Fed Almighty

July 3^rd 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Economic data dump: manufacturing takes a dive

* Bad news is good news

* Fed almighty

Risk assets rallying again today. Friday’s sharp relief rally (after the latest in an increasingly long string of supposedly “now-or-never” Euro-summits) faded on Monday but markets are resuming their move higher today, apparently on increased expectation of further Fed intervention.

Optimism that Bernanke et al will crank up the printing press once again appears to be founded on renewed signs of a weakening global economy. Yes it appears that once again bad news is good news – at least where risk assets are concerned.

Economic Data Dump

Central to the renewed sense of approaching economic doom was a raft of manufacturing data released on Monday. Firstly data from the ISM (Institute of Supply Management) showed a US economy in a state of deceleration verging on out-right contraction:

The data are negative almost without exception, but the standout data points in the above chart are:

·         collapsing new orders (down 12.3 % pts MoM)

·         prices down 10.5 %pts MoM

·         Overall PMI composite down 3.8 % pts MoM -- and perhaps more significantly, for the first time since July 2009 it breached 50, the threshold which separates expansion from contraction.

Another closely followed indicator added to the gloom on Monday, with the PMI from Markit/HSBC registering negative MoM growth in manufacturing activity for 16 out of 26 surveyed economies. Notably, Japan, Korea, Taiwan, Norway and South Africa all slipped into contraction territory in June.

In summary, not a good day for economic news.

That said, an ISM PMI reading below 50 is far from a sure-fire indicator of a coming recession. Examining historical PMI data shows a number of ‘false negatives’ during the past 60 or so years where the PMI has breached 50 but no recession has followed:

(Interestingly, these PMI ‘false-negatives’ have been occurring more frequently since the mid-80’s, probably in part a reflection of the evolution of the US economy and the increasing importance of the non-manufacturing sectors).

Bad News is Good News

Unarguably, however, the data are poor and the trend is worse. With such a raft of negative data being released, one might reasonably expect a re-pricing of growth-hungry risk assets such as equities and commodities.

In fact, the opposite is happening: risk assets are rallying in the face of a slowing economy as expectations rise of future Central Bank intervention in order to prop up growth.

Yet again we are observing the ‘good news is bad news’ phenomenon as traders punt on another slosh of liquidity courtesy of Berkanke and his pals at the Fed.

What this reinforces is the fact that for some time now the markets have been progressively de-coupling from economic fundamentals and becoming increasingly dependent on Central Bank policy.

An effectively functioning capital markets system this is not.

I fear we are storing up major trouble for the future as a result of this breakdown: malinvestment, misallocation of capital, excessive leverage and risk taking...if it sounds familiar that’s because it is. My concern is that the burst mortgage and property bubble of 2003-2007 is in the process of being replaced by something new and more dangerous. Hydra-like, one head is lopped off only for two more to grow back in its place.

Fed Almighty...for now

I continue to fight my longer-term bearish instincts and maintain the short-term expectation of rising asset prices over the next 3-4 months.

Federal Reserve intervention will continue to play an outsized role in driving financial markets and the likelihood of further money printing in the coming few months is high as the economy slows to a crawl.

With both the Presidential election and the dreaded ‘fiscal cliff’ approaching at the end of this year, the window of opportunity for such Fed action is closing rapidly before political inertia sets in, and I expect Bernanke to hit the switch sooner rather than later.

While I don't expect further montary easing to have much impact on the real economy, it would provide a further boost for risk assets as at least part of the freshly printed money is likely to find a home in equities and commodities.

It is wise not to stand in the way of this 'monetary freight train' but instead to either go with it or simply get out of the way. Longer term, however, ever-loosening monetary policy can surely not be immune to the law of diminishing returns and I expect that this fact will ultimately be exposed.

Once this occurs, and markets lose faith in the Fed Almighty, a major unravelling of confidence is possible and in that case -- watch out below. I suspect 2013 will bring us much closer to the endgame in this regard.

Hence looking beyond December 2012 I maintain a bearish outlook and am not committing long-term funds to risk assets. This increasingly feels like a market suitable only for short-term traders or investors with an ultra-long term time horizon. For those in between you have been warned.

“Market Mis-timing”: a study of the distribution of returns from the S&P 500 1950-2012

March 26th, 2012

Nick Hays

Dhaka, Bandladesh

No prizes here for “most catchy blog title”. However I hope this short article does exactly what it says on the tin.

This topic is an area of some interest to me because although I remain fascinated by the daily movements of markets and short-term trading, I am also an advocate of a conservative, long-term approach to investing.

While both strategies have their merits, my research has led me to conclude that for the average retail investor, the long-term ‘buy-and-forget’, index investment approach is by far the preferred approach.

This assertion will be the subject of an upcoming series which I am in the process of writing. In the meantime, this article examines one variable of the ‘buy-and-hold’ investment strategy: time horizon. In other words, how long the investor commits to locking up his funds.

A common fear amongst retail investors is buying at the ‘wrong’ time, or as I am calling it ‘market mis-timing’. Simply put, we are afraid that we may buy at the top of the market and just as the bull is running out of steam.

This fear is entirely rational when you consider recent history. For example, a buy-and-hold investor who bought the S&P 500 index at the peak of the dotcom bubble in March 2000 would have been sitting on paper loss for the next 7 years, and would still be nursing a negative return even today, 12 years later. That is a compounded annual return of -1.4% (including dividends, but before adjusting for inflation).

However, looked at from a longer-term perspective and the picture appears very different. From 1965-2011 the S&P 500 gave a buy-and-hold investor a compounded annual return of +9.2% (including dividends, before inflation).

The fact is that over the very long term, stocks have historically been a reliable source of positive returns for patient investors who were willing to accept a level of volatility and periods of negative returns.

While past performance is no indicator of future returns, I am a firm believer in the power of mean reversion in data sets that are sufficiently large and long-term in nature.

If we believe that the stock market’s positive trend remains intact over the very long-term, then intuitively we understand that the longer the period we are willing to lock our money up in the market, the less we need to worry about the risk of buying at the ‘wrong’ or ‘right’ time. The logical conclusion of this is that a theoretical ‘infinite’ time period would reduce the risk to the absolute minimum. (In fact it’s an oft-quoted fact that Warren Buffett’s preferred stock holding period is “forever”). Obviously in the real world we cannot entertain an ‘infinite’ holding period - eventually investors want the money back so that they can consume, hence a practical time horizon must be selected.

Put another way, there is a trade-off between, on the one hand, the risk of “market mis-timing” and on the other the time value of money – the opportunity cost of locking up our money for extended periods of time.

In summary, my aim is to quantify and estimate the appropriate minimum holding period for a buy-and-hold index investor. Note the “appropriate minimum holding period” is defined here as the period which adequately reduces the spread of the investor’s expected returns, as measured by the standard deviation. I have used the S&P 500 as an illustrative example, examining holding periods of 1 through 10 years commencing on every trading day within the period 3^rd January 1950 - 5^th March 2012.

The result is in line with what we intuitively know to be true. The below chart shows that the longer the holding period, the less extreme the distribution in potential returns:

As you can see, the standard deviation of returns declines quite gradually between the 4-10 year holding periods. However below 4 years, the volatility increases significantly, at which point the relationship starts to take on an exponential characteristic.

I am quite confident that if I were to examine other broad stock indices, or if I expanded the number of holding periods examined, e.g. between 1 month and 20 years, the pattern would look the same as above.

Using this as a guide, a minimum holding period of 4 years appears to offer a reasonable level of protection from volatility of returns while still being a ‘realistic’ time horizon for the average investor. 4 years is the point on the chart where the curve begins to flatten – that is to say that 4 years is the point of diminishing incremental benefit from longer holding periods.

Longer holding periods obviously offer greater protection, and investors must weight this benefit against the opportunity cost of locking up the money for a longer period.

Expressing the same data another way, the below chart shows the maximum, minimum and average (arithmetic mean) of returns for the same holding periods:

 

The idea for this chart I borrowed from Michael Keppler’s “Risk is not the same as Volatilty”. It neatly illustrates the relative risk/reward profiles of various holding periods.

As you can see, an investor with a time horizon of 1 year could have earned returns of anywhere between -49% and +69%. An investor with a 10 year horizon would have reduced the spread, with the minimum being at -6.5% and the maximum being +18%.

Note however that regardless of the holding period, over the 1950-2012 period the average return is quite consistent, fluctuating only between 8.5% (1 year) and 7.1% (years 4 and 6-10)

The Long and the Short?

Almost by definition, the average retail investor cannot consistently time the market to avoid buying at the ‘wrong time’. If this is accepted, then the average retail investor must accept the unknown risk of whether they are buying at the top of the cycle, the bottom, or somewhere in between.

S&P data from 1950-2012 suggest that an investor with a time horizon of only 1 or 2 years must accept a wide range of potential returns.

To reduce the uncertainty of future returns, the retail investor must extend his minimum holding period, weighing this against the opportunity cost / time value of money. The data indicate a holding period of 4 years as a potentially optimum point in this trade-off, though pin-pointing the actual optimum level would require an assumption to be made on the time value of money.

(Reduced time value of money due to unusually low interest rates - such as those seen today - would push the optimum period further out, as an investor would gladly 'pay' the extra required to reduce the potential return spread).

Riding the rally

March 17th, 2012

Nick Hays

Dhaka, Bangladesh

Today - on The Long and the Short:

* Right on the money?

* Sideline money - returning to the risk game

* Riding the rally

In last week's post I concluded with some words of caution about making any short bets on the S&P 500 index. The price action since then has shown that I was right on the money. Perhaps this was a case of being right for the wrong reasons or perhaps there is something to this technical analysis lark. Either way let's review which of my calls worked and which didn't.

On the short-side, last week I identified a pattern of negative RSI divergence which had been in place since mid-January, and a clear break below the index’s rising channel.  Last week’s chart below:

However I also cautioned that the short-term signals were bullish, in particular when looking at the key Fibonacci levels since the index made an intra-day bottom at around 1340 on Tuesday 6^th March. The chart I showed indicated that the index had quite easily broken through all the key Fibonacci levels:

I pointed out that the next important resistance levels to watch for on the S&P would be at the 100% retrace level (1378) and following that at the rising green trend line.

One week later, and it appears that the levels I identified did indeed prove to be significant.

The short-term chart below shows that 1378 on the S&P provided some initial resistance in early trading on Tuesday 11^th March, with the market ‘gapping up’ on opening and meeting that level almost exactly. After briefly falling back, the market had pushed through this level of resistance by mid-morning.

  

The next target for resistance which I identified, the lower band of the rising channel, also appears to have held some significance for the market, being approximately the level at which the strong rally of Tuesday 13^th was stopped out. This is highlighted in the chart below by the black circle.

Importantly, the lower channel actually provided support to the index on Wednesday 14^th and since then has closed above the lower channel for two days (Thursday 15^th and Friday 16^th). It could be that the index is now re-entering the original trading channel, or a new trend may be forming. Either way what is clear is that the market has shrugged off the recent correction and is looking to push higher.

Another reason to expect further gains in the short-term is that the RSI has bottomed and is now indicating bullish momentum, as highlighted in the chart above.

One call I got completely wrong was on the VIX ‘fear index’. Since last week’s post where I made a case for a spike in volatility on the basis of RSI divergence, the index has fallen 15% and is now trading below the trading channel I originally identified. The VIX is now 16% lower than when I first wrote about it, and 30% below its 1990-2012 average:

The current VIX levels indicate an element of market complacency which gives me some cause for concern. In the medium term, significant economic and political headwinds exist (some of which I identified here and here) and I maintain a bearish outlook within this time horizon.

However, in the short-term I am bullish due to a combination of the S&P technical indicators discussed above and my expectation that risk assets will continue to benefit from the current climate of easy monetary policy and massive liquidity injections by central banks.

"Sideline money"

In addition I anticipate institutional ‘sideline money’ re-entering the market during March and April, providing significant support to the current momentum in equity markets.

The reason I say this is that elevated Eurogeddon tail risk during the past few months has caused many asset managers to shield their client portfolios by going underweight equities and increasing allocations to cash. Their resulting benchmark underperformance means a great deal of pressure for these managers to boost returns during Q2.

With the risk of a ‘disorderly’ Greek default now off the table (at least for the time being), I expect this sideline money to flood back into the market as asset managers seek to get back in the game by loading up on risk. This wave of buying should provide support to the rally and should counter-act any end-of-quarter profit-taking and portfolio re-balancing by the large institutional players.

Riding the rally

There is undeniably a great deal of risk out there, however this is the case for every bull market. Rather than shy away from risk, a successful investor must accept the fact that uncertainty and the unknown are inescapable – they are fundamental characteristics of investing.

In the short-term we should look to ride the rally, remain flexible and be ready to adjust portfolios according to the changing technical and macro picture.