Category: Macroeconomics

The Great Substitution of Equity for Debt, Formerly Led by Private Equity

The Great Substitution of Equity for Debt, Formerly Led by Private Equity

When I do a review of links, I try not to do a linkfest, as much try to share my ideas, while annotating places where you can get more data.? I keep topical clipping folders.? Today’s review is on the Great Substitution of Equity for Debt, Formerly Led by Private Equity.? Usually I organize by subtopic when I write, but tonight I will do it by time, because it took me seven weeks to get back to this, and a lot has happened over those weeks.

Go back to mid-June.? 10-year Treasury rates were challenging 5.25%.? Rates all over the world had risen, and some predicted they would go higher, and choke off the private equity boom.? In hindsight, not a good argument, not because Treasury yields fell, but because junk credit spreads are more critical to private equity than treasury and high-grade yields.? In the short run, junk debt yields don’t react much to Treasury yields.? So most didn’t worry at the time.

Give Andy Kessler credit for timing. He expresses skepticism for private equity before Blackstone comes public, suggesting that all they do is borrow money against the assets of the target companies, and then foist them on the retail public later.? Well, that’s not all of what private equity does, but to a first approximation, that’s 90% of the deal.? He takes both sides of the issue, suggesting that conditions are stretched from a valuation standpoint, but suggesting that the insanity could go on for a while longer.

Failed deals often represent turning points, and by the end of June, both Thomson Learning and US Foodservice pulled their debt deals. The appetite for yield had diminished considerably, versus the need to protect capital.

In the short run though, the market is bouncy, and more deals piled up into early July, even as junk spreads began to widen.? I love the closing quote in this WSJ article: “It’s all worth keeping in mind as the market hits its rough spots. Roger Altman, chairman of Evercore Partners points out, for instance, that by any historical measure, the interest rates for junk bonds remain very cheap.? Barring a very steep climb in rates, Mr. Altman says, private equity ‘is a permanent feature of the capital markets. Nothing foreseeable can change that.'”? Mr. Altman is a bright man, no doubt, but turning points are only clear in hindsight.

Now, 2007 had already surpassed 2006 for private equity deals. Maybe completed deals are another issue.? Going to something more mundane, Mark Hulbert points out some research showing that companies that buyback their stock outperform the market.

By mid-July sentiment was definitely shifting in the debt markets, even as the equity markets rose.? More deals were having trouble getting done.? The willingness of lenders to take risk was declining, particularly on PIK bonds and Toggle notes.? Personally, I find it amazing that high yield investors buy instruments that may not pay interest in cash, given the dismal credit experience of such structures.? What would you expect from a company that doesn’t have enough money to make interest payments in cash?

The next article is a vision of the future. Five or so years from now, who will buy all of the new IPOs generated from today’s flood of private equity?? Then again, with the over-borrowing to make deals work, maybe not so many will come to market in the future, at least, not at the size that they left.

Take a look at the seven bad times to buy equities from John Hussman.? The last five of them came at times when the “Fed Model” would have told you to be in bonds.? The first two were close, but in the long haul, one was better off holding common stock through the declines.

By mid-July, we are a little past the recent peak, and buybacks are taking the place of LBOs in the market for shrinkage of the supply of equity.? With investment grade bond yields falling from mid-June, it seems like a reasonable thing to do.

I would never want to be a dedicated short investor.? Shorts are perpetually short the capital structure option, which the equity holders can exercise to lever up, when it is to their advantage to do so.? In this article, the difficulties of being short are explained, with the risks of private equity buyouts, and getting crowded out by naive shorts running 130/30 funds.? Jim Griffin at RealMoney takes an allied approach, suggesting that with equity getting replaced by debt, that equities are possibly a good deal here.

With rising junk spreads in the credit markets, by late July the buyer of choice for takeovers had become investment grade corporations because they could finance the purchase cheaply.? Private equity had gone quiet.? Things were bad enough, that investment banking bridge lenders wondered whether it wouldn’t be cheaper to drop out and pay the breakup fee on Texas Utilities rather than fund the deal personally.? The potential losses from many deals were mounting at the investment banks.? 46 deals had been pulled, versus zero in 2006.

So private equity is dead now, right?? I see it more as a sorting process.? Deals that make economic sense at higher lending rates will get done, and those that don’t make sense will be funded by the investment banks, or shelved for now, depending on the bridge lending deal terms.? It won’t be as big of a force in the market, but buybacks among investment grade corporations will continue to shrink the overall equity supply of the market for now.? I am still a moderate bull on the equity market.

Dissent on the Significance of the Bear Stearns Call

Dissent on the Significance of the Bear Stearns Call

Bond Market Last Two WeeksI know that Cramer and many others consider the news from the Bear Stearns call to be the financial equivalent of nuclear meltdown, but it’s not true: Exhibit 1 is the graphic above from The Wall Street Journal (full story here). If you look closely at the graph, junk bonds had a small positive return last week. That would not be true in a crisis.

So what is the crisis? The crisis is in the exotic stuff.

  • Subprime ABS [asset-backed securities]
  • Credit default swaps and other derivatives on Subprime ABS
  • CDOs that contain Subprime ABS and certain high yield bonds and loans
  • LBO debt that some of the investment banks are stuck with.
  • Some high yield bonds and loans on deals that got done before the music stopped
  • Derivatives on broad classes of instruments like LCDX and CMBX.

But for the most part, for most high yield debt, almost all investment grade debt, and vanilla structured securities, the market is functioning. If anyone knows differently please contact me.Natively, I tend to be a skeptic and a bear. But I try to be a realist above all. I was managing a large portfolio of corporate bonds 2001-2003, and a large portfolio of CMBS (with a little ABS and RMBS) from 1998-2001. In 2002, the investment grade bond market shut down briefly on the mornings of two days, in July and October. (I remember my favorite broker saying to me each time, “The markets are offered without bid. What would you like to do? I had spare capital for the occasion and offered enough lowball bids to satisfy the extreme liquidity needs of the frightened.) At that time, the VIX and other systemic risk variables were thorough the roof. Those variables aren’t there now. After 9/11, the whole fixed income market was closed for five days, and even once it re-opened, it took two weeks to approach anything near normal. (People told me I was courageous/stupid to offer lowball bids on day two after the market reopened. They turned out to be good trades. I have stories from that period… as a bond manager, I am at my best in crisis mode.)

In 1998, when LTCM blew up, the bond market shut down. Only the highest quality stuff traded for about three weeks. I remember buying some AAA CMBS for almost 2% over Treasuries. We aren’t there at present; not even close.

Bear Stearns can make the statements that they did because they have a concentration in areas that are affected. They also want to make it look like as much of a market problem as possible, and not a Bear Stearns problem. For Bear Stearns, this very well could be the worst bond market for them in 22 years. Just not for the Street as a whole, at least not yet.

I write this not to make people bullish, but just to point out that characterizing the bond market as a whole is tough, and that things are rarely as bad as they seem. From my angle, I will say that I have seen it worse.
PS — A final note. After any crisis, how does the fixed income market comes back? It start with trading of bonds that are high quality, high simplicity, and short in duration. As the crisis abates, bond managers get tempted by the high yields of bonds that are lower in quality, lower in simplicity, and longer in duration. As the risk appetite expands, eventually the whole bond market comes back.

The FOMC as a Social Institution

The FOMC as a Social Institution

There are many crying for the FOMC to cut rates, and soon.? I will use Babak’s unusual endorsement of Cramer as an example.? (I like both of them, but I disagree here.)

Because of the unusual structure of the FOMC, it is difficult to bring change rapidly.? The regional banks governors represent their areas, and if no one is hurting, they are unlikely to suggest loosening.? Those appointed by President Bush are moderate inflation hawks, and will need to hear how the real economy is suffering before they decide to act.? A mere financial crisis where we aren’t even in a bear market yet is not enough to goad action, particularly when none of the major commercial (not investment) banks are under threat yet.

Tell me, what regulated depositary institution is under threat at present?? Those are what the Fed cares about.? They could care less if hedge funds and non-bank lenders go under, so long as the banks aren’t affected.? Failures of non-bank lenders help the Fed in monetary policy, as less lending is outside of their control.

I don’t see the FOMC loosening in 2007.? That was a non-consensus view in December 2006, when I first said it, which became consensus (and I worried), and is now no longer consensus any more.? Inflation is still a threat, the real economy is not weak, but the FOMC does not want to tighten, because of risks in the financial markets.? We stay on hold, though the FOMC may soften language, as a sop to the financial markets.

Speculation Away From Subprime, Part 4

Speculation Away From Subprime, Part 4

A smaller piece to end this series.? If you have read all four parts of the series, you won’t need to read the compilation post that I am putting together for Barry Ritholtz at The Big Picture, so that he can use it in his linkfest.

  1. Regarding 130/30 funds, particularly in an era of record shorting, I don’t see how they can add a lot of value.? For the few that have good alpha generation from your longs, levering them up 30% is a help, but only if your shorting discipline doesn’t eat away as much alpha as the long strategy generates.? Few managers are good at both going long and short.? Few are good at going short, period.? One more thing, is it any surprise that after a long run in the market, we see 130/30 funds marketed, rather than the market-neutral funds that show up near the end of bear markets?
  2. Investors like yield.? This is true of institutional investors as well as retail investors.? Yield by its nature is a promise, offering certainty, whereas capital gains and losses are ephemeral.? This is one reason why I prefer high quality investments most of the time in fixed income investing.? I will happily make money by avoiding capital losses, while accepting less income in speculative environments.? Most investors aren’t this way, so they take undue risk in search of yield.? There is an actionable investment idea here!? Create the White Swan bond fund, where one invests in T-bills, and write out of the money options on a variety of fixed income risks that are directly underpriced in the fixed income markets, but fairly priced in the options markets.? Better, run an arb fund that attempts to extract the difference.
  3. Most of the time, I like corporate floating rate loan funds.? They provide a decent yield that floats of short rates, with low-ish credit risk.? But in this environment, where LBO financing is shaky, I would avoid the closed end funds unless the discount to NAV got above 8%, and I would not put on a full position, unless the discount exceeded 12%.? From the article, the fund with the ticker JGT intrigues me.
  4. This article from Information Arbitrage is dead on.? No regulator is ever as decisive as a margin desk.? The moment that a margin desk has a hint that it might lose money, it moves to liquidate collateral.
  5. As I have said before, there are many vultures and little carrion.? I am waiting for the vultures to get glutted.? At that point I could then say that the liquidity effect is spent. Then I would really be worried.
  6. Retail money trails.? No surprise here.? People who don’t follow the markets constantly get surprised by losses, and move to cut the posses, usually too late.
  7. One more for Information Arbitrage.? Hedge funds with real risk controls can survive environments like this, and make money on the other side of the cycle.? Where I differ with his opinion is how credit instruments should be priced.? Liquidation value is too severe in most environments, and does not give adequate value to those who exit, and gives too much value to those who enter.? Proper valuation considers both the likelihood of being a going concern, and being in liquidation.

That’s all for now.

More Slick VIX Tricks

More Slick VIX Tricks

Tonight’s article will be less mathematical, and more qualitative than last night’s article. Last night I did say:

The relationship of the VIX to the S&P 500 is an interesting one, one that I have studied for the past nine years. Over that time, I have used the relationships to:

  • Design investment strategies for insurance companies selling Equity Indexed Annuities.
  • Estimate the betas of common stocks. (Not that I believe in MPT?)
  • Trade corporate bonds.
  • Gauge the overall risk cycle, in concert with other indicators.

Investing to Back Equity Indexed Annuities

Let me talk about these applications. Equity indexed annuities [EIAs] are tricky to design an investment strategy for. Typically they contain long guarantees, say ten years or so, where the minimum payoff must be guaranteed. That payoff is typically 90% of the initial premium plus 3% compound interest. The optimal strategy invests 80% or so of the money to immunize that guarantee, while using the other 20% to invest short to pay for option premiums that match the payoff pattern promised in the EIA.

But here’s the problem. The forward market for 1-year implied volatility doesn’t exist in any deep way, so the insurance company decides that it will have to take its chances, and assume that volatility will mean revert over longer periods of time. Also, they try to build in enough policy flexibility that they can less favorable option terms to policyholders during times of high volatility (at the risk of higher lapsation). Certain bits of actuarial smoothing in the reserves can also be useful in assuming mean reversion. But what happens if volatility rises high and stays there a while? Unfortunately, that tends to be the same time when credit spreads are wide, because option implied volatility is positively correlated with credit spreads. So, at the time that the strategy needs the most help, option costs are high (or payouts are chintzy and lapse rates go up), and corporate bond prcies sag due to wider spreads.
If the insurance company can handle the lack of incremental income, investing in higher credit quality instruments in tight spread low implied volatility environments can mitigate the risks. The benefit to such a strategy is that in a higher spread and implied volatility environment, you can do a down-in-credit trade (lower credit quality) at the time that it is being rewarded. This takes real courage and foresight on the part of the insurance management team to manage this way, but it pays off in the long run. (Which is why the strategy doesn’t usually get used…)


Corporate Bonds Generally

On my monitor screens, I keep three things front and center: the S&P 500, the long bond, and the VIX. This served me well in 2001-2003 when I was a corporate bond manager. After 9/11, we did a massive down-in-credit trade, buying all of the industries that were out of favor because of fears of terrorism. This is the only time I can remember when our client, who never said “no” to incremental yield, told us to hold back. We were almost done anyway, but in the depths of November 2001, we questioned our own sanity. Then, as implied volatility fell, credit spreads did as well, and the prices of our bonds rose, so in the spring of 2002, we reversed the trade and then some. We were in great position for the double bottoms that happened in July and October of 2002. We played the risk cycle well. Following equity volatility aided structural management of the corporate bonds.
When implied volatility was so high, and volatile, I would use the S&P 500 and the VIX to aid the timing of my trades. When the S&P was falling, and the VIX rising, and the long (Treasury) bond rising in price and falling in yield, I would wait until the S&P 500 would level off, and the VIX begin to fall a little. Then I would buy the corporates that I had been targeting. I would get good executions because of the dourness of the day, but more often than not, the market would turn an hour after I bought as corporate spreads would begin to tighten in response to the better tone from the equity markets and implied volatility.Though we were a qualitative credit analysis shop, I would have analysts review companies when their stock price had fallen by more than 30% since the purchase of the bond, and where the equity’s implied volatility had risen by more than 30%. This test flagged Enron, and others, before they collapsed. Not everything that fits those parameters is a sell, but they are all to be reviewed.

One aspect of the bond market that outsiders don’t know about is that when it gets frothy, deals come and go rapidly. Some get announced and close in as little as seven minutes. Speed is critical at such times, but so is judgment on how fairly the deal is priced. When the market is that hot, a corporate bond manager does not have time to ask the credit analyst what he thinks about a given company. I developed what I called the one-minute drill, which when I explained it to my analysts, fascinated them. Using a Bloomberg terminal, I would check the equity price movement over the last twelve months (red flag — down a lot), equity implied volatility (red flag — up a lot), balance sheet (how much leverage, and what is the trend?), income statement (red flag — losing money), cash flow statement (red flag — negative cash flow from operations), and the credit ratings and their outlooks. I can do that in 30 seconds to a minute at most, giving me ample time to place an order, even if the deal closes seven minutes from its announcement. I told my analysts that I trusted their opinions, but in the few weeks that we might hold the bonds while they were working out their opinion, if I didn’t have any red flags, it was safe to hold the bonds for a month off of the one minute drill. If the analyst didn’t like the bonds, typically I would kick them out for a small gain.
For those with access to RealMoney, I recommend my articles on bonds and implied volatility. Changes in Corporate Bonds, Part 1 , and Changes in Corporate Bonds, Part 2.


Estimating Beta

You can estimate beta using the VIX. Here’s how: start with the Capital Asset Pricing Model (ugh), and apply a variance operator to each side. After simplification, the eventual result will be (math available on request):
BetaWhat this means is that the actual volatility of the individual stock is equal to the square of its beta times the actual volatility of the market portfolio, plus the firm-specific variance. Now, one can estimate this relationship using a non-linear optimizer (Solver in Excel can do it), regressing actual market volatility on the volatility of the individual firm, allowing for no intercept term, and constraining the errors to be positive, because firm specific variance can’t be negative. In place of actual volatility, implied volatility can be used, because the two are closely related.
I played around with this relationship and found that it yielded estimates of beta that I thought were reasonable. It’s a lot more work than the ordinary calculation, though. The estimate might be more stable than that from using returns.

Gauging the Overall Risk Cycle

When I look at systemic risk, the VIX plays a big role. Other option volatilities are valuable as well, bond volatilities, swaption volatilities, currency volatilities, etc. Also playing a role are credit spreads in the fixed income markets. Together, these help me analyze how much risk is being perceived in the market as a whole. I don’t have a single summary measure at present; different variables are important at different points in the cycle.


Profitable Trading Rules

I think that there are no lack of profitable trading rules for the S&P 500 from the VIX. But you have to choose your poison. Absolute rules tend to have few signals, and require holding for some time, but are quite profitable. Here’s an example: Buy the S&P 500 when the VIX goes over 40, and sell when it drops below 15. Relative rules tend to have more signals, and don’t require long holding periods, but are modestly profitable on average, with more losing trades. Example: buy when the VIX is over its 50-day moving average by 50%, and sell when it is less than the 50-day moving average.

I don’t use any of those rules for my investing, but I do watch the VIX out of the corner of my eye to help me decide when conditions are are more or less favorable to put on more risk. Along with my other variables for tracking the risk cycle, it can aid your investment performance as well.

For Wonks Only — The Math of Volatility Mean-Reversion

For Wonks Only — The Math of Volatility Mean-Reversion

I’ve estimated a number of mean-reverting models in my time. I had one of the best dynamic full yield curve models around in the mid-90s. The investment department at Provident Mutual said it was the first model that was not artificially constrained that behaved like the yield curve that they knew.


In yesterday’s article, I mentioned that I could give math behind estimating mean-reversion of volatility. In order to do the regression to estimate mean-reversion, we use a lognormal process, because volatility can’t be negative.

Mean Reversion 1

Taking the logs of both sides:

Mean Reversion 1.1

Alpha is the drift term, that will help us calculate the mean reversion level, beta is the daily mean reversion speed, and epsilon is a standard normal disturbance term.  Assume that there are no more random shocks, so that the volatility returns to its equilibrium level, which implies:

Mean Reversion 1.2

Substituting into the log-transformed equation, we get:
Mean Reversion 2

where V-bar is the mean reversion level for volatility. From there, the solution is straightforward:

Mean Reversion 3

Mean Reversion 4

Mean Reversion 5

From my regression, alpha equals 0.046000, and beta is 0.98436. That implies a mean reversion target of 18.937, and that volatility moves 1.564% toward the mean reversion target. One last note: the standard deviation of the error term was 6.3383%, which helps show that in the short run, the volatility of implied volatility is a larger effect than mean-reversion. But in the long-run, mean-reversion is more powerful, because with the law of large numbers, the average of all the disturbances gets closer to zero.

Is the S&P 500 30% undervalued?

Is the S&P 500 30% undervalued?

The relationship of the VIX to the S&P 500 is an interesting one, one that I have studied for the past nine years. Over that time, I have used the relationships to:

  • Design investment strategies for insurance companies selling Equity Indexed Annuities.
  • Estimate the betas of common stocks. (Not that I believe in MPT?)
  • Trade corporate bonds.
  • Gauge the overall risk cycle, in concert with other indicators.

If there is interest on the part of readers, I can go into the details of any of the above. Perhaps that could be the basis for future articles in this series. Today?s article is on the following relationships:

  • The relationship of percentage changes in the old VIX to percentage changes in the S&P 500.
  • The relationship of the old VIX to the new VIX.
  • How quickly does the VIX mean revert, and
  • The relationship of the VIX to price levels of the S&P 500.
  • Maybe there will even be some hints at profitable trading rules. 🙂

The relationship of percentage changes in the old VIX to percentage changes in the S&P 500

I have a rule of thumb that I calculated a long time ago that the percentage change in the old VIX (and the new VIX, almost) is usually about ten times the percentage change in the S&P 500, and with the opposite sign. Well, I went and re-estimated the relationships. What do they look like?

Chart 5

The best fit line almost goes through the origin, and the slope is ?0.0993. Inverting that, the value for my rule of thumb is 10.07. (Hey, that?s pretty close!) The best fit line explains about 50% of the variation in changes in the S&P 500.

I used the Old VIX because the data goes all the way back to the beginning of 1986, versus the new VIX, which starts at the beginning of 1990.

The relationship of the old VIX to the new VIX

I think differences in the two measures can be overstated. The two measures are 98.6% correlated. This equation describes the relationship:

New VIX = 2.04 + (Old VIX * 0.86)

Chart 6

The relationship is tighter when the VIXs are low, and gets a touch looser when the VIXs gets higher (no surprise, many relationships get strained in volatile times. That also implies that percentage changes in the new VIX should be about 86% of the changes in the old VIX, so my rule of thumb applied to the new VIX would be, ?The percentage change in the new VIX is usually about 8.6 times the percentage change in the S&P 500, and with the opposite sign.? Still close to 10. I can live with that.

How quickly does the VIX mean revert?

Back in 1998, when I was developing my first generation old VIX / S&P 500 models, I came up with a statistic that said that the VIX mean-reverted to a level of 16, and it would tend to return at the rate of 20%/month, while being jolted by random disturbances pushing it to and away from the mean. The jolts are more powerful in the short run, but the mean-reversion is like gravity, inexorably pulling.

I have nine years more data now. Much of that time was a higher VIX era, so it is no surprise that the mean reversion target is 18.94. What is more interesting is that the reversion happens a little faster, at a rate of 28.2%/month, which means absent other disturbances, it closes half of the gap to the mean reversion target over 44 days. (Hey, pretty close to 50 days? could that be significant?)

This helps to show that snapback rallies after crises are so reliable in their appearance. Given the strength of the mean reversion effect in volatility, for the VIX to stay elevated for a long period of time requires a series of crises akin to what we had in 1998-2002.

Chart 2


I experienced the pain of that firsthand managing mortgage and then corporate bonds. Bond yield spreads are very highly correlated with the implied volatilities of stocks, and the yield spreads on bond indexes are highly correlated with the implied volatility on broad market equity indexes, like the VIX.

(Note for wonks: I estimated the mean reversion level (which is very close to the historic mean, no surprise) by regressing the one-day lagged Old VIX on the Old VIX itself. If you want how the math works on that, I can provide it, but it will make most readers go ?huh??)

The relationship of the VIX to price levels of the S&P 500

Finally, the most controversial bit. The S&P 500 tends to be lower than trend when the VIX is high, and higher than trend when the VIX is low. In equation form, it would look like this. (Sn is the S&P 500 at time n, and the same for V, the Old VIX. The V with a bar over it is the mean reversion target for the VIX.

Equation 1

In other words, the S&P tends to rise at a constant rate r, over time n, unless the VIX is above or below its long run average. Now, this is an oversimplification. I am using a very simple function form to allow me to come up with a result for now. There is probably some better functional form our there based off of Black-Sholes, or something like that, that wil do a better job. This is what I have for now.

Taking logs and simplifying, I get:

Equation 2

I know the S&P 500 and the old VIX over time, so I can estimate the parameters a, r, and e. The regression explains 88% of the variation in the S&P 500. a works out to be 4.94, which implies an S0 of 263.42, which is not far off from the actual starting value of 242.17. The rate of growth for the S&P 500, r, is 9.30% which is consistent with the actual result of 9.45% (not counting dividends, and running from 1987 to the present). Finally, e, the shape parameter on the old VIX is 21.5%. What this means is when the old VIX is double its mean-reversion target, the S&P 500 should be 16% above trend, and when the old VIX is half its mean-reversion target, the S&P 500 should be 14% below trend.

Chart 4

Wait, isn?t that backwards? How can a high VIX be associated a high price for the S&P 500, and vice versa for a low VIX? (I blinked when I first saw this, but the coefficients are statistically significant at a very high level.) This is my explanation: when the VIX is high, the equation anticipates mean-reversion, and so gives a value that reflects what the S&P will be worth once volatility mean reverts. Vice-versa for when the VIX is low.

What does that imply for today? Putting the old VIX closing value of 25.18 into the equation would predict an S&P 500 price of 1898.90, a little more than 30% above the current quote. Time to buy!

Limitations

Well, not so fast. This is a deliberately simplified model compared to the realities of the market. Does the S&P 500 go up 9.3% annually? No, but over a long period, it seems to. Do I have the right functional form for the effect of the VIX? No, but this equation will be right to a first approximation. What about interest rates? Couldn?t they be included as a valuation parameter? Sure, maybe in the next round. They certainly helped in the ?Fed Model.?

Don?t I have lookback bias here? If I were back in early 1987, would I think that the mean reversion target for the VIX should be 18.94? Maybe back then, but one would scratch his head in 1994, 2002, and 2006. The data fits very well inside the sample, but how well it will work in the future is always open to question. Every economic era is special, and blindly applying old parameters when the game might be changing is dangerous.

Possible trading rules

All that said, here are a number of trading rules that can be concocted from this study, and many work in hindsight. They boil down to buy when the VIX is high (panic), and sell when it is low (complacency). In future posts, I can work through a few of them, subject to the warning that data-mining can be hazardous to your financial health. (I have tried to pass through the data as few times as possible, but I have doubts?) I have found that being picky can generate big gains, but with few signals over long time periods (wait, isn?t that just the rise in the market?), and shorter-term systems generate many signals, but over short time spans, for small gains.

As an example of a system, you can look at Babak?s method using distance of the VIX from its 50-day moving average. 50 days? Close to the half-life mean reversion time. Looks like it can generate some good trades. Anyway, more later; hope you enjoyed this article.

Speculation Away From Subprime, Part 3

Speculation Away From Subprime, Part 3

More on speculation, while avoiding subprime which is still over-reported.

  1. How much risk do hedge funds pose to the financial system?? My view is that the most severe risks of the financial system are being taken on by hedge funds.? If these hedge funds are fully capitalized by equity (not borrowing money or other assets), then there is little risk to the financial system.? The problem is that many do finance their positions, as has been seen in the Bear Stearns hedge funds, magnifying the loss, and wiping out most if not all of the equity.
  2. There is a tendency with hedge funds to hedge away “vanilla risks” (my phrase), while retaining the concentrated risks that have a greater tendency to be mispriced.? I want to get a copy of Richard Bookstaber’s new book that makes this point.? Let’s face it.? Most hedging is done through liquid instruments to hedge less liquid instruments with greater return potential.? Most hedge funds are fundamentally short liquidity, and are subject to trouble when liquidity gets scarce (which ususally means, credit spreads rise dramatically).
  3. Every investment strategy has a limit as to how much cash it can employ, no matter how smart the people are running the strategy.? Inefficiencies are finite.? Now Renaissance Institutional is feeling the pain.? My greater question here is whether they have pushed up the prices of assets that they own to levels not generally supportable in their absence, simply due to their growth in assets?? Big firms often create their own mini-bubbles when they pass the limit of how much money they can run in a strategy.? Asset growth is self-reinforcing to performance, until you pass the limit.
  4. I have seen the statistic criticized, but it is still true that we are at a high for short interest.? When short interest gets too high, it is difficult but not impossible for prices to fall a great deal.? The degree of short interest can affect the short-term price path of a security, but cannot affect the long term business outcome.? Shorts are “side bets” that do not affect the ultimate outcome (leaving aside toxic converts, etc.).
  5. I’ve said it before, and I’ll say it again, there are too many vulture investors in the present environment.? It is difficult for distressed assets to fall too far in such an environment, barring overleveraged assets like the Bear Funds.? That said, Sowood benefits from the liquidity of Citadel.
  6. Doug Kass takes a swipe at easy credit conditions that facilitated the aggressive nature of many hedge funds.? This is one to lay at the feet of foreign banks and US banks interested in keeping their earnings growing, without care for risk.
  7. Should you be worried if you have an interest in the equity of CDOs?? (Your defined benefit pension plan, should you have one, may own some of those…)? At present the key factors are these… does the CDO have exposure to subprime or Alt-A lending, home equity lending, or Single-B or lower high yield debt?? If so, you have reason to worry.? Those with investment grade debt, or non-housing related Asset-backed securities have less reason to worry.
  8. There have been a lot of bits and bytes spilled over mark-to-model.? I want to raise a slightly different issue: mark-to-models.? There isn’t just one model, and human nature being what it is, there is a tendency for economic actors to choose models that are more favorable to themselves.? This raises the problem that one long an illiquid asset, and one short an illiquid asset might choose different values for the asset, leading to a deadweight loss in aggregate, because when the position matures, on net, a loss will be taken between the two parties.? For a one-sided example of this you can review Berky’s attempts to close out Gen Re’s swap book; they lost a lot more than they anticipated, because their model marks were too favorable.
  9. If you need more proof of that point, review this article on how hedge funds are smoothing their returns through marks on illiquid securities.? Though the article doesn’t state that thereis any aggregate mis-marking, I personally would find that difficult to believe.
  10. If you need still more proof, consider this article.? The problem for hedge fund managers gets worse when illiquid assets are financed by debt.? At that point, variations in the marked prices become severe in their impacts, particularly if debt covenants are threatened.

That’s all in this series.? I’ll take up other issues tomorrow, DV.? Until then, be aware of the games people play when there are illiquid assets and leverage… definitely a toxic mix.? In this cycle, might simplicity will come into vogue again?? Could balanced funds become the new orthodoxy?? I’m not holding my breath.

Speculation Away From Subprime, Part 2

Speculation Away From Subprime, Part 2

What a week, huh? Even with all of my cash on hand, I did a little worse than the S&P 500. One house keeping note before I get started, the file problem from my last insurance post is fixed. On to speculation:

  1. When trading ended on Friday, my oscillator ended at the fourth most negative level ever. Going back to 1997, the other bad dates were May 2006, July 2002 and September 2001. At levels like this, we always get a bounce, at least, so far.
  2. We lost our NYSE feed on Bloomberg for the last 25 minutes of the trading day. Anyone else have a similar outage? I know Cramer is outraged over the break in the tape around 3PM, and how the lack of specialists exacerbated the move. Can’t say that I disagree; it may cost a little more to have an intermediated market, but if the specialist does his job (and many don’t), volatility is reduced, and panics are more slow to occur.
  3. Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
  4. The bond market on the whole responded rationally last week. There was a flight to quality. High yield spreads continued to move wider, and the more junky, the more widening. Less noticed: the yields on safe debt, high quality governments, agencies, mortgages, industrials and utilities fell, as the flight to quality benefitted high quality borrowers. Here’s another summary of the action on Thursday, though it should be noted that Treasury yields fell more than investment grade debt spreads rose.
  5. Shhhhh. I’m not sure I should say this, but maybe the investment banks are cheap here. I’ve seen several analyses showing that the exposure from LBO debt is small. Now there are other issues, but the investment banks generally benefit from increased volatility in their trading income.
  6. Comparisons to October 1987? My friend Aaron Pressman makes a bold effort, but I have to give the most serious difference between then and now. At the beginning of October 1987, BBB bonds yielded 7.05% more than the S&P 500 earnings yield. Today, that figure is closer to 0.40%. In October 1987, bonds were cheap to stocks; today it is the reverse.
  7. Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
  8. Now, a trailing indicator is mutual fund flows. Selling equities and high yield? No surprise. Most retail investors shut the barn door after the cow has run off.
  9. Deals get scrapped, at least for now, and the overall risk tenor of the market shifts because player come to their senses, realizing that the risk is higher than the reward. El-Erian of Harvard may suggest that we have hit upon a regime change, but I would argue that such a judgment is premature. We have too many bright people looking for turning points, which may make a turning point less likely.
  10. Are we really going to have credit difficulties with prime loans? I have suggested as much at RealMoney over the past two years, to much disbelief. Falling house prices will have negative impacts everywhere in housing. Still, it more likely that Alt-A loans get negative results, given the lower underwriting standards involved.

We’re going to have to end it here. Part 3 will come Monday evening.

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