Monday, January 4, 2010

2009 Year End Thoughts and Policy Risks


In October 2008 things got bad, then in March 2009 it got worse, but now it is all better... or is it? The coordinated government and central bank intervention was on a magnitude not seen even during the 1930s (see table below). Yet despite the 66% rally since the March lows, “many of the bulls don’t appreciate just how much the government props still under the economy are masking its weakness,” says Pimco’s CEO, El-Erian. As for Cervino Capital, we admit playing 2009 over-defensively in light of such “unimaginable” stimulus, having maintained throughout the year primarily a delta-neutral position when in hindsight we should have been delta long. As a result, the market’s momentum and upside persistence resulted in our put-side hedges sapping returns, while our call-side premium writes causing us to continuously manage that risk.

Nevertheless, our Diversified Options Strategy is ending the year positive—the fourth in a row—in line with our absolute return objective. In fact, since inception in January 2006, our non-leveraged D1X program has returned 26.88% whereas the S&P 500 returned -10.66%. At the same time, we managed to generate this performance with a Sharpe Ratio of 1.15 versus -0.16 for the S&P 500, and a beta of 0.06 which is essentially non-correlated to the S&P 500. In light of an economic crisis not seen in generations and an unprecedented government and central bank response, given that we are mainly trading options on the S&P 500, this is seen as an accomplishment. The key to superior money management from our perspective remains strategy discipline and risk management.

To say the least 2009 was a strange year. Dubbed “the Great Recession,” the current economic period which follows the excesses of the past decade has resulted in a magma of monetary and fiscal interventionism, superficial stabilization of the financial system, historically large unemployment and more confusion on the future of our economy. Capitalism survived but only nominally as central bank intervention, albeit mostly unavoidable, corrupted the true price discovery process of most asset classes. The law of unintended consequences is already at work and those who actively engage in financial activities–-whether virtually by trading or on the ground by building businesses-–have already felt the winds of change. Markets do not move as they used to, and micro and macro economic dynamics do not interact as business schools have taught us for decades. Political divining is now more important than ever as an element of decision-making and so is subtle understanding of monetary policy. If the last 25 years was representative of aggressive entrepreneurship, the next 10-25 years will probably require superior coziness with government.

But what does all this mean for the future of investing? How should we position ourselves and where should our chips land? I believe that the fluidity of the situation requires flexibility, diversification of asset classes and strategies, and much work toward aligning your interests with governments. More specifically, I believe asset class timing must be part of the process and alpha driven strategies should be the core of every portfolio. Unless global GDP growth wildly exceeds the expected 4% rate, it is difficult to imagine significant multiple expansion from here. 2010 may bring about the kind of environment where investors should be prepared for constant cross-currents and no defined trends. Equities may still do fine as a result of liquidity pressures and by benefiting from potential pockets of resurging globalization, but I see such market action as collared. If in the nineties we learned to trade the “Greenspan put,” this new dawn may bring about the “Bernanke collar.”

The elephant in the room could be the US Dollar. The greenback has showed an inverse correlation with equities for much of this decade as part of the liquidity/leverage boom bust cycle. The degree of bearishness on the USD reached significant levels in the last quarter of the year and eventually resulted in a strong rebound. At this point a lot of USD bearishness has been corrected and the outlook for next year depends on many variables.

The bearish argument resides on the idea of massive FED money printing and large fiscal deficits. While I cannot argue against this idea, I would caution on the timing of it. As of now the FED has not actually printed much money and most of its intervention was either done thru electronic adjustments and stabilization types of credit facilities. Most of the liquidity injected is just sitting on banks balance sheets and it is very short term in nature. Should that liquidity be channeled into the real economy and multiplied by our fractional system then the inflation worry would materialize.

This scenario may be one to two years away and it is subject to many variables. In this case, the USD would suffer and equities could increase in nominal values. On the other hand, I think a more likely scenario in the intermediate term is a continuation of the deleveraging of private sector balance sheets; this would entail a stronger USD and possibly sagging equities. I feel a stronger USD is in the cards also because of its relative position versus the Euro. While we have significant issues to work thru in our effort to stabilize our economic cycle, I believe Euroland has higher sovereign risk (Spain, Greece, Italy, Baltic States) and more structural and political restrictions to maneuver.

What the USD may do in the next twelve months has repercussions on commodities as well. If the USD gets stronger, there would be less pressure on commodities (priced in USD globally) to re-adjust upward. However, if all global currencies accelerate the new trend of competitive devaluation, then commodities and gold especially will continue to benefit from investment flows. Political divining and close monetary policy scrutiny will be paramount in dealing with this unfolding issue.

On the other hand, stocks are not as expensive as they have been for most of the last 15 years and they should benefit, in case of sudden economic dislocation, by the generosity of global central banks which understand very well the role of confidence in perpetuating the system. Volatility is hovering around its 15 year moving average (as measured by the VIX) indicating neither panic nor complacency within an historical perspective.

Diversified high yield portfolios still seem to make sense in a world where yields are very compressed; MLPs and fixed income closed end funds still bring value to the table but timing and risk control are still forefront issues. The spread of MLPs as an asset class versus the 10 year Treasuries has now fallen below 400 basis points and spreads are at low levels indicating short-term caution. The key term is short-term. On that level most studies I have been looking at are flashing caution for equities in general: corporate insiders sales, smart/dumb money spreads, stock/bond ratios, options indicators. Mid January could present us with a tradable correction. A more pronounced two way trading than the V shaped momentum driven environment of 2009 would play well for alpha strategies like our options trading programs to outperform the benchmarks.

In conclusion, I would like to take a moment to thank all of our clients that believe in our strategies, risk management and unbiased analysis. At Cervino Capital Management LLC we strive every day (and almost every night considering our different shifts) to be the best money managers as we relentlessly push the boundaries of analysis in the never ending quest for alpha.

--Davide Accomazzo, Managing Director

It's the End of the World As We Know It

Marcellus: Something is rotten in the state of Denmark.
--William Shakespeare, Hamlet Act 1, scene 4

In the 1950s, Leon Festinger and two others infiltrated a UFO doomsday cult that was expecting the imminent end of the world on a certain date, and documented the increased proselytization they exhibited after the leader’s “end of the world” prophecy failed to come true. The prediction of the Earth's destruction, supposedly sent by aliens to the leader of the group, became a disconfirmed expectancy that caused dissonance between the cognitions, “the world is going to end” and “the world did not end”. Although some members abandoned the group when the prophecy failed, most of the members lessened their dissonance by accepting a new belief—that the planet was spared because of the faith of the group.

The economic crisis of the last two years provides a haunting corollary to Festinger’s study. In an interview on CSPAN on January 27, 2009, House Representative Paul Kanjorski defended the original emergency actions by the United States government to halt the financial crisis. Kanjorski stated that the move to raise the guarantee money funds up to $250,000 was an emergency measure to stave off a massive “electronic run” on money markets that removed $550 billion from the system in a matter of hours on the morning of September 18, 2008. He further asserted that, if not stopped, the run would not only have caused the American economy to crash immediately, within 24 hours it would have brought down the world economy as well.

As the “end of the world” did not come to pass, there are those who question Kanjorski’s account such as Felix Salmon of Condé Nast Portfolio; although financial writer Daniel Gross confirmed some elements of the story, but prefaced his remarks by saying “I don’t know if his numbers are 100 percent correct”. Such criticism raises the question of how we prejudice “fact” from “truthiness” in the so-called "soft science" of economics, which in turn leads to questions about the assumptions underlying economic models. Joseph Stiglitz, the Nobel Prize-winning economist and Columbia University professor, stated that economists are among those at fault for the financial crisis, which exposed “major flaws” in prevailing ideas. The now-flawed premises include the ideas that economic participants behave rationally and that financial markets are competitive and efficient. In a damning remark, Stiglitz claimed that “Globalization had opened up a global marketplace for fools.”

What the world economy now faces is cognitive dissonance on a global basis. The conundrum with respect to cognitive bias is that implicit in the concept is the standard of comparison. In other words, peel the onion and we’re left with the unsettling question as to which denomination do we use to value assets. Relativity, it seems, goes to the very heart of the inflation versus deflation debate. Are investors making rational decisions as a result of the currency in which they form their perspective of valuation? In a world in which the US dollar is no longer the world’s reserve currency, what substitutes as safehaven in a “flight to quality”?

The question of how banks manage their collateral deals with other financial players is usually not of interest to ordinary investors. Until recently, the widely held assumption that the credit standing of European countries and the US was secure resulted in banks not demanding collateral when sovereign entities are involved. Similarly, when banks made loans to western sovereign nations, they typically do not post big reserves since such debt is deemed “zero-risk weighted” in bank regulatory rules. However, as a result of seemingly remote events, or “tail risks” having come to fruition these past two years, debt default in a developed country is no longer unthinkable. In fact, once upon a time even the US repudiated its debt in 1933 by outlawing the private ownership of gold, and requiring creditors to be paid in “legal tender coin or currency”.

The Triffin dilemma is the fundamental problem of the US dollar's role as the world’s reserve currency leading to a tension between national monetary policy and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, particularly in the US current account. According to Martin Wolf, chief economics commentator of the Financial Times, the host nation of a global reserve currency will inevitably run up a huge current account deficit that undermines the credibility of its currency and adversely impact the global economy. As it stands, the US currently has a national debt in excess of $12 trillion or almost $40,000 per citizen, with a debt to GDP ratio of more than 85 percent. “On the dollar, there is nothing to support this currency except the Chinese government and a few other governments that are prepared to buy it,” said Wolf at an event organized by the Singapore Institute of International Affairs.

More so, the perverse vendor-financing relationship between the Chinese renminbi and US dollar is highly destabilizing for the euro zone economy. The European Commission recently warned that public finances in half of the 16 euro-zone nations are at high risk of becoming unsustainable. Because there is little chance of European governments intervening in the foreign exchange markets to improve the competitiveness of the euro, American policy is effectively “shifting the recession from them(selves) to their trading partners,” according to Wolf. The decline of the US dollar underscores a phase of global power transition, with the balance of power moving from the US to Europe, China and India, Wolf argues, adding that the greenback’s loss of credibility as the dominant global reserve currency is part of this messy transition.

It is with this context in mind that one can begin to analyze the cognitive dissonance arising from the fundamental problem that the US cannot resolve this credit crisis by issuing more debt. Yet with the White House announcing that it had eliminated the maximum bailout cap for Fannie Mae and Freddie Mac on Christmas Eve, it seems that US policy-makers are finding yet another way to extend the process of quantitative easing. Such rule changes are the “tip of the spear” in a whole range of unprecedented policy actions which have hugely grown the monetary base in the hope that such action will “reflate” the economy. One likes to think that the US is a government-of-laws-not-men presiding over a level playing field, but in an effort to “save us from ourselves” it now seems that the US is constantly changing the rules anytime it wants. Unfortunately, such actions can only have the detrimental effect of undermining the moral standing of the US dollar long term. As the song says, “it’s the end of the world as we know, but I feel fine”.

- Mack Frankfurter, Managing Director