A room with a view…of the markets

September 27, 2011

Davide Accomazzo

Email: davide@cervinocapital.com

From the sometimes advantaged viewpoint of my trading room, let’s take a look at a variety of financial markets after what it could be called a “lively” quarter.

Equity markets around the world topped almost simultaneously at the beginning of the quarter (so much for diversification…) and initiated a vicious correction as a result of the renewed failure of Europeans to solve their sovereign debt issue, our domestic ineptitude related to fiscal policy and the subsequent Standard and Poor’s downgrade.

The SP 500 travelled a quick 20% to the downside perforating the 200 day moving average (the line between bull and bear market environment) like the Germans cut through the line Maginot some sixty years ago.  The WWII analogy is apropos since around the lowest point in the correction (August 8^th),  there were 67 declining stocks for every one that rose, the worst ratio in history going back to 1940 when German tanks broke thru French armies...even during the 1987 black Monday the ratio was not so negative (38 to 1).  This statistic shows the negativity associated with this move but it is also, most likely, the result of the predominant role of HFT and algo trading as we are getting more and more often this kind of really extreme market internals.

So far 1100 on the SP 500 seems to be strong support but I would not be surprised to see a quick and painful run at the round 1000 mark should Greece default (no.. it is not priced in yet…) or should our pathetic dance over our fiscal decisions be a repeat of the August near default.

From a technical point of view, we have an extreme number of stocks below their 10 week moving average and also below their 50 week moving average.  Such numbers have normally been followed by a rally.  Insiders buying was very positive at the bottom of the move and it has now moved to neutral but we do have the announcement by Warren Buffet of his first stock buyback.  Whether this is good news as it implies the market overall is cheap or it is bad news because the Oracle of Omaha can’t find good deals outside his own company is still unclear to me.

One thing is certain, volatility should stay with us until Santa Claus comes to town, so it is swing trading time for those with short time horizons or selective buying with some tail risk hedging for the long term investors.

Within the context of equities, our beloved sector (energy infrastructures related Master Limited Partnerships) has started to be attractive again on a spread basis versus the UST 10 year (over 400 basis points) and also versus the BBB benchmark.

Another market we follow closely, gold, has had an interesting quarter.  Gold experienced first a rally from a congestion area at 1500 to over 1900, then formed a double top and crashed back in typical shining metal fashion to an overnight low of 1533 and it is now trading around 1650.

The recent volatility of gold should not be surprising to most investors; the shining metal has a long history of violent swings to the upside and to the downside which are a reflection of what gold represents: a 5000 year hedge against fear.  Gold in itself produces no cash-flows and has very little industrial demand, therefore its price is largely dictated, and more disproportionately so in the last few years, by speculative flows.  In a world of disappearing trust in governments and institutions, 5000 years of trust become a useful characteristic; however, speculative funds are by definition shorter term and often leveraged, contributing to waves of swift and forced liquidation. The recent 400 point sell-off in gold is just the most recent example of gold volatile nature.

From a technical perspective, I expected gold to retrace to at least 1600 as that represented the level of the latest break-out; as previously mentioned, the December futures hit an overnight low of 1532.7, just a little higher than the 50 week moving average presently at 1500.63.  The 50 week m. a. has been a good trend indicator containing most retracements in the last few years.  Only in 2008 such level was broken significantly (albeit briefly) in the midst of the Lehman meltdown.

Looking forward, I continue to think that gold has regained an important place in most asset allocation models; therefore it should find a constant bid even though regular corrections will still mark its tempo.  The most likely scenario at this juncture should be a period of churning as the metal finds its new equilibrium and as it allows for a partial rotation of ownership from the most leveraged and shakiest hands to the longer term players.  Of course, just like all markets these days, we remain very headlines driven and should the Europeans fumble their responsibilities one more time, gold should find its footing much more quickly.

In regards to our Gold program, our strategy was built to respond exactly to this unnerving nature of gold.  Having a long term upside bias is one thing…being able to hold the position when in the midst of such highly volatile moves is quite another.  We built our collared strategy to capture the long term upside bias while significantly protecting our downside exposure.  We were always going to underperform parabolic moves to the upside but over the long term we should produce positive returns with much less volatility.  Volatility is a good friend of traders but a scary enemy of the longer term investor and gold demands a long term commitment as the financial and political world will require a long time to rebuild trust with all of us.

In FX, the US Dollar has regained some momentum as the Euro needed to price in its life threatening inconsistencies and the Yen was actively managed by the BOJ.  The Swiss Franc was run over by speculative funds looking for safety in a world where risk free is an oxymoron, and experienced some mind boggling moves until the Swiss Central Bank decided to peg to the Euro at the 1.2 level (later changed to 1.25). Their promise to print as many Swissies as necessary to stop the inflow of capital is a medicine that may end up killing the patient.  We are not trading this market at the moment but we watch intensely for future opportunities. 

The Swiss are not unique in their fight against undue currency appreciation; this is just Part Deux of the crisis.  In a world of shrinking aggregate demand, nobody wants to import capital (as it means exporting employment) and currency wars will continue to be our headache.

As far as the energy markets, we like crude oil as a trading affair into the end of the year where buying dips and selling rallies may produce profits.

Arrivederci!

Contact details:

davide@cervinocapital.com

Exotic Fixed Income

Prof. Davide Accomazzo

Email: davide@cervinocapital.com

In a universe of zero interest rates and demoted US Treasuries yielding negative real rates of returns (when accounting for inflation), the modern fixed income investor faces great challenges in order to capture reasonable risk adjusted yields.

In this piece we are going to take a look at two fixed income alternatives which are offering interesting possibilities in a field of disappearing opportunities: Emerging Market Corporates and Linkers also known in the US as Treasury Inflation Protected Securities (TIPS). 

Emerging Markets fixed income has normally been confined to Sovereign issues while the corporate sector was mostly localized and when offered to the international markets it was usually done via the institutional oriented EuroBond market and via small size issues.  However, EM Corporates are now an asset class that is coming of age in sync with the consistent growth of its underlying economies.  William Perry in the Journal of Indexes (September/October 2011 issue) highlights that the EM Corporate space has evolved from a market with a $20 billion in annual issuance volume to an average annual issuance in excess of $100 billion and a total outstanding size moving toward $1 trillion.

The growth of this asset class reflects the increasing economic power that emerging economies are yielding globally; in a world where developed economies are struggling with slowing GDPs and increasing debt burdens, the macroeconomic picture of developing markets is uncovering new opportunities.  As these economies develop, not only is their growth improving but so are their capital market structure and their legal framework; both elements help increase the value of Emerging Market Corporates.

Based on different macro metrics, it could be argued that the fundamentals of developing economies are indeed better than developed markets therefore a more significant allocation to EM Corporates may be where real opportunities lie.  One index that tries to replicate this new space is the Corporate Emerging Market Bond Index (CEMBI, William Perry in Journal of Indexes). This index reflects US denominated EM Corporates where Asia is represented at 41%, emerging Europe at 12.4%, Latin America at 28.47% and Middle East/Africa at 18.25%.

Another instrument with available global diversification and potentially more attractive real yields than traditional fixed income are Inflation Linked Bonds.  Such instruments are designed to guarantee investors a real rate of return regardless of inflation.  The coupon and the principal can be adjusted to deliver a real rate of return.  These are great tools for those investors that fear strong inflationary pressures may be the end result of our present fiscal and monetary policies.  Linkers are issued by governments around the world providing investors with a truly global menu; the US, Italy, Japan, France, the UK and most Emerging Economies are all large issuers of Linkers. 

One word of caution, especially for the retail investor, is the different characteristics of gaining exposure via individual Linkers or funds.  A typical fund will target a constant duration which may or not (unless the exposure is actively managed by the individual investor) be the best approach to match the investor’s future liabilities. Also funds (such as ETFs) could become overbought or oversold depending on market sentiment distorting the ultimate total return to the investor and potentially negating the sought after inflation protection.

 Contact details: davide@cervinocapital.com

Stop the Madness!

Davide Accomazzo

Email: davide@cervinocapital.com

In spite of all the drama that is unfolding on the international stage, the path to a better global economic environment is fairly simple.

First the US should maneuver its fiscal position with a long term deficit reduction goal in mind (not short term rash actions) while shifting the mix of policies toward investment projects and education rather than pure consumption. 

Then Europe should face up to its responsibilities and issue a Eurobond which is really the only solution to save the Euro if that is indeed the ultimate policy goal; otherwise, all the European talking heads should announce a press conference and tell the whole world that they were just kidding about a common currency and now the joke is over.

Then last but not least, China (and most exporting economies… including Germany) should shift their systems toward increasing domestic demand rather than pursuing merely mercantilist policies.

If these three steps could be undertaken, the whole world would witness an amazing period of high growth and improving global standards of living (and…yes some higher commodity prices as well…).

Unfortunately, the cumulative imbalances of all the policy mistakes of the last 15 years and the reality of today’s politics, is condemning all of us to a seemingly never ending cold winter in classic Kondratieff style.

In an almost surreal fashion, our beloved leaders are pursuing the exact opposite policies in a futile attempt to perpetuate their own special interests and the short-term survival of their personal power.  In this framework, global leadership is producing rushed and unbalanced austerity plans, growing global balance of payments dislocations and out of control monetary policies.  Savers are robbed through financial repression (read: artificially low yields), honest investors are hit with higher than necessary volatility, genuine entrepreneurs are forced out of the system by uncertainty of rules and regulations and a disappearing of real opportunities.

In this context we lived through the Jackson Hole meeting, where all the most important financial alchemists converged at the end of August for a few days of brain storming. Last year, Chairman Bernanke utilized this forum to launch Quantitative Easing Part Deux, which just like in a bad movie sequel, failed to spark economic activity and/or lasting increases in asset prices.  More liquidity is clearly not the answer in a balance sheet recession like the one we are experiencing but this eventually will not stop central banks from giving a hand to their commercial/investment banking friends. Bernanke was relatively tight lipped about his options and seemed to hint that Congress was better positioned to deal with the crisis at this juncture.  Nevertheless, the idea that the Fed will engage in some kind of Operation Twist like few decades ago (in essence a lengthening of the duration of the Fed’s portfolio in an attempt to keep longer term rates low)  is taking hold in the collective mindset.  No new details were provided on such an undertaking in last Thursday new Bernanke’s speech but the consensus remains he will push for it.  On Thursday, we also had President Obama’s speech on his job plan; while the proposed headline number was higher than expected (around $450 billions over an expected $300 billions) the lack of details and the short term nature of the remedies proposed failed to inspire investors worldwide.

Ultimately growth and a subsiding of assets volatility will not come back to the markets until somebody stop the madness (or better: the stupidity).  Markets are dysfunctional because they mirror dysfunctional political systems and political players and dysfunctional monetary policies.

Time to reset….. 

Contact details:

davide@cervinocapital.com

You Cannot Be Serious!

Davide Accomazzo

Email: davide@cervinocapital.com

“You cannot be serious!!!!!” This was the sarcastic line John McEnroe used to lash out at referees and umpires every time he felt a bad call was made against him.  John was a master at channeling negative energy and leverage it to overcome the opponent; he throve on negativity….so much for all those self-help books teaching about channeling positive energy to succeed but what do they know about winning Grand Slams!

Traders find themselves in an environment similar to professional tennis: high pressure, confrontational yet isolating and possibly lonely, with a clear and direct relationship between action taken and negative or positive result. 

In these environments, a highly polarized flux of energy flows thru the body of the trader and his/hers ability to harness the power of positive or negative thinking becomes a great difference between winning or losing.  The game of trading is highly based on a foundation of confidence and everyone builds that foundation differently but not everyone consciously knows how to build it in a fashion that will be long lasting.

Quant oriented traders derive a lot of their confidence by the support of mathematics and computing power; they leverage the isolation factor to transcend all other external sources of confusion.  However, when the comfort of computing power fails they often find themselves unable of regrouping.  Discretionary traders, on the other hand, will take the rest of the world head on leveraging mostly negative energy – a la McEnroe – but when hit hard, maybe in an unexpected sequence, they will find their confidence utterly shattered.

The successful trader will be able to do the following at the beginning of his/her career:

-         build confidence based on a mix of scientific foundation and animal spirit

-         understand what really makes you stronger: negative or positive energy

-         deal with the isolation factor – either leverage it or mitigate it depending on your personal psychology

-         detach yourself from the process

There are many easier ways to make a living than trading but only very few will push you to fully discover who you really are…and if you end up not liking what you see, you can always look at yourself in the mirror and scream: “You cannot be serious!!!!”

Contact details:

davide@cervinocapital.com

The Inefficient Market Advantage

Davide Accomazzo

Email: davide@cervinocapital.com

For decades Wall Street has pushed forward an investment agenda based on the academic research initiated in the 1960’s by Prof. Markowitz, the now notorious Market Portfolio Theory (MPT) and the Efficient Frontier.

While the historical investment context in which MPT  developed was indeed lacking some sort of scientific support to analyze risk and performances, the answer provided by the theory – mean-variance optimized portfolios – ended up overlooking the real fabric of the markets and therefore failing investors once the going got tough.

Markets are not efficient because market participants – much to the chagrin of MPT followers - are not fully rational agents.  But more sadly, markets are inefficient also because of massive asymmetrical information and manipulation of markets structure by better positioned economic agents.

So if markets are not efficient, how do we take advantage of anomalies and more importantly how do we protect our portfolios from those frequent and damaging grey and black swans?

Of course there is not one answer; the proper approach is a function of the individual investor’s resources, interest, risk profile and time.  An interesting portfolio management approach that is sophisticated yet relatively simple and low maintenance is the “Core-Satellite” construction.

In its most simplistic form, an investor would allocate a larger percentage of his/her funds to a beta replication instrument like a passively managed index ETF or a mix of subsectors ETFs (the core).  This portion of the portfolio would be beta driven but also cost-effective from an implementation point of view; there will be no high management fees, almost inexistent transaction/slippage costs and low taxes.  The satellite (a smaller percentage of the total of the portfolio) would be dedicated to alpha seeking strategies or in other words skill based, uncorrelated investment programs.  This portion would be actively managed, priced accordingly and with an uncorrelated and/or higher expected rate of return.

In today’s environment of generally low rates of returns across all traditional asset classes and with beta having largely disappointed all investors, a more complex approach to core-satellite is due.  I like to create a core that is low cost and essentially multi-beta driven with an additional embedded risk management mechanism in place and a satellite that is truly defined by superior skills and that can possibly lower my systematic risk.

Years ago I came across a study by Mebane Faber[1] that utilized the 10 month moving average as a buy/sell filter for a portfolio of 5 major asset classes: Domestic Equities, International Equities, Real Estate, Commodities and Bonds.  This approach works very well and easily for the construction of a cost efficient, multi-beta driven yet actively managed core.  Based on the data of the study, the risk adjusted combined results were quite attractive.

Utilizing ETFs, the investor can tailor a multi-beta core at low cost by choosing different subsectors (from more traditional strategic allocations to more refined and personalized ones) and utilize the 10 month moving average as the risk filter that will liquidate any segment of the core that falls below the moving average.

The satellite could then be built by investing in skill based, uncorrelated to the core strategies like managed futures.  Managed Futures, usually structured as Commodity Trading Advisors (CTA), operate strategies based on futures and options in diversified global markets such as commodities, market indexes, interest rates and metals.  Including a precious metal strategy in your satellite should also help lower the systematic risk of the overall portfolio since gold is estimated to be a zero-beta asset with generally no covariance with traditional asset classes.

In conclusion, the difficult and often dislocating investment environment of these past ten years is probably going to continue; the investment universe is hardly as rational and prone to exact modeling as MPT leads to believe. The world is messy and a more pro-active approach is needed to build portfolios that can withstand the stress of our times.

Contact details:

davide@cervinocapital.com

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[1] Mebane Faber, “A Quantitative Approach to Tactical Asset Allocation” Journal of Wealth Management 2007

The 10 Essential Investment Rules

Davide Accomazzo

Email: davide@cervinocapital.com

At the end of 14 grueling weeks in my Portfolio Management class at Pepperdine University, I wrap it up with this 10 rule list.  After all the fancy formulas and complex graphs we review in class, the art of investing comes down to common sense and risk management. After my many years in the trenches, managing money for investors from all over the world in multiple and very different markets, I can confidently say that these 10 rules are your lifeline.

1. Understand the nature of expected returns.

One of the keys to a long and successful investing career is to truly understand the nature of the expected returns; in other words WHY should this particular investment or strategy produce a positive return, what are the drivers of price formation, what is the investment thesis supporting our decision and are past circumstances going to have the same weight in the future?

2. Fully understand the risk

Understanding the reasons for expected returns is only half the story; you must also understand the risk associated with the investment. You must run a stress test and identify what contingencies could develop and how your investment would perform in those situations.  Do not rely on static historical correlations but adopt a correlation scenario approach where you allow for specific disruptions to occur.

3. Analyze performance on a risk adjusted basis

Looking at performance numbers in a vacuum is meaningless and yet incredibly common; you must always put performance into the context of risk; do not assume that higher performance numbers are the result of superior management; is it superior investment selection (or superior timing) or just leveraged beta?  

     4. Risk management is the most important element of investing

This is by far THE MOST IMPORTANT rule of all.  Finding investments is easy, entering trades is easy…controlling the risk is hard.  Never allow for a loss to be terminal to your account; always have an exit strategy BEFORE you enter the trade. A classic market truism says: “Good traders know how to make money, great traders know how to take a loss.”

                       

      5. Discipline overrides conviction

Investing is a probability game; if you can be disciplined and follow a process based on rules 1 and 2 AND you constantly control the risk so that a loss will never take you out of the game, you will succeed in the art of investing.  Never be emotionally involved, never “marry” a position and…never take it personally when things don’t work out. 

6. Adapt your style to changing market conditions (market structure changes)

Rule 6 may sound contradictory to rule 5 but in fact it is complementary.  You must be disciplined but you must also have a review process that alerts you when “structural” changes happen in the market which may require you to adapt.

     7. Opportunities are made up more easily than losses

When in doubt…pass. Over 40 markets are open every day for business, opportunities abound. Losses are practically and emotionally tough to make back.

    8. Emotions are your worst enemy

Treat investing/trading as a job; have a process, have risk management and if you are looking for a thrill go to Vegas or take on paragliding. Investing should be boring and not emotionally charged.

    9. Act independently of the crowd (but do not be a contrarian just for the sake of it)

Being a sheep does not produce consistent superior returns in the investment universe. However, you must have a process to identify out of the box ideas and to identify peaks of complacency or fear among the crowd so that you can take the other side of the trade. In other words be creative but do not be a contrarian just for the sake of it.

  10. Perception is reality.

As Gordon Gekko eloquently said 25 years ago: perception is reality when you invest. Remember that as an investor you are making a guess of what the average investors’ guess is of an uncertain future outcome.

Good luck!

Currency Wars and the Future of Money

Davide Accomazzo

email: davide@cervinocapital.com

When in 1992 Francis Fukuyama published his best-seller “The End of History and the Last Man,” he made the case that the success of Western Liberal Democracy was going to sign the end of man’s evolution toward its final form of government and so mark the end of history.

The book made me chuckle then and even more today while not only can’t we agree on a final form of social organization but we can’t even agree on a global payment system.  The remaining and now most pressing legacy of the 2008 global financial crisis seems to be the determination of the future for the International Monetary System (IMS) or in layman terms the way we trade and pay each other globally.

Historically, every major financial and social crisis ended with a re-designing of the IMS; WWI marked the end of the first wave of globalization and virtually ended the pure global gold standard which was forever abandoned after the Great Depression; at the end of WWII, the Bretton Woods agreement established the US Dollar as the global reserve currency and the only currency convertible into gold.  This convertibility ended amidst the stagflation crisis of the 1970 when Nixon closed the conversion window in 1971.

Here we are, forty years later, staring down the abyss hoping for a global flash of ingenuity and a new mantra to fix a badly imbalanced monetary system.

So what went wrong? 

During the Bretton Woods agreement, J. M. Keynes advocated the creation of a global currency, the Bancor, to be utilized to settle all international trade.  The Bancor would also have required the creation of a global Clearing Union which would have managed the inevitable trade surpluses and deficits among nations. The Union would have implemented rules to curb such imbalances and hopefully pushed the system toward more equilibrium.  Ironically but understandably, the US opposed such view and successfully lobbied for the Dollar to virtually become THE global currency.  I suppose winning a global war while retaining intact all of your production facilities and storing most of the available reserves of gold would give you such a negotiation advantage…

Being the provider of the global currency allowed the US great financial benefits, at least for a few years.  The constant demand for Dollars to settle international trade lowered the US cost of financing and allowed for larger trade and fiscal deficits that would have been possible otherwise.  Another by-product of this position was to practically impose globally our monetary policy; as John Connally, Secretary of the Treasury during the Nixon administration, famously said to a delegation of European politicians: “The Dollar is our currency but your problem.” 

Or is it?

In light of today’s crisis we may rephrase: the Dollar is our currency and everybody’s problem.  The initial advantage, I referred earlier, to run larger deficits thanks to the currency role as a global reserve unit, lead to the Triffin Dilemma.  Trifflin warned that a country providing the global reserve currency would have had eventually an incentive in running TOO large deficits and then inflate its way out them.  A perhaps unforeseen element a few years ago might have also accelerated the process; not only the US was incentivized to run large trade deficits but many emerging markets decided to marry their fortunes to the “produce-at-the-lowest-cost-and-export” model and heavily manipulated their currency vis-à-vis the dollar to achieve trade advantages.  Systemic and chronic imbalances were created. 

We are now locked into an unsustainable global position where the large exporting countries feel they cannot succeed without a constantly undervalued currency, the US will eventually inflate its way out of trouble and virtually all players will engage in some form or another of currency wars. The high stakes poker game is on.

While short term solutions vary from allowing for a faster appreciation of the Chinese Renminbi (China running the largest trade surplus) to a diversification of global reserves from just the USD to include other currencies, the question remains on what kind of system we can agree globally that might, in the long term, be more stable than the present one. 

A nostalgic fringe has been calling for a restoration of the gold standard but this is impractical for a number of reasons.  A pure gold standard tends to be deflationary (albeit proponents of this solution might actually find this a plus) and probably would not really end mercantilist policies.  The present geographical distribution of the metal would also pose logistical and political problems during the transition to the new system.  A not so pure gold standard based on paper claims or other types of derivatives would eventually end up manipulated just as our current currency system. [1]  Yet gold does have certain characteristics that might help finessing the system.  It has been accepted globally for thousand of years as a store of value and a medium of exchange; it is finite, it does not decay, it is malleable.  And its price responds to perceived instability and global inflationary pressures.

If gold is not the answer then is a global currency, just like Keynes advocated seventy years ago, a workable and likable solution?  Possible but with a number of precautions.  Common currencies are complicated affairs; think of the Euro and its disconnect between the monetary union it represents and the fiscal disunion that characterizes it.  A common currency requires to some degree a loss of sovereign power; another famous macroeconomic dilemma or better “trilemma” highlights the three major objectives a government will want to achieve while only able to achieve two of them:

-         an open current account

-         stable currency

-         domestically oriented monetary policy.

In other words, a global currency will require some sort of supranational oversight in terms of trade policy, like limiting surpluses and monetary/fiscal policy in order to avoid inflationary temptations. 

Robert Zoellick, President of the World Bank, has recently called for a mixed system of different major currencies, including a liberalized Renminbi and gold as an international reference point for global monetary policy.  The details are vague and it is unclear which entity would enforce the given parameters; in fact it is unclear whether any country would trade domestically oriented monetary policy for FX stability.

Will we need another crisis to force us into a disciplined approach?

Contact details: davide@cervinocapital.com 

Sources:

Robert Zoellick, The G20 must look beyond Bretton Woods II, Financial Times, November 7, 2010

International Monetary Fund, Reserve Accumulation and International Monetary Stability, April 13, 2010

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[1] Disclaimer: as a money manager I trade a gold based strategy.