Stocks – Page 143 – The Aleph Blog

Speculation Away From Subprime, Compendium

Posted on 3 August 2007 by David Merkel

Subprime lending is grabbing a lot of attention, but it is only a tiny portion of what goes on in our capital markets.? Tonight I want to talk about speculation in our markets, while largely ignoring subprime.

I have grown to like the blog Accrued Interest.? There aren?t many blogs dealing with fixed income issues; it fills a real void.? This article deals with bridge loans; increasingly, as investors have grown more skittish over LBO debt, investment banks have had to retain the bridge loans, rather than selling off the loans to other investors.? Google ?Ohio Mattress,? and you can see the danger here.? Deals where the debt interests don?t get sold off can become toxic to the investment banks extending the bridge loans.? (And being a Milwaukee native, I can appreciate the concept of a ?bridge to nowhere.?? Maybe the investment bankers should visit Milwaukee, because the ?bridge to nowhere? eventually completed, and made it to South Milwaukee.? Quite an improvement over nowhere, right? Right?!? Sigh.)
Also from Accrued Interest, the credit markets have some sand in the gears.? I remember fondly the pit in my stomach when my brokers called me on July 27th and October 9th, 2002, and said, ?The markets are offered without bid.? We?ve never seen it this bad.? What do you want to do??? I had cash on hand for bargains both times, but when the credit markets are dislocated, nothing much happens for a little while.? This was true after LTCM and 9/11 as well.
I?ve seen a number of reviews of Dr. Bookstaber?s new book.? It looks like a good one. As in the last point, when the markets get spooked, spreads widen dramatically,and trading slows until confidence returns.? More bad things are feared to happen than actually do happen.
I?m not a fan of shorting, particularly in this environment.? Too many players are short without a real edge.? High valuations are not enough, you need to have an uncommon edge.? When I short, that typically means an accounting anomaly.? That said, there is more demand for short ideas with the advent of 130/30 and 120/20 funds.? Personally, I think they are asking for more than the system can deliver.? Obvious shorts are full up, and inobvious shorts are inobvious for a reason; they aren?t easy money.
From the ?Too Many Vultures? file, Goldman announces a $12.5 billion mezzanine fund.? With so much money chasing failures, the prices paid to failures will rise in the short run, until the vultures get scared.
Finally, and investment bank that understands the risk behind CPDOs.? I have been a bear on these for some time; perhaps the rapidly rising spread environment might cause a CPDO to unwind?
Passive futures as a diversifier made a lot of sense before so many pension plans and endowments invested in it.? Recent returns have been disappointing, leading some passive investors to leave their investments in crude oil (and other commodities).? With less pressure on the roll in crude oil, the contango has lessened, which makes a passive investment in commodities, particularly crude oil, more attractive.
Becoming more proactive on ratings?? I?m not holding my breath but Fitch may be heading that way on CMBS.? Don?t hold your breath, though.
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.
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.
Perhaps Babak at Trader?s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
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.
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.
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.
Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
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.
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.
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.
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.
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).
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.
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.).
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.
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.
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.
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.
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.
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.
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?
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.
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.
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.
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.
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.
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 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.

Deerfield: A Difficult Rebalancing Trade

Posted on 2 August 2007 by David Merkel

The following things that I write are more risky than normal, and may be wrong.? If you decide to imitate what I have done, you are doing so at your own risk.? Please do your own due diligence.

I have bought more Deerfield Triarc [DFR] today @ $9.76.? A sharp-eyed reader noted (see the first comment) that DFR must have been past my rebalance point, and wondered why I hadn’t bought more.?? Truth is, I had been working on the issue for two weeks.? Whenever a security falls dramatically (it was close to a second rebalancing sell for me at one point), I do a review.? I don’t automatically do rebalancing buys when a company is under stress.

Okay, what gave me confidence to buy? DFR is levered; the main risk here is that they cannot continue to finance the positions that they hold.? Point one that gives me comfort is that the financing is likely secure.

Most of it is repo funding on prime mortgage collateral, most of which is floating rate.? Though there is a high degree of leverage there, the hedging inherent in managing such funding is a common skill.? You could contrast Deerfield and Annaly.? The collateral and leverage are similar; the main difference is that Deerfield uses swaps and floors to manage interest rate risk, and Annaly uses longer repo terms (1-3 years) than Deerfield (0-3 months).

The trust preferreds are not putable, and they lever up their alternative assets through CDO structures, which are not callable.? The risk there is that the equity and subordinate bonds that they hold could be worthless.? Unlikely, but a possible loss somewhere north of $50 million.? They also have warehouse lines, where assets are held prior to securitization.? I don’t know what might be in their warehouse lines now, but they did recently complete a securitization which freed up $230 million of those lines.? (Note: they couldn’t sell the BBB securities.)? The lines are capable of financing $375 million, and extend to April of 2008 at minimum.

Point two is that very little of the assets inside DFR’s CDOs are subprime.? The total risk to DFR is from the Pinetree CDO, which if they end up writing off the CDO equity, will reduce net worth by $12 million.? Not huge.

Point three is that they might not be able to consummate the merger with Deerfield? Capital Management [DCM], since DFR has to pony up $145 million.? I find it unlikely that they could not get the financing for what is a profitable asset where Debt/Operating Income is around 6.? But even if they can’t do the deal, that does not affect DFR, except that they don’t get to purchase an asset manager at a bargain price, which is even more of? bargain now, given that the stock price has fallen, and the deal terms (half stock, half cash) don’t adjust.

Point four is might the deal terms adjust?? Couldn’t DCM allege a material adverse change, and try to get the terms changed?? It’s a little late for that.? The DFR shareholders meeting is one week from today.? Besides, many of the same problems facing DFR are facing DCM.

Point five is that much of what DCM manages are ABS CDOs.? Much of the ABS collateral is subprime residential mortgages.? (For more details, here is an S&P report from last year.) Now, aside from about $20 million of investments in the CDOs that they manage, they don’t have any more risk exposure.? There is the outside possibility that they could be removed as manager on some of the deals that they manage, but that doesn’t happen often.? The current market environment could have a negative impact on their ability to issue more ABS CDOs and other CDOs, but once things clear up, those that? are still in the game of issuing CDOs will make much better interest spreads than they made in the last two years.

In summary, why did I buy more?

The losses look limited, if they occur at all
The financing seems secure
Exposure to subprime losses are small, and
I think the deal goes through.

Could I be wrong on some of these points and lose badly?? Yes.

Full disclosure: Long DFR

More Slick VIX Tricks

Posted on 1 August 20072 August 2007 by David Merkel

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):
What 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.

Is the S&P 500 30% undervalued?

Posted on 31 July 200720 June 2017 by David Merkel

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?

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)

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.

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. (S_n 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.

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:

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.

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

Posted on 30 July 2007 by David Merkel

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

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.
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).
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.
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.).
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.
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.
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.
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.
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.
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

Posted on 28 July 200729 July 2007 by David Merkel

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:

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.
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.
Perhaps Babak at Trader’s Narrative would agree on the likelihood of a bounce, with the put/call ratio so high.
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.
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.
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.
Along those same lines, if investment grade corporations continue to put up good earnings, this decline will reverse.
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.
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.
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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Book Review ? An American Hedge Fund by Timothy Sykes

Posted on 28 July 20075 September 2007 by David Merkel

An old boss of mine once said that in the investing world, it paid to do favors for people, because you can never tell what good will come from it. I have read an advance copy of Timothy Sykes? forthcoming book, An American Hedge Fund.

Aside from our common love of investing, it is hard to find similarities between Mr. Sykes and me. He trades rapidly and aggressively; I trade infrequently. He relies on momentum; I resist momentum. He became a professional investor early in life, and has always worked for himself; I became a professional investor later in life (38), and have always worked for others. Loss control for Mr. Sykes is a fast hand on the sell button (or the buy button if he is short); for me it is diversification, margin of safety, etc.

I have always maintained that there is something to be learned from analyzing those that do not invest like I do, particularly if they are successful by means that strike me as unlikely. I learned seven lessons from the book:

1) One thing that I share with Mr. Sykes is understanding where my edge is. Early on, Timothy Sykes figured out that he had an advantage in analyzing the technicals in micro-cap stocks. He pressed that advantage assiduously, and did exceptionally well, though with significant pullbacks.

2) Another thing that I share with him is that I don?t give up easily. He persevered through some drawdowns that would make most people give up.

3) The book helps reinforce the lesson of sticking to your edge. If you?re a momentum guy, don?t try to be a fundamental investor, and vice-versa. Once you know your edge, stick to it. If you don?t, your results will likely suffer.

4) Another lesson that the book holds is the psychological differences in running other people?s money. It ain?t easy; risks that you are comfortable taking for yourself, you might not be comfortable taking for others.

5) As a professional, one must investigate the carrying capacity of the edge that you employ. How much money can you run before your strategy stops working?

6) Is a great investment strategy and track record enough to start an investment firm? Early money is hard to come by. There are many who contribute only when a firm is obviously successful, and few that will contribute to a fledgling firm. Also, good fund marketers are hard to come by at a reasonable price, if they exist at all. So far in my life, I haven?t met one.

7) The last lesson: do what you are good at; do what you love, but recognize realities. There are times when opportunity knocks, and times when it doesn?t. Pursue the advantage you see in front of you, until a better advantage presents itself.

In summary, I enjoyed An American Hedge Fund. Through the lens of Timothy Sykes, I got to see the creation of an investment process, a hedge fund, and all the difficulties that go along with it.? The book is available for purchase at Amazon.com.

Insurance Earnings So Far 2Q07 ? Part V

Posted on 28 July 200728 July 2007 by David Merkel

We’re not even midway through earnings season for insurance, and I have a dirty secret to share: Insurance stocks are down on the year on average. 🙁 What a scandal, particularly for an industry with little ties to the sectors in the market with the most credit stress.

Here’s the most recent file on insurance stock performance at earnings. Here are the main lessons, so far:

Beating earnings by 10% leads to beating the price performance of the index by about 1%.
Brokers and Commercial Lines are doing the best so far.
Positive price performance is associated with growing revenues, and rising guidance.
With the credit furor going on, it is no surprise that financial insurers are doing the worst of all of the subgroups.
Asset sensitive life insurers are faring badly in the face of good earnings, because with the fall in the equity markets, insurers might have lower asset based fees coming.

Looking at Eleven of my Indicators

Posted on 27 July 2007 by David Merkel

I may or may not get to my part 2 on speculation because of the market action today.? I will get to that tomorrow.? Today I think it would be best for my readers if I just run through my market indicators.? Here goes:

My knockoff of a famous oscillator indicates that we are ready for a short-term bounce.? That bounce may have started at 3PM yesterday, when volume climaxed near the low of the day.? That biases me long in the short run.
On the other hand, the VIX under-reacted to the fall yesterday, indicating that not enough player reached for puts to hedge their positions.
The Merger Fund has had a bigger correction than in February-March.? It is likely due to difficulties with deal financing.? Nonetheless, it is an indicator of how the gears of the market are jamming up.
Bond volatility, whether measured by the MOVE or LBOX indexes, indicate a more volatile environment.? No surprise that prime mortgage securities have been hit.
Credit spreads have widened dramatically.? Yields are another matter.? With the fall in Treasury yields, yields on bonds single-A and above have fallen in yield, whereas bonds BBB and below have risen in yield.? High credit quality corporations have a real advantage in this market.
The emerging markets have gotten whacked, wholesale.
The Euro and Yen are strong, and looking at falling forward interest rate differentials, threaten to get stronger.
There is some liquidation happening in some carry trades.? The New Zealand Dollar has gotten whacked versus the yen over the past two days.? In general, the last three days have differentiated between countries with weak trade positions, and those with strong positions.
Closed-end floating rate bank loan funds have gotten hammered recently.? Another casualty of the LBO financing problem, but worse than the raw economics of the funds would indicate.? Prices are falling much harder than NAVs.
The FOMC seems tight at present, with Total Fed Credit growing slowly.? Fed funds has missed the target on the upside on average since the last meeting, and no permanent open market operations have happened.
Equity and mortgage REITs have both been hit, with equity REITs hit harder (but still expensive), and mortgage REITs nearer to fair value on average.

That’s all for now.? In general, we are oversold, and should get a bounce Friday or Monday.? I favor Friday. This bounce will be short-term in nature, so don’t put a lot of long exposure on for now.

Insurance Earnings So Far 2Q07 ? Part IV

Posted on 26 July 2007 by David Merkel

Insurance stocks got hit as hard today as on Tuesday.? In general, though, away from financial insurers, earnings have been pretty good.? Here’s the file with the data for this earnings season so far.? I’ve added a chart, showing how much price outperformance generally happens from beating earnings.? General findings so far:

Beating earnings by 10% leads to beating the price performance of the index by about 1%.
Brokers and Commercial Lines are doing the best so far.
Positive price performance is associated with growing revenues, and raising guidance.
With the credit furor going on, it is no surprise that financial insurers are doing the worst of all of the subgroups.

Of the companies reporting that I own, both beat estimates.? Hartford is a well-run battleship of a company, very well balanced.? Aspen had fewer UK flood claims than the market feared, but who can tell about 3Q?? With a growing top line, looks promising for the future.

Full disclosure: long AHL HIG