Sunday, July 8, 2007

2nd Qtr 2007 Review and Black Swans


My business partner and I have recently discussed at length the anti-probabilistic theories and philosophical musings based on a book we both recently read, “The Black Swan; The Impact of the Highly Improbable” by Nassim Nicholas Taleb.

This book has recently made the rounds quite extensively in the hedge fund community because of its caustic approach about life and trading, and for having been written by one of us.

One of the points I had been making to friends and colleagues before the book came out—and ‘corroborated’ (pun intended) to a certain extent by Taleb’s thought process—is the increasing cosmogonic awareness of uncontrolled chaos around us.

This is not a soul searching exercise but part of an ongoing discussion in the intellectual vanguard of market analysis; that is, the impact that acute random events as well as seemingly trivial random events may have on the markets, and by implication on the highly leveraged trading environment we find ourselves managing.

Long-held ideas and passed-down wisdom teaches us to explain markets based on likely relationships between certain cause and effect dynamics. In the case of option theory, traders also utilize quantitative calculations based on the Black-Scholes model, Cox-Ross-Rubinstein binomial tree, and/or Monte Carlo simulations, all which stand solidly on the shoulders of conventional statistics and probability assumptions.

Taleb, however, puts forward that ‘we’ live in an increasingly complex world of unpredictability and inequality resulting in situations of huge disparity between efforts and rewards; accordingly, Gaussian bell curves are “intellectual frauds.” My contention is that ‘we’ live and trade in a world of “self-fulfilling prophecy,” until one day ‘we’ wake up to find long-held assumptions are turned upside down (‘the trend is your friend until it ends).

Regardless, this past year has certainly increased my awareness, as well as in others, of a disruption in traditionally-understood economic relationships: “When America sneezes, the rest of the world's economies may no longer catch a cold” (The Economist, “The Alternative Engine,” October 19, 2006).

Philosophy aside, our performance has been less than stellar in the first part of this year, but I do not want to sound defensive by claiming randomness as an excuse—I’m not. However, knowing that smart traders like Taleb are buying the insurance we’re selling (and for which we receive premiums) induces us in turn to prudently reinsure some of our positions.

Appropriately we have increased our S&P hedges and also made our trading more diversified than last year as a proactive way to deal with hurtful “grey swans” that may be potentially overlooked by our models. At the same time, the increase in volatility from the doldrums last year and earlier this year is generally welcomed, and we have made adjustments to capture the upside in this new environment within reasonable risk parameters.

With respect to market fundamentals, my thesis is bullish on energy, while remaining short term cautious in equities where I have assumed a more benign outlook for the intermediate term. One of the reasons for such an intermediate bullish outlook resides with the attitude of the ‘smart money.’ A number of studies tracking large commercial players show a fairly bullish set up; history has taught us that betting against these investors may be a mistake.

We are a bit disappointed with silver and gold; especially since the latter seems to trade mostly on physical demand while investment demand has waned. I also question gold’s reflection of the inflationary environment which I still believe is miserably (or should I say self-servingly?) misrepresented by the official statistics.

In conclusion, we expect volatile waters to navigate going forward but think we have trimmed our sails accordingly and look forward to the second half of 2007. Having set our compass, should we see a black swan we will kindly remind him of Black-Scholes’ greeks.

- Davide Accomazzo, Managing Director

Saturday, July 7, 2007

Managed Futures and Incubating Talent


"Managed Futures: A Model for Incubating Talent" was originally published by Focus Point Press, Inc. (Emerging Manager Focus) on June 18, 2007.

“Until lions have their historians, tales of the hunt shall always glorify the hunters.” --African Proverb

The idea of traders staking other traders for a slice of profits is probably as old as trading itself. Fast forward to the late 1970s and one unearths Commodity Corp. which is remembered for launching the renown careers of Michael Marcus and Bruce Kovner. And in 1983 Richard Dennis is legendary for having made a bet with William Eckhardt which led to his recruiting and training the “turtles.”

One of Richard Dennis’ earliest if not first client was Bradley N. Rotter,[1] who established a successful track record by investing early with traders like Joe and Bob Hickey, Willis-Jenkins, Mississippi River, EMC Capital and Hawksbill Capital. In 1990 Rotter founded a company called The Echelon Group with the idea of forming joint ventures with talented traders and then helping them grow into niche money management firms.

Then there is Arpad “Arki” Busson, who began his career raising capital for Paul Tudor Jones and is the founder of EIM Group with $8bn in assets.[2] Busson made his name betting not in stocks, bonds or derivatives, but rather in upstart managers some who became hedge fund titans.

The common thread between these trailblazers is the niche segment of the alternative investments industry they got their start in—managed futures.

Managed futures has always been the little kid brother to the hedge fund juggernaut. Nonetheless its impact upon the industry is writ large in two significant and related ways: first, the managed futures industry unlike its brethren hedge funds operate in a highly regulated environment; second, this same regulated environment which imposes disclosure and reporting requirements lends itself to fomenting lower barriers of entry for new talent to evolve.

Money managers within the futures industry operate under registrations either as Commodity Trading Advisors (CTA) or Commodity Pool Operators (CPO). The latter in practice is a regulated hedge fund,[3] but it is the CTA structure we’re most interested here.

Key to the development of any emerging trader is the ability to establish a legitimate performance record and quickly raise assets. Managed futures addresses both of these concerns.

With respect to raising client investments, managed accounts are an established and widely accepted vehicle within the managed futures industry. This arrangement provides a variety of benefits from the investors’ perspective. Advantages include the fact that futures accounts are mark-to-market daily, transparent and easy to monitor, and most importantly liquid in the sense that an investor can easily fire a CTA (as a matter of practice CTAs usually liquidate positions on instruction in 24-48 hours or even less). On this basis it can be argued that the managed account structure is a more attractive vehicle for investors who focus on emerging traders, especially when compared to concerns about hedge funds’ delay in performance reporting (often it is quarterly), lack of transparency, as well as investment lock-ups and redemption cycles.

Sophisticated investors in managed futures utilize what is known as the cross-margin account structure where a cash account is capitalized and collateralizes trading accounts traded on a nominal or notional basis. The result is a customized multi-advisor portfolio with the ability, at least hypothetically, to control the leverage utilized by CTAs that capital is allocated to.

Managed accounts provide several advantages for emerging traders too. The legal, administrative and audit costs in setting up a hedge fund can be prohibitive and requires traders to try and raise at least $5 to $10 million in client assets before they commence trading. Meanwhile, it is not uncommon for CTAs to establish themselves starting with $100k in assets. Minimum account sizes within the industry range from $25k (exception rather than the rule) to $5 million, with smaller minimums making it easier to attract clients.

The other advantage managed futures provides emerging traders—a regulated environment for establishing a money management business—is exactly that aspect which many traders perceive as a major disadvantage. It is in actuality quite the opposite situation.

The Commodity Futures Trading Commission and the industry’s self regulatory organization, the National Futures Association, have set forth clear accounting and disclosure guidelines with respect to CTA managed account composite performance reporting. The rules are also well established in regards to disclosure of client trading versus proprietary trading as well as hypothetical presentations.

There are too many nuances for this article to delve into a detailed examination of certain issues regarding reported CTA performance data. Suffice it to say that the formalized composite methodology and the ability to publicly disseminate composite performance on managed accounts, something which is a significant regulatory constraint for private placements, is a great boon to emerging CTAs in terms of their ability to publicly market their track record.[4]

In fact, the only consistently reported data in the early days of alternative investments initially came from CTAs, not hedge funds. This data became the basis for an academic body of research on managed futures which includes studies by Lintner (1983), Baratz and Eresian (1985, 1989), Oberuc (1990) and Schneeweis (1996).

One can point to the beginning of the institutionalization of alternative investments as partly a result of CTA performance tracking databases such as Managed Account Reports which grew into MAR/Hedge, and TASS Management which is now Lipper/TASS. These organizations, like many focused on managed futures in the 1980s and 1990s, subsequently evolved from boutique businesses to industry insiders within the hedge fund universe.

This returns us to the original idea that managed futures is and has always been a fertile area of the industry for developing emerging talent apart from those with institutional pedigree.

Managed futures remains mainly a boutique shop industry. Start-up costs are relatively immaterial and many CTAs are or began as one-man shops by leveraging proprietary track records, registering with the NFA and filing a disclosure document. Established industry databases collect and present CTA performance via websites such as and At the same time, there is an established network of Introducing Brokers (IBs) and Associated Persons who focus primarily on marketing CTA programs.

There are pitfalls, however. Due diligence on many of these operations would reveal that they are light on the operational side. While certain administrative activities can be outsourced, it still remains the trader’s responsibility to establish sound practices and comply with the ever-expanding burden of rules and regulations. Yet a trader focused on operations and marketing is not focused on the markets, research and trading.

Another approach to starting up a CTA is partnering with operationally minded personnel that can relieve many of the administrative requirements from the trader’s shoulders.

This is the approach my business partner and I took when we established Cervino Capital Management LLC, a CTA and RIA. Leveraging my background with Rotter in the 1990s incubating emerging traders and then running the operations-side, I co-founded Cervino with Davide Accomazzo. Davide also has prior experience in managed futures previously running a CTA as a one-man operation as well as an offshore hedge fund.

Besides the segregation of duties—Davide is Cervino Capital’s principal trader and concentrates his attention on the markets—development of our trading program began by first considering how we would differentiate our product from competitor programs. We achieved this by creating a well-defined yet robust mandate in which the trading program operates. This was done in view of what we thought prospective clients would desire in terms of various factors including but not limited to performance objectives versus equity volatility, margin-to-equity utilization which allows leverage through notional funding, and a best practices approach to operations.

This is atypical of how many CTAs get their start, and reveals other questions for investors to consider when allocating to an emerging CTA program, including: applicability of proprietary results as representative of prospective trading in client accounts; amount of leverage used to generate returns, serious consideration and commitment by trader as to the program’s capacity limitations; as well as accessibility and organizational professionalism.

Unfortunately, while “past performance is not necessarily indicative of past results,” there is a tendency with many who invest in managed futures to chase hot performance. Rather, what should take priority in investor’s thinking is the robustness of the underlying trading strategy as it pertains to varying market environments—when does an approach work best, when does it not work and how does the CTA manage risk and drawdowns during such periods?

Investors who invest with emerging CTAs (and the same applies to investing in established CTAs) should seek to develop robust multi-advisor portfolios with these questions in mind.

Likewise, if making allocations to emerging CTAs is considered an attractive investment, then what about the business model of incubating CTAs? The economies of scale that derive from leveraging standardized and professional operations with multiple sources of trading talent, has from my experience, always been an attractive opportunity.

- Mack Frankfurter, Managing Director

[1] Futures Magazine, “Rotter thrives on investing from the gut” by Staff, February 1991
[2] Financial Times, “To live and dream hedge funds” by Stephen Schurr, March 29, 2006
[3] Report of The President’s Working Group on Financial Markets, “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management,” April 1999
[4] Note: This is not necessarily applicable to CPOs, most which are structured as limited partnership private placements (or other similar entity based on jurisdiction) and if domiciled in the U.S. concurrently operate under the same SEC exemption rules as hedge funds; CTAs, on the other hand, are generally not subject to certain exemption rules which limit marketing to the public because they trade managed accounts.

This article was first published by Focus Point Press, Inc. (Emerging Manager Focus) It is republished here by permission. Every effort has been made to ensure that the contents have been compiled or derived from sources believed reliable and contain information and opinions, which are accurate and complete. There is no guarantee that the forecasts made, if any, will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. This material does not constitute a solicitation to invest in any program offered by Cervino Capital Management LLC which may only be made upon receipt of its Disclosure Document. Past performance is not necessarily indicative of future results. Investment involves risk. Investing in foreign markets involves currency and political risks. The risk of loss in trading commodities can be substantial.

Tuesday, April 10, 2007

1st Qtr 2007 Review and Exogenous Risk


As I sit down to write the first quarterly market review for 2007, I've been replaying February 27th’s abrupt fall and our trading in response, searching for clarity to the causes that precipitated the sudden bout of volatility on that date.

For the quarter ending March 31, 2007, our Diversified Option Strategy program returned a negative 3.59%. Regrettably, we have to analyze our first negative quarter, along with the first negative quarter for the Dow Jones Industrial Average in quite some time, which makes it more so disappointing when compared to our absolute return mission.

It turns out we got what we wished for… ironically, just a little too fast and a little to dislocating than what we had bargained. So it is not without some pain that we zoom in on the negatives along some positives.

At the end of 2006 we were pointing to an extremely low volatility level – especially in equities – which in our view did not correctly reflect the risk built into the market. As we grew more and more uncomfortable with the market complacency, we built hedges to our routine S&P 500 short puts. However, performance anxiety forced us to have positions, that although hedged, in hindsight we may have preferred not to have at all. From a probability perspective the statistical chance of such a storm at the end of February were rather slim and so we rolled the dice.

When the correction hit it developed in a span of a few hours, the machine of the NYSE jammed, the market grew unstable and volatility had its quickest and largest percentage-wise jump in more than a decade. The VIX, a key indicator for option traders, almost doubled in a couple of hours and the DOW made a precipitous fall of 200 points in a matter of minutes.

While we moved to cover our most aggressive positions, gamma exploded and uncorrelated markets began to move suddenly in sync due to fire-sale liquidations across the board. The technical problem at the NYSE unfortunately exacerbated the situation creating the condition for what we typically refer to as the “exogenous event.”

In our stress testing calculations, we run scenarios for this kind of day and we had calculated that an event of such characteristics would probably cost the portfolio around 6.75%. On a daily basis that level was approximately our max drawdown and on a monthly basis we finished February down a little over 4%.

It is at these times that a trading program’s risk management principles involving risk-of-ruin scenarios comes into sharp focus. The way our strategy responded seems to indicate that under duress our approach works and our backtesting was indeed on the mark.

We think the key difference between our approach and other option players is to quickly liquidate/stop out problematic positions in order to reduce exposure. It is our understanding that certain other CTAs employing option strategies held onto their positions. For some this gamble paid off because the market came back strong by option expiration date; for others they were forced out of positions because of margin calls.

The question to ask, though, is what would have happened if the market kept falling?

To one degree or another, premium capture strategies involve probabilities. Stops, however, tighten standard deviation parameters and increase the probability of booking losses. Booking losses makes it more difficult to regain positive performance because of the need to reset positions and time to recapture premium. However, not employing stops increases account volatility and the likelihood that at some point there will be substantial losses.

The interesting aspect that resurfaced in light of this recent market action was that a marketwide repricing of risk leads positions to move in the same direction. Thus the primary lesson of 1998 was revisited in February and our being less levered than some of our competitors made it is easier for us to weather the spike in volatility. In the end, a directional prognosis may be correct, but over-leveraging a strategy exposes investors to an insight attributed to the economist John Maynard Keynes, who is said to have warned that although markets do tend toward rational positions in the long run, "the market can stay irrational longer than you can stay solvent."

After a debacle, the first instinct is to come back as quickly as possible; we felt that the new volatility parameters were now in our favor for enhanced returns. Unfortunately, while we were well positioned to take advantage of a further downside move with the expectation that our debit spread would widen, the market followed our worse case scenario and reversed almost straight up after coming straight down.

While we still think that overall increased market volatility will help us in generating solid returns going forward, we have decided to ease into the new market environment incrementally. We recognize that volatility is our friend but it also represents new and still unresolved issues in the financial environment.

We ended March positive though still far from breakeven. We look forward to the rest of the year and while the top range of our annual performance objective now seems a bit rich, we still believe that the low-end, ten percent, is still in the cards.

- Davide Accomazzo, Managing Director

Playing Liars Poker in a Kudlowian World

“It may well be that the booming American economy is still the greatest story never told. But the reality is that low-tax free-market policies are triumphing here and around the world.”
-- Lawrence Kudlow, host of CNBC’s Kudlow & Company

They say, “don't argue with the tape.”

Fair enough… admittedly we have been bearish of late and conflicted about the potential risks to and outlook for the economy versus equities’ unrelenting upward trajectory. This tension culminated on February 27th when the market hit a wall, bounced after becoming short-term oversold middle of March (expected), and then as of early April almost fully retraced the “correction” without hardly looking back (unexpected).

Not surprisingly, the bottom of this volatile move coincided with the week that Goldman Sachs (3/13/2007), Lehman Brothers (3/14/2007) and Bear Stearns (3/15/2007) came out with their earnings release. It seems Goldman Sachs and gang used the opportunity to declare that the “contagion of sub-prime risk was contained” and it was so.

All the same, Goldman Sachs is not an uninterested party…

Several years ago a variety of investment banks including the ones mentioned above began acquiring ‘sub-prime’ lenders which they historically had regarded with disdain. Thanks to financial engineering, though, these banks were able to get into the sub-prime origination business while at the same time limit their own exposure. They did this by bundling these speculative-grade loans into a Drexel invention called collateralized debt obligations (CDOs). These “derivatives,” which divided the underlying loans into pieces with credit ratings as high as AAA and riskier parts called equity tranches or toxic waste because they are first in line for any losses, where then sold to yield-hungry investors from hedge funds to pension plans. Fees for managers of CDOs can range from 45 basis points to 75 basis points of the amount of the CDO, and so the origination and securitization of these mortgages evolved into a booming business.

Only problem was that these banks still had toxic waste left on their books when things began to unravel. So like any good poker player, my take is that they bluffed to gain time to work out their book, while the market with its multiple institutional players vested to the long side bought into and supported the story willingly. “If you can't spot the fool in the game, it's probably you.” [See here for more on the shenanigans of Goldman Sachs]

So as I write this a little over a month after 2007.15, another in an evolving series of Nostradamus dates predicted by the jailed Martin A. Armstrong, we have increasing clarity on just what market forces are really at play here…

First, the U.S. stock market according to a gauge called the price-earnings ratio is far better valued than it has been for some years. To gain some perspective, a week before the recent bull market began in October 2002, shares of companies in the S&P 500 traded at 26.5 times reported profit. Now, the price-earnings ratio stands at 17.1 times, which is by the way neither cheap nor expensive relative to long-term historical averages.

However, according to the Fed Model stocks are inexpensive relative to bonds. The profits of companies in the S&P 500 Index is growing faster than shares outstanding, and represents a yield of 6.5 percent compared with 4.7 percent for the 10-year U.S. Treasury notes. This gap, the widest since 1986, is encouraging investors because consensus earnings forecasts indicate the U.S. will keep growing, while bond yields have been showing confidence that inflation will stay in check.

In fact, the widening gap between what companies yield in earnings and the cost of borrowing is what sustains company buybacks, mergers and acquisitions, and private equity leverage buyouts. The result is a circular reference or what George Soros calls reflexivity, where the yield on the market is driven up by buybacks, M&A and LBOs thereby reducing share float and increasing earnings yield, which then in turn encourages more borrowing to finance the same because of the widening gap between companies yield in earnings versus the cost of borrowing. So as long as earnings yields stay north of financing costs, the theory goes that there will be a wall of corporate buyback and private equity money looking to turn any sell-off into a buying opportunity.

The problem with the Fed Model is that the lower yields go, the higher the implied value of stocks, even while the economy slows. This is why any weak economic data is a signal for investors to rally the market, and goes to explain the myopic focus on the probability of the Fed cutting rates later this year despite economic data showing indications that inflation pressures are still present.

In the meantime, any positive economic data is also treated as constructive because it is supportive of continued profit growth and diminishes the concern of a recession due to the housing slowdown. Effectively, we’re in a goldilocks environment the bulls argue.

The second significant market force is the global economy…

Another saying goes, “if the U.S. sneezes, the rest of the world catches a cold.” Countries including China, Japan and Germany run large trade surpluses with the U.S., supporting the assumption that a pullback in American demand will hurt their growth. But lately developing nations are becoming less dependent on the U.S. because of stronger demand in other industrial nations, making the world’s economy more “resilient.”

Germany's economy, which as recently as 2005 was derided as the “sick man” of Europe, grew by 2.7 percent in 2006. Germany is Europe's biggest economy and after Japan the world's third-largest in terms of gross domestic product. Germany’s growth points to elements of a broader and deeper sustained growth in Europe which exists independently of the U.S. economy.

At the same time Japanese consumer spending is showing signs of picking up as Japan’s economy, which has been battling against deflationary pressures for some time, extends its longest expansion since World War II with business confidence near a two year high. Recent indications of a pickup in personal consumption will also help to offset slower export growth in the face of a possible slowdown in the U.S., Japan’s largest market.

Emerging markets such as China and Brazil are also coming to the fore with consumer and capital spending last year growing at twice the rate of developed nations. Also the Persian Gulf states including Saudi Arabia and the United Arab Emirates are investing billions of dollars gleaned from higher oil prices, much of it reinvested locally in an effort to restructure their countries into more diversified and self-sustaining economies.

With the IMF predicting that world GDP will increase 4.9 percent this year, the fourth straight year above 4.5 percent and the best performance since 1980 when the IMF started keeping records, it is looking like most countries are in a position to “decouple” from the U.S. economy and sustain strong growth through a U.S. slowdown. This would reverse the trend of the past five U.S. recessions, when 3/4ths of industrial countries suffered downturns due to a slump in the U.S. economy.

Ironically, it is demand from overseas that is throwing a lifeline to America. And the lower dollar is helping. With exports accelerating and imports shrinking, trade this year may add to growth instead of subtracting from it for the first time in more than a decade.

Still, even though the importance of the U.S. economy has diminished, there are still dangers of “spillover” from a slowdown in the world’s largest economy because so many companies and investors in the rest of the world have ties to American businesses and markets.

So what are the major risks that Wall Street is weighing as we start the second quarter of 2007?

Perhaps the surest ticket to a bear market in stocks would be for Americans to close their wallets, either because they’re spent out or because they’re nervous about their finances or their job outlook. Investors have no recent experience with a consumer-led recession as the last one was 17 years ago in 1990. The 2001 recession, by contrast, was led by a plunge in business outlays. Since consumer spending accounts for more than 2/3rds of U.S. gross domestic product, the economy could go into a deep freeze.

Another risk is that corporate earnings shrink. Wall Street is fully expecting a slowdown in profit growth this year with a weaker domestic economy, but an outright decline in earnings might come as a shock. While the price-earnings ratio now stands at 17.1 times, if earnings fell and the price-earnings multiple were to rise the market would perceive stocks as more costly.

Finally and probably most importantly, there is concern about the dollar. The U.S. economy has been built on foreign money over the last two decades as massive inflows of capital from overseas have been needed to cover the nation’s trade and budget deficits. Other countries’ savings is what underwrites our spending.

This is where things get dicey…

High U.S. rates compared to countries like Japan which has resulted in the carry trade help support the dollar’s value. If the U.S. economy were to weaken and the Fed were to cut rates, the result could be a steep plunge in the dollar, which in turn could spark inflation by raising prices of the imports U.S. consumers crave. If inflation rose, the Fed presumably would have to go back to tightening credit which likely would cause a revaluation of stocks as the Fed Model goes into reverse mode.

This is where I see the Fed being caught between a rock and a hard place given the current economic balance that has been achieved here and abroad.

As things stand now, the Fed can neither raise the target rate because that would further tighten liquidity in the credit markets and likely push the U.S. into a consumer-led recession by further harming the housing market, the effects of which would eventually be felt globally; nor can they lower rates because such a move might cause the dollar to decline precariously stoking inflationary pressures while at the same time chase away foreign investors from our Treasuries for other higher-yielding currencies such as the Euro—this in turn would also cause U.S. long-term rates to go up.

As the world’s reserve currency since the Bretton Woods Agreement in 1944, the U.S. Dollar has enjoyed the enviable position of the most important international currency. Up until WWII, the British Pound had been the major currency by which most others were compared. Presently, however, due to structural problems with the ongoing problem of trade and budget deficits, sustainability of the Dollar as reserve currency of the world has increasingly come under question.

Interestingly, the economic conundrum we find ourselves in now is similar to concerns raised in the early part of the 20th century. In his book The Economic Consequences of the Peace (1919) John Maynard Keynes wrote:

“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.”

“Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

It may be controversial if not sacrilegious to reference Lenin, but consider the following debate by these two media pundits…

On one hand you have Lou Dobbs, anchor and managing editor of Lou Dobbs Tonight which attracts CNN's largest audience of about 800,000. Originally a classically conservative economist, Dobbs' views have changed over time, and he is now a strong critic of the “excesses of capitalism,” which he identifies as globalization, offshore outsourcing, illegal immigration, free trade deals, corporate/big business influence in government and the Bush administration's tax cuts. A populist for “main street America,” he warns that the erosion of the American dream is being facilitated by political agendas in Washington that are controlled by big business and special interest groups, or worse just “plain” incompetence.

Dobb’s uses several bylines to highlight his points: “Exporting America,” “Broken Borders” and “War on the Middle Class.”

Then you have Lawrence Kudlow, a supply-side economic commentator and host of Kudlow and Company on CNBC. He opposes estate taxes, as well as taxes on dividends and capital gains, advocates that employees be compelled to make greater contributions to their pension and medical costs (suggesting that these expenses are an undue burden on corporations), defends high executive compensation and opposes most forms of government regulation. He believes that reducing taxes will increase revenue, and in general, supports a smaller government that does less and citizens who take more individual responsibility. He advocates wide ownership of stocks and is what we would call a populist for the “investor class.”

Kudlow’s catchphrase is that “the booming American economy is the greatest story never told.”

So who is right? In my mind both arguments have merit but the answer to this dichotomy may rest with Keynes too…

The Marshall Plan after Second World War is a similar system to that proposed by Keynes in The Economic Consequences of the Peace. The Marshall Plan was a massive spending program adopted by the United States after World War II to rebuild war-torn Europe and Japan. In a similar fashion, James Paulson of Wells Capital Management has theorized that the chronic U.S. trade deficits of the last fifteen years represent a similar Marshall Plan aimed at jump-starting and stimulating the development of emerging economies. Indeed, total emerging consumption is now slightly more than one-half U.S. consumption and the U.S. consumer is no longer the sole locomotive for growth.

This is a big positive because new consumption leadership is emerging where the standard of living needs to be raised most. But meantime the cost is a depreciating Dollar.

The argument over whether the standard-of-living in the U.S. has declined or not for the average American due to these large external forces is unclear to us. What is obvious is that there is more than ever an “arbitrary rearrangement of riches” due to the extreme levels of leverage being used to finance this great experiment called globalization.

In effect, Lenin was on to something. The process of wealth-getting for many middle class Americans has degenerated into a gamble and a lottery—overheated home equity appreciation in the last few years being just another example.

- Mack Frankfurter, Managing Director

Wednesday, January 10, 2007

December 2006 Review and Year End Chat


As we begin 2007 and close the curtain on 2006, our first year of trading for Cervino Capital Management LLC, we look back at a year of many accomplishments:

- robust and positive performance – our Diversified Options Strategy program was up 0.46% for December and 10.35% for the year

- steady growth of assets under management

- established test investment portfolios in Master Limited Partnerships and Closed End Funds that exceeded S&P 500 returns

- an increasingly important role in the investment community stressed by speaking engagements on matters of finance at various academic institutions, and articles published in investment magazines and on websites

These accomplishments, however, are no reason to rest on our laurels as we recognize that the path to trading success is arduous and unpredictable. Year-end, on the other hand, is a good opportunity to make an introspective review our trading and risk management philosophy and approach. Interested investors should note that the best place to begin a thorough review of our trading program, associated risk factors and specific risk management strategies is our disclosure document. What can better be discussed here is the broader context in which our trading operates.

Our core philosophy is based on the principles of modern portfolio theory which states that, the addition of an uncorrelated asset with a positive expected return to an existing portfolio will increase that portfolio's risk-adjusted return.

While past performance is not necessarily indicative of future results, Barclay Group reports that our correlation to key indices (based on monthly returns Jan. - Dec. 2006) are as follows: S&P
-0.03, EAFE -0.18, Barclay CTA Index -0.32, and US Treasury +0.53. Within the context of a diversified portfolio of stocks/bonds and based on our correlation numbers and positive returns to date, an allocation to our program this past year would have likely enhanced the efficient frontier of the typical stock/bond portfolio.

At the same time proper diversification of trading styles is important when seeking to construct a robust multi-advisor managed futures portfolio. This is a complicated subject made much more difficult by the intricacies of standardizing/comparing performance records and risk/return profiles. Jack Schwager (of Market Wizards fame) wrote an excellent book on the subject we highly recommend called "Managed Trading Myths & Truths" which delves into various factors related to the evaluation of Commodity Trading Advisor (CTA) performance and the potential pitfalls and issues when comparing a CTA's performance with other CTAs or industry indices.

Below are some broad risk/return considerations when comparing our program relative to other CTA programs, and within the context of a multi-advisor portfolio:

1) Generally speaking we believe a good risk-return profile for CTAs is one that over the long run can consistently generate 2.5 to 3 times positive return relative to subsequent drawdowns. For example, a CTA that generates 30% return should manage peak-to-trough drawdowns to no more than 10%, and so on. Given that our fully-funded return objective is 10-15% annually, we designed our options program with the intent of keeping peak-to-trough drawdowns between 3-5%. That said we cannot guarantee that we can always contain drawdowns as such, and there is ample risk as better explained in our disclosure document for substantially greater loss.

2) Trading futures is less than a zero sum game; for every winner there is a loser plus commission. The key question is who in the futures market is taking money from whom (hedger, speculator)? What's the trader's "edge" (blackbox, scalper, etc.)? What type of market does the program best operate: choppy, trending, high volatility, low volatility, time horizon?

When putting together a multi-advisor CTA portfolio it is important to try and combine trading programs that are non-correlated and smooth out overall portfolio volatility. For example, a potential complimentary match is a trend following futures program with our program which often trades options on a contra-trend basis. While our options program may underperform a trend following program for any particular period, it is likely to outperform when markets are choppy or at turning points, thereby helping smooth out the portfolio's overall returns as this is most likely when trend following programs have difficulty.

3) The high degree of leverage in futures and options can work both for you as well as against you. Unfortunately many investors involved in managed futures are geared toward chasing "hot returns" without due consideration as to the risk/leverage that was utilized to generate outsize returns. It is a common tendency for many new CTAs to start out with strong proprietary or first year returns that quickly attract assets but also set up return expectations that are unsustainable over the long run, especially when assets substantially increase and capacity/liquidity constraints become an issue.

When we developed our Diversified Options Strategy the goal was to design an absolute return type program that reflected conservative performance utilizing a 15-45% initial margin/equity range. Rather than leveraging up performance in an effort to quickly attract assets, we sought to establish a program with reasonable and sustainable risk/return expectations. We think that is best done by setting specific performance goals and margin constraints, and then allowing investors to adjust leverage of risk/returns through notional funding.

4) In order to properly compare multiple CTA track records one has to take into consideration the cost structure (commissions, trading velocity, management/incentive fees, interest, etc.) reflected in the actual performance of each CTA being evaluated, as well as the respective "model trading levels" including leverage utilized (margin/trading level) to generate returns. Unfortunately, "model trading levels" are not standardized from CTA to CTA. Moreover, as margin/equity ratio is a misleading indicator of value at risk, standardizing the performance measurement of risk adjusted returns becomes complicated, especially when option trading is involved and time decay and probabilities are factors.

Most investors fail to recognize the nature of the returns they are analyzing; in many cases returns are just a function of leverage and higher risk rather than “alpha” or in layman terms the component of return generated by a trader’s skill. If not for the mechanism of price arbitrage with the underlying cash asset, as well as the insurance premium bona-fide hedgers are willing to pay, the returns that speculators in futures generate should largely be a function of skill or “alpha.” For previous generations of professional futures traders profitable trading opportunities were more easily exploitable. But now the playing field is increasingly competitive and a trader’s “edge” is more likely to be linked to a particular systematic approach that does well under certain market environments.

Options on the other hand are wasting assets linked to probabilities of an event risk. For the most part, premium writers can “allow time to do the heavy lifting” in producing returns. The trading model for pure option writers is simple, easily repeatable and generally profitable provided that again certain favorable and consistent market conditions prevail.

To a sophisticated investor we are restating the obvious. But this is where we believe ourselves to be differentiated from the majority of other CTA option programs which from our analysis tend to be one-dimensional and systematic in their approach…

Market conditions are constantly changing, bringing along with it new unforeseen risks. Regardless of instruments traded, we believe that what investors are ultimately hiring us for is our trading skill; that is, the skill in being able to recognize and adapt to different market conditions, readiness to exploit opportunities as they arise, and most importantly the flexibility to manage associated risk. With that perspective in mind, the question we constantly ask ourselves when working to adapt and refine our trading is whether we are increasing “alpha” or just leveraging risk exposure in order to enhance returns.

Paradoxically, a flexible and adaptive trading approach needs to be integrated within a disciplined trading/risk management framework, which for our program we have outlined below:

A) Unlike most other CTA option programs that focus only on the SP, Cervino trades a diversified portfolio which includes equities, currencies, fixed income, agriculturals, energies and metals. We routinely studies in excess of ten markets (SP, EC, JY, CL, GC, SI, NG, C, OJ, US, SB, HG) and our program is typically engaged in active trading on an average of 3-4 contracts.

By performing market analysis across a variety of asset classes and underlying contracts we expose our program to increased profit opportunities as well as diversify risk exposure. Additionally, we can observe the interplay between contracts and their fundamentals thereby placing ourselves in a better position to identify “viral” market risks.

B) Because options include directional, time decay, volatility and probability characteristics, various multi-dimensional strategies can be established on any single underlying contract simultaneously thereby diversifying opportunity and risk exposure further. For example, we may have on the SP between 3 and 6 different option positions/tactics in play at any particular time each with different opportunity objectives and risk profiles.

Effectively, the trading strategies we deploy are designed to capture returns in several ways, including but not limited to: (i) replicable relative value spread positions with the intent of capturing premiums; (ii) fundamentally based trades involving a directional trend bias that can be deployed through either long or short option positions, or debit or credit spreads; and (iii) opportunistic volatility plays that take advantage of option under- or over-valuations as well as trend reversal/mean reversion opportunities.

C) Our trading methodology allows for regular adjustment of positions as material shifts in market conditions may warrant. From a risk management perspective this is an advantage over many CTA systematic option writing programs we have analyzed and who typically rely on the probability that their routine option positions will expire worthless. But as a result, our program may have higher commission costs than other option programs.

What should also be noted here is the fact that the option markets have become increasingly efficient. Because we are “upstairs traders” and subject to bid-ask spreads, commissions and other costs/constraints such as market liquidity, our trades are essentially positional in nature with time horizons ranging from 2-3 weeks to 3-6 months. This increased efficiency has also impacted, but to a lesser degree, option floor traders/scalpers as bid-ask spreads have become tighter.

D) Most of the investing public harbor misunderstandings about the mechanics and risks associated with options as an investment tool. We typically establish option positions out-of-the-money where the probability that the underlying goes into-the-money is a major consideration. Such positions will start out with a reduced delta exposure relative to the underlying futures contract; in other words, a point move in the futures contract will result in a reduced directional movement in the options contract.

This is one of the important ways in which we manage account volatility. It also explains why the majority of our daily equity swings tend to be in the 10-40bps range, and why our program’s volatility is generally much lower than that of CTAs who focus their trading mainly on futures.

That said, the main risk concern with respect to short option positions is managing positions when either a trending market evolves against a strike price or an abrupt exogenous event occurs and option writes convert to a futures equivalent exposure. This is why when we write options or credit spreads our trading focus becomes keyed on risk management stewardship.

On the other hand the same above scenarios (trending market, exogenous event) work in favor of long option or debit spreads, assuming it is in the same direction as the established position; which is why when appropriate we encompass those tactics within our portfolio approach too. Alternatively, risk is inherently limited in long option or debit spread positions.

E) Another important underpinning in our managing risk is achieved through position sizing adjusted according to account size, volatility and risk-reward analysis. Generally we adjust positions sizes to $50k levels, and sometimes we refine risk exposure by changing the traded strike. Additionally, we may choose to increase or decrease position size/leverage based on our confidence level in a particular trade. And with delta neutral type strategies (strangles, condors, etc.) we may skew contract quantities to one side or the other.

F) Risk control is also achieved through money management rules and the utilization of stops (see Section 3.10 of our disclosure document for a discussion on risks associated with the use of stop-loss techniques). Occasionally we may adjust positions either by entering into new positions which hedge existing market exposure, or by liquidating/covering existing positions in order to reduce market exposure, or reset a position at a different strike price and/or contract expiration. For example, we may lift one leg of a credit spread to take advantage of a trending market, then “roll-up” and reestablish the credit spread at a higher level.

G) Lastly but just as importantly, what lies beneath our trading framework/methodology as outlined above, and what ultimately triggers trading decisions, is a blended analytical process combining quantitative analysis, fundamental studies, and technical and sentiment indicators. Our disclosure document goes into more detail on this aspect and should also be refer to for a more complete description of principal risk factors associated with our Diversified Options Strategy, something which cannot be adequately addressed in this piece.

When all is said and done, we feel that our approach is unique among many of the other CTA option programs. Our trading encompasses a core disciplined methodology yet allows for the application of multi-dimensional trading strategies depending on perceived market conditions, opportunities and related risk. The result is a program that is not static but dynamic and focused on increasing alpha rather then leverage in order generate consistent risk-adjusted returns.

This piece would not be complete without a macro-level analysis of the current market environment as that reflects in option valuations and by extension our program.

As indicated above, implied volatility is central to any option program and a key factor in the risk associated with collecting premiums. A review of our program's performance shows that three of our best four monthly returns in 2006 were during June, July and August. This is not by accident but reflects a period when implied volatility in the S&P 500 (as measured by the VIX) was at its highest for the year. At the time we were exploiting a premium capture strategy. Conversely, it is transition points in market volatility such as in May when the S&P first began its correction that indicate periods of greater risk to existing option write positions.

October and November 2006 has also been a period of high risk for option writers but for different reasons, specifically the strong trending stock market and imploding volatility. In fact, the VIX hit lows not seen since January 1994.

Sellers of options during this period have had to either increase their positions and/or place their selected strikes closer and closer to the underlying price in order to collect the premium/maintain the returns they have historically generated; or alternatively they have had to reduce risk and accept lower returns by selecting option strikes that are more in line with historical price standard deviations. Our response to this extreme market environment has been to shift more of our tactics to purchasing options through debit spreads. For that reason November ended up being our strongest month with a Euro debit spread position we put on the prior month working strongly in our favor as the contract rallied.

To emphasize this point here is a link to a chart going back to 1990 showing the S&P and VIX (the link also provides an interesting esoteric piece about the construction of the VIX). The chart clearly shows that from 2003 to present volatility has been steadily declining. Given the three year bull market in the S&P and the bear market in the VIX, the chart makes obvious in hindsight the reason for the performance/success of CTAs who just write puts on the S&P.

Our aim here is to illustrate that different trading approaches work best in different market environments. During the late 1990s, breakout and trending markets were a rarity in commodities and therefore trend-following programs generally suffered.

For option programs, however, return potential is not a function of markets going up or down, but of implied volatility which has recently evaporated. The time of greatest risk (as well as profit potential) for option strategies is when implied volatility diverges from mean historical volatility, which happens to be the situation now.

This raises two questions: first, is this trend in low volatility here to stay, or is it just a short-term phenomenon and we eventually return to a period when the VIX averages between 15-25; and second, how prepared are the plethora of option programs that have come into existence in the past few years set up to manage risk in a potentially different market environment in the future.

When all is said and done, we believe our primary job to be sensitive to risks and manage them when they arise. Backed by our many years of professional experience in the managed futures industry, we strive to be the “thinking man’s trader” and deliver for our clients a conservative yet robust trading approach that is a value-added augmentation to an investor’s total portfolio.

In conclusion and given that it is the beginning of a new year, we would like to try our hand at predicting the future and review a few elements we think will become part of this year’s strategy.

Continuing along the line of the last comments, we believe that 2007 will show increasing volatility across a number of markets: equities, dollar, possibly bonds. Volatility in crude oil should remain high and it should increase again in gold albeit not as high as this past spring. As stated in previous pieces, we still expect a recession sometime next year courtesy, among other factors, of a further decline in the housing market. Energy will prove to be a good buying opportunity after the recent declines and should a recession indeed occur and depress oil further we will look to accumulate the commodity.

Having said that, we endeavor to think flexibly and trade the markets as they evolve in real time. We will always strive to be agile enough to never act as if we are smarter than the market, and use prudence when constructing profitable positions with the benefit of our clients in mind.

We wish you a prosperous new year!

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

Tuesday, January 9, 2007

The Mysterious Case of Massive Liquidity

“Perhaps when a man has special knowledge and special powers like my own, it rather encourages him to seek a complex explanation when a simpler one is at hand.”
— Sherlock Holmes, The Adventure of the Abbey Grange (1904)

Professionals in the markets are more suggestible than a layman might imagine. Try as we might, we can never know the one thing we really want to know—that is, the future. Not knowing, we compare notes with others. Most are brave together at the tops and meek together at the bottoms.

As we finished 2006, the general consensus was that the latter half was spurred by a wave of global liquidity with U.S. and European stock markets gaining double-digit returns, and the emerging markets doing even better. Alongside the liquidity came a remarkable fall in volatility with the CBOE’s VIX index (known as the “fear gauge”) falling to 13-year lows in November and December.

All was rosy as strategists at twelve of the biggest Wall Street firms agreeing that U.S. stocks will rally in 2007. With everybody lining up in the bull camp, however, Davide and I are a little nervous about the market’s complacency—ironically the last year Wall Street strategists were this rosy was in 2001 when the S&P 500 Index dropped 13%.

Assuming that Bernanke has maneuvered us into a “soft-landing” and we are in a “goldilocks” economic environment, what could go wrong?

Based on last year’s actions by Goldman Sachs when they poached Lachlan Edwards, one of Europe’s financial restructuring gurus, the “smart money” is gearing up for a credit crunch—that is, a reversal of the liquidity tide that investors find themselves floating on. History shows that when mass scale restructurings occur, they tend to do so very rapidly like tsunamis—often triggered by an unexpected economic downturn or political shock.

Our main job as money managers is risk management. Looking forward we try to best assess where potential risks may come from. If the concern is about liquidity and the credit markets, then we need to understand how this sanguine market environment came about.

Monetarists such as Milton Friedman, who recently passed away at age 94, believed that “money supply” was the key to the ups and downs in the economy. Further, he thought that the Fed's sole job was to "expand the money supply in a steady manner by 3% per year."

The Greenspan legacy, however, is for the Fed to intervene in the markets strategically during times of financial crisis. He first did so early in his career back in 1987 when the Fed added heavy doses of liquidity to arrest the stock market crash. Then there was the expansion of money supply in the weeks leading up to the end of the 20th century when the so-called Y2K computer bug was expected to disrupt financial systems. Lastly, in response to the 2001 recession Greenspan lowered overnight rates to a 1958 low of 1 percent resulting in record mortgage refinancings that minimized the recession. Intervention, rather than being a brief rescue effort, seems to have become a permanent policy.

Another wave of stimulus came from the 2001 and 2003 “Bush tax cuts.” There are two ways in which tax cuts can stimulate growth—in the near term by generating extra demand, and in the long run by encouraging increased supply, labor or capital. Add to this the 108th and 109th Congress gone-amuck earmark spending as well as the increased military budget to finance two wars (the Iraq war now is estimated to have cost $350bn so far and is still costing $7bn a month), and the combination of monetary and fiscal stimulus in the first half of this decade set the stage for a tidal wave of liquidity.

The overhang of fear resulting from the 2001-2002 bear market also contributed to the current environment as money gravitated from the stock market into “safe assets” such as government and agency bonds. This in turn drove down interest rates on the long end of the yield curve which further lowered borrowing costs, and functioned to help corporations get their balance sheets in order as well as support real estate prices upwards through the 2001 recession.

Effectively, lower interest rates led to a boom in home buying which caused real estate prices to double and triple in some locations. One result was owners taking advantage of their increased home values in the form of mortgage equity loans. The impact was not insignificant on the economy. According to Calculated Risk, GDP as reported for the last six years has appreciably improved as a direct result of home equity withdrawals, a trend that first began in 2001. The process of incurring debt collateralized by an inflated asset is similar to margining a securities brokerage account as stock prices go up, the result is additional liquidity and leverage.

Because of inflated home valuations the use of exotic mortgage products such as ARMs, I/Os, etc. increased from very limited usage to approximately 50 percent of the mortgages used to finance homes in California. The seriousness of the potential fallout is not lost on the Federal Reserve Board and the Office of Thrift Supervision who recently came out with warnings regarding "payment shock," essentially “margin calls,” associated with sharp upward adjustments of a loan's interest rate after initial low-rate discount periods on exotic mortgage products. Such payment shocks are expected to increase substantially in 2007 and 2008.

In addition, the Center for Responsible Lending just published a report suggesting that 2.2m American households could lose their homes and as much as $164bn due to foreclosures in the ‘subprime’ mortgage market. To put this report into historical perspective, at the peak of the credit boom in the 1930s, home mortgage loans were offered without the usual documentation, a practice that in the last few years has again become enormously popular through so-called “stated income,” “low-doc” or “no-doc” loans. Stated income loans, originally conceived to improve access to prime credit for self-employed people with irregular income, has spread like a virus down through the lending industry, where it is a virtual invitation to fraud.

Credit fraud is a liquidity multiplier. The link between fraud and liquidity is documented by several white papers in relation to international banking. A paper written by Dr. Wimboh Stantoso, Senior Researcher at the Directorate of Banking Research and Regulation Bank Indonesia, points out that the 1998 Pacific Rim currency crisis resulted in the Indonesian government revoking permits on 16 private national banks whose “sources of problems for those banks were mainly illiquidity and insolvency as a result of credit defaults, fraud and liquidity mismatches.” Another paper by Jean-Claude Berthelemy on “Financial Reforms and Financial Development in Arab Countries” writes about non performing loan (NPLs) and “cases of fraud and liquidity problems faced by the banking sector” in regards to bad debt with a delay of servicing over one year.

The topic of NPLs brings us overseas to the shores of China. China is dealing with a mountain of bad loans—how much is the question. In May 2006 Ernst & Young reported that NPL exposure for China was estimated at US$911bn, but subsequently withdrew the report. According to the China Banking Regulatory Commission, as of the end of the third quarter of 2006, the total number of NPLs in China’s commercial banks was approximately US$160bn. However, this amount does not include NPLs that are presently held by foreign investors such as hedge funds that have been on a buying binge in Chinese distressed debt. Based on the 1999 transfers that investors have resolved, the implication is that E&Y’s NPL estimate is not miscalculated. The main inference, however, is that these NPLs represent a significant liquidity multiplier and risk.

China’s economy, in the meantime, is on track to grow by more than 10 percent for the third year in a row. In November 2006 China reported that its foreign currency reserves, the world’s largest, had exceeded $1,000bn for the first time. China has effectively outsourced its monetary policy to the U.S. resulting in talk of pressure from the incoming Democratic Congress in the form of “currency manipulation anti-subsidy laws” to persuade China’s government to revalue its currency. Even Fed Chairman Bernanke stepped into the fray with his remarks branding China’s undervalued currency an “effective subsidy” for exporters that was distorting trade. At the same time, China’s monetary policy committee complained that the main responsibility for this imbalance lies with the U.S. Treasury printing too much money. The upshot is that a fundamental change in reserve allocation/diversification away from the dollar is taking place and not just with China.

The subject of dollar imbalances brings us to the so-called Japan carry-trade. With the Bank of Japan keeping rates pegged to a measly 0.25 percent, this bubble has been ballooning in which people borrow cheaply in yen and then invest in higher-yielding assets abroad. The economic effect is again similar to leveraging your brokerage account with margin, except that this is taking place on a global scale with hedge funds leading the way. Concern is that a sudden flowback of yen, such as what happened in 1998 when the yen went from Y140 to the dollar to Y110 in just two days, could trigger financial chaos as far abroad as Iceland and India. Even the U.S. is not immune as some market participants blame the limited unwinding of the carry-trade that occurred in April 2006 as initiating the sharp decline in the stock market in May 2006.

Another liquidity multiplier is all the petrodollars that have been created with oil prices rising from the $20-$30 range to $78 dollars as of August 2006. Last year will be remembered in the Middle East for Iraq’s tragic slide into sectarian conflict and Israel’s miscalculated? war in Lebanon. Less noticed, though no less dramatic, has been the oil-fuelled economic boom in the Gulf and a surge in financial liquidity that has been transforming the face of the region. Oil wealth translates into political advantage on the world stage as petrodollars are deployed and recycled in the local region and abroad. The key question is whether oil producers can turn this boon into a lasting opportunity and create more robust economies that can sustain themselves through periods of low oil prices. Referring once again to reserve diversification, Russia and Opec have reduced their exposure to the dollar and shifted oil income into euros, yen and sterling.

But more interestingly has been the proliferation in the issuance of “sukuk” or “Islamic bonds.” Usury in Islam is prohibited, but banks today are adopting methods to get around this by combining Islamically permissible contracts to produce what is effectively interest-bearing loans. The effective result is not only the leveraging of petrodollars, but the evolution of an Islamic monetary system similar to modern Western banking system which had historically evolved from the practices of European goldsmiths in the 17th century. Back then, the receipts issued and backed by deposits of gold coins on deposit for safekeeping with goldsmiths transformed these merchants into money-lenders who manufactured “bank money” on such receipts, giving rise to the concept of money supply.

Money supply creation is no longer something constrained to banks, but now something that is easily produced between two parties through derivatives trading. When Greenspan took over the Federal Reserve Bank much attention was focused on gauges of money supply defined as M-1, M-2 and M-3. Disregarding the debate on the importance money supply as a reliable measure and indicator of future inflation, a new type of money supply which I've coined “M-0” has increased explosively alongside the growth of derivatives since the early 1990s. "M-0" is the “notional” valuation associated with a derivatives contract; that is, for example, the difference between the $250,000 nominal face value of an S&P futures contract and the $25,000 actual cash required to trade the instrument. The definition of financial leverage is liquidity magnified. Derivatives, while very effective as a risk diversifier, also has had the effect of leveraging asset values throughout the economic system.

And round and round it goes—the examples of liquidity expanding throughout our global monetary system are nearly endless. Many would argue this is all good and point to how robust the world economic landscape has been in the last few years as globablization has spread. And on an encouraging note, the World Bank recently hypothesized in a report that if growth around the world continues at about its current pace, by 2030 the number of middle-class people living in developing nations will triple to 1.2 billion.

However, the problem with liquidity is that it is like an addictive drug—initially it produces euphoria which then disappears with increasing tolerance. Once an economy is hooked it needs more and more in order to sustain itself and withdrawal can be difficult.

Key to the creation of liquidity is credit. “Credit” is a financial term with a moral lineage. Its first meaning is “debt.” John Locke once wrote “Credit is nothing but the expectation of money, within some limited time.” To credit is to believe, and to lend money it is necessary to trust someone. Yet, financial history is rife with periods when prolonged prosperity wore down the skepticism of creditors only to result in eras of economic hardships.

The riddle is whether the central banks have succeeded in breaking the cycle, not the inflationary cycle which in fact it has enthusiastically subsidized, but the deflationary cycle. Has the sheer bulk of global liquidity forestalled the kind of contraction that paralyzed business activity in the depression and demoralized speculative activity for a generation after that?

I started out this piece by asking what could go wrong…

Sudden economic downturns are typically instigated by event risks from unexpected places. Looking at the tea leaves we’ve identified several areas of concern:

The price of oil this past week has dropped to $55. A further implosion in the price of oil would undermine a major source of revenue for countries who produce this commodity. The recent windfall has allowed such nations to build foreign reserves and improve the quality of their debt resulting in lower interest rates and helping drive an infrastructure investment binge. This could unwind if investors begin to pull money from emerging equity and debt markets resulting in an increase in interest rates. In this scenario, the combination of reduced oil revenue and higher interest rates would cause infrastructure projects to grind to a halt triggering a global recession.

Another area of concern is geopolitical risk where mismanagement of monetary and fiscal policies spreads to other markets. For example, the Asian financial crisis of 1997-98 began in Thailand with the devaluation of the baht. Recently Thailand’s newly minted military government stumbled badly by imposing capital controls. Such controls demonstrate a poor grasp of such action’s consequences. In a world where China, Japan, Taiwan, South Korea, Russia and Singapore control two-thirds of the world’s reserves, we find ourselves exposed to these nation’s monetary or fiscal policies. Who knows where its starts: a miscalculation by China’s central bank in its efforts to manage excess liquidity could trigger a global recession, or the Bank for International Settlement’s Basle II standards forcing new hedge fund investment rules in Japan may trigger widespread redemptions there and an unwinding of the carry trade.

A third concern is that the U.S. economy will in fact grow as expected, but the markets come to realize that growth rate is in fact not so great. Analysts close to the Fed believe most policymakers now see U.S. potential growth as being between 2.5-3 percent, a decline from the 3-3.25 percent range commonly cited a few years ago. Many private sector analysts interpret a decline in productivity growth as likely to put upward pressure on inflation and interest rates. Given that the U.S. stock market is “fairly valued” at earnings ratios based on record productivity levels, if corporate earnings cool off the stock market could begin to melt down. Add to this an economy fueled by leveraged loans and looser lending standards, S&P warns that a sudden change in appetite from investors could force banks to absorb large leverage loans on to their own balance sheets. This in turn could cause a re-pricing of credit risk resulting in higher interest rates causing the economy to spiral downward.

Then again, perhaps given the enormous attention to the riddle of liquidity in the financial press, this is all but a tempest in a teapot—economists can’t seem to agree whether there’s too much or too little. As so eloquently said by Sherlock Holmes, “My dear Watson, there we come into those realms of conjecture where the most logical mind may be at fault.”

- Mack Frankfurter, Managing Director