Wednesday, December 30, 2009

Yield Curve Near Historically High End of its Range

The yield curve has been the subject of an increasing amount of chatter in recent weeks, as long-term interest rates rise and short-term rates remain low. Some stories have suggested that the curve is at record highs, but based on the official definition from the NY Fed, while the yield curve spread is extremely high, it is not quite at a record.

According to literature from the NY Fed's website, the yield curve is defined as, "the spread between the interest rates on the ten-year Treasury note and the three-month Treasury bill." On a historical basis it has been "a valuable forecasting predicting recessions two to six quarters ahead."

Using the Fed's definition of the yield curve, the chart below shows the historical spread between the yields on the 3-month and 10-year US Treasury (in basis points). As shown in the chart below, the current level of the yield curve is nearly two standard deviations above its historical average. The only other time that the spread got this wide was back in August 1982.

Yield Curve123009

Might the recovery be more robust than widely expected? Wall Street’s most respected pessimist thinks so.

Illustration by André Carrilho

Blessedly, 2009 did not turn out to be the utter catastrophe many once feared it would be—no bank runs, no bread lines, no sport-hunting of the rich. But it’s far from certain whether the worst has been truly averted, or, to use a phrase that became fashionable, the can was merely kicked down the road. The signals are, at best, mixed. Jobs are still being lost, if not at the same wildfire rate. Many small businesses lack credit, not to mention customers. So what lies ahead?

Between the yahoos who tout every market uptick as the stirrings of the next boom and the doom peddlers who cling to their prophecies of societal breakdown, a consensus has cohered around what investment strategist John Mauldin, a hero of the blogosphere, calls “the muddle-through economy,” a protracted period of elevated unemployment rates and sluggish growth. Federal Reserve chairman Ben Bernanke, who once spoke of “green shoots,” now describes the “considerable headwinds” that the economy faces. Goldman Sachs economist Jan Hatzius sees double-digit unemployment persisting through the end of 2011.

Within this school of forecasters, a popular approach is to characterize the United States in terms of other countries’ trademark miseries. So we are Japan— a major Paul Krugman meme—staring down the barrel of our own “lost decade” of deflation, zombie banks, and cultural inertia. Or we are Europe, afflicted by the “sclerosis” of high structural unemployment and gigantic government. Or, as former IMF official Simon Johnson asserts, we are “a banana republic,” debasing our once-mighty currency by recklessly printing it to cover our debts.

But describing current conditions is only part of the game. Correctly calling the next crisis is the great status bake-off of economics. Which is why it was bracing to receive a recent investment newsletter from one of the most distinguished pessimists on Wall Street with this headline: “On the Coming Shortage of Labor.”

It was not a joke.

The bi-weekly newsletter, Grant’s Interest Rate Observer, is published from a picturesque office on Wall Street overlooking Trinity Church. The proprietor is a former journalist turned finance philosopher named James Grant, who—in addition to turning out the newsletter, which costs subscribers $850 a year, and hosting conferences at the Plaza Hotel that feature some of the sharpest minds in the investing business—has written six books, including a history of debt (surprisingly engaging) and a biography of John Adams (better than David McCullough’s, some say). But his ample intelligence has often left him out of sync with the animal spirits that rule Wall Street. Over a quarter-century in which the economy mostly boomed, Grant stayed mostly gloomy. His view has been that the economy is a Frankenstein creation of cheap credit that drove up prices and instilled a false sense of prosperous stability.

At critical moments, such as the great collapse of the eighties boom, this analysis proved brave and useful, swelling Grant’s subscriber rolls and turning him into a star of sorts. But it also led to him advising caution and restraint as some of the most vigorous bull markets in history commenced. Indeed, the nineties was not kind to pessimists. “In this business,” he says, “everything is cyclical, including one’s evident IQ. One goes from genius to moron all too quickly. And so I went from being regarded as one of the brighter people on Wall Street to being, let’s see, a perma-bear, and there was truth in that. I wasn’t supple enough, wasn’t flexible enough. I was in love with our story, which had been so successful, and didn’t see the world change.”

Having made this mistake more than once, Grant is determined never to make it again. The financial crisis ratified many of his core convictions about the pitfalls of debt and loose monetary policy, and the panic of people who didn’t see the crisis coming produced great opportunities for those who did. The transition from bear to bull was difficult for Grant, but before 2008 was over, he was recommending to his subscribers that they shop for bargains, including, yes, houses in Detroit. “One year ago, we turned bullish on tradable bank debt, certain ‘toxic’ mortgages, junk bonds and other such unwanted debris,” he says. “In March, we turned bullish on bank stocks. And now we are bullish on the economy.”

Grant’s optimism is built on two pillars. The first is his analysis of cyclical trends. Like a rubber ball thrown against pavement, the U.S. economy has historically bounced back with a force roughly approximate to that with which it fell. So the tepid recoveries of the early nineties and early aughts, the ones that preoccupy many analysts today because job growth was so torturously slow in both cases, were just the predictable aftermath of what Grant describes as “toy recessions.” A better model for our present circumstances, he says, is the early eighties, when the economy was in shambles (double-digit unemployment then, too) and then suddenly, to the shock of learned people everywhere, staged a stupendous recovery. Yes, there are seemingly unique impediments to such a recovery this time around—the indebtedness of U.S. consumers, to name one—but there are always such seemingly unique impediments, and the U.S. economy has repeatedly demonstrated the power to adapt.

This is especially true in the emotional, highly fraught area of unemployment. In a worrying climate of dying professions, it’s hard to get a grip on what takes their place. “Though we humans do our best,” he wrote, “we usually underestimate the capacity of market economies to reinvent the nature of work.” How exactly it will work this time, says Grant, we don’t know. We never know until after the fact.

Consider the now-conventional analysis of the U.S. economy over the last decade: It was, we have had drilled into us, built on the swampy ground of real-estate speculation and the feverish spending of borrowed money. Okay, sure. But it was also about the explosion of information technology, the concomitant surge in productivity, and unprecedented access to low-cost labor, both domestically (Latin American immigrants) and globally (Chinese), which lowered the prices of goods and services for all Americans. These conditions, unlike the housing market, have not gone away.

Grant’s second cause for optimism is an observation about human nature, summed up by an epigram he borrowed from the late British economist Arthur C. Pigou: “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant.” As peculiar as our economic circumstances may seem to us right now, the way people behave has a certain reassuring constancy—which is to say, we freak out and then we get over it.

Though economic forecasting is a major part of what his subscribers pay him for, Grant considers much of it a pseudo-intellectual parlor game. “Mindful that the future is a mystery,” he wrote in recent newsletter, “we do not pretend to know what nobody can know.” The past offers only so much help. In the industrial history of the United States, there have only been about 30 economic recoveries, a minuscule sample size. (If somebody touted a medical breakthrough based on a study of 30 patients, who would rush to sign up for this new wonder drug?) As for the data itself, consider that the dominant measure of economic activity, gross domestic product, is an antique that does a poor job of capturing the intangible investments that abound in the information economy. The numbers that drive the markets up and down, like jobless figures, are glorified guesses subject to constant revision. The latest issue of Grant’s Interest Rate Observer notes that annualized GDP growth for the third quarter of 1983 has been revised ten times, including just this fall! How much can we possibly know about the future if we’re still unsure about 1983?

Grant, too, harbors deep concerns about what lies beyond the bounce-back. He sees long-term problems in the government’s massive efforts to save the economy, especially the low interest rates that Bernanke shows little inclination to raise. “Inflation is upon us,” he says. “Not too much money chasing too few goods, but too much money. The object of the money’s desire varies from one cycle to another. It could chase skirts, toothpaste, and automobiles, as it did in the seventies. Or it could chase stocks, houses, or income-producing buildings, as it did a few years back.”

Grant, in other words, hasn’t forsaken pessimism so much as postponed it. Hyper inflation could produce the kind of volatility that enables traders to make a killing while the rest of us suffer sticker shock in the breakfast-cereal aisle. Then it’ll be the sport-hunting vigilantes who are doing the chasing.

Dow Yield Versus Treasury Yield

There has been quite a bit of chatter recently about the widening spread between the yield on 10-Year Treasuries and the dividend yield for stocks. Currently, the 10-Year Treasury Note is yielding 3.84% versus the Dow's dividend yield of roughly 2.6%. One of the arguments for stocks at the bottom of the bear earlier this year was that they were yielding more than Treasuries. As shown below, that hadn't happened in nearly 50 years. The consensus for 2010 is that stocks will rise (dividend yields lower) while the 10-Year yield will rise as well. This would make the spread tick lower into the "red zone" in the chart below. You be the judge on whether this will be a negative for stocks or not.


Sunday, December 20, 2009


Below we highlight the percent of world stock market cap that various countries make up and how the numbers have changed this year. As shown, the US remains the biggest country with its stocks making up 29.61% of world market cap. This is more than three times Japan's representation in second place at 7.68%. At the start of the year, the US had 32.75% of world market cap, so its representation is down 9% in 2009 even though US equity markets are up. At 7.27%, China overtook the UK in third place in 2009 and is closing in on Japan.

Brazil's percent of world market cap increased the most in 2009 at 58.2%. Its weighting has gone from 1.84% to 2.92%. Indonesia, India, Australia, Turkey, China, Russia, and Taiwan have all seen their weightings increase by 25% or more this year. On the flip side, Japan has lost the most market share of the developed countries, declining from 10.28% to 7.68%.



Since November 9th, the S&P 500 has essentially traded sideways. We broke the index into deciles (10 groups of 50 stocks) based on market cap and then calculated the average performance of stocks in each decile since 11/9 to see what impact a company's size has had on the market recently. As shown below, the two deciles (100 stocks) of the biggest stocks in the S&P 500 are up just slightly (about 0.20%), while the rest of the deciles have averaged a gain of more than 2%. Clearly the blue chip stocks have been holding the markets back during this sideways trading pattern.


Do TIPS Work?

Are Treasury Inflation Protected Securities (TIPS), for which the Treasury adjusts the principal based on the Consumer Price Index for all urban consumers (CPI-U), effective as an inflation hedge? In their September 2009 paper entitled "A TIPS Scorecard: Are TIPS Accomplishing What They Were Supposed to Accomplish? Can They Be Improved?", Michelle Barnes, Zvi Bodie, Robert Triest and Christina Wang evaluate the progress of the TIPS market toward providing: (1) consumers with a hedge against real interest rate risk; (2) holders of nominal bonds with a hedge against inflation risk; and, (3) everyone with a reliable indicator of expected inflation. Using inflation rate and bond yield data available since the introduction of TIPS in September 1997, they conclude that:

  • TIPS provide a good real-return hedge, despite CPI measurement error and possible demographic differences among TIPS investors. TIPS indexed to CPI are as good as TIPS indexed to other inflation measures, because inflation risk is largely independent of the measure used.
  • TIPS better protect long-term, buy-and-hold investors than investors who hold TIPS for less than the full maturity. Over relatively short horizons, bond price volatility overwhelms the relatively small deviations between actual and expected inflation.
  • The inflation rate implied by the difference in yields between nominal Treasury and TIPS markets are neither clean measures of expected future inflation nor likely to be good predictors of future inflation (see chart below).
  • A "ladder" of TIPS, with maturities linked to anticipated expenditure timeframes, would help investors in or near retirement hedge against inflation in nominal expenses over time.

The following chart, taken from the paper, shows in simplified form how the nominal Treasury yield can be broken down into a TIPS part (expected real rate plus a real rate risk premium) and an inflation compensation part (expected inflation plus an inflation risk premium). This diagram illustrates why there is no easy way to extract the expected inflation rate from the difference between nominal and TIPS yields.

In summary, TIPS work reasonably well as an inflation hedge for long-term holders, but they are not particularly useful in measuring inflation expectations.

Thursday, December 17, 2009

Alpha versus beta?

Alpha beta separation? Can't beat beta? Beta based asset allocation is supposedly the driver of returns. Many papers claim that it is almost all that matters. That mistake has dominated conventional wisdom for too long. They reached that sample biased conclusion because asset allocation is what the selected investors focused on. Setting a stock/bond/alternatives mix determines variability of returns ONLY if you emphasize it. It is easy to debunk this portfolio construction "axiom" if you seek reliable performance.

Suppose corporate pensions were required to invest 100% in the plan sponsor's equity. Then we would conclude that security selection drove returns. If investors flipped coins each month to be 100% stocks or bonds then market timing would be the factor. You only have to look at a few conventional portfolios to see that "choose your betas" asset allocation needs NEW thinking. Some say that long term investors should have more in risky assets due to the alleged higher "expected" return. Instead investors would be wise to focus on the alpha/beta weight. For anyone with lower risk tolerances and dislike of deep drawdowns, alpha gets the vote.

The true determinant of superior risk-adjusted returns is investment SKILL not the percentage in different UNSKILLED asset classes. If the "seminal" studies had confined their analysis to high frequency portfolios obviously they would find that ability at high frequency trading drives performance! Is it valuable information to "discover" that asset allocators' returns largely depend on their asset allocation? More importantly EVERY high performing portfolio over the long term focused on alpha so why spend so much time and money on beta?

It's been a great decade for the S&P500. No beta for index fund fans but every day had an opportunity set of 500 fluctuating securities to capture alpha. It was an even better 25 years for the Nikkei. Again no beta but vast alpha was generated from security selection and timing by those with skill. In aggregate, "stocks" can and do underperform "bonds" for decades. 60/40 sounded prudent until rephrased as 90/10 risk. Why have a risk appetite when equity indices fail to compensate with sufficient reward even in bull markets. Last century's 8% return on 16% volatility was an insult but a negative total return with even more risk is absurd.

The more vituperative commentary on hedge funds, the more cash one should invest in alpha vendors. Why tie up precious capital in high risk beta when lower risk alpha is available? Better to identify mispricings and arbitrages than invest in "the market" itself. It is safer to minimize market exposure and analyze specific securities to short sell and buy. Most portfolios are still very beta biased while some investors implement a beta plus alpha model. The INEVITABLE progression is to alpha only which has a superior efficient frontier. I do not understand why investors should surrender wealth to the volatility of long only beta.

Selecting the RIGHT betas at the RIGHT time is a form of alpha anyway. Choosing the WHICH and WHEN of asset classes takes as much talent and expertise as at the security level. I have no idea where the markets are going in the long term but will not take the risk of finding out. Asset and security selection, timing and hedging skill, though rare, are the only properties a conservative investor can rely on if they need adequate and consistent absolute returns. Beta is passive but do we live in a world that rewards passivity in any activity? I don't think so which is why they are called ACTIVITIES. Alpha comes from acumen-driven ACTION.

Alpha/beta separation is trendy but beta tends to swamp alpha as we saw in the downs and ups of 2008/9. That was the error inherent in the awful portable alpha idea. It was a beta-centric way of getting people into hedge funds but failed because it kept asset allocation front and centre. It diluted the absolute return attribute and changed it into a relative return enhanced index product. The alpha/beta separation framework still has too much risk budget in beta. Why bother with beta at all? Cheap beta is expensive considering its risk. Risk and cost conscious investors favor alpha.

Successful investing is about leveraging your informational, structural and analytical advantages or outsourcing to those that do. Let's look at some portfolios that did well over long periods but didn't asset allocate, instead focusing on security selection or timing. A low frequency trading firm like Warren Buffett's Berkshire Hathaway identifies specific multiyear opportunities in currencies, commodities, stock and bond markets, derivatives and event driven special situations. In contrast the high frequency trading of Jim Simons' Medallion Fund times thousands of liquid securities over shorter holding periods down to microseconds. Munehisa Honma's managed futures fund specialised in trading one security in multiple time frames. Producing alpha depends on the knowledge and technology edge being applied to the appropriate time horizon.

Beta bets drive most portfolios because that is what most investors do. It is like the people who assume carbon is necessary for life because the science they know and only lifeforms they have analyzed are carbon-based. The anthropic principle applied to finance! It is false logic similar to the "all swans are white because every swan I encounter is white" phenomenon. Asset allocation fit nicely into the established body of theory which is why it remains popular despite its weakness. Efficient, unbeatable markets imply the non-existence of skill! Choose beta because alpha is just "random" luck in a zero sum game? Beta people like index funds because they want you to invest in "the market". But the safest way to achieve absolute returns at the total portfolio level is to be alpha-centric.

Beta vendors don't manage risk, don't time and outsource security selection to benchmark construction firms. They stay fully invested even in bear markets! A beta-centric portfolio is where investors decide a policy or strategic asset allocation and then look around for managers to basically deliver the return from that asset class and hopefully a bit of alpha on top from tracking error constrained active mandates. Most long only funds have an R-squared with their benchmark over 70% - ie beta explains most of their returns. Alpha strategies and manager selection shouldn't be secondary but that is the result when RISKY beta bets dominate the allocation of investment capital.

Alpha vendors see a market of securities offering long/short opportunities over numerous time horizons within and between asset classes. An alpha centric portfolio is where investors hire managers to analyze, trade and hedge. Of course you have to be very good and work extremely hard to find alpha. Any manager that depends on beta is NOT running a hedge fund. A truly efficient portfolio does not pollute itself with any beta. Dismissing all hedge funds is like avoiding all stocks because of Enron, Worldcom and Nortel. Don't invest in fixed-income because some bonds default?

Naturally pure alpha sources do not fit well into the beta allocation process that some find so compelling. Since they are not assets, treating hedge funds as an asset class is wrong. The dispersion of returns across the industry is very high. So variable that AVERAGE performance has little meaning. 10,000 hedge funds, 10,000 strategies. People like to know if "hedge funds" were up or down each month. But what does that mean? Some made money and some lost money. Likewise I am often asked where I think the "market" is going. That is a beta question. Some stocks go up and others go down. Seek alpha.

Do I want "hedge funds" that outperform? No. I want hedge funds that make money which is a different target. I know that good hedge funds will have high risk-adjusted returns and bad ones will not. Alternative beta is just another beta and is therefore to be avoided. Most betas are becoming more correlated whether by geography or the equity/credit/real estate connection to the economy. I am not concerned whether a hedge fund manager's strategy is "market neutral" or not. But they MUST be able to deliver absolute returns that are "economy neutral".

Alpha is the TRUE diversifier because there are so MANY different ways of generating it. Focus on alpha if you want reliable performance regardless of the economy. Why pay attention to asset classes when investing in different SKILL-BASED STRATEGIES makes more sense? For the risk averse conservative investor alpha and beta is inferior to an alpha only portfolio. And leave the speculators to their beta only bets.

Monday, December 14, 2009

A steeper path to follow

Sovereign debt yield curves are steepening.

On Thursday, US 30-year yields hit four-month highs after a government long-dated auction received poor demand and revived worries over the federal budget deficit.

With reason. Outstanding Treasury debt currently looks like this:

US Treasury outstanding debt - Bloomberg

In fact, according to Bloomberg, the Treasury yield curve has now hit its steepest since at least 1980. Here at least is how today’s curves compare to those in 2007.

As they stand today:
Yield curves - Bloomberg

And how they stood two years ago:

Yield curves 2007 - Bloomberg

And for those interested to see how US liabilities have been dispersed, here’s the current distribution of US public debt according to TreasuryDirect:

US debt distribution - Treasury direct

Tuesday, December 08, 2009

The death of sec lending in prime brokerages?

Dec 7th, 2009 |

hardly knew yaThe world is full of middle-men: Walk into a car dealership to purchase a car and you go through a salesperson, who takes a cut for showing you the car; walk through a house or apartment and the real estate broker takes a cut for opening the doors and closets.

Like it or not, and as counter-intuitive as it sometimes may be, it is the way transactions work.

So it’s been with the securities, or “sec” lenders: institutions that have access to “lendable” securities. Asset managers who have securities under management, custodian banks holding securities for third parties or third party lenders who access securities automatically via the asset holder’s custodian have for years taken a nice slice of the pie to lend back out stocks to others who need them.

In its most basic form, sec lending is where a loan results in a transfer of title/ownership to the borrower, who is obligated to return the same type and amount of securities. The loaned securities are collateralized, typically 102-105%, reducing the lender’s credit exposure to the borrower (as illustrated in the chart below provided to by automated securities lending and borrowing marketplace Automated Equity Finance Markets (AQS) – click to enlarge).

sec lending 530

When the banking and financial systems were functioning normally, all of this was considered par for the course. Indeed, for long/short and short-only hedge funds in particular, the ability to go to their prime broker for their sec lending needs was a value-added proposition not even questioned.

At least until Bear Stearns blew up, Lehman Brothers was allowed to go bankrupt and all H-E-double-hockey-sticks broke loose, bringing into question for the first time the notion of whether too big to fail – and too big not to be concerned with the physical securities your prime broker was lending back out to someone else at a profit – were going to get taken away from you.

It was this kind of talk that dominated the Securities Lending Debate produced by consulting firm Finadium and Markets Media and held in New York last week as part of Markets Media’s Global Markets Summit.

Among the many key points of debate: the use of multiple primes, the need for speed, liquidity and premium pricing in the form of new, accessible platforms, the notion of “bundled” services for hedge funds and the concept of “central” borrowing – literally going back to the old five-day settlement cycle, where all securities going through a central clearing house get settled within a specific period. Also of note, sec lending spreads are still at historically wide standards, meaning there is still profit to be made in lending out securities (as the data below collected by Finadium shows):

sec lending

But by far the most contentious point of debate were projected changes in prime brokerage – in the sec lending food chain, that is – and what will inevitably mean fundamental changes in the prime brokerage business model.

“I think it’s going to be a significant trend for 2010,” noted Josh Galper, Finadium’s managing principal, who opened up the forum at the Waldorf Astoria hotel last week and hosted the event. “I can see at this time the development of two separate markets: hedge funds borrowing securities lending from prime brokers versus hedge funds engaging in borrowing from electronic markets and other non-prime broker dominated venues.”

Galper said that driving the anticipated trend will be hedge funds who want to go to lenders directly, rather than finagle with their prime brokers. Also driving the trend will inevitably be regulatory oversight of both sec lending and short selling, with the SEC and others recasting rules concerning leverage, margin requirements and how over-the-counter derivatives and other instruments are viewed and regulated.

AUM GrowthOf course, speculating on how the sec lending and prime brokerage businesses pan out over the next few years is all about what part of the industry you reside in. For their part, the prime brokers aren’t going to walk away from something that provides both value-added and makes them additional money. At the same time, non-prime broker service providers, in particular custodians and others who are either getting into or expanding their sec lending game, aren’t about to throw away an opportunity either.

There are also new ways to skin cats, so to speak — ways of doing the long/short game that so far only third parties and less-known markets can accommodate.

One thing is for sure: the Lehman debacle – in particular the Lehman UK debacle – has made the entire alternatives industry re-think how it looks at sec lending, and how best orchestrate it safely, securely and cost-efficiently.

The prime brokers that offer it up as value-added service at competitive rates likely won’t have much to worry about. The only thing they’ll need to get used to is some additional competition.

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.