Monday, December 22, 2008

2008 Year End Thoughts Going Into 2009


Given hindsight, my commentary from the end of 2007 now seems quaint when I wrote: “The long and winding year of 2007 has come to a close... In the annals of trading, this is one ‘vintage’ that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.”

Unfortunately, any hopes for a calm year was dashed back in January. 2008 is not a year on which even the most hardened veterans of the market shall look back gladly—it has turned out to be an Annus Horribilis. And as we approach the start of 2009, I can almost hear the sigh of relief of many for whom this December 31st could not come any sooner. Indeed, we have witnessed an unprecedented global meltdown of the financial system and experienced massive wealth destruction in these turbulent twelve months.

Nevertheless, in this storm Cervino Capital Management LLC managed to post a positive year for the Diversified Options Strategy keeping true to this programs mandate of absolute returns. As of the end of November 2008, the D1X program is up 2.94% and the D2X levered program is up 7.43%. And although our year-to-date performance is currently less than desired, for most of this year until the market crash in October, our rolling twelve month rate-of-return was above our stated objective.

This is no small feat given that many CTA option programs this year suffered through significant drawdowns greater than 50%, and some are no longer even trading. Our understanding is that many CTA option programs, even now, are sidelined waiting for the historically volatile market conditions to settle down.

Meanwhile, our more beta exposed investment advisory portfolios were not so lucky and while they generally outperformed the benchmarks and held very well for 3/4 of the year, they eventually cracked with everything else in this dramatic autumn. The relatively stable performance of the Diversified Options Strategy is therefore striking in the context of such a ravaging bear market, where no asset class was spared and practically no strategy worked.

So much for Modern Portfolio Theory… just ask the much praised Harvard University Endowment. Then again this is what bear markets do: wholesale asset price destruction. It is interesting to note that bear markets will do more damage to your portfolio than wars—just look at a long-term chart of the Dow. But more on asset performances and expected return later…

What makes this bear more ferocious and treacherous to trade than any other meltdown since the 1930s is in the way our capital markets became dysfunctional during this crisis. The Fed and the Treasury (and most of their counterparts around the globe) have been engaged in massive interventions via standard monetary policy decisions, quantitative easing, capital injections in an effort to stop a seemingly unstoppable predicament.

While I do not believe they had much of an alternative, such conduct (and the possibly avoidable lack of consistency) has created recurrent unintended consequences, many of which we will not even face until years from now. This environment of uncertainty has had the additional destabilizing effect of making markets practically untradeable and even more dysfunctional. One day we can short, the next we can’t; one day the Treasury will buy a certain asset class, the next it will not; and so on…. not an environment conducive to improved functionality and liquidity in the global markets.

As mentioned above, the alternatives to these policy choices were practically non existent but in the long term we may be seeding more problems than solutions. I have argued in previous writings that hyperactive monetary policy such as the one implemented by the Federal Reserve Bank in the last fifteen years is highly correlated with the increasing frequency as well as the increasing size of financial crises.

Is the tail wagging the dog? Quite possibly…

The obsession of the Fed and most politicians to erase the business cycle is the direct cause of this hyperactive monetary approach. However, if the result of trying to eliminate mild but recurrent recessions (frankly, a necessary and not so negative part of an efficient economic system) is the creation of cumulative imbalances that threaten the system at its core, then perhaps a different approach may be appropriate.

For more on my views of this topic, see "A New Qualitative Capitalism"

But enough about the past—what should we expect going forward? The current situation makes it extremely hard to forecast as we are not even sure exactly what kind of economic system we are going to operate in going forward: capitalism, socialism or statist? This is a question that no Western country has had to face in almost 40 years, and yet today it is at the core of an investor long term strategy.

I wrote extensively on the kind of new qualitative capitalism that I would like to see flourishing after this crisis, but I doubt I will get my wish. For the moment we are clearly going thru a socialistic phase rather unavoidable given the collective missteps of our bankers, leaders, and let us admit it, the “average Joe” at large.

While most pundits have been likening these times to those of the Great Depression, I think we are beginning to look more like Japan—a sad, long deflationary nightmare. Perhaps this is how all “fiat” economic systems must end. I am no fan of the gold standard but there must be a price to pay for unbridled credit creation and the promotion of a standard-of-living greatly superior to the long term rate of growth of GDP.

The bond market seems to agree with the Japanese analogy and it recently went parabolic from an already overpriced level. I have occasionally tried to take the other side of this trade in the past few months. My belief was that even in the event of a Japanese scenario, one systemic variable was completely different—the Japanese ran a trade surplus and most of their debt was held internally while we are in the opposite position.

On the positive side, we have another difference: the U.S. has historically been a more dynamic socio-economic system, and unless we forget completely our entrepreneurial spirit, we might just be able to turn things around a bit more quickly. However, such a quicker turn-around would likely spell “inflation emergency” with all the dire consequences for bondholders.

Another explanation for the parabolic moves of the bonds (especially the 30 year) might be clever alchemy from Ben and Hank. Lets say you were to triple your debt load, and at the same time control interest rates, would you not also try to massively reduce the cost of money? In the real world, if a creditor triples its debt/equity ratio its cost of servicing such debt would go up percentage wise and in absolute numbers. However, if you are the U.S. government you can drive interest rates down artificially to refinance your debt long term. Seemingly, the typical rules don’t apply to the world’s reserve currency.

The U.S. is able to pull this off by getting the Chinese to play along. And despite all protestations, they seem happy to oblige considering the massive capital gains they are being gifted with for their old positions.

All the same, going forward the yield on U.S. debt is not attractive, which typically results in a weaker currency. But since the Chinese renmimbi is practically pegged to the dollar, it too will be devaluated, which in a deflationary environment is not such a bad thing (especially when you don’t have to take the blame for it, when oil is at a 5 year low, and you are the low cost producer of the world and want to stay that way). Furthermore, with yields so low, this will allow Hank and Ben to make a nice little (well not so little) profit on all those preferreds they bought from the banks which pay around 8%.

And to think the U.S. sent Martha Stewart to the jailhouse for insider trading, go figure…

As far as equities, this 2008 was a landmark year in terms of exposing the limitation of equities as solid beta components of long term investment/savings accounts. While I do expect equities to perform much better in the next ten years than in the past ten, I also believe that 2008 was the year that the “buy and hold” mantra was finally killed.

This “black swan” data-point, in my view, changes the return expectation of this asset class in general, and it does so within the context of a much worsened volatility profile. What seems clear now is that the long term viability of a passive equity portfolio depends solely on a favorable valuation of the asset class in general—the more undervalued equities are, the longer the affordable time horizon the investor has, and the more passive he/she may be. On the other hand, the higher the valuations, the more active portfolio management must be. This relationship is direct and accelerates at the extremes points of valuation.

Beta portfolios and passive indexing as increasingly perpetuated by the industry have massively failed the test of reality. I believe investors will have to resort to a much more active asset allocation and /or to a much smaller equity allocation. And this does not take into consideration a secular shift toward socialism which would imply a significantly reduced forward return-on-earnings in equities.

Not to get too sour, a bright spot next year might end up being real estate. The convergence of steep price reductions in the last 18 months, the cumulative efforts of all government agencies to reduce mortgage rates and possibly alter the price discovery process of this asset class in general, and a surfacing interest by foreign buyers may just be that needed energy to stop the bleeding sooner than expected.

With respect to option trading, we think that as 2009 evolves, actual volatility will start to settle down while implied volatility will remain high for a longer period of time. This is an optimum environment for volatility arbitrage using options. And after 2008, we could all benefit from quieter markets. In the least, any unexpected turns in the market will not come as such a surprise after Annus Horribilis.

- Davide Accomazzo, Managing Director

Steamrolling Over Option Trading Programs

[Originally published October 21, 2008 on SafeHaven and MarketOracle.]

"In days of old, seers entered a trance state and then informed anxious seekers what kind of mood the gods were in, and whether this was an auspicious time to begin a journey, get married, or start a war. The prophets of Israel repaired to the desert and then returned to announce whether Yahweh was feeling benevolent or wrathful. Today The Market's fickle will is clarified by daily reports from Wall Street and other sensory organs of finance. Thus we can learn on a day-to-day basis that The Market is "apprehensive," "relieved," "nervous," or even at times "jubilant." On the basis of this revelation awed adepts make critical decisions about whether to buy or sell. Like one of the devouring gods of old, The Market -- aptly embodied in a bull or a bear -- must be fed and kept happy under all circumstances. True, at times its appetite may seem excessive -- a $35 billion bailout here, a $50 billion one there -- but the alternative to assuaging its hunger is too terrible to contemplate."
--Dr. Harvey Cox, Atlantic Monthly (1999)
“To fly an airplane it must fly ‘in the zone.’ Too slow and
you stall and lose control; too fast and the wings come off.”
This is what Captain Dan Ryder, a former Navy fighter pilot who also served as Underway Command Duty Officer on U.S.S. Nimitz, explained as we sailed around Santa Cruz Island in a 37’ Tartan. That conversation took place the weekend before the “bailout” vote, and it has stuck with me ever since.

Since then world equity markets have plunged in a dive that hasn’t been seen since the Great Crash of 1929 stoking fears that we may be headed for the worst recession since the 1930s. Amid mounting fears that the frozen credit markets pose an imminent danger, the pressure for a coordinated rescue by the world’s economic policymakers has become acute. As stated in this weekend’s Financial Times in a telling quote, “Five years ago central bankers seemed almost omnipotent; now they seem scared.”

No doubt sentiment has materially changed since October 2006 when equity markets were in the midst of an extended bull run and the VIX, also known as the fear gauge, was hovering in a range between 10 and 12. For comparison, on Friday October 10th, the VIX hit an all time record intraday high of 76.94—that is 7 times higher than 2 years ago, and almost 3.5 times greater than levels for the VIX just a month ago. [Since writing this article, the VIX has hit 80 two times.]

The importance that volatility plays in options trading should not be underestimated. In fact, it is the key factor which drives how much premium can be charged/received when purchasing/writing options.

Low volatility makes for a difficult environment to write options and capture premium in a risk adverse manner. Like an airplane flying too slow, volatility during much of 2006 and through February 2007 was too low. This became apparent on February 27, 2007 when the VIX spiked nearly 100% and several option writing programs collapsed, giving back two or three years of accrued profits in a day.

Since that date volatility began to rise with the VIX trending higher. But this presented another problem for many CTA option writing programs—the transition from low volatility to higher volatility can be treacherous. Nonetheless, a group of these programs managed the transition, and arrived at what could be considered the “sweet spot” or “zone” for premium capture—a VIX ranging between 20 and 30.

This is the average range for the VIX from 1997 through 2003. But to gain insight into volatility spikes during this time period one must look back to three events. The first event was during the summer of 1998 with the implosion of Long Term Capital Management when the VIX reached 45. The second event was after 9/11/2001 when the VIX spiked to 44. This was followed by a VIX high of 45 during the 2002 bottom. However, each of these readings is far below a VIX of 70+ reached this past Friday.

More recently, since February 2007 the VIX has spike above 30 several times: first on 8/16/2007 when it closed at 30.83, then on 11/12/2007 at 31.09, followed by a spike on 1/22/2008 with a reading of 31.01. But the most memorable day was March 17, 2008 when the Federal Reserve Bank financed JP Morgan’s takeover of Bear Stearns in a controversial deal. The VIX spiked to 32.24 and market pundits debated on whether the Fed overreacted, or had helped us narrowly avert a crisis due to systemic counterparty risk.

We got our answer on September 14, 2008, when in one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself to Bank of America, while Lehman Brothers filed for bankruptcy protection and hurtled toward liquidation after it failed to find a buyer. That event set off the domino effect when on September 18th, the Fed provided AIG with an $85 billion loan in return for a government stake of 79.9 percent and effective control of the company—an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system.

It’s been downhill ever since with the largest financial “bailout” in United States history causing an existential crisis amongst those who hold to purest free market ideology. Yet, even with its passage—noting that financial market “rescues” have precedence in U.S. history dating back to Alexander Hamilton—the deterioration in the markets has not stopped (yet, as of this writing).

It is a classic case of the road to hell paved with good intentions. Every action that central banks, the treasury or governments have taken so far to try and stem the bleeding has been dismissed by the markets. And last week it seemed that the metaphorical wings of market volatility finally came off.

With the VIX above 50, much less given its rise above 70, market conditions have become extremely imprudent to trade. This is the conclusion that we came to, resulting in our liquidating positions.

Has the options trading model blown up?

Investor interest is options programs is a study in contrarian behavior. During the 1990s there was a great deal of aversion to the strategy of writing options. This began to change after 2003 when the S&P 500 bull market and the VIX bear market provided a “goldilocks” environment for naked option writing. The result was a proliferation of CTAs offering such programs by the end of 2006.

The irony is that low volatility going into 2006 created increasingly dangerous conditions to engage in option writing. In order to maintain return expectations from prior years, a CTA had to increase risk by either moving the strike price closer to the underlying price, and/or increase the number of positions.

Conventional wisdom at the time was that these programs were uncorrelated to the underlying market. As a result, there was a flood of investor interest in option programs seeking 20+ percent returns. Then came the subsequent transition to higher volatility since February 2007 which has yet again chastened many investors.

There is an old saying when it comes to options trading—it is like picking up nickels and dimes in front of a steamroller. It turns out many players offering option programs in 2005 and 2006 were relatively new to the space, untutored in the violence of short “gamma” as happened during 1998, 2001 and 2002.

So what distinguishes one option program from another, as well as risky trading from less risky trading? The answer is qualitative, but the trick is to produce “risk-adjusted returns,” in which positive returns are generated while mitigating volatility and exposure to risk. In options trading, this is a difficult feat.

First, investors need to recognize that there is a direct correlation between leverage and return with any managed futures program. A program which produces a 30% return is not necessarily better than a program which produced a 15% return. In fact, these returns could be produced by exactly the same trading programs with one using twice the leverage as the other for the same size account. The key is risk-adjusted returns.

One of the crucial factors which provides for consistent absolute returns in option writing/premium capture strategies is “theta,” or time decay. Consequently, the most important responsibility for a trader to manage is the risk of positions in his/her book, which should be considered liabilities until expiration.

A standard strategy is to write options far out-of-the-money, with the idea that the probability such options will go into-the-money by expiration represents a low probability event. In this strategy, traders will “white knuckle” their positions with expiration the only true stop loss. Investors are required to suffer high intra-month equity volatility in their accounts with the expectation that if the options eventually expire out-of-the-money, any unrealized losses plus premium written will be earned.

Risk of ruin is high with this kind of approach, and there is a tendency for the “deer in the headlight” syndrome. If traders do cover such positions, thereby booking large “painful” losses, they will often “roll” the contract to another strike price in the hope that the market won’t reach that subsequent level.

This kind of strategy has worked reasonably well for many option programs, with some using variations of the strategy to mitigate risk and equity volatility by utilizing bull spreads and/or calendar spreads.

The critical question in this current environment is if implementing routine trading strategies is still viable or more importantly, is it prudent? There are rumors that certain CTA option programs have utilized more margin than the agreed-to account size. This situation, in my opinion, represents irresponsible trading.

The bulk of investment performance is typically a function of strategy and risk taken. Yet the complexity of human behavior can never be fully modeled. Therefore, a discretionary common sense approach is needed—one which balances the quantitative with the qualitative in order to manage cycles of volatility.

Traders like to talk about how they provide “alpha” or skill-based returns. Alpha is a byproduct of “beta,” which is often referred to as a benchmark. In alternative investments, one can think of beta as the core strategy and alpha as the tactical overlay in response to changing market conditions.

This is the strength of discretionary trading—the ability to tactically adapt to changing conditions.

Unfortunately, the ‘quality of returns’ is a difficult concept to quantify. My recommendation is not to analyze how well traders have performed in normal market conditions, but how they have performed under stressful market conditions such as February 2007, March 2008 and now during October 2008.

Where does option trading go from here?

The seeds of the economic crisis we currently find ourselves is founded on the ‘forward contract exclusion’ from Section 2(a)(1)(A) of the Commodity Exchange Act of 1936. From this loophole in the Act, and various court cases since 1936, as well as the CFTC’s 1992 exemptive order issued under then-chairperson Wendy Gramm, evolved the unregulated over-the-counter (OTC) derivatives market. It is this history, along with deregulation built into the Commodity Futures Modernization Act of 2000, which allowed for the exponential growth of the $50-$60 trillion credit default swaps (CDS) market.

But for the ISDA and its former CEO, Robert Pickle, previous market crises such as the Orange County and Metalgesellschaft derivatives debacles in 1994, as well as the implosion of Long-Term Capital Management in 1998, should have long ago forced OTC derivatives onto exchanges such as the CME.

The persistency of frozen credit market conditions in the face of multiple central bank, treasury and government actions/interventions is cause for great alarm. Meanwhile, the Sword of Damocles overhanging this crisis has always been the CDS market. Draconian as it may be, some are calling for international action to declare credit default swaps null and void. But could this fear be overblown?

Fear culminated in panic last week as the market eyed Friday’s Lehman Brothers CDS auction in New York. The average price at the auction was below 10 cents, and worry was that financial institutions worldwide would have to face a bill of as much as $400 billion leading to significant writedowns.

It turns out, however, that the net payouts that CDS sellers have to make on defaulted Lehman Brothers debt is only a small fraction of the amount of insurance that was written. According to the DTCC, the “multilateral” calculations it performed on swaps tied to Lehman “indicate that net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range.”

This is excellent news as it proves to the market that net exposure on CDS transactions is substantially less than the $50-$60 trillion nominal figure often cited, which in fact references the “underlying” bonds and loans being protected. In other words, contract offsets greatly reduced overall market exposure.

Meanwhile, there has been an announcement that the CME Group will launch by the end of November the first electronic trading platform that is fully integrated with a central counterparty clearing facility for the CDS market. At the same time, the G-7 has pledged to do everything in their power to prevent any more Lehman Brothers-style failures of systemically important financial institutions.

Nevertheless, there will be more dislocations to come. Concern now is focusing on insurance companies and automakers. At the same time, the cost of protecting Dubai’s debt surged last week as concerns mounted about potential investment losses in the Emirate and the refinancing of up to $22 billion of debt.

Meanwhile, Standard & Poor’s stated that GM and Ford may go bankrupt, which is just one indication that substantial damage has been done to the “real economy.” Further, expectation is that unemployment will increase causing a feedback loop into lower consumer spending and reduced earnings for companies.

All this leads to the idea that the US stock market is susceptible to a long malaise where the predominant trend will be wide ranging sideways action. Yet, after we turn this page in market history, systemic risk will also have been greatly reduced, and it is unlikely we will see the VIX at 60+ again for a generation.

Current volatility as of today makes any attempt at establishing option positions very risky/expensive. However, once the market finds technical support, the setup is one where there will be greater implied volatility than the actual volatility as exhibited by the market. This is a perfect environment for arbitrage.

So for option traders who survived and proved their mettle in managing risk, investors should recognize that markets over the next few years will likely be “in the zone” for these programs.

- Mack Frankfurter, Managing Director

Thursday, October 2, 2008

3rd Qtr 2008 Review and Nonno's Mistake


At the end of WWII, my grandfather looked around and, devastated by the surrounding destruction and by the fall of an ideology he believed in, decided to sell for a song the family fortune, buildings, land and businesses. In my business, we would say he sold the lowest downtick as Italy went on to rebuild its infrastructures and to become at its height the fifth most industrialized country in the world.

In my career as a money manager and a speculator, I often race in my mind to this memory to remind myself that crisis breeds opportunities… as long as you don’t put yourself in the position to sell the lowest downtick, and as long as you don’t let ideologies run your decision making.

The financial crisis we have been fighting for the last year is the product of many practical distortions and ideological falsities, which Congress has loudly reminded us in its pathetic bickering over the rescue package. However, from the ashes of crisis, true and real recoveries take shape and opportunities are created. The life of an investor is about dodging, covering, attacking, covering again, retreating and attacking once more; always making sure that any losses that may come his/her way will not be terminal.

Our financial system has been under duress for over a year now and our posture at Cervino has been constantly adaptive to the difficult market conditions: we dodged, covered, and also attacked when visibility allowed. Such visibility is still very limited and therefore size and posture must be tuned accordingly. Flexibility and under-leverage are still in my opinion the name of the game until confidence is restored in the system, until people will feel safe about storing, lending, investing their money in financial institutions.

So what are we doing collectively to restore such confidence?

Treasury Secretary Paulson provided a plan that, admittedly vague, tries to address the liquidity issue most banks have been facing: leveraged balance sheets loaded with illiquid asset backed securities (affected by a collateral decreasing in value). Paulson proposed for the US Government to practically be the market maker of these complex securities, allowing the government to purchase such illiquid assets and hold them until better times, thereby backstopping the vicious spiral of lower prices forcing additional liquidation which in turn generates even lower prices.

Initially, Congress and the American people balked at the price ($700 billion) of the rescue package and the idea of rescuing fat bankers. Without spending too much time to point out that everyone is to blame in this disaster: politicians, many homebuyers, regulators and certainly bankers.

As I mentioned earlier ideologies are never good starting points for investment decisions. The rescue package is aimed to help all of us by providing stability, that in times of massive dislocations such as this, only the government can provide.

I believe in free markets and in free enterprise, but I also must be honest and pragmatic about the fact that even before this mess markets were neither free nor fair. The complexities of our society make it impossible to run a system completely free and fully meritocratic—that is just the way it is. No doubt, I keep a copy of “Capitalism and Freedom” by Martin Friedman on my nightstand but I recognize that our financial and social system is more complex than just shouting slogans like so many false free marketers (media pundits, politicians and regular Joes) have a tendency to do.

The real problem with the Paulson plan is not ideological or an issue of fairness, but with its execution if signed into law. The key to the plan is the pricing of assets, assets that in some cases have been constructed in complex and opaque ways. Price the asset too high and the tax payer will end up with a loss, price it too low and the plan will not succeed. Pricing these assets correctly is difficult but not at all impossible. After all about 95% of all mortgages are performing, and 75% of subprime mortgages are also still performing; even allowing for a haircut to cover increases in defaults and some additional decrease in the value of the collateral, most of this paper is worth more than the forced liquidation prices we are witnessing.

We may ask if this is the case, why is it that private equity is not aggressively buying them? The answer is “reflexivity.”

The uncertainty of the situation and the shakiness of the financial system make it hard for an investor to step in at this point. As a result, a vicious circle is now in full play. That is why the system must be stabilized. The uncertainty of the regulatory environment and the opaqueness of these markets are additional reasons why new investors are on the sideline. Stability and clarity must be the foundations of any rescue plan.

This is not the first time a banking crisis of this nature occurs (and certainly it will not be the last) and it is curable. Think of the banking crisis that happened in Sweden twenty years ago. Then, like now, a real estate bust caused the Swedish banking system to practically go bankrupt. The government purchased shares in its banks to recapitalize them and years later sold them at a nice profit. Sweden in the immediate aftermath of the crisis saw its unemployment numbers rise from 2% to 10% and a painful reduction in income occurred as well. However, while the crisis lasted three years, the recovery lasted fifteen years and Sweden produced a GDP growth more than 3% in average, double the rate produced by its European partners.

The idea to recapitalize the banks should also be part of the Paulson plan. George Soros has been very vocal about this lately to the extent that he thinks this should be the main element of any rescue package. I believe a combination of a transparent market making facility and a recapitalization package would go a long way to stabilize the situation.

Another element that increased instability and forced liquidation is the accounting rule FAS157 or “fair value pricing.” FAS157 requires marketable securities to be marked to market on the holder’s balance sheets. However, fair value of long maturity and illiquid securities such as Mortgage Backed Securities and Asset Backed Securities is not reflected by its market price since now there is practically no market.

In this situation, fire-sale prices become the pricing benchmark which ends up exacerbating the crisis. Changing or suspending FAS157 is a little like changing the rules in the middle of the game and it should not be done without a proper solution on how to price these securities. Most of these assets should be priced based on their cash flow and based on realistic assumptions on the price of the collateral. A few of these securities, the so called toxic waste, might prove more challenging.

Ultimately, a global approach is needed. Governments, central bankers, regulators and sovereign wealth funds should all participate in the solution of what is the most frightening crisis the financial world has experienced since the Great Depression. When credit markets completely freeze like it is now happening (the spike in the TED spread reflected a seven standard deviations move) the issue is not bailing out bankers or safeguarding taxpayers money, the issue becomes survival of the economic system that all of us used and have benefited from since the industrial revolution.

From a trading perspective, we stress again that size and posture must be adjusted for the level of volatility which in many regards is unprecedented. Time horizon also must be either really short or really long. In our absolute return programs we have shrunk our time horizon and we have also reduced size. While in our longer term portfolios, we are looking to start positioning in specific and strategic sectors maintaining a very long term horizon.

We think the dollar rally may have more to go as the deleveraging process continues and requires dollars to be repurchased to pay off the debt (not to mention that none of the currencies is on an absolute level strong). As far as US Bonds is concerned, we still expect them lower due to their historically low yields especially in the context of a rising deficit. Additionally, we don’t expect the commodities to resume their rally any time soon due to the deflationary environment and the large outflow of speculative funds. This includes gold as well with the caveat that in a panic situation, it still represents the strongest flight to safety.

In conclusion, we expect equities to be volatile for a while but we also think that the risk reward ratio is tilting in favour of being long for time horizons that are either very short or very long. However, should the credit markets fail to unlock, all bets are off.


-Davide Accomazzo, Managing Director

Moral Hazard and Aggregate Wealth Portfolio

"His name was George F. Babbitt. He was 46 years old now, in April 1920, and he made nothing in particular, neither butter nor shoes nor poetry, but he was nimble in the calling of selling houses for more than people could afford to pay."
--"Babbitt" by Sinclair Lewis (1922)

The largest financial bailout in United States history, which some traders are starting to call the ‘Securitized Housing Investment Trust’ (hint: think acronym), is causing an existential crisis amongst those who hold to purest free market ideology. Senator Jim Bunning, Republican of Kentucky, echoed this sentiment when he said, “The free market for all intents and purposes is dead in America.” These ideologues doth protest too much, methinks.

Since the 1929 crash, the last time the nation faced an economic train-wreck of this magnitude, the U.S. Government has effectively been in the insurance business and it has generally served us well. The vast majority of laws and regulations are designed to mitigate risk. Drunk driving laws minimize the number of car wrecks, and the short uptick rule (until recently eliminated) prevented unfettered short-selling from forcing solvent companies into insolvency.

Government institutions enforce these policies. What is the purpose of the military but insurance against an attack from other nations? What is the key purpose of a central bank other than insurance against a run on banks?

In fact, the present-day capital market system, which has been responsible for raising living standards to the highest in world history, relies upon laws and regulations: the Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Investment Advisers Act of 1940. Although not perfect (and definitely requiring an overhaul), these laws have served Wall Street and LaSalle Street very well over time.

The problem with fundamentalist free market ideology is that it is only theoretical, and ultimately not pragmatic. Truth is, without government establishing the premise of private property enforced through law and justice, contract markets would soon devolve and be quickly replaced by gangster capitalism akin to Putin’s Russia. There is a term for the unfettered combination of concentrated power, ideological adherence and capitalistic greed, it is called “fascism.”

There is another term “beta,” which defines the systematic return/risk of assets. This concept is related to Modern Portfolio Theory and underlies the oft-stated investment strategy of buy-and-hold. What is not well-understood, even by many sophisticated investors, is that this theory is flawed. The issue is benchmark portfolio construction. Accordingly, the definition of “true beta” or “true market portfolio” must be extended to encompass other economic factors.

What academics came to recognize was that approximately one-third of non-governmental tangible assets in the U.S. are owned by the corporate sector, and only one-third of these corporate assets are financed by equity. As a result, Jagannathan and Wang (1993) concluded that assumptions underlying the concept of beta must be altered in order to resolve anomalies in the model. In other words, “true beta” or the “true market portfolio” must include the “aggregate wealth portfolio of all agents in the economy.” This is a revolutionary view with both political and economic ramifications.

Business balance sheets do not in practice reflect public infrastructure assets which businesses are dependent on. For example, a trucking company’s greatest asset is not its fleet of trucks, but the U.S. Highway system. Likewise, public liabilities such as the cost of pollution are also not reflected on corporate balance sheets. This is beginning to change with the idea of integrating regulations into “cap-and-trade” contract markets involving emission allowances.

It is time for a new economic ideology to take hold which adheres to the middle way. Government and free enterprise are actually joint partners in promoting economic growth and well-being. Certainly, political will effects a constant tug-of-war between interests, but this is not unlike the struggle between a sales-trading desk which drive revenues for an investment bank, and internal compliance/risk managers who ensure balance between risk and reward.

The problem with the prevalent populist stream of conversation regarding free markets versus socialism is that such dialogue is anachronistic. Rather, the conversation needs to shift to good versus bad governance, and public policy which enhances the value of the aggregate wealth portfolio of all agents in the economy.

- Mack Frankfurter, Managing Director

Tuesday, April 29, 2008

1st Qtr 2008 Review and Atypical Markets


Courtesy of the credit mess and massive mispricing of risk that has built up in our system over the past decade, the first quarter of 2008 was for both the fixed income and equity markets one of the worst starts to a year in a rather long time.

The question now being asked, a little over a month after the global economy ‘whistled past’ the Bear Stearns’ run on the bank (which might of resulted in a systemic meltdown), is whether the Federal Reserve’s invocation of emergency powers was the right decision or wrong decision to make. This will remain into perpetuity an unanswered question, but on the morning of March 17th, Fed Chief Bernanke’s decision to finance $30 billion of illiquid Bear assets to secure its takeover by JPMorgan Chase & Co. came as a great relief to a market susceptible to another 1987.

Fortunately for our clients invested in the Diversified Options Strategy, we ended the 1st quarter with a solid 3.64% for the 1X program and 7.90% for the 2X program.

At the end of last year, our 2008 forecast called for continuing high volatility, strength in gold, and propositioned that the controversial idea of nationalizing losses was going to be put on the table in order to “save the markets.” In light of this framework, we traded the Diversified Options Strategy rather conservatively. The systemic risk was never this great and risk management was our main priority.

At the end of February, the odds of a systemic breakdown were, in our analysis, higher than ever and we constructed positions that would have withstood nicely such an event.

This prescience proved fortuitous, and even during the frightful hours around the Bear Stearns’ collapse and MF Global’s rout to a low of 3.64 from the previous day’s close of 17.35 (a 79% drop in price), our positions' volatility remained extremely low and the program was never at serious risk of loss.

Our Diversified Options Strategy’s risk-reward approach is validated by our Top 2 standing in BarclayHedge’s option strategy CTA ranking by Sharpe ratio.

Looking forward for the 2nd quarter, most studies based on sentiment indicators have been illustrating historical levels of negativity, especially when measured from the peak of October 2007 to the bottom of January 2008. This is in line with other recessionary periods. However, this negative sentiment often serves as a contrary indicator of where stock prices may go in the future.

Admittedly, the Damocles sword of additional credit market write-offs remains. This could eventually lead to a more pronounced credit contraction phase, resulting in more retrenchment by an overly leveraged consumer. But for the time being, mean reversion seems to be the leading factor driving the current retracement in stock prices.

For now, our outlook for the securities market in the second quarter of 2008 is more positive, at least in the near term. We expect the longer term will likely produce more disappointments, but the shorter term indicates a reversal to the mean type of action.

While on the subject of mean reversion, we would like to point out what we think are key differences between the capital markets versus the commodity markets. And in the process, also spend a few moments to provide a fresh analysis our trading in the Commodity Options Program.

Securities in general, and certainly stock market indexes, tend to be very mean reverting and therefore they offer numerous opportunities to play contrarian and volatility arbitrage strategies. On the other hand, the leveraged structure, speculative skew and liquidity constraints of commodity markets, as well as sudden changes in supply-demand dynamics, make commodities much more prone to reflexivity.

This state of affairs is due to a number of reasons, some clear cut and some more debatable. In any case, we do not believe one can routinely trade commodity options as you would normally trade stock index options.

Our underlying philosophy for the Commodity Options Program is to integrate income generation strategies with a significant number of directional bets. By definition such an approach will make the program performance more volatile and subject to a number of speculative market calls during the year.

That said, commodities in general have experienced record moves since the beginning of the year. This is a result of a combination of massive speculative inflows, and an inflationary monetary policy put forward by the Fed in response to the systemic risk posed by the credit crisis.

The convergence of these two factors overran our initial thesis that a global slowdown in the economy, and the need for a credit deleveraging, would force the commodity complex into a correction. The resulting situation put the Commodity Options Program into a difficult situation.

This specific program produces results based on a mix of mean reverting trades and directional bets (as opposed to the Diversified Options Strategy which is primarily mean reverting). Mean reversion—selling overbought and buying oversold assets—ended up having a poor risk-reward profile for commodities as three sigma moves became the norm. This was especially true in two markets where we were engaged: wheat and crude oil.

The historical trading anomalies of wheat were enough reason to cause an uproar from the farming industry as the futures-spot price convergence ceased to function properly. Crude has also started to pose valuation problems as it has begun to act more like an inverse dollar proxy than a commodity. In this environment even directional trades were not exhibiting positive risk profiles.

Notwithstanding the headwinds, the majority of our trades in this program were successful, but the poor risk-reward profile produced larger than expected losses in the wheat and oil contracts.

Going forward, we feel that the opportunities for a more rational trading may have finally developed for the Commodity Options Program after the entire commodity complex was hijacked by sheer speculation.


-Davide Accomazzo, Managing Director

We Need to Eliminate the Enron Loophole

Excerpt from my article: "The Mysterious Case of the Commodity Conundrum, Securitization of Commodities, and Systemic Concerns."

"The theories which I have expressed there, and which appear to you to be so chimerical, are really extremely practical—so practical that I depend upon them for my bread and cheese."

— Sherlock Holmes, A Study in Scarlet (1888)

The mysterious case of the commodity conundrum is sure to elicit passionate debate on either side of the equation—is the commodity boom due to speculation or fundamentals?

Rising prices and a widespread bull market in commodities should indicate that there is a growing scarcity of hard assets. However, traditional forces of supply and demand cannot fully account for recent prices.

To be precise, the normal price-inventory relationship has been altered. This is the assertion of an expanding list of bona fide hedgers, commodity professionals and economists. Specifically, dynamics have changed because securitized commodity-linked instruments are now considered an investment rather than risk management tools. Of late, this has caused a self-perpetuating feedback loop of ever higher prices.

In a statement to the CFTC, Tom Buis, president of National Farmers Union, testified, “If [farmers] can’t market their crops at these higher prices, we’ve got a train wreck coming that’s going to be greater than anything we’ve ever seen in agriculture.” Billy Dunavant, head of cotton merchant Dunavant Enterprises, was more blunt, “The market is broken, it’s out of whack—someone has to step in and give some relief.”

Even CFTC Commissioner Jill Sommers acknowledged charges that speculators are skewing the market, in an apparent turnaround from the CFTC statement of April 21st which implied that commodity markets are functioning properly. Nevertheless, the official CFTC stance is that speculative trading is not the primary culprit behind surging commodity prices, but other factors such as the declining dollar are contributors.

Yet, it is undeniable that the physical delivery markets for grains, which require that the actual commodity be delivered against expiring futures contracts, are no longer converging. This is probably just the tip of the proverbial iceberg—it is arguable other hard assets are priced “out of whack” for any number of reasons.

For example, public policy plays a role in pricing issues too. For example, continuous accumulation of strategic oil reserves by multiple governments implies rising support levels. In that sense, speculative pressures can expose “bad” application of otherwise well-intentioned government policies, such as subsidies for ethanol production or programs which pay farmers to take erosion-able lands out of production. All the same, governments’ counter-response to excessive speculation can be unhelpful, and shutdowns of free market activities are occurring.

The problem for the public is that theses issues can be complicated, and in a sound bite society which desires easy answers and easier solutions, the predominant view is currently biased to commodities as an investment hedge against inflation and speculators as an easy scapegoat for all the world’s commodity woes.

Unfortunately, this thinking is a self-fulfilling prophecy which ultimately may feed into a negative economic cycle where legitimate commercials are squeezed out of business thereby reducing supply, protectionism gains traction, trade breaks down, hoarding ensues, riots occur and wars erupt over access.

Fact is, the genie is out of the bottle and it is not going to be put back. But the financial services industry also needs to acknowledge the imbalances it has wrought in the commodity markets. The following sets the record straight...

Futures and forward contracts are intrinsically different instruments than securities which are derived from the capital markets (e.g., fixed income or equities). This is underappreciated.

Derivatives are risk management tools, a “zero-sum game,” fundamentally different from the “rising tide raises all ships” concept of the capital formation markets. While, there is an established theoretical basis and considerable empirical evidence that link investment in capital market assets to positive expected returns over time, notwithstanding the recent surge in commodity prices, a legacy of academic disagreement supports the claim that, on an inflation-adjusted basis, the same cannot be said about commodities.

As noted by Greer (1997), the inherent problem is that commodities are not capital assets but instead consumable, transformable and perishable assets with unique attributes. Hence, speculative trading, by definition any commodity trading facilitated for financial rather than commercial reasons, likely results in “zero systematic risk.”

The conundrum for financial “investors” is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in futures/forward contracts—they are simply agreements which commit a seller to deliver an asset to a buyer at some place/point in time. Accordingly, the derivatives and securities markets require two different types of regulation. Why?

The percentage of open interest in futures contracts relative to crop size is out of proportion. For some crops, only 10,000 contracts are needed by bona fide hedgers. For comparison, the year-to-date volume of wheat contracts traded through March 2008 is 5.7 million contracts. Meanwhile, the CFTC requires hedgers to provide large trader reporting, but unregulated participants have no such requirements. Further, there are systemic issues with big moves happening overnight and taking place off-exchange.

This is explained in further detailed in more detail in the complete version of this article (to request a PDF version, email:

As a CFTC registrant and participant in the managed futures industry, I am personally baffled at our lack of representation regarding the “closing the Enron loophole” issue. Managed futures represent a class of regulated speculators who have traditionally provided liquidity to the bona fide hedgers. Our role is indispensible to the proper balance to commodity trading because we go both long and short commodities. However, if we do not ensure our place at the table, we may lose our rights if not the viability of our industry.

In effect, the “securitization of commodities,” a difficult topic in itself to analyze given the proliferation of different types of securitized commodity instruments, has led to an undermining of the prime economic purpose of the commodity futures market. The primary benefit provided by futures markets is that it allows commercial producers, distributors and consumers of an underlying cash commodity to hedge.

Investors must recognize that risk management markets exist primarily for the benefit of bona fide hedgers. Securitized commodity products are not structured to serve that purpose. Rather, this innovation has allowed money flows to distort price discovery, while at the same time undermine the all-important hedging utility. Further, they are sold as investments, when in fact these products are speculative.

As discussed in detail in the complete version of this article, the “Enron loopholes” within the Commodity Futures Modernization Act have served to undermine the authority of the CFTC, and put the futures industry as well as the economy at risk. It is time to rein in excessive market speculation which is occurring on the “dark exchanges’ and support the transition of unregulated commodity speculation back into the domain of the regulated futures industry.

The Close the Enron Loophole Act (S.2058), introduced by Senator Carl Levin of Michigan, would rearm the CFTC with the tools needed to subject “dark markets” to the same oversight as traditional futures exchanges. Exempt commodity exchanges would be made subject to the same standards as traditional contract markets regarding position limits, large trader reporting and transparency requirements. The proposed Act would also require large-trader reporting for domestic trades on foreign exchanges.

If a facility for trading commodities looks like a futures exchange and acts like a futures exchange, then it should be regulated like a futures exchange.

At the same time, securitized commodity products should come under regulations similar to that which has been imposed on single-stock futures. Recent events reveal that long-bias commodity index funds and commodity-linked ETFs may systemically represent a form of market manipulation.

If investors are interested in investing in commodities on an unleveraged basis, then the futures exchanges should develop “fully-funded” non-leveraged instruments, similar to mini-futures, for investors to trade.

Further, Series 7 securities representatives should be disallowed from marketing commodity-related investment products without also having a Series 3 license and registration as associated persons.

Additionally, commodity-related securities products should be subject to NFA 4-29 marketing rules as is imposed on futures industry registrants. For example, hypothetical concepts such as the roll return should have attendant hypothetical disclosures as would be required of futures professionals.

As to the institutionalization of financial investments in long-biased commodity positions, index funds need to accordingly recognize their inherent responsibility in financing credit lines to utilities which facilitate physical deliveries of commodities. Admittedly, this may be difficult under current law.

These concerns raise a key question for the futures industry, managed futures, and bona fide hedgers. Why are securities professionals allowed to hold themselves out as commodity professionals? The debasing of this core rule has led to confusion in the public's mind and threatens the futures industry profession, thereby undermining the CFTC's authority as granted by the CEA.

Has there been an abrogation of responsibility by the CFTC? Is this regulatory body now beholden to interests other than the constituents it is suppose to serve and regulate?

A key responsibility of the CFTC is to ensure that prices on the futures market reflect the laws of supply and demand rather than manipulative practices or excessive speculation.

The 2006 U.S. Senate Staff Report by the Permanent Subcommittee on Investigations concludes as follows:

“It is critical for U.S. policy makers, analysts, regulators, investors and the public to understand the true reasons for skyrocketing energy prices. If price increases are due to supply and demand imbalances, economic policies can be developed to encourage investments in new energy sources and conservation of existing supplies. If price increases are due to geopolitical factors in producer countries, foreign policies can be developed to mitigate these factors. If price increases are due to hurricane damage, investment s to protect producing and refining facilities from natural disasters may become a priority. To the extent that energy prices are the result of market manipulation or excess speculation, a cop on the beat with both oversight and enforcement authority will be effective.”

Ironically, we’ve been here before... The Commodity Exchange Act of 1936 repeats the same in a more concise fashion, “Excessive speculation in any commodity under contracts of sale of such commodity for future delivery… causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity.”

The more things change, the more things stay the same. “Eliminate all other factors, and the one which remains must be the truth.” Perhaps, we can take heart from Sherlock Holmes in “His Last Bow.”

“Good old Watson! You are the one fixed point in a changing age. There's an east wind coming all the same, such a wind as never blew on England yet. It will be cold and bitter, Watson, and a good many of us may wither before its blast. But it's God's own wind none the less, and a cleaner, better, stronger land will lie in the sunshine when the storm has cleared. Start her up, Watson, for it’s time that we were on our way. I have a check for 500 pounds which should be cashed early, for the drawer is quite capable of stopping it if he

- Mack Frankfurter, Managing Director

Wednesday, January 16, 2008

2007 Year End Thoughts Going Into 2008


The long and winding year of 2007 has come to a close... In the annals of trading, this is one “vintage” that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.

Exactly one year ago, we at Cervino Capital were advocating caution and making noise about the badly skewed risk-reward equation, especially in the equity markets. This is documented here in our blog.

In the early part of the year, we traded small and with little conviction, mostly getting frustrated. Such strategic frustration, however, allowed us to overcome the expected change in volatility that started in February and that is still continuing now.

Several other aggressive money managers who also trade options were not so prescient and are no longer managing. We do not say this to “rub it in” but to remind us all, including ourselves, that investing in the futures market is a tricky game.

Leveraged strategies must always be treated with kid gloves, and risk management should be the first priority—that is our philosophy. By sticking to our convictions we believe that, for the prudent and patient, robust investment returns will follow in due course.

At the risk of trying to forecast the future, these are the potential investment themes that we expect may develop in 2008:

US dollar rebound. While the structural weakness of the dollar will be an established theme for some time as a result of numerous bad fiscal decisions made by politicians and consumers alike—when everyone is leaning one way, expect the opposite. The need to repay our debt may spur a rally.

High volatility. Volatility should be here to stay. This measure of risk is cyclical in nature, and as we continue through this period of credit contraction and risk reassessment, it is reasonable to expect a protracted cycle of high volatility.

Energy leadership. Given the continued imbalances of supply and demand, energy will maintain its position of market leadership, with interest in alternatives and carbon allowances continuing to grow too. Even in the event of an economic slowdown, we believe that the price of crude oil will remain high, and energy needs will remain a predominant factor.

Gold strength. With the Fed between a rock and a hard place, and the investment community walking the tightrope between housing/credit deflation and growth stimulation, gold will prove to be the most comfortable “global value benchmark.”

Nationalization of losses. Wall Street’s new credo seems to be: “privatize profits, socialize losses.” We fully expect bail-out plans to be implemented for the ‘rationally irrational’ (or is that, ‘irrationally rational’?) risk takers in the housing market.

Sovereign wealth funds. This is the new significant player in the game, and they are likely to change the market landscape as much if not more than the influence wrought by the hedge funds. Generally, this development is positive, but the markets should demand more transparency.

As a final prognostication, we’re hedging our bets that 2008 will be at minimum another interesting year, and we look forward to trade it. In anticipation, Cervino Capital launched a Commodity Options Program in July 2007, and is now offering a 2X leveraged version of its Diversified Options Strategy.

Our goal is to produce risk-adjusted returns utilizing strategies that enhance portfolio diversification by taking advantage of the situations we highlighted above.

- Davide Accomazzo, Managing Director

Prepared Speech on the Subject of Volatility

The following is from a speech prepared by Davide Accomazzo for the quarterly review of the Pepperdine Investment Club, a class which manages real money in a real portfolio.

Let me begin by thanking you for inviting me here tonight; it is an honor and a privilege.

This opportunity you have in running a portfolio with actual money is a great tool to become acquainted with the true meaning of portfolio management. When I took my investment classes in business school, part of the program was to individually manage a $100,000 portfolio for the duration of the class. Whoever had the best performance would win…

Of course, this was not “real” $100,000, which in my case was rather good since after spending about half the class comfortably at number one, I decided to take a leveraged bet on the dollar index just before the U.S. Government shutdown in 1995. From there, I miserably dropped from first place to last place, where I concluded the class.

Later, when I called my professor to tell him that I was going to Wall Street to trade euro convertible bonds for an investment bank, he said, “When I saw you blow it all up with that trade, I knew you were going to go to Wall Street!”

Well… ten years later and after dodging many bullets, with real respect for risk and volatility, and a much better understanding of risk management and discipline, I can say that blowing up that hypothetical portfolio was a worthy experience. Because of this, I would like to touch upon the subject of volatility, and hopefully provoke interest as well as more analysis on your part in your quest to become money managers.

Many years ago, a friend of J. P. Morgan, at the time the most powerful banker and investor in America, if not the world, asked him what his outlook for stocks were for the coming year. The legend states that J. P. answered, “Stocks will go up and stocks will go down.”

Such a seemingly overly-simplistic comment probably disappointed Morgan’s friend but in reality it was the truest analysis Morgan could have given. Even today, with all the advances in quantitative science and the power of technology, the “tea leaf reading” activity in guessing market direction is still, at best, a matter of batting averages and discipline. In other words: stocks will go up and stocks will go down.

What I believe is of utmost importance, and often underestimated, is a clear understanding of the potential violence of those swings; how deep stocks might go down and how high stocks may fly. I am referring to stock market volatility. The process of incorporating volatility analysis and volatility forecasting in portfolio analysis is in my view of paramount importance.

There are many ways to refer to such volatility and one now commonly used benchmark is the VIX, a measure of market volatility calculated by averaging the weighted prices of out-of-the-money puts and calls on the S&P 500 index.

While this benchmark was confined mostly to derivative players for years as an analytical tool, it has recently come to the forefront. I believe that an understanding of how the VIX illustrates and maps market participants’ risk behavior can only improve your portfolio management technique.

There are also lessons to be learned from studying volatility behavior in its historical contexts. One should always be on the lookout for warnings flags as indicated by irrational market behavior—the madness of crowds—as well as disconnections between implied and statistical volatility.

The past is littered with examples: absurdly low volatility levels in 2006, followed by a slew of blow-ups in 2007 including subprime hedge funds, CDO mispricings, and quant hedge funds are recent cases in point. Going just a few years back, there is the 2001-2002 bear market volatility spikes, and before that is the 1998 LTCM volatility convergence trade fiasco.

Consequently, you should imprint onto your psyche the potentially misleading significance of Gaussian calculations in trading, and in turn focus on the importance of volatility cyclicality, the value of common sense, and the need for strategic insurance.

Always ask yourself: Am I being paid enough for the risk I am taking?

Or, on the other side of the coin: Are opportunities undervalued given the market’s structural and behavioral profile, and should I increase exposure?

And always keep in mind the effect of the unforeseen event, now commonly referred to on trading desks as the “Black Swan.” How you can protect your portfolio, or likewise profit from it… because that is or certainly should be, why people pay you to be their money manager.

- Davide Accomazzo, Managing Director