′etre of our industry should be to provide superior money management to clients. Unfortunately this altruistic objective has in varying degrees been complicated by well-meaning regulators, sales practices distorted by conflicts of interest, but most importantly human nature itself where the intrinsic need for social acceptance and validation undermines essential qualities that are prevalent with successful investors – that of nonconformity and unorthodox thinking. Yet as soon as the mainstream assimilates maverick strategies into their portfolios, the seeds of demise are laid for such investment approaches due to a concept George Soros calls reflexivity.

The term “hedge fund” as it is now commonly used is a misnomer. It is loosely defined to be either synonymous with any type of non-regulated fund regardless of investment strategy, or jargon meant to represent all alternative investments strategies in general. Even the Department of Treasury, Board of Governors of the Federal Reserve System, Securities Exchange Commission and Commodity Futures Trading Commission in their 1999 report on “Hedge Funds, Leverage and the Lessons of Long-Term Capital Management” admit that the term is “not statutorily defined.”

Hedge funds first came into existence in 1949 when Alfred Winslow Jones opened an equity fund that was organized as a private partnership to provide maximum latitude and flexibility in constructing a portfolio. He took both long and short positions in securities (thus the name) to increase returns while reducing net market exposure and used leverage to further enhance the performance. To those investors who regarded short selling with suspicion, Jones would simply say that he was using ‘speculative techniques for conservative ends.’ Not only did Jones’ fund outperform the best mutual funds, he kept all of his own money in the fund and employed a performance-based fee structure.

It is interesting to note that Jones operated in near obscurity for seventeen years. Nevertheless, by 1968 approximately 200 hedge funds were recognized to exist, most notably those managed by George Soros and Michael Steinhardt.

During the 1960s bull market, many new hedge fund managers found that selling short impaired absolute performance while leveraging created exceptional returns. Such leveraged exposure turned out to be dangerous as many of these new funds perished after the market downturn of 1969. In 1984 only 68 hedge funds were identified, but this trough marked the beginning of an upsurge with $39 billion under management and 550 funds documented in 1990 growing into $1.2 trillion in assets and over 8,800 hedge funds in existence today.

This growth was not in a vacuum. In response to Congress’ actions with respect to the Small Business Investment Incentive Act of 1980, the SEC proposed Regulation D to replace existing private and limited offering exemptions contained in Rules 146, 240 and 242. Regulation D recognized that there are situations in which there may be no need for the registration provision of the Securities Act, and it also further clarified the definition of “accredited investor.” Shortly after adoption of Regulation D, in a series of no-action letters, the SEC confirmed that hedge funds that made offerings of securities under Rule 506 could rely on Section 3(c)(1) under the Investment Company Act, assuming they had no more than 100 investors. Ultimately, hedge funds came to rely heavily on Section 203(b)(3) of the 1940 Investment Advisers Act which exempts from registration an adviser with fewer than 15 clients during the prior 12 months and who does not hold himself out to the public as an investment adviser, and does not act as an adviser to a registered investment company.

The “retailization” of hedge funds is based on Section 203(b)(3), and the fact that historically the SEC has interpreted a "client" to be someone who is given financial advice by the investment adviser. Since investors in a hedge fund do not receive advice—they are simply investing their money—the recipient of the advice is the fund itself as administered by the investment adviser. What evolved in practice is a non-regulated structure in which a hedge fund manager could advise15 funds (ie, 15 clients), each with 100 investors or 1,500 ultimate investors. This is an example of regulatory arbitrage.

In 2004 the SEC concluded that the “retailization” of hedge funds merited regulatory action and proposed a rule requiring registration. In its push to expand its regulatory oversight to hedge funds, the SEC contended that the meaning of “client” should include the ultimate investors and under this new definition regulators would ‘look through’ the fund to the actual number of investors in the fund.

This rule was put into effect in February 2006. Hedge funds with at least $30 million in assets and investment lockups of less than two years were required to register with the Commission. But to the surprise of many, the U.S. Court of Appeals for the District of Columbia Circuit recently ruled in favor of a lawsuit brought by a hedge fund manager named Phillip Goldstein. In their unanimous ruling the Court stated that the SEC’s argument for imposing hedge fund registration was unconvincing and its rule “arbitrary.”

But this is only one half of the story…

As suggested previously, hedge funds have evolved to represent the vehicle of choice for most alternative investment strategies. These investment strategies as tracked by The Barclay Group include: convertible arbitrage, distressed securities, emerging markets, equity long bias, equity long/short, equity market neutral, equity short bias, event driven, fixed income arbitrage, global macro, merger arbitrage and multi strategy.

Such strategies use to be niche plays disregarded by the mainstream financial services industry as recently as the late 1980s. But in the aftermath of the great bull market of the 1990s they are now being marketed vis-à-vis name-brand wirehouses as institutionalized financial products. Give such acceptance, what does the future hold for this segment of the industry when “fund-of-hedge funds” have successfully exploited the Section 203(b)(3) loophole to become multi-billion dollar “retail” products?

What we do know is that at this size hedge funds need to operate differently than they have in the past.

Already we have seen one hedge fund purchase a controlling interest in K-Mart for the land underneath, while others have been engaged in private investments in public equity (PIPEs) or involved with leverage buy-outs reminiscent of the Michael Milken days. At the same time certain investment companies have redirected their efforts into offering alternative investments within the mutual fund product structure. There is no explicit rule against derivatives in mutual funds, but rather usage of such instruments is constrained by various rules such as “cover requirements,” “illiquid assets" 15 percent rule, and Subchapter M “diversification test,” and “90 percent” and “30 percent gross income” tests.

Many respected opinion makers including James Altucher in his Financial Times article “A thriving juggernaut that is getting too greedy” and Bradley Rotter in his MARHedge guest commentary “Why I’m Getting Out of Hedge Funds” have pointed out that returns have diminished significantly and many opportunities have dissipated as the “anomalies and arbitrage situations these funds earned their keep on don’t really exist any more.” Further, they argue that given recent performance, most of these hedge funds do not deserve the management and incentive fees they’re charging, much less all the other administration fees “fund-of-hedge funds” tack on.

Yet there is still very much a need for superior risk adjusted performance notwithstanding the effort by the industry to commoditize performance with absurd ideas such as hedge fund indices. So what are savvy investors to do?

The answer is to identify emerging niche money managers who operate transparently with agility in markets where anomalies still exist, but also where larger hedge funds cannot trade profitably without incurring undue risk for miniscule returns relative to their size. This is known as the “investor’s edge,” an explainable source for returns and an advantage with respect to trading skills and performance. Institutions call this “alpha.”

For us at Cervino Capital Management, we understand that our clients' returns and by extension our success depends on how we approach the following issues:

Problem #1: Structure—hedge fund structure has certain advantages, but disadvantages include lack of transparency, greater potential for conflicts of interest, lockup periods that restrict redemptions to timeframes inconvenient for investors, and with respect to “fund-of-funds” the layering of fees resulting in much higher costs.

Solution #1: Separate Managed Accounts—clients assets are held by a third party custodian resulting in full transparency and the ability to monitor trading activities on a daily basis; increased flexibility with respect to account additions and withdrawals; ability to revoke trading authorization at any time; competitive fee schedule when compared to the “fund-of-funds” structure due to fee layering.

Problem #2: Regulations—hedge funds are not free from all regulation, but a substantial change in regulations regarding hedge funds poses a major threat to the industry as it is an important factor when assessing the sustainability of certain strategies.

Solution #2: CFTC Oversight—managed futures is unique within the alternative investment universe in that it has operated in a highly regulated environment for the last 30 years under the purview of the Commodity Futures Trading Commission and self-regulatory organization National Futures Association.

Problem #3: Performance—the new paradigm of “portable alpha” proposes that market return (ie, beta) can acquired cheaply and excess returns (ie, alpha) can be “ported” onto beta through exposure to hedge funds; problem is that in recent years hedge funds have reflected performance that is highly correlated to the market as witnessed this May 2006.

Solution #3: Absolute Returns— diversification across a variety of relative value trading strategies with high probability for positive outcomes is the best way to achieve “absolute returns” on a consistent basis; recognition that capacity limitations are a material hindrance to large funds, but the upside is that market anomalies remain in existence with money managers who operate at a smaller size; repeatable strategies utilizing speculative techniques for conservative ends is best way to achieve “alpha.”

Cervino Capital Management has incorporated all the above solutions into its Diversified Options Strategy program. Our vision is to remain a niche money manager utilizing sustainable and lucrative trading techniques in which we can explain where our returns are derived from. We believe that fundamentally the outlook to the global economy present situations that cannot remain in equilibrium. The eventual dislocation of major trends is wonderful for nimble players, where volatility is the friend. For funds whose size prohibit agility, this is a minefield. For the best trading talent, it is a gold mine.

- Davide Accomazzo, Managing Director
- Mack Frankfurter, Managing Director

Sunday, September 3, 2006

They're Just Mad Enough To Be Mountebanks

'There is nothing so impossible in nature, but mountebanks will undertake; nothing; so incredible, but they will affirm.' As truly might he have added, that there is nothing mountebanks can undertake, which John Bull will not think possible; nothing they
can affirm, which he will not believe.
— Dr. John Gordon, 'The Doctrines of Gall and Spurzheim'
, 1815

I recently attended a brilliantly marketed event held at a certain hotel. The costly mailer advertised that several Genuine MILLIONAIRE Experts including a certain celebrity would share the “secrets and strategies” to creating wealth. One of their testimonials touted:

“I’ve almost tripled my portfolio in the last 11 months from just under $1M to over $2.7M. Thanks!”

While archetypal of claims made on late night infomercials, financial professionals are well aware that the Investment Advisers Act of 1940 prohibits advisers from making misleading statements or omitting material facts. In particular, "false advertising or mis- representation includes the use of testimonials or endorsements which is prohibited." This bears repeating... THE USE OF TESTIMONIALS OR ENDORSEMENTS IS PROHIBITIED.

My curiosity piqued, and so I decided to investigate this "once in a lifetime" celebrity symposium. Who were these guys, what were they promoting, and how were they able to skate by industry regulations?

The definition of a charlatan is a person practicing quackery or some similar confidence trick in order to obtain money or advantage by false pretenses. Unlike a conman, he does not try to create a personal relationship with his marks, or set up an elaborate hoax using roleplay. Rather, charlatans resort to quackery, pseudoscience, or some knowingly employed bogus means of impressing people in order to swindle victims by selling them worthless nostrums, goods or services that will not deliver on the promises made for them. The word calls forth the image of an old-time medicine show operator, who has long left town by the time the people who bought his snake oil tonic realize that it does not perform as advertised.

Could it be that these guys are the modern day equivalent of financial snake oil operators?

Before conveying what transpired, let me emphasize that the majority of the professionals I know, from insurance agents and financial advisors to professionals in related fields of accounting and estate planning, behave honorably and in the best interests of their clients. Additionally, there are ample regulations in place as well as industry watchdogs and administrative bodies imposing strict guidelines pertaining to its members’ conduct and ethics.

All the same... “Caveat emptor”

Unfortunately this age-old piece of wisdom raises the pragmatic question of how such advice should be put into practice. The answer is twofold: first, educate yourself; second, follow the money.

Most (but not all) financial products are commission-based, that is why the economic foundation and core culture of many brand name commercial banks and brokerage houses rests in their sales force. Yet all because financial products are packaged and sold, it does not automatically make such investments “bad” for the consumer. The question is whether the traditional product-driven, commission-based sales culture that permeates the financial services industry best serves the interests of investors?

As investors have become more educated and less inclined to be “sold” financial products, there has been a transformation in the financial services industry. Have you noticed that there are no more “stockbrokers” or “insurance agents”? Financial product salespeople have evolved into “Vice Presidents,” “Private Bankers,” “Estate Planning Specialists,” Financial Planners,” and all manner of intriguing and captivating titles denoting trustworthiness, wisdom, experience and financial acumen. These titles—they may be well earned and deserved—are meant to boost professional credibility, and to provide consumers with confidence that they are being advised rather than sold, which may or may not be reality.

Fact is that the majority of stock and bond market “advisors” are commission-based “registered representatives,” which is their official regulatory title and indicates that they are agents of their employers (broker-dealers), and are registered and licensed (Series 6 or 7) to receive commissions for the sale of securities (stocks, bonds, etc.). Ludicrously, the Series tests are not at all difficult to pass, and bragging rights often go to those with the lowest passing scores because they are “most likely to succeed”—I am not kidding.

In effect, registered representatives are distribution agents for broker-dealers—it is their job to sell products to the investing public, for which in turn they are paid a percentage of the commission. The percentage a registered representative receives is dependent upon the trailing level of “production” (ie, sales) that he or she generates for the firm. That’s why broker-dealers refer to their agents as “producers” and every representative’s goal is to become a “top producer”. As in any sales culture, compensation is the ultimate benchmark used to measure effectiveness—not the performance of clients’ accounts. A top producer ranking means that he or she is among the biggest generators of sales commissions for the firm and is among the highest compensated agents.

The untarnished truth is that the majority of well-known brokerage firms (also known as wirehouses) push new advisors to sell, sell, sell and only pay lip service to the building of a financial practice with the clients’ best interest in mind.

But I digress… What were these "celebrity" get-rich-quick experts selling? The answer is half truths wrapped in a ‘one size fits all’ motivational pitch designed to push all the right “greed” buttons and get you to buy their snake oil. And the crowd was gobbling it up!

Looking sharp in an expensive business suit and carrying the swagger of a just retired football quarterback, our first presenter was selling a website that provided systematic buy/sell entry/exit points for “only $8,000”. Showing charts with well known and commonly used indicators such as MACD, RSI and stochastics he illustrated on two huge screens presentations of back-fitted trades all perfectly aligned to make money at every twist and turn of the stock. He went on to claim that “these technical tools can help you [us] make a 95% annual return, which over twenty years can turn a $5,000 investment into over $3 billion dollars!! Now, wouldn’t you [us] all like to make a billion dollars?” He extolled to the whoops and applause of a roused audience. So as to nail it home, this charismatic and authoritative speaker was willing to offer us the whole package at a reduced price of just $3,000 including a two day seminar required to make attendees overnight experts on his website system.

I was amazed to watch a large group of the attendees flock to the back tables and happily plunk down $3K knowing that armed with this man’s “secrets” (and their remaining $5k from the $8k “actual cost”) they too will turn into multi-millionaires. Unfortunately they d
idn’t realize that this so-called “knowledge” about systematic trading is well documented on the business bookshelf at their local Borders Bookstore. And as far as all those charts and indicators on his website, these services can be easily obtained without charge on multiple websites not to mention that most brokerage firms now provide excellent trading portals with an abundance of similar tools.

Of personal interest was the regulatory loophole that allowed this mountebank to use unsubstantiated testimonials—technically he was only selling “investment education” and access to a website. And because he positioned himself as an “educator” and not an advisor, he did not have to be registered. At the same time, while websites providing specific buy/sell investment advice given should be a regulatory cause of concern, my suspicion is that his firm side-step this issue by having their subscribers input their own buy/sell rules based on the two-day seminar each must attend. What was most devious about the slideshow was that the so-called systematic entry/exit points shown were back-fitted and selectively presented. There is not enough room here to go into the development of robust trading systems, but I’ll relay to you what the National Futures Association (NFA) has to say about this:


Next was a Juris Doctor appropriately bespectacled to substantiate his intellectual lawyerly demeanor. Just as polished and motivational as the prior speaker, his pitch began with C-Corps. According to him every single one of us was losing out on all sorts of tax deductions and needed to immediately establish our own C-Corp using his easy-to-use book of forms (for only another few thousand dollars, I might add). What about having legitimate business income? “Well aren’t you all going to make big bucks with that trading system you were just shown,” he taunted, “that’s legitimate business income!” Then without skipping a beat he was off and promoting Charitable Remainder Trusts as if this structure was appropriately suitable for each and every attendee.

Now there is no doubt that such structures in certain situations can be beneficial. But the operative words are “appropriate” and “suitable.” For some J.D. who isn’t even a practicing attorney in the State of California to be flatly suggesting that we ALL could benefit from his one-stop-shopping advice made my stomach crawl.

But wait, there’s more! The third expert was about to speak about the “safest, most lucrative, investment strategy in America”—tax liens. To learn everything I needed to know to set myself up only would cost me only another “measly” $3,000.
I had enough... I could go on about tax liens as I was once responsible for winding down a portfolio of tax liens purchased from Kidder Peabody by the investment boutique I worked for, but I think my point is made.

So what is to be learned from all this?

Savvy investors know that good investment results requires the steady and persistent application of knowledge, hard work and prudence. Obtaining outsize returns can only be generated by outsized risk—sophisticated investors understand how to measure risk in relation to the returns their portfolio generates. They also ensure that their portfolio is well diversified across a variety of trading strategies as well as asset classes, and monitor the markets and make tactical adjustments as necessary. In order to do this properly
institutional and sophisticated investors delegate portfolio management to money managers who have expertise in specific investment strategies.

I hear a lot of criticism about the financial services industry and us professionals in the business—some is deserved, but more often criticisms reflect a level of confusion about investments in general. Yes, it helps to be familiar with the structure of the financial services industry, the sales culture that it propagates, and how your advisor is being paid. But if your not comfortable with investing on your own, that should not prevent you from seeking help to create a personal financial plan and structure a well diversified investment portfolio.

So whether you invest on your own or work with an advisor(s), the key to successful investing is education, diversification and disciplined approach(es). When using a professional seek out advisors who take the time to communicate the costs, risks and benefits of their investment approach. Reputable advisors encourage the public and their clients to become ever more knowlegable about the investment process and risk-return concepts, as that translates into the ability to advise on sophisticated strategies.

Postscript: What about the celebrity? Who was he? Without naming names, it’s enough to say he was a participant in some reality TV show. Like I said, half-truths…

- Mack Frankfurter, Managing Director

Sunday, August 6, 2006

July 2006 Review and the China Factor


We are pleased to report that our Diversified Option Strategy program returned a positive 1.47% for the month of July 2006, resulting in a year-to-date return of 5.50% and continuing seven straight months of positive performance. This is in comparison to the S&P 500 Index (GSPC) which returned 0.51% for July and 2.28% for the year; meanwhile, the Barclay CTA Index, as of this writing, is down 1.26% for July and up only 1.45% for the year.

Most of our July gains in the Diversified Option Strategy program came from our quant-oriented positions in expiring S&P contracts, and a fundamentally based position in natural gas. Increased volatility overall has helped us achieve higher returns in the past couple months just as at the beginning of the year our monthly numbers were slightly depressed by the lack of volatility. For more information, please visit our website at

During the month some interesting macro economic numbers were released; in particular, those relating to the Chinese economy were the most attention-grabbing. For the second quarter 2006 China’s gross domestic product (GDP) grew 11.3 percent over the year earlier, while industrial output clocked in at a record 19.5 percent rate in June. At the same time investment and exports have catapulted China’s economy to the world’s fourth largest in the 28 years since free-market reforms began. It is worthy to note that the China boom is hurtling along at its fastest pace since 1994 when its economy was one-fourth its current size.

The situation in China reflects a global economic landscape that has undergone a seismic shift in the last decade, and is echoed by the fact that the combined economies of China and India are now greater than the United States. According to the Bank of Nova Scotia emerging and newly industrialized Asian nations, excluding Japan, now account for 30 percent of the world’s economic growth when GDP is adjusted to reflect purchasing power parity. Meanwhile, the countries that make up the G7 (Canada, France, Germany, Italy, Japan, Britain and the United States) currently represent 41 percent of global GDP, down 6 percent from a decade ago.

Asia’s ascendance as an economic superpower has been augmented by robust regional dynamics. Trade within the Asian region centered around China is now nearly twice as large as the trade that takes place within the NAFTA zone. As a result of the boom, infrastructure projects in the area are undergoing a massive expansion, and the furious pace has spurred a migration of people from the country to cities and led to rapidly rising income levels, which has in turn boosted consumer spending.

The problem is that this level of growth in China is not sustainable as it leads to rampant inflation, inefficiencies in capital allocation, margin compression and increased banking instability. The Chinese government recognizes this and has embarked on a series of steps to try and rebalance the economy. These steps include an increase in the banks’ reserve requirements, a cut in tax rebates from exports, tighter controls on land development and a range of other “administrative measures.” However, while there are signs these actions are starting to have some impact, most are far from optimal.

Administrative measures are blunt instruments that create distortions elsewhere in the economy. They are also hard to enforce. It is reported that the majority of recent land transactions in some provinces are illegal because local governments have defied Beijing’s directives to restrain property investment. By the time orders do get implemented, there is a risk that it will be too little too late. In the meantime, a belated increase in interest rates is widely expected soon, although such increase is unlikely to rise by enough to restore neutrality. As a result, monetary policy is set to remain over-stimulative for the time-being.

In their defense, China’s central bank’s caution to use monetary policy may partly be because the effectiveness of such tools in China’s economy is limited. But that point reveals a central issue—that China is NOT YET a mature free market country, and in fact has a primitive financial system which is still centralized and steered by politicians who act primarily to benefit their political interests first.

Given decisions to date China’s policymakers are more concerned with denting growth. China needs GDP growth north of 7% a year just to stay even with its massive population and new job seekers. Reducing unemployment and underemployment requires even faster growth. At the same time, the government is alarmed by runaway real estate prices because unaffordable housing has become a major political flashpoint for the majority of urban Chinese.

This poses a real conundrum for the Chinese government. As long as China is fueled by cheap money, slowing down one sector through “administrative measures” only means that the money will flow into other sectors and create an asset bubble somewhere else. In any case, at this point Beijing is for now reluctant to effectively tackle the growing domestic imbalances in its economy by implementing “modern” fiscal and monetary policies.

With that in mind we can attempt, by looking at the interests of the political elite, to make an educated guess as to the timing of when China may be forced to face the ramifications of its extreme growth.

In two years China will host the largest international event: the 2008 Olympics. This will be the perfect showcase for the new China, a country which knows well that for the first time in its modern history it has an opportunity to position itself as a global economic and political superpower. As it stands the idea that American hegemony is overstretched and fatigued represents thinking advocated/ believed by many, Russia’s economy under its “oily curtain” is too reliant on the vagaries of international commodities markets, India remains the acknowledged tortoise in the economic race between the two Asian giants, while "old" Europe–too busy figuring out the meaning of life–shuffles from one crisis of confidence to another.

So until 2008, notwithstanding any uncontrollable economic tsunami occurring, China will continue to aggressively build up its infrastructure and secure more raw materials and energy supplies at any cost whatsoever. This factor has already been evident in the magnitude of increased demand many commodity markets have already experienced. If China follows this script then Chinese economic growth and supply-side demand will be prolonged for at least the next two years. Therefore, as a general trading framework, we should look to take advantage of any short term technical weakness in commodities, keeping in mind the summer of 2008.

What about after the 2008 Olympics? I think China (and the world) will have to come face-to-face with its enormous portfolio of non-performing loans which will cripple China’s banking system. The ramifications are potentially scary when one thinks about the fact that China is the second biggest holder of U.S. Treasuries and together with Japan accounts for more than half of world reserve accumulation between 2002 and 2005. In fact, the United States now needs to attract about $2.5 billion a day to fund the trade gap and keep the value of the dollar steady.

The build up of reserves and a growing trade deficit with China has given U.S. politicians fodder to demand change. The U.S. has been pushing China to let its currency trade more in line with market forces. Fed Chairman Ben Bernanke also chimed in saying “I don’t think that we can continue to finance the current account deficit at 6 percent or 7 percent of GDP indefinitely, and it’s desirable for us to bring down that ratio over a period of time.”

Yet others argue that the squeals in Washington at the yawning U.S. trade deficit with China are overblown. The basis for the viewpoint is that the wide difference between both sides’ data is overstated. After ironing out data discrepancies, Oxford Economics found that China’s share has hovered at about a fifth of the total U.S. merchandise deficit since 1995. By most measures, the U.S. is still the top manufacturing nation producing almost a quarter of global output, the same as in 1994. If U.S. manufacturing is stronger than many Americans believe, China poses a weaker challenge than is often supposed as its output is still less than half that of the U.S. and many of its industries are suffering a severe profits squeeze. According to the Institute for International Economics and the Center for Strategic and International Studies, on average two-thirds of the value of Chinese products is imported. Further many big-ticket Chinese exports are of things no longer made in the U.S. or that have never been made here. Therefore a large renminbi revaluation would merely shift Chinese production to lower-cost locations elsewhere.

When push comes to shove, the recent tumult in the middle-east and the resulting “flight-to-quality” into U.S. Treasuries reminds us that for the time-being the greenback’s status is still “the” world currency reserve. And when all is said and done, those who would fear China imposing a new economic world order should think back to when the same was said of Japan.

However things evolve economically and/or politically, the Chinese proverb “may you live in interesting times” seems appropriate at this juncture in our world’s history.

- Davide Accomazzo, Managing Director

Tuesday, August 1, 2006

Relative Performance vs. Absolute Returns

"And so instead of absolute places and motions, we use relative ones; and that without any inconvenience in common affairs; but in philosophical disquisitions, we ought to abstract from our senses, and consider things themselves, distinct from what are only sensible measures of them." invest in cervino capital management invest in cervino capital management invest - Isaac Newton, 1687

It seems simple but knowing whether a portfolio manager is doing a good job can be a challenge. It's difficult to define what good is because it depends on how the rest of the market is performing. For example, in a bull market 2% is a horrible return. But in a bear market, when investors are down 20%, just preserving your capital would be considered a triumph. In that case 2% doesn't look so bad.

Absolute return is the fixed percent an asset or portfolio returned over a certain period. Therefore, the 2% mentioned in the paragraph above is considered absolute return. If a mutual fund returned 8% last year, then that 8% would be its absolute return.

Relative return, on the other hand, is the difference between the absolute return and the performance of the market (or other similar investments), which is gauged by a benchmark or index such as the S&P 500. Relative return is the reason why a 2% return is bad in a bull market and good in a bear market. For example, if the absolute return of your portfolio is 10% and the performance of the S&P 500 during the same time period is 6%, then you have a relative return of 4% greater than the market (10% - 6% = 4%). If, however, during this same time period the S&P 500 returns 15%, then you have a relative return of -5% (10% - 15% = -5%).

Why is relative return so important? Because it is the generally accepted method for measuring the performance of actively managed portfolios, which should get a return greater than that of the market. After all, you can just buy an index fund that has a low management expense ratio and will proxy the market’s return. However, if you’re paying a portfolio manager to perform better than the market and the investment doesn’t have a positive relative return, it may be worth finding a new manager or just buying an index fund.

But this is where it can get complicated. Who is to say what the “market” is? The S&P 500 index is often cited as the benchmark for the U.S. stock market but in actuality it represents mostly large capitalization stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States, while the Lehman Aggregate Bond Index is comprised of fixed income securities to simulate the universe of bonds in the market. Relative return can also be used within a context smaller than the entire market. For example, a technology fund's performance could be measured or benchmarked against other technology funds. What about foreign stock markets? Have you heard of the FTSE, DAX, Nikkei, or All Ordinaries? These benchmarks represent stock indices for London, German, Japanese and Australian equities, respectively.

It’s wise to look at relative return to see how an investment's return compares to other similar investments. The trick is finding a comparable benchmark in which to measure your investment's return; then make a decision of whether your investment is doing well or poorly. That said, in the final analysis, the power of compounding is best accomplished with consistent positive returns year-in/year-out regardless of market conditions. Investors re-learned this fact after the 2000-2002 bear market, and this is why so many institutional investors have substantially increased their allocations to absolute return programs.

Realizing that traditional methodologies may not be sufficient in helping achieve investment goals leads to the problem of finding absolute return strategies. In order to accomplish this sophisticated investors have increasingly embraced a new paradigm that rejects total return as the measure of a strategy's worth. The concept is that any strategy's total return can be divided into a market return (beta) and 'ideally' a net excess return (alpha). What is of real value is an investment strategy's ability to consistently generate alpha.

The bottom line is it is not easy to find strategies that consistently generate risk-adjusted excess returns. For example, investors must be able to distingish market returns (beta) from excess returns resulting from skill-based actions ("true" alpha) and excess returns resulting from non-skill-based actions (e.g., consistently holding large cash positions, taking increased benchmark risk, or using leverage). Even when one is knowledgable about these performance evaluation concepts, the investor must have access to alternative investment managers (many have high minimums and require "accredited investor" status), be comfortable with the structure, and after making an investment, monitor existing managers to ensure their approach continues to provide desired alpha.

The greatest barrier to acceptance for this investment approach is often psychosocial: the unwillingness to try something new based on frequently cited "conventional wisdom" that is marketed by an industry riddled with conflicts of interest, not to mention regulators and regulations that end up institutionalizing "good" from "bad" investment approaches. The herd mentality always tends to rule. Luckily, innovative investment strategies, such as those offered by the regulated approach called managed futures or unregulated vehicles known as hedge funds, are increasingly becoming accepted as a desirable means for diversification. (In the opinion of this author, hedge funds should be regulated but not the investment strategies they promote.)

The move to the new paradigm of alternative investments, absolute returns, separation and recombination of beta and alpha requires that investors think differently about the investment process and their investment portfolio. No one is claiming that investors should rush to embrace this new paradigm. Instead, they should carefully evaluate this shift to determine its benefits and risks. This understanding will alow investors to develop a prudent plan so they can properly respond to new opportunities.

In conclusion, the separation and recombination of beta and alpha is only one of the fundamental principles of the new investment paradigm. The other, the acceptance of alpha-based strategies as a part of an investor's asset allocation policy is equally important. The search for alpha is difficult, especially when the source of alpha is the asset class itself, such as with managed futures. The key objective for investors is to distinguish manager skill from market returns and factor in investment management costs; that is, pay minimal fees for beta, and only pay for uncorrelated alpha.

The Diversified Option Strategy of Cervino Capital Management is an example of an absolute return program where returns are derived primarily from skill-based trading decisions. While past performance is not necessarily indicative of future results, the program has been able to sustain consistent positive monthly performance since inception as well as very low correlation when compared to the S&P 500 index. Positions are diversified across various financial and commodity markets, and entail complex option strategies that have varying degrees of market direction exposure: long, short or neutral. A key part of this strategy is recognizing that options are a wasting asset. Accordingly, the trading model is similar to the insurance business model whereby premiums are collected and risk management is the primary focus. For more information, visit

- Mack Frankfurter, Managing Director

Saturday, July 8, 2006

June 2006 Review and Inflation Concerns


Cervino Capital Management is pleased to announce June 2006 performance returns for our Diversified Option Strategy program, which operates under our Commodity Trading Adviser (CTA) registration. This month was the program's best month yet with a positive return of 1.68% for June 2006 at a time when equities showed continued uncertainty from the prior month. So far year-to-date we've return a composite 3.98% in this program versus the S&P 500 Index (GSPC) up 1.76% as of June 30th. The non-correlated performance between our program and the stock market is not by chance, but by design—consequence of a multifaceted approach based on selection of markets, flexible instruments and a variety of decision inputs. For more information, please visit our website at

While satisfied with this past month’s accomplishment, our focus remains on evolving macroeconomic trends and prospective trading opportunities. That said, much of the recent global market turmoil has been linked to market participants’ perception of inflation pressures going forward, which in turn effects interest rates, fiscal policy and consequently asset prices. But in order to envisage how such percpetions may influence investors' future actions, we need to first cover what's happened in the last couple months. Here’s a play-by-play of the recent market correction:

At the beginning of May the DJIA was nearing its January 2000 all-time high of 11,723 on expectations that the Fed would stop raising the Federal Funds rate. Then on May 11th, a day after the Fed raised rates by a quarter point to 5%, market sentiment “suddenly” shifted to the threat of inflation in response to the FOMC policy statement which indicated the potential for further Fed tightening. The market corroborated its fear on May 17th with the Core-CPI number coming in at 0.3%, “significantly?” over market expectations of 0.2%. Since the bottom (closing price) on June 13th, the market has posted two strong up days with consensus saying it was due to short covering.

The lack of clarity in communiqués from a transformed Fed council (not only is Bernanke new to the Fed Chief role but there are also a number of new board members) added to the confusion. A cynic would suggest that for the Fed... “to decide is to succumb to the preponderance of one set of influences over another set.” Yet it is no surprise that the Fed has been leaving its options open. The same uncertainties exist today as after the Fed meeting in May with respect to the intensity of inflationary pressures versus the robustness of the economy. This is reflected in how different markets are saying different things or the same thing differently.

The stock market vacillates between bear and bull concerned about whether we’re in for a “soft” versus a “hard landing” with the bulls arguing continued strong productivity and corporate earnings. The U.S. yield curve is shifting between flat and inverted projecting a recession, but remaining vigilant on the inflation front due to 'many years in the making' excess global liquidity. All the while speculation in certain commodities markets (also reflected in certain emerging markets) is creating a frothy trading environment—but this time, unlike the late 1990’s technology stock era, what is good for producers comes at a cost for consumers. And let us not forget the ongoing fiscal concerns about the U.S. current account deficit underlying the decline in the dollar. There has even been some suggestion of a 1970’s economic redux coined “stagflation-lite.”

All this uncertainty reflects a potentially more complex set of factors underlying current inflationary concerns as opposed to economic cycles in the collective past memory. There is in fact a battle between assets and goods that are under strong inflationary influences versus services and wage costs that are still under deflationary pressures. Labor and the service sector has been and continues to be under downward pressure largely due to the power of technological improvements that came with the internet. This situation has created what is referred to as the ‘global labor arbitrage’ which, while helping corporate margins in the short term, over the long term has depressed U.S. workers’ income and therefore the disposable income of the world’s biggest consumer economy.

Meanwhile, consumer staples and other items of necessity are rapidly increasing in cost (e.g., energy, food, health care, rent). For many years the U.S. consumer has benefited from globalization and the importing of low priced goods. But now, a developing shortage of key raw materials as the world’s economy grows is creating an economic environment in which raw materials prices are rising faster than finished goods prices. This trend is likely to continue and as a result certain countries, specifically China and Russia, may find it in their best interests to allow their currencies to appreciate against the dollar. An appreciating currency will cause a country’s finished goods export prices to rise, but it will also lower that same country’s respective import costs of raw materials. Assuming the ongoing trade deficit, this means U.S. consumers end up importing inflation from abroad. The logic follows that if inflationary pressures are felt most on necessities the resulting impact on consumer spending behavior will ultimately be reflected in corporate earnings.

At the same time, assets such as real estate and stocks, which have greatly benefited from a “goldilocks” environment of strong growth and low inflation, have reached valuation levels that are subject to rational scepticism. Housing-rent parity, proliferation of sub-prime and adjustable rate mortgages, tapping out of home equity lines of credit, consumer debt levels, and historically low household savings underlies our concern about real estate. If a bearish housing market evolves, consumer discretionary spending will come under even more pressure, as in the past few years much of this spending was subsidized by the home equity extraction strategy.

As for equities—yes, productivity and earnings have been persistently strong, and the balance sheets of corporations for the most part are solid. However, deeper analysis shows that we are, at the moment, in a period of unusually high earnings—which does not bode well for future returns. Further, the graying of baby boomers is expected to have broad economic impact. Not only will this population shift encumber public entitlements such as Social Security and Medicare, the burden is already being felt on private and state pensions’ as they struggle to match future liabilities. As this generation’s age accelerates past 65, it may spark an asset meltdown affecting equity returns just when increasing numbers begin to tap their investments.

Finally, credit experts agree that some turn in the credit cycle seems overdue—leverage multiples are sky high, banking covenants have been relaxed, and as we write this, a growth slowdown is being instigated by the co-ordinated removal of liquidity by the world’s central banks. This is occurring at a time when the credit spreads between high yield and investment grade debt are at cyclical lows. Between 2000-2002 the spread on corporate high yield bonds over US Treasuries was 6-11 points versus 3 points at present. Any renewed market turbulence could reduce risk appetite further, just as credit fundamentals start to weaken. Unfortunately, many investors have grown so unhealthily used to chasing returns at almost any price that any slight up-tick in spreads will be seen as a buying opportunity.

This line of reasoning causes us to conclude that a 2007 recession should be almost unavoidable. In light of expected actions by the Bank of Japan (“Tokyo’s revised growth forecasts point to rate rise” Financial Times, July 8, 2006) and European Central Bank (“ECB signals likelihood of interest rate rise early next month” Financial Times, July 7, 2006), their actions at this juncture seems to be far more important to the macroeconomic picture than Fed actions now and even after its next meeting August 2006. With this perspective in mind we will try to navigate the seas of global investing as profitably as possible in full recognition that the assets you have entrusted to us were earned with hard work.

- Davide Accomazzo, Managing Director