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