Wednesday, April 20, 2011

Niels Jensen’s Confessions of an Investor

The problems with Modern Portfolio Theory (MPT)

“..I would like to spend a moment on MPT, as I believe it is important to understand the shortcomings of the prevailing approach to investment and risk management. [..] Let’s take a closer look at three of the most important assumptions behind MPT (there are many more assumptions behind Modern Portfolio Theory. Wikipedia is a good place to start should you wish to read more about it):

1. Risk-free investments exist and every rational investor invests at least some of his savings in such assets, which pay a risk-free rate of return.

2. Returns are independently and identically-distributed random variables (returns are trendless and follow a normal distribution, in plain English).

3. Investors can establish objective and accurate forecasts of future returns by observing historical return patterns. Strictly speaking, this assumption was relaxed by Fischer Black in 1972 when he demonstrated that MPT doesn’t require the presence of a risk-free asset; an asset with a beta of zero to the market would suffice.

Well, if these assumptions are meant to stand the test of time, then good old Markowitz (the father of MPT) is in trouble. Truth be told, none of the three stand up to closer scrutiny. The concept of risk-free investing no longer exists, post 2008. Banks are giant hedge funds which cannot be trusted and even government bonds look dicey in today’s world. Secondly, returns are clearly not random. If you have any doubts, just look at how the trend-following managed futures funds make their money. Thirdly, from 26 years of investment experience, I can testify to the fact that historical returns provide little or no guidance as to the direction of future returns.

A new approach is required.

So what does all of this mean? First of all it means that universities and business schools all over the world should clear up their acts. Two generations of so-called financial experts have been indoctrinated to believe that MPT is how you should approach the management of investments and risk whereas, in reality, nothing could be further from the truth. It also means that investors should kick some old habits and re-think how they do their portfolio construction. Specifically, it means that: [..]

i. the notion of the “market portfolio” being an appropriate performance benchmark should be discarded;

ii. there is in reality no meaningful distinction between strategic and tactical asset allocation – the difference is illusory;

iii. investors should once and for all reject the notion that there is an optimal portfolio for each investor from which he or she should only deviate “tactically” in the shorter run;

iv. market timing deserves more credit than it is given;

v. MPT is a straitjacket preventing investors from rotating between different classes of risky assets (with vastly different risk/return profiles) as market conditions change.

Please note that this does not imply that asset allocation is irrelevant. Far from it. However, it does mean that a bespoke approach to asset allocation, where individual circumstances drive portfolio construction, is likely to be superior to a more generic approach based on a strategic core and a tactical overlay.

[..]

A solution to the problem

Here is what I would do in terms of applying his thinking into a modern day investment approach:

1. Do what you do best. Some investors are made for short-term trading. Others are much more suited for long-term investing (like me). Don’t be shy to utilize whatever edge you may have. MPT suggests that markets are efficient. Nothing could be further from the truth. If you have spent your entire career in the medical device industry, the chances are that you understand this industry better than most. Use it when managing your own assets. Insider trading is illegal; utilizing a life time of experience is not.

2. Take advantage of mean reversion. Mean reversion is one of the most powerful mechanisms in the world of investments. At the highest of levels, wealth has a long term ‘equilibrium’ value of about 3.5 times GDP. As recently as 2007, wealth was well above the long term equilibrium value and signaled overvaluation in many asset classes. But be careful with the timing aspect of mean reversion. The fact that an asset class is over - or undervalued relative to its long term average tells you nothing in terms of when the trend will reverse. A good rule of thumb is to buy into asset classes when they are at least a couple of standard deviations below their mean value.

3. Be cognizant of herding. We are all guilty of keeping at least one eye on other investors, and we are certainly guilty of letting it influence our own investment decisions. This is how investment trends become investment bubbles and fortunes are wiped out. Herding is relatively easy to spot despite the fact that former Fed chairman Alan Greenspan argued otherwise – probably because it was a convenient argument at the time. But herding is also subject to the greater fool theory. You can make a lot of money investing in fundamentally unsound assets, as long as you can find a greater fool to whom you can sell it at a higher price. It works fine but only to a point.

4. Think outside-the-box. All those millions of baby boomers all over the western world who will retire in the next 10-15 years have been told by the MPT-trained financial advisers that they need to lighten up on equities and fill their portfolios with bonds, because they need the income to live on in old age. STOP! Who says that bonds can’t be riskier investments than equities? When circumstances change, you should change your investment approach accordingly and not rely on historical norms. Given the state of fiscal affairs in Europe and North America, it does not seem unreasonable to suggest that circumstances have indeed changed.

5. Bring non-correlated asset classes into the frame. One should consider having a core allocation to non-correlated assets. Traditionally, many non-correlated asset classes have not met the liquidity terms required by the majority of investors [..], but there are exceptions, the most obvious one being managed futures. The asset class proved its worth in 2008 with managed futures funds typically up in the range of 20-30% that year.

6. Take advantage of investor constraints and biases. The classic, but by no means only, example is the outsized impact a downgrade to below investment grade (i.e. a credit rating below BBB) may have on corporate bonds, as some institutional investors are not permitted to own high yield bonds and are thus forced to sell regardless of price when the downgrade takes place.”

Monday, April 18, 2011

Key Global Events - The Week Behind and Ahead On April 17th

Ritholtz's succinct summation of week's events (04-15-2011)

Positives:

1) Retail Sales in March were good, notwithstanding rising gasoline and food prices
2) NY mfr'g survey in April rises to 1 yr high but with rising prices paid and received
3) Apr UoM confidence bounces 2 pts from lowest level since Nov '09 with still elevated 1 yr inflation expectations
4) China reports stronger than expected Q1 GDP, retail sales and IP but also higher than forecasted CPI and PPI
5) Singapore tightens policy to fend off higher import prices

Negatives:

1) US CPI rises 2.7% y/o/y, most since Dec '09 and Import Prices rise 9.7% y/o/y
2) Initial Jobless Claims rise back above 400k for the 1st time since early March
3) Higher than expected trade deficit and lower than expected rise in business inventories send Q1 GDP forecasts down to around 2%
4) NFIB small business optimism index falls to 5 month low as price pressures rise, and plans to hire, expectations of better economy and better sales fall. Cap ex component did rise
5) Soft start to Q1 earnings season as seen with AA, JPM, GOOG and BAC
6) Yields in Greece, Portugal, Ireland and Spain all rise as clock ticks on inevitable timing of Greek debt restructuring. Greek 2 yr yield up 225 bps on the week and CDS goes to record high
7) Gold at record high, direct indictment of Fed policy

Goldman summarizes the past week, and forecast the next 4 business days (Friday is a holiday)

What Matters in FX This Week : Business Surveys in Europe and Turkish Central Bank Meeting

From a macro perspective, last week's data offered a slightly more positive mix of growth vs. inflation. CPI data in the US showed a more moderate increase in core inflation, while consumer confidence in the US came in slightly better than expected and long-term inflation expectations eased.

In terms of our own market views, we re-emphasized our Dollar bearish bias in the FX Monthly but also highlighted that limited further upside in European rates together with slightly more volatile risk sentiment could temporarily hurt our long EUR/US $ exposure. Our commodities strategy team turned more neutral in the near term for oil, and as a result, we closed our long recommendation in Canadian equities.

Week Ahead

The week ahead is reasonably light on data. The European PMIs and the German IFO will be the key releases to watch. So far, these forward-looking growth indicators have remained steady at remarkably high levels, and it will be interesting to watch whether it extends for another month.

As a result of our more neutral stance on oil, we are watching our RUB trade closely. If the CBR remains hawkish then there is room for RUB to continue to perform even if oil prices correct lower in the near term. Therefore, watching next week's investment data is key for our view on the economy and the central bank's next move.

Next week's central bank meeting in Turkey is unlikely to provide a negative backdrop for our long EURTRY recommendation as we do not expect CBRT to raise reserve requirements again.

Monday 18 April

RBA Board Meeting Minutes.

Hungary Monetary Policy Meeting: We expect the National Bank of Hungary to keep rates unchanged at 6%.

Also of interest: Poland wages, US homebuilders' survey, Singapore trade balance. Fed speeches by Bullard, Fischer & Lockhart.

Tuesday 19 April

Eurozone Flash PMIs (Apr): We expect the manufacturing PMI to print at 57.2, very close to last month's print (of 57.5). Similarly for the services PMI we expect 57, which would be slightly below last month's 57.2 print.

Russia Investment Statistics (Mar): The strength of the rebound in domestic demand will be important to watch in order to assess the odds for further monetary tightening in the near term in Russia. Our long RUB basket recommendation is predicated on a hawkish CBR stance.

US Housing Starts (Mar): We expect a 5% increase in starts vs consensus forecasts of 9.6%.

Also of interest: Canada CPI (Mar), Japan trade balance (Mar), Hungary Wages (Feb), Poland IP (Mar).

Wednesday 20 April

Thailand Central Bank Meeting: We expect a 25bp hike of the policy rate to 2.75%, on the back of rising inflationary pressures.

Taiwan Export Orders (Mar): The March 11 earthquake in Japan is likely to distort export numbers across the region.

Sweden MPC Meeting: We expect the Riksbank to hike rates by 25bps to 1.75%. This is in line with consensus expectations.

UK MPC Meeting Minutes: It would be a surprise if any committee member had switched votes between March and April.

US Existing Home Sales (Mar): We forecast a decline of 6% mom vs a 2.5%mom increase that consensus expects.

Also of interest: South Africa Retail Sales, Mexico INPC inflation.

Thursday 21 April

Germany IFO (Apr): We will be watching whether the IFO continues to point to substantial strength in the German manufacturing sector. The components will also be of interest in terms of assessing the course for business expectations and current trends in the retail and wholesale sectors.

Turkey Monetary Policy Meeting: We expect the Bank to leave rates unchanged at 6.25%. We do not expect the bank to hike reserve requirements (RRR).

Japanese Portfolio Flow data for the week ending April 15. The last data set showed large Japanese selling of foreign debt. In comparison to previous years, we think it is related to fiscal year end. If the trend continues, it may signal repatriation of foreign assets in response to last month's earthquake.

US Philly Fed (Apr): We expect the Philly Fed indicator to decline to 33 from 43.4, consensus expects a decline to 36 only.

Also of interest: US initial claims, Canada retail sales.


Sources:

Succinct Summation of Week’s Events (4.15.11)

Global Key Economic Event And Bond Issuance Summary For The Upcoming Week


Sunday, April 17, 2011

TLV Potential Breakout



We notice the increased volume supporting the TLV price (daily chart above) pushing into the 50% retracement of the March - December 2010 downtrend after escaping the Fibo fan. The price seems ready to spring through 1.53 resistance targeting at least the obvious 61.8% Fib retracement in the 1.60 - 1.65 area until beginning of May.

Relative to BETXT (daily chart below), TLV is also showing signs of potential overperformance. After a strong underperformance, the stock moved mainly in line with the index since October last year shaping a potential reversal Head & Shoulders formation which may trigger TLV relative strength during the next cycle ending in June.


The BETFI Index Correction



As noted in a previous post, BETFI pulled back from the strong resistance found in the 27 000 - 28 000 points area where wave 3 of the uptrend (started in December 2010) may have ended. An a-b-c 4th wave correction started towards the 25 000 point support area which has almost been touched before reversing higher.

As long as the 25 000 point support area holds, the chances are the 5th impulsive wave starts running towards the 30 000 or even 34 000 area until end of May (see the chart above).


On the daily relative strength chart of BETFI against BETXT (chart below) we also notice a correction that reached support in the EMAs and broken downtrend area from where the BETFI may start overperforming again into the next time cycle.


Nevertheless, on the weekly relative strength chart (above) we notice BETFI is struggling to overperform while still being below the downtrend. We shall have to check if it breaks higher or continue lower during the next cycle.

Friday, April 15, 2011

George Soros Bloomberg Interview


On stimulus vs. austerity and whether U.S. debt impacts the world:

"If you have a growing economy, you can tolerate a higher level of debt. And if you have too much debt and you have a recession, you get into what they called debt check. This is the big issue. "

"I am afraid it is overshadowed by political considerations. You have a financial crisis in Europe. There is the pressure of Spain and Portugal and so on. But debt is a different problem. Those countries are part of the European bloc and they are not in a position to issue their own currency. We can issue our own currency. In fact, the dollar is quite strong. It is really a matter of political judgment. That is where you have different opinions."

"There is very a strong push to tighten the budget as a way to reduce government spending. It's a resistance to any kind of tax increase and tightening, particularly the budget of the states. The [U.S.] states cannot issue their own currency. They are in a similar situation to Spain and Portugal. There is a danger that by pushing this too far, you could abort the very fragile economic recovery that you are currently enjoying and push the economy once again into a slowdown or a recession."

"I rather fear these political forces will push it into a recession. In my opinion, the country could actually absorb some more debt in order to get the economy going."

On the ECB vs. the Fed – who is doing it right?:

"Two different directives govern the European Central bank and the U.S. Federal Reserve. In the case of Europe, it's a one-sided directive. Their only job is to prevent inflation, and in the case of the U.S., it is more balanced, to maintain employment and financial stability."

On whether the U.S. dollar is still a safe asset:

"There's a big question is whether the U.S. dollar should be the main reserve currency and in fact it no longer is because it maybe accounts for two-thirds of the monetary reserves. The euro is an alternative and there's a lot of diversification into other currencies and even more into commodities. Not only gold, but actually oil is now an asset class for investors. That has put some upward pressure on the commodities."

On whether the sovereign debt crisis has diminished euro's chances of becoming a reserve currency:

"The euro is under a cloud, but that is exactly because there are some inflationary pressures from the price of commodities, particularly now oil and also food prices have risen. That is what has induced the European Central Bank to raise interest rates at a time which is, in my opinion, quite inappropriate…It is not appropriate in current circumstances when you have a number of countries that are suffering from too much debt and high interest rates that they have to pay."

On China's economy:

"China has really stimulated its economy full force very successfully and now it is trying to rein in the rate of growth, and is exercising very strong constraints on the banking system. But because of that constraint, and because of the big demand for money, a shadow banking system has arisen and is growing very rapidly. So while the big banks under direct central control are in fact refusing to lend, there is a shadow banking system that is growing out of control. There is a real danger there of wage price inflation because prices have gone up, particularly real estate prices have gone up because there was a real estate boom."

"Therefore, wage demands have risen, and we now have 20%, 30% wage increases. The Chinese government has made a mistake not allowing its currency to appreciate, which would have controlled the price of inflation. Instead of that, we now have this wage pressure, which is a little bit out of their control."

On the Chinese economic approach and whether they did something right:

"[The Chinese] were the major beneficiaries of globalization. They were the big winners in the financial crash because their economy was largely isolated because they have capital controls on their currency. They have a two-tiered currency system, whereas the rest of the world allows free movement for capital, and you had a runaway expansion of credit and leverage which then resulted in the financial crash, and China was largely immune. So, they benefited tremendously."

"Their system, which really stands in contrast to the international system, international capitalism with free movement of capital, and then there is a system where the state controls the economy. That system actually has performed significantly better than the international system. So now it is beginning to be imitated by others, but I think it is a tremendous mistake, because that was just one particular set of circumstances when it worked better. They had an advantage because they were the only ones that were controlling capital flows. So as a result, they not only control their own currency, they effectively controlled the world currency system. Now other countries, defensively, are beginning to follow them. For instance, Brazil just doubled the surcharge on capital inflows. That is not good for Brazil, and it is not good for the global economy."

Link

Monday, April 11, 2011

EURUSD Bullish Cycle Magic



The weekly chart above shows the EURUSD breakout higher through the downtrend challenging the 61.8% Fib level into the next 21-week cycle potentially targeting 1.50 - 1.515 area or even higher until August 2011.

Below we see the daily chart of the EURUSD breakout pushing higher when the 21-day cycle ticks.


CRB Index Marching Higher



As shown in the weekly chart above and the daily chart below, the CRB Index is making new highs pushing into the 61.8% Fib resistance which can be overcome this following week opening the way to the 2008 highs. Notice the strong and long still running weekly uptrend.


US 10-year Treasury Yield Pushing Higher



We notice the bounce in bond yield form the 20 and 50 EMAs back above the 200 SMA in the weekly chart above.

The daily chart below shows the break above 61.8% Fib level up trending towards latest February high. Both charts are bullish and could target the 4% strong resistance area.


Sunday, April 03, 2011

MSCI Emerging Markets Index is Bullish Again



In the weekly chart (above) and daily chart (below) we notice the breakout to the upside of a 5-month long range (after the top in November discussed here) with high chances of touching 1250 area (Fib extensions and previous 2008 high) until end of April.

In the longer term the new weekly cycle can drive the index further up to challenge the all time highs around 1350 until August 2011.


The chart below is the relative strength of S&P500 Index (proxy for developed markets) against MSCI Emerging Markets Index. As noted in a previous post, the developed markets enjoyed an overperforming trend that seems to have just finished (see the trend break below).

The probability is now tilted to the return of the secular emerging markets overperformance.

ARAX Breakout


Nice breakout in ARAX after managing to escape a range and a Fib resistance.

Short term the move is first targeting 0.18 and then 2010 highs around 0.20 during the new time cycle ending around Easter.

BETFI Index Enter Strong Resistance Area


The BETFI Index entered in the 27 000 - 28 000 targeted area just before end of March as noted in a previous post. The index is trending up but the strong Fibonacci and chart resistance around the 28 000 level can trigger a pullback (see updated chart above).

The break of the 28 000 resistance is targeting 30 000 and then 34 000 later on while a pullback towards 25 000 should be bought with stop loss levels just below.

EURRON Downtrend Correction


As noted here and here, EURRON almost touched the targeted 2010 lows (around 4.06) after dropping through the critical 4.19 - 4.20 support area. The short term downtrend ended and a correction is in place with 4.15 and then 4.19 - 4.20 potential targets.

Nevertheless, EURRON is still bearish and a reversal could happen above the 4.19 - 4.20 area (now resistance). We may see a new band of trading between 4.10 and 4.20.