Thursday, March 15th, 2012
Via Peter Tchir of TF Market Advisors,
Without a doubt, retail has fallen in love with corporate bonds. Fund flows were originally into mutual funds, and have shifted more and more into the ETF’s. The ETF’s are gaining a greater institutional following as well – their daily trading volumes cannot be ignored, and for the high yield space, many hedgers believe it mimics their portfolio far better than the CDS indices.
The investment grade market looks extremely dangerous right now as the rationale for investing in corporate bonds – spreads are cheap – and the investment vehicles – yield based products.
LQD which is up to almost $20 billion in assets is a good proxy for the risk investors are taking. LQD has the advantage of being “market weight” the financials. After the stress tests, that is a positive since portfolio managers that were underweight financials will buy, and the “spread compression” opportunities could offset the rate risk. On the other hand, 4 of the top 10 individual bond holdings have maturities in 2037 and longer. There is an immense amount of duration risk. LQD is down about 2% from its recent higher. Not much, but with a yield of only 4.2%, that will take 6 months of carry to offset. Any investor who bought back in November at 110 is still in good shape, but virtually anyone who bought this year on the back of the Fed’s pledge of low rates is now underwater.
I do not like the move in treasuries. ZIRP can hold down the short end of the curve. Operation Twist can help keep the longer end anchored and focused on the short end, but that is more difficult to accomplish. The further out the curve, the less control the Fed has. With LQD having a very long duration and trading at a premium to NAV, I think there is room for more weakness here. Investors will learn that investment grade bond investments can lose money even as spreads tighten.
High Yield may also have far more rate risk than people realize. Typically HY can do well in a bad treasury environment, because the implied improvement in economic conditions helps spread more than the yield issue. But there is nothing normal about this “high yield” market. The market seems to have 3 distinct asset classes. Yield to call type bonds, that have low yields, but high spread, because they are trading to 2 or 3 year calls. There is virtually no upside left in these bonds. They will generally drift lower towards their call price – horrible convexity. Then there are “story” bonds. Bonds that require a lot of faith in management and the economic turnaround to be comfortable with. Any upside in the market is in these bonds. Finally, there are all the high quality “liquid” bonds that have decent duration. The problem is that most of these trade at relatively tight spreads, but also very low yields (certainly by HY standards). How many of these bonds can withstand a treasury sell-off without significant price action? High yield investors are particularly good at analyzing credit, they tend not to be as good at managing rate risk – since normally the move in rates is secondary.
With corporate bonds spreads (investment grade and high yield) already reflecting a lot of the move in equities, it will be critical to see how well they can withstand the pressure from the treasury markets – I don’t think they will do well near term, and would look near term declines in NAV and the premium to shrink.
Tags: Bond Holdings, Bond Investments, Corporate Bonds, ETF, Fund Flows, Good Shape, Hedgers, high yield, Investment Bonds, Investment Grade Bonds, Investment Vehicles, Love Affair, Lqd, Maturities, Portfolio Managers, Rate Risk, Rationale, Stress Tests, Treasuries, Underweight
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Monday, January 23rd, 2012
As of a few hours ago, Goldman’s Francesco Garzarelli has officially told the firm’s clients to go ahead and short 10 Year Treasurys via March 2012 futures, with a 126-00 target. While Garzarelli is hardly Stolper (and we will have more on the latest Stolpering out in a second), the fact that Goldman is now openly buying Treasurys two days ahead of this week’s FOMC statement makes us wonder just how much of a rates positive statement will the Fed make on Wednesday at 2:15 pm. From Goldman: “Since the end of last August, we have argued that 10-yr US Treasury yields would not be able to sustain levels much below 2% in this cycle. Yields have traded in a tight range around an average 2% since September, including so far into 2012. We are now of the view that a break to the upside, to 2.25-2.50%, is likely and recommend going tactically short. Using Mar-12 futures contracts, which closed on Friday at 130-08, we would aim for a target of 126-00 and stops on a close above 132-00.” As a reminder, don’t do what Goldman says, do what it does, especially when one looks the firm’s Top 6 trades for 2012, of which 5 are losing money, and 2 have been stopped out less than a month into the year.
What is Goldman’s rationale for shorting 10 Years?
At this stage of the cycle, growth expectations are in the driver’s seat: The value of intermediate maturity government bonds can be related to expectations of future policy rates, activity growth and inflation, and a ‘risk factor’ highly correlated across the main countries. These simple relationships are captured by our Sudoku econometric framework for 10-yr maturity yields. In coming months, we expect effective overnight rates to remain close to zero in the main currency blocs (US, Japan, Euroland, and UK) and retail price inflation to hover around 1.5-2.0% – consistent with the forwards and central banks’ objectives. With policy rates and inflation ‘dormant’ at this stage of the business cycle, bond yields (and the 2-10-yr slope of the yield curve) will likely react mostly to shifts in growth expectations.
Bond valuations are already stretched relative to consensus growth expectations: Around the turn of the year, the outlook on economic activity was buffeted by cross-currents reflecting the adverse credit conditions in the Euro area on the one hand, and the upward revisions to US GDP growth on the other. Our Sudoku model, which helps us trade-off these shifts, indicates that 10-yr government bond yields are currently trading too low (to the tune of 50-75bp) when mapped against prevailing macro expectations. Taking into account the cumulative impact of the Fed’s security purchases, the degree of mis-valuation of 10-yr bonds is roughly the same across the main regions.
Bond yields are lagging the improvement in industrial activity seen since late 2011: The momentum of our Global Leading Indicator (GLI) for the industrial cycle bottomed out in the fourth quarter of 2011, although the revised series after the latest data show it steadily improving through the second half of last year. The sequential improvement has extended into this year. We observe that, since policy rates have been floored in early 2010, intermediate maturity yields have tended to lag improvements in the GLI by around 2-3 months. With central banks on hold providing ‘carry’, fixed income investors may have been wary to trade on early cyclical signals until these received validation in the early ‘hard’ data.
Real rates (and the 2-10 curve) could play catch-up with cyclical stocks: We have identified a relatively tight positive relationship between the relative performance of US cyclical stocks vs. defensives (as captured, for example, by our US Wavefront Growth equity basket), and the 2-10-yr slope of the Treasury curve. The departure from this relationship since the turn of the year is now eye-catching. Cyclical stocks have strongly outperformed the broader market, a move probably amplified by positioning, while bond yields have barely moved, underpinned by US domestic investors’ continued attraction for ‘carry’ strategies. At a closer inspection, yields out to the 5-yr maturity have continued to decline in real terms, and are now in deeply negative territory (-150bp in 2-yr and -100bp in 5-yr, near the early November lows), while 5-yr 5-yr forward rates are barely above zero. Our estimates suggest that forward rates (5-yr 5-yr forward) are now too low. Incidentally, the fact that a potential rise in yields would come from a depressed base and mostly in response to an improvement in growth prospects (which should also influence earnings growth expectations) means that a fixed income sell-off should not pose a threat to the equity market.
The FOMC statement could provide a near-term catalyst: According to a client survey by our US trading desk, around half of those polled expect the Fed announcement to ease financial conditions further, with only 12% expecting a tightening. Around two-thirds of participants believe the mid-point of the ‘central tendency’ range for the Fed funds rate at the end of 2014 will be 75bp (the forwards) or below. Finally, 72% of respondents expect the FOMC will announce a long-run neutral policy rate of less than 4%. These results are consistent with our impression that Wednesday’s announcement is now largely discounted to represent an ‘easing event’. With the data improving, treasury yields below ‘equilibrium’, current coupon 30-yr mortgage yields at all-time lows, and discussions on policy easing shifting to ways to support the improvement in the housing market more directly, such expectations may be disappointed, in our view.
Tags: Business Cycle, Central Banks, Euroland, Fomc Statement, Forwards, Futures Contracts, Garzarelli, Goldman, Government Bonds, Growth Expectations, Maturity, Overnight Rates, Price Inflation, Rationale, Risk Factor, S Francesco, Target, Tight Range, Treasurys, Us Treasury Yields
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Friday, January 13th, 2012
A guest contribution by Anna W. via The Big Picture
The following comes from an asset manager, formerly of New York, since relocated to Colorado. Because of his employer’s rules on publishing, this is anonymous. We shall call him The Bond Specialist. I know him and his colleagues for many years, and can attest to his 35 year career on Wall Street.
2011 was a confusing year from start to finish on Wall Street and the arrival of 2012 is not offering much relief. Today the popular message is that the economy is getting better in the U.S. and problems abroad can be overcome. Recession has been avoided and “escape velocity” will be achieved in the second half. Our economy can “decouple” from Europe and some of the big developing nations that have seen their economies slow such as China, India and Russia, now that they have run into trouble. Most economists and stock market strategists seem to have cut and pasted their 2011 forecast into their 2012 forecast. (How is that for the pot calling the kettle black?) But the concerns that clouded the outlook a year ago only seem to have gotten deeper. The positive messaging is focused on the following;
-The politicians will kick the can down the road and therefore avoid the kind of austerity that could derail the recovery. The Fed will engage in more quantitative easing (a euphemism for money-printing) if the economy or the stock market falters.
-Interest rates and inflation have nowhere to go but up so the least attractive place to put your money is in the bond market. That is, unless you keep the maturities short and stick with “spread product” like corporate bonds and bonds issued by foreign governments.
-The S&P 500 will be up 10% by year end. I have been in the business for 35 years and for the last 20, the prediction for the market has always been “up 10% or more”. The rationale changes but the upside prediction does not. This year the place to be is “dividend paying stocks” that pay so much more than Treasury notes and have a great track record of increasing dividends. Also, the 3rd and 4th years of the Presidential Cycle are usually positive for stocks. Last year the emphasis was on domestic small cap, international and emerging market stocks because of their superior growth potential.
-The dollar will be weak because our fiscal and monetary situation is worse than those other countries that we have decoupled from since they are in so much trouble. Gold will be higher because some Central Banks are substituting gold for dollars as a reserve asset and lots of women will be getting married in India.
-Commodity prices will be higher in general. Oil and fertilizer are in short supply and all the rural Chinese are planning to motor on down to Kentucky Fried Chicken for some protein sooner or later.
-The housing market and home prices are finding a bottom.
Based on the popular forecast for 2012, you can buy practically anything but long term bonds and probably do just fine as long as you are diversified.
That is not the way it worked in 2011 and it seems to me to be even less likely in 2012. The S&P 500 was exactly unchanged in price for the year, providing only a 2% dividend return. It was like a video game where many aliens were destroyed and many points were scored, but it was game over on December 30th and we will have to put another quarter in on January 3rd. Small capitalization stocks (Russell 2000) were down 5% and the Dow Jones Industrial Average, the home of dividend paying stocks, was up 6%. European and Emerging Market indexes generally delivered double digit losses. They all had big swings during 2011, but the big story was how many times that the stock indexes were up or down more than 1% (100 Dow points) or more in a day. It seemed like all of them.
Gold and silver roared earlier in the year, but gold is down 18% from a high of $1900 just since September and silver peaked in May at $50. It is now $28. Gold was up 11% in 2011 and silver was down 10%. The dollar index was flat. Oil was up 9% but natural gas was down 37% to a multi-year low. Copper was down 22%. Corn was flat and wheat was down 18%. For the most part, confusion reigned.
But there was no confusion in the bond market. In 2011, the most abhorred investment vehicles; long term Treasury bonds and long term Municipal bonds were the two best performing major asset classes. After a swoon in January, long term bonds just marched up in price (down in yield) practically without interruption for the remainder of the year. As is always the case when interest rates are declining, the longest maturity and highest quality bonds perform the best. The 2039 Treasury Strip (0% coupon bond) returned 62% in 2011 and the average leveraged Closed End Municipal Bond fund returned 21%. Closed End Build America Bond funds, which contain taxable municipals where the Federal government pays 35% of the interest, did even better with an average return of 28% in 2011. The important question to ask is: in what ways will 2012 be different and how will it be similar?
As previously mentioned, the majority of pundits think that, even though they missed the boat in 2011, it is only a matter of timing and it will sail in 2012. That sentiment is understandable, but the expectation that the economy is going to return to a trend of expanding organic growth and a return to the secular credit expansion lacks credibility (no pun intended). To paraphrase Bob Farrell, in the early stages of a new secular paradigm the market is adapting to a new set of rules while most market participants are still playing by the old rules. But the old paradigm of credit expansion must resume if stocks and commodities are to appreciate, housing prices are to stabilize, the government is to avoid raising taxes and slashing spending and interest rates are to rise. As disappointing as it is, a far less rosy outcome is more likely.
Tags: 35 Years, Asset Manager, Attractive Place, Austerity, Big Picture, Bond Market, Corporate Bonds, Developing Nations, Dividend Paying Stocks, Economists, Escape Velocity, Euphemism, inflation, Market Strategists, Maturities, Money Printing, Rationale, Recession, Stock Market, Year End
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Thursday, December 1st, 2011
I am writing to you from my hotel room in New York, keeping the post short and to the point as a full day of appointments lies ahead.
Further to my post of two days ago, “U.S. equities – downtrend arrested?“, my short-term technical buy signal for the S&P 500 Index has been confirmed. The rationale is explained below.
The Shiller S&P 500 PE10 has broken the 40-day moving average on the upside.
The PE10 has broken both the 12- and 26-day exponential moving averages on the upside, while the 12-day moving average is about to cross the 26-day moving average on the upside.
The MACD of the PE10 is bottoming.
The VIX has broken the short-term support.
The MACD has crossed its nine-day moving average and signaled a buy for the PE10.
But it will be a rough ride. The VIX is likely to encounter support at 24.
The RSI of the VIX is entering oversold territory.
The PE10 has closed the gap with the VIX.
The RSI of the PE10 and VIX (inverse) has bounced from an oversold level.
Sources: I-Net Bridge; CBOE; Plexus Asset Management.
Tags: Amp, Appointments, Bridge, Cboe, Exponential Moving Averages, Gap, Hotel Room, Level Sources, Macd, Moving Average, Plexus Asset Management, Rationale, Rough Ride, Rsi, S&P 500, Shiller, Stocks, Vix
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Thursday, September 22nd, 2011
TD’s Ryan Lewenza, Senior Analyst, U.S. Equities, and his group, have issued their latest report, which is highlighted below, and available for your review, below. Use Full Screen to enlarge, or download the report.
Rationale for a Defensive Portfolio Position
· The North American equity markets are likely to experience continued challenges in the years ahead, and deliver lower returns than were experienced in the bull market of the 1980s and 1990s. The reason for this is simple: Stocks go through long-term bull and bear cycles that can last between 15 and 20 years.
· From an intermediate perspective, which we define as 6-18 months, our defensive positioning is reinforced by: 1) weak U.S. economic growth, 2) high U.S. unemployment, and 3) continued weakness in the U.S. housing market.
· Over the near-term, the technicals and news flow remain negative and reinforce our defensive view.
· While we’ve painted a rather dour picture we need to balance the negatives we currently see with the positives that do exist. In particular, stock valuations are quite attractive with the S&P 500 trading at 12x earnings, a steep discount to its long-term average of 16.5x. Stocks look attractive relative to government bonds with the 10-year U.S. Treasury yielding below 2%. Furthermore, dividend yields both in Canada and the U.S. are above their respective 10-year government bond yields. Finally, corporate earnings, for which we do expect to see negative earnings revisions, should hold up reasonably well during this weak economic patch.
· We will get through this difficult period, as we always do, but until then, continue to position portfolios defensively, by: 1) maintaining higher than normal cash balances; 2) overweighting defensive stocks relative to cyclicals; and 3) focusing on large-cap, high-quality companies that pay healthy and reliable dividend streams.
Tags: American Equity, Bonds, Bull And Bear, Canadian Market, Cash Balances, Corporate Earnings, Cyclicals, Defensive Stocks, Difficult Period, Dividend Yields, Earnings Revisions, Economic Growth, Government Bond, Government Bonds, Housing Market, Quality Companies, Rationale, Senior Analyst, Steep Discount, Stock Valuations, Technicals, U S Treasury
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Wednesday, June 1st, 2011
Sector Weights: On Average Wrong, But Dynamically Right
by John West, Research Affiliates
In Marcel Duchamp’s famous 1912 painting, Nude Descending a Staircase, No. 2, the French painter captured the sense of motion by illustrating a series of images— all displayed in one frame.1 The controversial painting was inspired by Cubism’s breakdown of familiar images into multiple perspectives. But it went one better than the Cubists—who typically used static images—by adding motion, reflecting the influence of the nascent motion picture industry.2 The painting forced the observer to rethink how he or she viewed art.
Similarly, the Fundamental Index® methodology forces investors to rethink how they view portfolio returns. Investors typically dissect returns, trying to understand how much of performance is attributable to sector bets and how much to stock selection. Like Cubists, they are deconstructing reality and then putting it back together. But what if we—like Duchamp—add motion to the picture?
We are commonly asked why the Fundamental Index methodology overweights and underweights certain sectors. What’s the rationale? Why does the strategy “like” this sector or that sector? In recent years, the methodology has overweighted financials and underweighted energy, leading a rational person to conclude that holding such wrong weights surely caused performance problems. In this issue, we show such structural sector bets, in fact, don’t matter over the long term. Indeed, the Fundamental Index strategy can be wrong on average but right in the long run because of its ability to contra-trade against market fads, crashes, bubbles, and speculation. Investors need to look at the movement embodied in such strategies—not just their average holdings over a period in time.
Contra-Trading—The Great Equalizer
The markets have been through an extraordinarily volatile period the past five years, beginning with strong equity returns in 2006–2007, followed by the Global Financial Crisis (GFC) in 2008, and the subsequent Mother of All Recovery rallies in 2009–2010. Talk about a full market cycle! Within this period, sector returns have varied widely as evidenced in Figure 1.
During this period, energy and financial stocks have experienced dichotomous lives. Energy stocks jumped 10% per year and led all sectors of the market. Meanwhile, the GFC pounded financial stocks. To be fair, some financial institutions caused the GFC and were punished accordingly with the sector losing over 10% per annum. Indeed, financial stocks were the only sector to actually lose money and the only sector to underperform the S&P 500 Index during this time span. The other nine sectors all outperformed the broad market.
The FTSE RAFI® US 1000 held an average weighting of 24% in financials since it went live in November 2005, compared with the S&P 500’s average weighting of 18%. In other words, the Fundamental Index concept held an average overweight of 6%. Uh-oh. At one point in this cycle, financials registered the worst performing oneyear period for any sector going back to 1989,3 even worse than technology stocks after the collapse of the TMT bubble. With the RAFI strategy’s sizable overweight to the lone absolute and relative loser of the last five years, a logical expectation would be a big shortfall in RAFI’s performance relative to cap-weighting. In reality, the FTSE RAFI US 1000 beat the S&P by 2.3% per year, similar to the excess return as published in the original research!4
This counterintuitive result provides a good example of how the Fundamental Index concept adds value through the contra-trading embedded into the annual rebalance back to fundamental weights—that is, back to the economic footprint of the constituent companies. Figure 2 shows the FTSE RAFI US 1000’s relative financial weights (in other words, the active sector bet versus the S&P 500). Financials had a slight overweight in the FTSE RAFI US 1000 until the March 2008 rebalance, when the strategy took on an 8% overweight after bank share prices began to fall in summer 2007. In March 2009—six months after Lehman Brothers Holdings’ spectacular collapse and changes that forever changed the face of the financial services industry—financials were again rebalanced back to their fundamental weights of 25% (versus 11% for the S&P). Then the sector—left for dead in early 2009—took off. The financials weight of the FTSE RAFI US 1000 reached almost 20% more than the respective S&P 500 weight in fall 2009. As bank prices rebounded strongly, the March 2010 rebalancing witnessed a trimming of financial weights back to their fundamental scale. All told, the RAFI strategy made profits in spite of a large overweight in a sector that would have lost half its value if the weight had not been adjusted from March 2006.
There’s a lesson here. The Fundamental Index approach isn’t designed to “pick” winning sectors (or even stocks). Rather, the methodology succeeds by breaking the link between stock price and portfolio weight. A price-indifferent approach like the Fundamental Index strategy makes the link between pricing errors and portfolio weights random, not structural. The expected result? Half the portfolio winds up in overpriced stocks and half in underpriced stocks. The errors cancel.
But don’t take our word for it. Equal-weighted indexes break the link between price and weight and provide the same automated rebalancing as the Fundamental Index methodology (with a far less scalable and tougher to implement portfolio). Yet equal-weighting has had a substantial underweight to energy stocks. Why? Because the energy sector is narrow—a few mega-cap integrated oil companies dominate.5 There are only 40 stocks in the energy sector in the S&P 500; at a 0.2% weight for each, that creates an 8% target weight in the equal-weighted index. In contrast, the cap-weighted S&P 500 has a 12% weight in energy stocks, led by Exxon Mobil at nearly 3.5%, followed by very large weights in Chevron, Schlumberger, and ConocoPhillips. In spite of a large underweight in top-performing energy stocks, the S&P 500 Equal Weighted Index beat the cap-weighted S&P 500 over the last five years by the same margin that FTSE RAFI did: 5.2% versus 2.9%.6 Two independent non-price-weighted indexes—one with a huge overweight to the worst performing sector and one with a sizeable underweight to the best performing sector—beat the cap-weighted S&P 500 by more than 2%.
When Duchamp made art history with his notorious nude, he adopted Cubist ideas about deconstructing ideas while mocking its pretensions. He deconstructed images methodologically, but added motion and a jocular title painted along the bottom of the picture. In fact, Paris’s Salon des Independents rejected the work because the jury believed that Duchamp “was poking fun at Cubist art.”7 In reality, he laid the foundation for two new art movements: Futurism and Dadaism.
Our story is less controversial, but the idea of examining an idea—whether it’s art or investment returns—from multiple perspectives is important. We are often asked why the RAFI strategy is taking “bets” in certain sectors. The answer is the RAFI strategy’s average sector bets just don’t matter. The Fundamental Index methodology doesn’t need structural (static) sector bets to succeed. In fact, the approach can succeed even when making “wrong” structural sector bets as we have seen with financials and energy during the GFC. All the Fundamental Index methodology needs to provide excess returns over the cap-weighted index is market volatility that inevitably occurs when investor ebullience or capitulation lead to mean reversion of security prices.
The author wishes to thank Joel Chernoff, our resident art historian, and Ryan Larson, our analyst without compare, for their substantial contributions.
1. See http://www.philamuseum.org/collections/permanent/51449.html.
2. See http://www.understandingduchamp.com/text.html.
3. The S&P 500 Financials returned -70% for the one-year period ending February 28, 2009; the next worst one-year return was -63% for S&P 500 Technology for the 12-month period ending September 30, 2001.
4. See Arnott, Hsu, and Moore (2005).
5. This lack of representativeness is another drawback to the equal-weighting approach.
6. We chose energy because it was the best performing sector and was a very large underweight by equal-weighting. However, the story was seen across the portfolio. Of the best four sectors that drove positive results in
the period, equal-weighting was underweight in three. Also, equal-weighting was neutral in weight in financials, meaning it derived no benefit in that sector. In total, the S&P Equal Weighting Index was unfavorably
positioned on a structural sector basis, yet beat the S&P handily.
7. See http://www.understandingduchamp.com/text.html.
Tags: Bubbles, Cubism, Cubists, Fads, French Painter, Great Equalizer, Index Methodology, Index Strategy, Marcel Duchamp, Motion Picture, Nude Descending A Staircase, Performance Problems, Portfolio Returns, Rational Person, Rationale, Research Affiliates, Static Images, Stock Selection, Volatile Period, Weights
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Sunday, May 15th, 2011
How to Make Money in Microseconds
by Donald Mackenzie (excerpt)
Human beings can, and still do, send orders from their computers to the matching engines, but this accounts for less than half of all US share trading. The remainder is algorithmic: it results from share-trading computer programs. Some of these programs are used by big institutions such as mutual funds, pension funds and insurance companies, or by brokers acting on their behalf. The drawback of being big is that when you try to buy or sell a large block of shares, the order typically can’t be executed straightaway (if it’s a large order to buy, for example, it will usually exceed the number of sell orders in the matching engine that are close to the current market price), and if traders spot a large order that has been only partly executed they will change their own orders and their price quotes in order to exploit the knowledge. The result is what market participants call ‘slippage’: prices rise as you try to buy, and fall as you try to sell.
In an attempt to get around this problem, big institutions often use ‘execution algorithms’, which take large orders, break them up into smaller slices, and choose the size of those slices and the times at which they send them to the market in such a way as to minimise slippage. For example, ‘volume participation’ algorithms calculate the number of a company’s shares bought and sold in a given period – the previous minute, say – and then send in a slice of the institution’s overall order whose size is proportional to that number, the rationale being that there will be less slippage when markets are busy than when they are quiet. The most common execution algorithm, known as a volume-weighted average price or VWAP algorithm (it’s pronounced ‘veewap’), does its slicing in a slightly different way, using statistical data on the volumes of shares that have traded in the equivalent time periods on previous days. The clock-time periodicities found by Hasbrouck and Saar almost certainly result from the way VWAPs and other execution algorithms chop up time into intervals of fixed length.
The goal of execution algorithms is to avoid losing money while trading. The other major classes of algorithm are designed to make money by trading, and it is their operation that gives rise to the spasms found by Hasbrouck and Saar. ‘Electronic market-making’ algorithms replicate what human market makers have always tried to do – continuously post a price at which they will sell a corporation’s shares and a lower price at which they will buy them, in the hope of earning the ‘spread’ between the two prices – but they revise prices as market conditions change far faster than any human being can. Their doing so is almost certainly the main component of the flood of orders and cancellations that follows even minor changes in supply and demand.
‘Statistical arbitrage’ algorithms search for transient disturbances in price patterns from which to profit. For example, the price of a corporation’s shares often seems to fluctuate around a relatively slow-moving average. A big order to buy will cause a short-term increase in price, and a sell order will lead to a temporary fall. Some statistical arbitrage algorithms simply calculate a moving average price; they buy if prices are more than a certain amount below it and sell if they are above it, thus betting on prices reverting to the average. More complicated algorithms search for disturbances in price patterns involving more than one company’s shares. One example of such a pattern, explained to me by a former statistical arbitrageur, involved the shares of Southwest Airlines, Delta and ExxonMobil. A rise in the price of oil would benefit Exxon’s shares and hurt Delta’s, while having little effect on Southwest’s (because market participants knew that, unlike Delta, Southwest entered into hedging trades to offset its exposure to changes in the price of oil). In consequence, there was normally what was in effect a rough equation among relative changes in the three corporations’ stock prices: Delta + ExxonMobil = Southwest Airlines. If that equation temporarily broke down, statistical arbitrageurs would dive in and bet (usually successfully) on its reasserting itself.
No one in the markets contests the legitimacy of electronic market making or statistical arbitrage. Far more controversial are algorithms that effectively prey on other algorithms. Some algorithms, for example, can detect the electronic signature of a big VWAP, a process called ‘algo-sniffing’. This can earn its owner substantial sums: if the VWAP is programmed to buy a particular corporation’s shares, the algo-sniffing program will buy those shares faster than the VWAP, then sell them to it at a profit. Algo-sniffing often makes users of VWAPs and other execution algorithms furious: they condemn it as unfair, and there is a growing business in adding ‘anti-gaming’ features to execution algorithms to make it harder to detect and exploit them. However, a New York broker I spoke to last October defended algo-sniffing:
I don’t look at it as in any way evil … I don’t think the guy who’s trying to hide the supply-demand imbalance [by using an execution algorithm] is any better a human being than the person trying to discover the true supply-demand. I don’t know why … someone who runs an algo-sniffing strategy is bad … he’s trying to discover the guy who has a million shares [to sell] and the price then should readjust to the fact that there’s a million shares to buy.
Donald MacKenzie is a professor of sociology at Edinburgh University. His books include An Engine, Not a Camera: How Financial Models Shape Markets and Material Markets: How Economic Agents Are Constructed.
Tags: Algorithms, Clock Time, Computer Programs, Current Market, Donald Mackenzie, Drawback, Excerpt, Execution Algorithm, How To Make Money, Human Beings, Insurance Companies, Market Participants, Microseconds, Mutual Funds, Pension Funds, Rationale, Slippage, Statistical Data, Time Periods, Volume Weighted Average Price
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Monday, May 9th, 2011
A recent Q&A with Mark Mobius, Templeton Asset Management’s emerging markets guru, follows below, courtesy of the company’s monthly newsletter.
What are frontier markets?
Frontier markets are commonly used to describe a subset of emerging markets which have lower market capitalization and liquidity than the more developed emerging markets. More importantly they are markets that have not yet been “discovered” by the majority of investors. They are markets where there is limited research available to investors.
Frontier markets may generally be smaller and less developed than emerging markets, but they continue to experience strong economic growth and maintain a low debt-to-GDP ratio. They are where many emerging markets were 20 years ago. In the future, we expect these markets – at least some of them – to become quite important and to eventually become full-fledged emerging markets.
What is your rationale for investing in them and what’s the essence of your investment strategy?
Economic growth in many frontier market countries remains high and is even faster than some emerging markets and exceeds the growth in developed markets by a wide margin. The growth is not only economic growth but also growth in capital markets. Some of these markets are moving from small and illiquid status to large and liquid.
Many frontier countries are also leading producers of oil, gas and precious metals, and they are well positioned to benefit from the high global demand for these resources. Additionally, as the economies of frontier market countries expand, they continue to increase investments in infrastructure, offering valuable opportunities in the construction, transportation, banking and finance and telecommunications industries. Rising consumption provides these economies with strong purchasing power and the ability to spend their way into growth. Moreover, frontier market countries have been, and continue to be, positively impacted by the substantial investments made by large emerging market countries such as China, India, Russia and Brazil.
The economic drivers across frontier markets are diverse. For example, Botswana, one of the world’s largest diamond exporters, is introducing call and data processing centers. On the other hand, Kazakhstan, a country rich in oil and other natural resources, is seeing significant investments in infrastructure development. These varied economic themes across frontier markets ensure a diversified portfolio.
And why should investors care about frontier markets? Aren’t emerging markets already “risky” enough?
Frontier markets are actually not more risky than emerging markets or developed markets. Although there are a lot of uncertainties because of the general lack of knowledge among investors who don’t have the resources to study those markets, the actual risks are not significantly different from other markets. Although individual markets can be volatile, combined in a diversified portfolio they could be less volatile than a portfolio of developed market stocks.
How does the disaster in Japan (and potential slower growth from Japan), as well as the turmoil in Middle East, factor in one’s analysis of frontier markets?
The Japan and Middle East situations are not having any more impact on frontier markets than any other markets around the world. Of course, in the case of some of the Middle East markets there has been some volatility. However, the wide range of frontier markets going from places like Nigeria, to Vietnam and Ukraine means that events in, say, Egypt, will not have much impact on the other markets.
In fact, we continue to invest in Middle East companies that we believe will survive the current turmoil and prosper over the next five years. Generally speaking the “information revolution” where people of all walks of live and in every economic status can communicate quickly and efficiently with cell phone and through the internet means that it will be more and more difficult for corrupt and dictatorial regimes to survive. This is quite beneficial for the development of capital markets and particularly stock markets so we are quite optimistic regarding the Middle East. Emerging markets growth rates and per capita income are moving up at a rapid pace. As foreign reserves in these countries reach sky-high levels, and their safety profile continues to improve, perceptions about emerging markets also continue to improve. People are beginning to realize they’re not as risky as they seem. Moreover, there’s quite a lot of value in emerging markets, because earnings growth is keeping up at a rapid pace, so we still are finding opportunities.
Do events such as the instability in the MENA region make “investing” during these volatile times more attractive? Or simply more dangerous?
If you have good research on the frontier market companies, volatility can be very good since with panic selling prices can come down temporarily to very low levels enabling the patient and knowledgeable investors buy stocks cheaply.
What are the challenges of investing in frontier markets and how do you try to circumvent them?
While frontier markets offer a potentially attractive investment opportunity, an array of challenges also exists. Examples include poor information flow, illiquid stocks and sudden government policy changes. Frontier markets are subject to additional, heightened risks due to a lack of established legal, political, business and social frameworks to support securities markets. Relying on seasoned international fund managers who have demonstrated knowledge in navigating through these relatively new and volatile markets is essential.
Our emerging markets team has over 40 investment professionals working from offices in 17 locations. In employing Templeton’s ground-up investment approach, our local analysts are able to address such issues because they not only understand the local languages and culture, but they get to know the companies and the market environment by meeting with company management teams, understanding the impact of local regulations, and talking with local customers and competitors. Frontier market investing often requires additional time and due diligence to assess the quality of the management team including more frequent on site visits to evaluate the business effectively.
Which countries and sectors in frontier markets look interesting?
We do not favor any particular market but select stocks which are the most attractive across all markets. A look at the breakdown of our frontier market funds country investments will show where we are finding the most bargains at this stage. Currently, our largest exposures are to Nigeria, Saudi Arabia, Egypt, Vietnam, Kazakhstan, Qatar, Ukraine and Argentina. Liquidity is the key concern for most investors, so markets that are the most liquid could attract greater investment flows.
In terms of sectors, our focus has been on what we refer to as the two ‘Cs’: consumers and commodities. Middle class expansion and the deceleration of population growth has triggered rising per capita income and increasing demand for consumer products. This in turn has led to positive earnings growth outlook for consumer-related companies. We look for opportunities not only in areas related to consumer products, such as automobiles and retailing, but also consider services such as finance, banking and telecommunications. Commodities can offer another way to access the high growth trajectory of nations like China and India and take advantage of greater demand. We are look for companies that are strong producers of commodities such as oil, iron ore, aluminum, copper, nickel and platinum. While infrastructure development in emerging markets has led to continued demand for hard commodities, demand for soft commodities such as sugar, cocoa and select grains has also increased. Resource-rich countries in Latin America, too, are benefiting from increasing global demand.
How can investors get exposure frontier markets?
The best way for retail investors to get exposure to frontier markets is to purchase a frontier markets fund. We have two major frontier markets funds. The total assets in our frontier markets funds has grown to about US$1.5 billion, probably making us the largest frontier markets investor. Trying to invest directly for an individual market is simply not practical since access too many of the markets is complex and expensive for the individual.
Source: Mark Mobius, Franklin Templeton Investments – Emerging Markets Overview, May 5, 2011.
Tags: Banking And Finance, Brazil, Capital Markets, Construction Transportation, Economic Growth, Emerging Markets, Frontier Markets, Gdp Ratio, Global Demand, India, Infrastructure, Investment Strategy, liquidity, Mark Mobius, Market Capitalization, Market Countries, Oil and Gas, precious metals, Purchasing Power, Rationale, Telecommunications Industries, Templeton Asset Management, Wide Margin
Posted in Brazil, India, Infrastructure, Markets | Comments Off
Thursday, September 30th, 2010
Kim Shannon, portfolio manager and founder of Sionna Investment Managers, which manages mutual funds for Brandes Investment Partners, discusses her outlook and views on the Canadian bank sector with Dan Richards, of ClientInsights.ca
Dan Richards: Kim, can we start today by talking about Canadian Banks. Can we begin by talking about how Canadian banks have performed over the last little while.
Kim Shannon: They’ve had quite a volatile ride. We’ve had them be quite challenged in ’08, and then have a pretty phoenomenal recovery, and a couple of the banks are back at the highs that they were in 2007, and back in 2007 we had blue skies as far as the eyes could see for banking.
We don’t have that future forecast today.
DR: The end of June, looking at the public data on the funds you manage, you had about a 10%-age weighting in Canadian banks, and that’s just over half of the weight of banks in the index. Can you talk about the rationale for that.
KS: We think that the Canadian banks are expensive today. They have shown up incredibly well in our model for most of the last 25 years, but recently, they are not showing up well in the models, so intrinsically they are not inexpensively any longer, like they have been in the past.
And that’s largely the reason we are underweight. Our concern is that they’ll be dead money for investors, basically earning you a dividend yield at best, and our job is to create wealth for investors.
DR: And could you elaborate when you “they show up in your model, as attractive in the past, not as attractive today?”
KS: Our model identifies which stocks are truly cheap in the universe, and traditionally banks have been inexpensive relative to the other opportunities, that of stocks in the universe. Today, they are not showing up in the universe of 140 cheapest stocks, which means that they’re expensive relative to their traditional earnings power. On top of that we’re concerned that the earnings power is likely to be subpar what we’ve seen in the last decade.
DR: Now, the one bank that you do own that’s roughly at the index weight would be Bank of Nova Scotia. So it sounds like in an environment where you’re not crazy about banks, that’s one bank that you don’t mind. Can you talk a little about that?
KS: Well, that one shows up as relatively less expensive than the rest overall. But, its also an incredibly well managed bank, and its always had a better than average efficiency ratios, its had an incredibly strong culture that survived new CEOs coming and going into the role. For a future focus, we really like the fact that they’re international in nature, and they actually have true potential for real growth because they are embedded in emerging markets that are under-banked. The rest of the banks in Canada are primarily located in Canada, with some entities mostly in the United States, and those are very mature banking environments, and so any growth they can enjoy means they’re having to steal it from a competitor.
DR: Kim, final question. Over the last little while, we’ve seen some earnings disappointments by some Canadian banks. Do you want to comment on that?
KS: We’ve been talking to investors for quite some time about what we believe to be ongoing pressures on Return on Equity and earnings and so we’re not surprised that there’s been a stumble here because that fits in with our analysis that it will be very hard to enjoy the strong earnings that we saw for the middle part of this past decade in banking.
DR: Kim, thank you very much.
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Tags: Autoload, Blue Skies, Brandes Investment Partners, Canadian Banks, Canadian Market, Dead Money, Dividend Yield, Flv Player, Investment Managers, Investors, Job, Models, Mutual Funds, Outlook, Portfolio Manager, Rationale, Shannon, Stocks, True Loop, Universe, Universe Today
Posted in Canadian Market, Markets, Outlook | Comments Off
Thursday, August 12th, 2010
This article is a guest contribution by John R. Taylor, Jr., Chief Investment Officer, F/X Concepts, the world’s largest currency hedge fund.
Everything was fine last week. Even the ugly US employment numbers that were released on Friday morning were greeted with enthusiasm by the global marketplace as both the bond market and the equity market rallied. What could be better? The numbers weren’t that bad and there was always next month when they could improve. Why not hope for the better outcome in the future as the government authorities and the news reports wanted you to believe? Basically numbers like the ones last Friday are ‘Goldilocks’ numbers, not too hot and not too cold. They allow everyone to think that things are not great, but the authorities can, and will, make them better. Poor employment numbers imply the Fed will lower rates, which would make equities more attractive in the future (using the dividend discount model or something similar). At the same time bonds rally as a result of the projected lower rates, and finally the dollar declines which helps commodities and carry trades, also making it easier to repay outstanding dollar-denominated debts. Winners all around. “Sweet!”, as they say in the lottery ads here in New York.
From the foreign exchange point of view, the market calls this the “dollar smile”. If the dollar’s economic numbers are weak, but not terrible, then the dollar will decline while all other markets rally – this is the dip in the middle of the smile. If the numbers are good, then the dollar will rally – twisting the right end higher. But if the US numbers are truly terrible, then the dollar will rally as well. The rationale seems complex but the forces moving the dollar are very powerful. If the US economy is perceived as heading into recession, then banks and other financial actors take risk off the table, cutting back their balance sheets, which sets off a scramble for dollars. In the modern marketplace, recessions make the dollar go higher. The very aggressive dollar rally in the fall of 2008 is a powerful example of what happens to the left end of the dollar smile. From the US point of view, this is clearly a dollar smile, but when the same thing is seen from the rest of the world, it becomes a global frown. If the US is either strong or weak, the global markets suffer. Profits are made only when the US economy is struggling along, and losses multiply when the US either goes on a positive tear or gets into serious trouble.
Things changed dramatically between Friday, when the weak employment numbers were released, and Tuesday afternoon when the Fed announced it was edging back toward Quantitative Easing by taking the roughly $180 million it received from interest and pay-downs in its MBS portfolio and reinvesting that cash in the Treasury market. This move told the world the Fed saw the US economy headed into a recession. Although both Friday and Tuesday signaled a weak US economy, the Fed’s position only became clear on Tuesday, and by early Wednesday, the whole world knew the US economy was headed lower. The Fed’s move signaled the situation was not a lukewarm Goldilocks but a cold one on the way to getting colder. At FX Concepts, we have been calling for a recession next year, and as the Fed – and the market players – come to realize this, equity markets, commodity prices and currencies (except the yen) should all decline. At the same time, liquidity should tighten dramatically, credit spreads should widen, and government bond markets should rally strongly. Although the US signaled the beginning of the coming recession, the Eurozone is still naively expecting its €750 billion rescue plan with austerity thrown in to save the day. Our analysis argues that this plan will start crumbling within the next few weeks, sending the euro sharply lower once again and ushering in the deep recession of 2011.
Copyright (c) F/X Concepts
Tags: Balance Sheets, Bond Market, Chief Investment Officer, Commodities, Debts, Dividend Discount Model, Dollar Declines, Dollar Smile, Economic Numbers, Employment Numbers, Foreign Exchange, Friday Morning, Global Marketplace, Gold, Government Authorities, Hedge Fund, John R Taylor, Last Friday, News Reports, Rationale, Recession, Taylor Jr
Posted in Bonds, Commodities, Gold, Markets | Comments Off