Are you having good ex?

Should the above not be vague enough for you I could always try to muddy the waters a little more and ask a few questions:

What is the best result when it comes to best execution?

Which client are you specifically referring to ?

MIFID has caused untold amount of headaches. I’m not here to re-hash them as I have probably already lost about half the people who clicked on this link.

Best execution could dimly be seen as a way for European regulators to clamp down on what they thought were cosy deals between broker and client where commissions, CSA payments, research budgets and benefits flowed between counterpart’s like fine wine at a bunga bunga party.

Admittedly there was largesse in the industry and some less than value added business practises. However from where I sat I wintessed MIFID bringing a great opportunity for the talented people that I worked day-to-day with to actually prove their worth. Both human and electronic (hi touch & low touch) trading standards have grown exponentially now that those teams responsible at the large brokers have the mandate to go and prove their worth. Rather than passively receiving flows from clients based on relationships or CSA agreements or what was known as “soft dollars.”

Soft dollars was an easy way to pay brokers for their overall contribution to you as a client. It was a recognition that its actually quite hard to value research provided on the universe of names that you are interested in. However to be critical it did not encourage the pursuit of excellence in a given area of broking.

What regulation has given with one hand it has also taken away with the other. Trading and execution standards have drastically increased with a laser like focus on costs, impact, trading styles and pre and post trade techniques that would make traders of old blush at their previous laissez fare style. PB financing agreements definitely seem more competitive but that is obviously hard to say on average across the industry due to the vastly different needs of all clients but from where I was sitting it seemed fair to me.

What has suffered is the research coverage. While it has always been a concern we are starting to hear more and more complaints from fundamental style investment firms where small cap names in particular are not receiving coverage from the large banks and therefore not only will they suffer and find it harder to grow but also the investments and liquidity in these names are declining. This too shall pass though as the finance industry has a way of adapting and providing value where value is sought. I envision an industry made up of small research providers similar to the law industry or medical practitioners, platforms like RSRCHXchange will continue to be a big winner here I feel.

I wont even talk about the regulatory cost pressure as that is well documented.

The main point here is what is best ex? As the title of this post was a salacious attempt to catch eyeballs – It seems appropriate to defer to the famous Judge Potter Stewart quote here ” Il know it when i see it.”

The two questions I asked at the start of this post is the best place to start. As I posed in a previous post https://everydayeconomicsblog.wordpress.com/2019/01/17/the-art-of-execution/ The Art of Execution best ex is a very personal matter.

Dividing best ex into two separate problem areas -External and Internal costs, we can attack the problem from two angles.

External costs:

Best ex from an external costs perspective is all about aligning your trading with brokers that can serve as the best medium for what you are trying to achieve. Negotiating lower trading commissions is not just a process of demanding a certain rate but rather working with your broker pro-actively and trying to look forward and quantify what level of business you are “likely” to produce this year based on informed estimates from previous years. As always data… data…and more data is key here. Put it down on paper and treat it like a business pitch, the more information you know about the characteristics of your own business and how its likely to evolve in the future is gold dust to a broker who can then make a decision about what levels they can profitably facilitate your business. Brokers are not a charity and have the same business pressures you and I have, as I have said before work with them and they will happily work with you.

PB and financing arrangements if you are employing leverage to your strategies are also a significant form of external cost. Again this is going to be driven by your behaviour, understand what you have done in the past and are likely to do in the future and then provide the information and you will receive much more dialogue and assistance in driving down these costs. but the information is key as the brokers needs to know what they are working with- remember you are renting their balance sheet in an industry where having a safe balance sheet is key to their regulators.

Internal costs:

This is where the bulk of the work must be done. Like I said brokers are the medium to which you achieve your business goals. Therefore the more you focus on Internal costs the better. Focusing on internal costs does not mean reducing headcount or slashing back on the coffee machine. What it means is thoroughly understanding the strategies you are employing and what is the best result in terms of execution to your company and strategies.

The investment management, hedge fund or trading landscape is both diverse and narrow in its approach. What works for one company is very unlikely to work exactly the same for another. There is no one size fits all approach to take. How can you employ the same execution styles for a HFT firm as you do for an institutional long only equity manager. While they are both trying to increase returns and make money on their investments their approach to doing things requires two drastically different styles of execution.

Determining what best ex is for your style is key to overall success and should look entirely different to how your neighbour views best ex.

Time for a basic example here:

Firm A is a institutional deep value money manager and wants to buy a large block of stock in a tech company which got severely de-rated in Q4 2018. They view this as an attractive entry point in a name that got away from them the previous year and they have been working on for some time. They are likely to hold this name for at least five years and under the best scenario will never have to sell it.

Firm B a multi-asset manager in the hedge fund space employs a catalyst driven manager who views the same company in a positive light and thinks the market has overdone this name to the downside and is looking for a +10% re-rating in the name after what she feels should be better than expected earnings. She is not in the name for a long time but rather a good time so to speak and is looking to apply her timing, trading and position sizing skills to best effect.

How do you buy stock for both of these managers to achieve best ex ? ? What even is best Ex to both of these managers and importantly their underlying client base??

Lets start by looking at some of the underlying motivations of each manager:

Firm A:

• Eager to deploy cash in a name they like after sitting on cash reserves waiting for a pullback ( So time is an issue to some extent)
• Looking to make a large investment in the name – likely many times the Average daily volume (ADV).
• Unlikely to be employing leverage and therefore financing costs are not that much of an issue.
• Looking to achieve a total return in the name over many years far in excess of what is likely to be the daily movements in the name over the short run.
• Aware that merely sitting on the order book trying to buy the stock in that size will trigger off “reactions” in the market and likely to spoil their own agenda.

Firm B:

• Eager to buy the name but has concerns over the current trend as feel might be counter trending a name.
• Looking to add to a book of levered trades – investment is likely to be a fraction of Firm A- but on a levered basis will have an immediate impact on PNL should there be a decent move (in either direction)
• Looking to make an absolute return over a short space of time of circa 10%.
• Size of the order is not as much of a concern as she has specifically chosen this name as the ADV can comfortably accommodate her usual trading “clip size”
• Likely to be out of this name directly after earnings and onto the next one.
• Does not want to pay hi-touch rates as the duration and risk of the trade could mean losing up to 40bps of the already expected tight return and if goes wrong compound the error more.

Lets just remember that both of the above have underlying clients again all with a different level of expectations. So again I pose the question how do you approach both trades in the same way to achieve best ex?

Only through a deep understanding of the nature of your strategies and what the “proclivities” of your flow tends to look like can you then sit down and determine what best ex means to the success of your overall firm. The challenge here is most trading desks have been downsized for various reasons and a one size fits all approach has dominated under the assumption of costs management rather than focusing on what I define as internal costs.

Efficient trade execution is a process of give and take. You cannot eliminate trading costs. Well thats not true…you can …dont trade. But no matter what your average duration of a trade looks like whether its miliseconds or forever, you have to come to market sometime. In my mind best ex comes from designing a trading strategy that takes some costs in one area in order to minimise the costs in the other but all in an attempt to get the best out of the actual strategy and therefore help boost returns. That is the ultimate goal of the company and more importantly the underlying investors, which ultimately is the raison d’etre of MIFID.

Doing so in a one size fits all approach can certainly reduce noise and seem efficient as algos buzz away and “process” a large magnitude of flow and may appear like best ex.  But digging deeper and taking both a quantitative and qualitative assessment of your flow can lead to actual best ex that is personal to the unique goals of your strategies and overall company. Everyone is always looking for an edge, I am a big fan of Sir Dave Brailsford management style of seeking an edge in the marginal gains. Improving each of your processes to achieve even a 1% improvement leads to overall success.

MIFID has undoubtedly been a pain, but mostly a necessary one, I think the response so far from both the broker and buy side community has been strong in terms of redesigning the trading architecture and processes. In my mind stage one is complete and rather than standing on the air carrier and declaring “mission accomplished” now its time to really push forward an drill into execution strategies to improve each one individually. The tools, platform and skills are there lets make sure we use them appropriately.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Art of Execution

Fair warning this is not a tweet ….I repeat this is not a tweet. Grab a coffee and settle in for a few minutes.

Having found some time on my hands I decided to document some thoughts on the state of play in the asset management industry specifically how it applies to trading. In my humble and for anyone who knows me, obviously very biased opinion execution trading has become an integral part of any asset management business. Conversely, although still seen as a cost it is in fact on the front line in protecting client’s assets in a world where returns have dwindled and squeezing every penny out of a trade has become more scientific and important. MIFID in my view while has been an administrative nightmare and logistical challenge has delivered a rapid change of approach to how trading is conducted. A much more scientific and professional approach has been adopted by both the buy and sell side and the reduction of related trading costs has been immense.

To some of us who have been around for more than a couple of years this is a big change and the temptation is to shake your head and tut tut at the state of play and lack of human interaction. To some it has been a de-skilling of dare I say it an art form developed over many years of long battles fought with order books, brokers and “the market” in general.  “Back in the war” a trader who was committed enough had to live a pretty high stress life and really immerse yourself in order book dynamics – there was an art to sniffing out whether you are the aggressor or is the bogeyman on the other side the aggressor and then adjust accordingly. That’s all trading in the short term is – who wants it more. The much vaunted “more buyers than sellers” has always raised a laugh and while obviously it’s silly it takes away from the important point of who is the “more motivated buyers than motivated sellers” or vice –versa.  Judging the panic or lack of panic in the opposing order is still a thing of beauty when executed correctly.

As with most industries you either adapt or die.

Now we have large trading volumes spread across the equity market mostly conducted by algorithms. The human element is gone or so most would say. But let’s not forget what an algorithm at its basest level is – a set of instructions designed by a human to process a task. We get lost in words sometimes and has been the case very much recently where big time money managers with great track records blame their poor performance on the “algos” like they are a living breathing thing. They are not – they are a set of instructions designed by a human. Understand that humans perspective and you will likely have a better clue of their algorithm and what it’s doing and why. Most of the brokers I have had relationships will attest to my very apparent reaction when they attempt to explain what their algo does and why it’s the best. A cloud comes over the room and I just want to know what the simple basis for what this algo does is. Is it trying to be aggressive or is it trying to be passive? Once I know that I know how to use it correctly, that is if I evn need to use it.

The “electronification” of the trading landscape and use of algorithms for executions has been vast. Why might this be the case? A variety of reasons come to mind:

Cost cutting: Asset managers and banks believe that using algorithms for doing a once human task is a cost saver. It’s hard to argue with this point on the face of it. In almost all industries labour has always been one of the largest costs of production and almost always been replaced by machinery where possible.  The finance industry was certainly no different and probably was one of the largest examples of largesse when it came to pay. I believe in paying for performance so in that respect I would argue that a lot of it was fair ….often mind boggling numbers but fair if they performed. Before I became a trader the desk that I serviced had somewhere close to 25-30 traders covering just large and mid-cap Pan Europe & UK, that’s not even counting the sales staff. That same desk probably has most likely less than ten now on a good day, at least 2-3 of which are likely to be grads. My most recent experience saw me conduct trading for over $200bln notional a year all on my lonesome and barely broke a sweat. So fair enough you have reduced headcount and most likely increased efficiency. However the costs don’t just go away I’m afraid. There is a huge tech spend associated with all this electronic trading. Data, its storage and use does not come for free either. While this is decimating the mid-tier brokerage industry the large or bulge bracket banks have responded in my view brilliantly to this changing landscape and invested heavily in their trading architecture, some more so than others but that an argument for a different day. It’s fair to say that there are 9 banks worthy of taking on large electronic trading volumes – five of which will be the eventual “winners”.

Consolidation of assets: While there were always mega pension or mutual funds back in the day – the growth in AUM of a concentrated bunch of asset managers has been mind boggling. We all know the names of the people I’m talking about – and they exist in hedge fund, ETF and pension fund space. While you will hear many complaining about how regulation has killed the industry most of the people at these mega funds must be crying out for “more more more” as the barriers to entry have increased significantly in the asset management industry. Had it not been for electronification of the industry all those traders I serviced back in the day would have merely moved from the sell side to the buy side and shifted that cost base from one to the other. Adapt or die, AUM of a large magnitude correlates pretty strongly to an enormous amount of continuous trading.

Success breeds imitators: All traders biggest problems over the last ten years on a day to day basis could often have been reduced down to “what the hell are the HFT crowd doing to me.” HFT or ELP’s whatever you want to call them nowadays have received a pretty bad rap over the years and while I don’t condone predatory behaviour or illegal trading practises I do wonder what everyone is complaining about. These guys are just doing what everyone has always done in trading. As referenced above they are sniffing out who is a more motivated buyer or seller and reacting accordingly. It just so happens they can do it a million times a day and not be tired. So they are exploiting an advantage over human traders. I really struggle to see the objection to them (again assuming it’s all legal practises). These guys made a killing and if sharpe ratio in its normal form applied to them (which it sort of doesn’t) it must be mouth wateringly large. Now that the light was shone upon them and the haters hated enough it’s a bit more difficult for them. Also the brokers have responded to try and design their algorithms to temper the worst behaviour from them. However the point being is that the rapid and frightening success of these strategies led most people to the forced conclusion of “if you cant beat them join em”. While most electronic trading is not even comparable to what HFT does the concept of using algorithms to execute being more efficient has stuck.

Style shift: Factor rotation, Risk parity and target vol for the most part require a large amount of continuous trading. While returns have not been on fire over the last few years this would suggest that you also need to ensure your cost base is low and nothing eats into a trading strategy more than inefficient trading costs. A typical long short equity portfolio that employs leverage has to contend with large financing costs at their friendly PB and execution commissions and that’s before they even think about what slippage they will experience between the signal to trade and the trade execution. While financing costs are usually the most expensive you also cant afford to pay the 15-25bps per trade that brokers used to garner on the hi-touch side you need to pay the much lower costs on the low touch side. This makes more sense when you look at the typical trading which is usually never big in any one name but rather made up of lots of little trades across a very diversified universe. What I’m trying to say here is that these type of strategies trade a lot but do not need nor can afford a hi-touch service.

ETF’s: Writing this the day after Jack Bogle passed away I couldn’t not mention the staggering growth of AUM in ETF’s over the last ten years. Jack Bogle has done amazing things for the average investor and truly made it easier and cheaper than ever for Main Street to participate in the market at the right price.  The mostly low management fees of these products and fervent focus on tracking error requires a large and continuous amount of trading. Again none of which would be possible under the old hi-touch model.

So these are some of the reasons why we got here. Now that we are here what do we do about it.

If we were in a world where returns were buoyant and everyone was crushing it and making money – I wouldn’t be writing this post because no one would care. We aren’t and haven’t been for some time. When returns diminish costs have to come down also. Never waste a crisis and all that. The work that is going on now under the hood in most asset managers to reduce costs will in the future pay dividends as long as discipline is kept as returns are unlikely to stay low for long. A good execution desk is worth its weight in gold to an asset manager and the end investors.  Don’t throw the baby out with the bathwater. Execution desks have always been sniffed at by “traders” as they are thought to just blindly execute like a monkey. I’m sure there are examples of this but in my experience it’s a skill like any other. It’s the same skills as portfolio managers possess just the time frame is different. PM’s must filter through the constant barrage of noise to identify an opportunity for a trade or investment. It’s the same for an execution desk only the one thing you don’t have is choice. You are handed a trade or bunch of trades that you did not devise of often in stocks or whatever asset you have never traded and you have to think quick and fast about what is the right approach to take with this trade given the incomplete information you have.

As mentioned high trading costs are cancer to a trading strategy. They eat into returns that we have already established are on the low side with a ravenous appetite. So many strategies on paper have an equity curve that goes from bottom left to top right in a nice trending fashion until you factor in trading costs.

There are two different classification of trading costs in my opinion – those that can be controlled at the broker level and those that are an in-house problem. I often say to brokers that is a YP or a MP (Your problem or My problem).  Too often I feel asset managers have made trading costs a broker problem. Purely focusing on driving down commission costs and declaring victory over trading costs is only half the battle won. Controlling these costs come down to negotiation and having a strong working relationship with a broker. The old combative relationship between brokers and clients are long gone – you are partners whether you like it or not – brokers are the necessary medium you use to achieve the results you want- don’t forget it, work with them and they will happily work with you.

The much bigger impact a trading desk can have is to identify the role they play in driving down the in-house costs (an MP) to a trading strategy and as I keep referring to adapt or die. Your role has become less about waging that war with the market day in-day out and more of a strategist. You need to identify the characteristics of your flow or trading over time and then employ or match your trading strategy to those of the alpha signal or generator.

For very basic examples there are often two distinct styles of investing- let’s say that X PM  has a value orientated approach to equities while Y PM has a momentum approach to equities. Is it good enough to simply receive orders from both PM’s and route to a broker algo and work the same way? Clearly not – one style demands an approach that will likely be more aggressive in trading than the other. One style earns its alpha from capturing short term gyrations and trends – so you better make sure you capture as much of that often fleeting trend as you can. A momentum strategy is inherently of the belief that stock ABC is going up/down at a faster rate than stock XYZ so you better get on the train quickly to capture that. Employing an aggressive liquidity seeking type algo for these trades makes sense in theory right? The very widespread adoption of momentum strategies (definitely a post for another day) would suggest that if you don’t aggress someone else will.

Conversely a value type strategy can often be described as being contra or early to the party. So often a good value strategy is picking up unloved stocks or selling ones that have strayed too far from their thought to be intrinsic valuation, either way at the heartbeat of the alpha is usually swinging the opposite way from the crowd currently. Do you stand and buy these names?  No, you employ a much less aggressive style and let the stock come to you, it’s more likely than not that there are currently more motivated sellers than buyers in this name.

Obviously this is not going to “work” in 100% of the trades that you do – but show me a strategy that does and I will show you a liar or a fool. What you are attempting to do is win the marathon not the 100 metre dash. If you can control your in-house trading costs and achieve a smooth profile over the long run that is worth more to any strategy than a blind squirrel who finds a nut every now and then.

This is all well and good and a very simplistic approach to take correct? Where it goes wrong is in two ways: first off the PM doesn’t know their own style and you don’t have enough data captured to make an informed opinion on what their style is. Simple remedy to this is to talk it over with PMs and identify a basic plan that sounds like the right approach to take over time. The next part is important …DATA DATA DATA. Yes I know it’s boring and hard to do, methodical tasks are often just that.  But you have to collect a variety of nuggets of data every single time you come to market. Without that feedback you are shooting in the dark. The data may show inconsistent results but not just my guess but my experience is if you capture and measure correctly over time the correct approach screams out from the spreadsheet. Also pro tip – don’t need a fancy off the shelf very expensive TCA package – you can build in house in excel very easily depending on your requirements.

Problem number two that many face is do you have the stomach to stick to a strategy over time and do you have the buy in from the business? If you lack A then you will almost certainly lack B and if you have A it doesn’t mean you have B. PM’s, the CIO and the business managers must be involved and behind this approach and take a more active approach in treating the execution desk as vital to the goals of the organisation and the underlying clients. Best ex is not just about broker selection it’s about managing both the YP’s and the MP’s in a pro-active and efficient manner. The more importance and focus put on in-house trading costs the better returns will be in theory –(it won’t correct a failing strategy- it’s not a miracle worker)  which is all around just better for business.

The main point here is that a good desk must match their trading style for each order to the characteristics of the alpha signal or generator and over time you will achieve a smooth slippage profile or to put simply you can control and put structure around the in-house problems. You do this by adapting to the new environment and changing how you do things – you have graduated from foot soldier to general, focus on what strategy best suits your organisation and its goals.

Timing is everything II

A quick one for once …..

I wrote before how timing is everything – obviously hard work is a major factor of success but timing is everything both good and bad.

Imagine if you will you became president of America. “Ugh” is probably your first thought but lets play pretend here and assume you had to do it. We all have ideas in our head of what we would like to do to ” change the world”, I would argue that you can do much more in times of crisis than times of posterity.

I am by no means advocating support for Donald Trump ( neither am i advocating resistance FYI ) but if you look objectively at it which time in history would you prefer to become President of the US ? Now or 8 years ago when Obama came into office.

On the face of it 8 years ago seems like a horrible time to come into office. The world was literally reeling from a global financial shock to the system, massive social unrest and the treasury was holding a gun to the head of congress looking for $800bln of tax money to bail out the fat cats on wall St and so on and so on.

Now Donald Trump inherits an office in charge of an economy at near full employment, despite what he says which is trucking along nicely- not killing it but not doing badly either.  Where some of the biggest arguments of the last year or so has come from whether they should let transgender individuals use which ever bathroom they associate with – hardly a bear market pre-occupation.

If you legitimately want to change things – and I would argue that if you take Trump at his word ( a hard thing to do admittedly ) then it seems much easier to change things in a crisis than in times of relative prosperity.

“Never waste a good crisis”

I find it inconceivable that DT will actually be able to change anything – because at the moment no one is feeling enough pain to consider it completely broken. It would seem that Hank Paulson had the right idea 8 years ago – he sensed the urgency in the air and he took advantage – he gave politicians almost no choice and he got what he wanted. DT needs an environment of crisis to achieve the things he wants to do in my opinion and it will take him time to realize that.

Politicians move slowly – businessmen do not. Businessmen are adept at applying pressure at the right time to get what they want – in this respect I think DT will actually welcome with open arms a weak business environment – the sooner he realizes that the better.

Im not saying he will create weakness in the economy on purpose ( as I doubt he is capable of doing it anyway) but I certainly think if things started moving to the downside he would be wise to not stand in its way….. risky strategy but so is doing nothing for four years.

Trade the narrative but dont buy into it

Narratives are all around us – none more so than the equity market in which I am but one of many participants. Narratives or as many of the synonyms above like- tales, stories, portrayals etc etc can be very entertaining and powerful things. One of the first things I try to look at when looking at markets is – “whats the narrative?”.

We use narratives in the equity markets because its much easier than going into detail on the given topic, if I were to blog about the many different factors making up not just the domestic equity markets but also the global equity markets then I fear I would have to include many pictures of sideboob or some salacious headlines littered through this post just to keep your attention – a la Daily mail style.

What is much easier is narratives. What I am interested in, is when narratives start to intermingle, change or stop dead in their tracks. For examples of this its easier to just stick the US equity markets, after politics probably one of the biggest circuses in town- laden with narratives.

Just in the last few years we have had some of the following narratives:

• Monetary policy is inflating the stock market
• The FED will step in whenever it gets ugly
• Low oil prices will provide a boost to the consumer and bump in inflation
• Rebounding oil prices will cause a drag on the consumer and deflation
• Structural investment will make America Great again
• Donald Trump will bring back manufacturing jobs to America
• Tax reform will be a boost to stock market
• Trumpflation, Trump Bump, Trump Trade

All these sentences have been uttered to describe why the equity markets have been going up over the last few years, but whats most interesting is the eternal optimism of equity markets – especially in the US.

One of the most powerful narratives since the GFC has been QE, monetary policy and the FED all combining to provide protection on the downside and squeezing asset prices higher to stoke inflation. My bet is that if you asked most equity participants to write down the mechanics of structurally how QE was operated and how that actually translated into a squeeze in equity markets you would be met with a lot of blank paper. However that was the dominant narrative and the engagement of this narrative ranged from those who downright accepted that in theory it worked, those who grudgingly accepted the policy and did not want to “fight the fed” and there were those who just got carried out fighting the narrative altogether.

Whats very interesting is that despite QE ending over two and half years ago the narrative prevailed long after. The FED tapered and eventually simply stopped outright purchases and some time later even eased themselves into a tightening cycle. How frightening – we needed a new narrative, and bloody quickly. If you look at the price action in 2016 this is what a “narrative-less” market looks like. Completely sideways, basically there was nothing to excite in either direction.

As I argued in the following blog post  What has monetary policy done for you lately? we needed to convert from a state of monetary policy holding up equity markets to fiscal policy. (See below excerpt from said post)

And boy did we transition sharply. No sooner was it confirmed that the supposedly populist candidate Donald Trump was to be the next President of America so too did equity markets quite literally buy into the “hype”, “narrative”, “tale”, “story”. Quite literally by the open of the equity market the next day equity prices were rising and rising quick smart. Small cap equities – a proxy for the “rise of the middle class” under President Trump rose an astonishing 22% straight through till End of November and for now is still maintaining those highs.

The narrative is pretty clear –

Through a combination of tax reform, infrastructure investment, immigration control and most importantly regulation reform Donald Trump will make America great again and unleash growth that has been held down for years.

Now another rule I like to follow in equity markets is that the markets just dont give a damn what you think. You can slap your forehead and give me all kinds of economic theories as to why Donald Trump will not achieve anything, first of all most of this is to do with your own biases. Most people I know dont like DT. Its a fact that the majority of voters didn’t actually like him in that he lost the popular vote. Your opinion on DT quite literally has nothing to do with anything. What matters is will he do what he says he wants to do – and then will it work ??

Equity markets so far have traded the narrative – the big question is have they bought the narrative, i.e. how long are they willing to be commited to this narrative before things start to come unstuck. The market is long equities – how long they are is anyone’s guess and it often ranges between styles etc.

One of the more popular styles out there is Risk parity- I am no genius on this strategy but I think its safe to say that with the increase in bond volatility relative to historic norms and the massive slump in equity volatility relative to historic norms this is a potent combination for those managers following RP to be turbo long equities and not too bothered re bonds, if I were a risk manager at a certain Connecticut based risk parity led hedge-fund with gods money under management I would be feeling extremely uncomfortable at the moment at definitely out of my comfort zone.

What could cause this narrative to become unstuck. Like I say – I would prefer to align myself with the narrative BUT be prepared or wary of triggers that can unhinge it or indeed re-enforce it. Narratives need maintenance after all.  What triggers am I looking at/for?

• We already have evidence that its not going to be cake walk for DT. His relationship with Paul Ryan the speaker of the house and Republican seems to be strained. It could well be fast becoming a reality of that old cliche of an “outsider” who is trying to change things is going to experience a lot of frustration. I think DT got his first taste of ” how we do things around here” last week when he tried to rush through amendments to the ACA and his own party halted him in his tracks – despite spending the last 8 years railing against Obamacare.
• Then we start hearing quotes from same Paul Ryan suggesting that obviously they are open to tax reform but it may take considerable time. Well of course it will take time to implement this – unfortunately that’s not what markets want to hear – we bought equities in November and now we need another oomph to get this thing moving again or we will look elsewhere.
• The theme that DT tends to act hastily, off the cuff, without thought has always been an overhang – from his late night tweets to his sometimes off comments in a presser. So far this has only emboldened him and seemed to make him more appealing to his die hard supporters, everyone loves a “character.”
• I literally know nothing about Geo-politics outside of the headlines- but guess what?- so does about 99% of the population, his latest move to sanction a fistful of rocket launches on Syria in retaliation for a chemical attack by Assad on his own people certainly seemed to me like a hasty act. I will not rule out there may well have been good motive or strategic rationale for doing it, but for sure it seemed out of the blue and hastily arranged. Also see his supposed tweets upon the very same subject : (obviously I am not going to scroll through DT’s timeline for verification of these tweets- so if its “fake news” then ok- Ive been duped )

• Yes a lot of the right are gun toting nuts that like to talk tough, but I also think they bought into the idea of why should Americans be solving international disputes – especially when its unlikely most people could confidently locate Syria on a map if asked on the spot. A lot of Trump’s campaign had a theme of isolationism and putting America first – this resonated with people and I think its something that his support will give him a pass on this time, but will not tolerate him getting into any kind of protracted war down the road. Sadly he may have already forced himself into one but this remains to be seen. But its a trigger and I will be looking for signs of waning enthusiasm form his core support.
• If his relations with the media take a sudden change for the better it would be a trigger for me too, it probably means something is coming that he needs positive publicity on, it would make me ultra cautious of risks to the upside.
• If the same people that are standing in opposition of him start to make positive noises about tax reform or repatriation of profits to US from corporate’s abroad then again this is a trigger to the upside- a re-affirmation of the narrative if you will.

About this time I usually like to wrap things up by saying something like “to make a long story short”  but the whole point of this post is that I have tried to make the short story long.  Knowing the buzzwords of the narrative and simply repeating the mantra in your head will not get you anywhere- knowing the narrative and understanding the mechanisms behind it will put you in a much better position to trade the narrative but not get sold on it.

Be long change

“To sum up, it is not volatility that scares good investors, its the opposite – calmness. Calmness indicates you are with the herd, and while that can be comforting at times, it ultimately leads to some very scary moments and dealings with wolves.”

This is something I wrote previously on the topic of volatility (Volatility- The punishment for Group-Think) and how I believe it is the ultimate force to correct group-think in financial markets especially.

I cant help but the note how currently the inverse of that statement is true, if volatility is the punishment for group-think , then lack of volatility is the punishment for anti-group think or contrarianism.

I will often be found grumbling like a cantankerous old man about the dangers of selling vol. I dont like it as a “strategy” full stop and I will probably never be convinced otherwise.

However, I am of course completely wrong . As a strategy over the long term selling vol has proven to be very profitable. See below return profile of a hypothetical put option writing strategy ( CBOE S&P500 PutWrite Index). Any strategist, PM, Quant etc would dream to have a pnl curve that goes from bottom left to top right with relatively very little interference in between. Sure there have been periods of drawdown but over the long term its hard to argue its merits. If I was correct, there would be no insurance companies in the world.

However, I am still not a convert. it matters very much at what point on this hypothetical pnl curve you enter the mix. Lets say you started to employ this strategy but a few years ago , like say 2011/2012 – why 2011 you ask ? well that is roughly when XIV US entered the mix. An ETF that replicates a short VIX strategy. It too has been very successful as per below. Price appreciation has gone again from bottom left to top right with a little more vol in between but never the less it got there.

You can tell from the above chart how it now matters more where upon you join the pnl curve when implementing a strategy. Just put your hand up against the screen and cover years 2015 and 2016. The pnl curve still looked very handsome until all of a sudden a big draw down occurred …twice in succession I may add.

I could use the old cliche of picking up pennies in front of a steam roller but I prefer to think of it now as being “short change”. Shorting vol is an admission that nothing is going to change and therefore I do not want positive exposure to change but rather seek to profit from stagnant behavior. If you are to think of it like this then the last few years makes a lot of sense.

How has vol continued to trade lower over the last few years when all around us we are often witnessing terrible economic problems, political uncertainty and massive change?

The only possible explanation I can give is despite all these issues that are going on in the real world, the financial world, or those in charge of fiduciary responsibilities have taken the view that come what come may the central banks have broad enough shoulders (or indeed will have to have) to absorb “any” economic shocks. As recently as a few months ago when the largest German bank was in a perilous situation in the market the over riding message was that the Bundesbank/ ECB  or German government would step in and save the day should anything go seriously awry. This is probably the case, but the ease at which people let that thought escape from their mouth without the slightest thought for the implications of this I find fascinating.

This dogma that central banks have it covered is a frighteningly lazy state of conscious for any money manager to employ, it would also go a long way to describing how this pro-longed but unloved equity rally has endured for so long. You will find few people who agree in entirety that all will end well when discussing the behavior of global central banks, most are begrudgingly going with the flow out of fear of taking on the central banks. The phrase “don’t fight the FED” has been in imprinted on most investors mind for many years now. Most agree that it will all end in tears – they just dont know when.

The power of the market has been all but deputized to the central banks. I cant think of a more dangerous scenario than when hundreds and thousands of people, investors, professionals, etc etc all defer responsibility to a small group of individuals often totally unsuited to managing anything in the real world. The role of financial markets is really often quite simple- ebb and flow back and forth to find a valuation for a given asset class at a given time. Handing this power over to central banks implicitly or tacitly is like building a dam, it will stem the tide for as long as possible, but one day the crack will appear.

I cant think of a better scenario where I would like to be positioned with positive exposure to when this situation changes. Like everyone else, I dont know when the shoe is going to fall, if I did I would be an exceedingly rich man already, but by putting myself on the side of change I stand a greater chance of not being squashed by the steamroller and picking up vastly more than pennies.

 

 

 

 

 

 

 

 

 

 

A brief foray out of hibernation

I will try to be brief here but a few bearish charts to look over and just have a think.

• Corporate buybacks
• Capital goods orders
• Restaurant performance index
• US personal savings

First a lot has been said about corporate buybacks and how there are the only source of capital holding up equity markets. This is usually the throwback from a frustrated bear who cannot put any rhyme or reason on the seemingly teflon like nature of the stock market. Every time the market looks vulnerable to a sell off low and behold the invisible hand steps in and lifts the market back to new highs. Most have attributed this to corporate buybacks. Its true to say that Corporate buybacks have been a strong feature of this rally. Sadly its also true to say that corporations are the worst stock traders in the market and this cycle since the GFC has been no exception.

Two charts below show a number of things to worry about. If you subscribe to the theory that the “only thing keeping this market up is buybacks” then look at the drop off in activity over the last three months. I have no doubt the pending elections in the US have something to do with this as companies adopt the wait and see approach for whats in store for them come November but its a stark withdrawal of capital that was sitting on the bid and in my view makes us very vulnerable to a sharp sell off very soon.

(Chart courtesy of Bloomberg)

To say that buybacks are out of the norm and the only thing holding up the market is to ignore the pretty strong history that buyback activity has enjoyed please see the activity levels preceding the GFC and the resulting lower levels of activity after the GFC. Corporations only buy back stock when they are expensive ( it is after all only a way to engineer the appearance of a rising stock price nearing the end of a cycle)

 

Another reason buybacks may be down is that companies are noticing the below drop off in capital goods orders. See below 2016 cap good orders vs  the 3 y avg, doesn’t look great does it ? FYI the S5INDU index of cap goods stocks are trading higher than 3 yr avg – like 20-25% higher…….

 

Although i have referenced capital goods above I dont really view the US a manufacturing based economy anymore, that ship sailed long time ago ( and it was built elsewhere!), i do however often think that it is a country where over 50% of the people serve the rest in some way related to food, drink entertainment etc etc . the restaurant performance index is not looking to healthy either despite a few decent months in Q1 this year it would appear it wasn’t the best summer season for them.

If it was not the best summer season and restaurant performance is declining that would suggest tips and wages are probably declining too, that will make it just that bit harder for the average US consumer to finance two things: Their shiny new car and the loan or financing that came with it ( despite probably purchasing it for almost zero financing and cheap petroleum) and perhaps also their hefty student loan. Chart A below shows the stunning performance of auto sales recently ( up approx 14% on avg)

Now if you put all that together and mix it in with a toxic energy drink like a new presidential regime in a few weeks and the uncertainty that can have on markets for a period of time, it may well explain how the US consumer has changed it ways slightly. They are not spending with wreckless abandon and actually starting to dare i say save money. US personal savings has some way to go to get back to an “average” level but a pronounced bounce off the lows – currently 5.7 – average of 8.5ish

 

 

None of this scream growth- some of it certainly in my mind screams correction- if it were me I would be eyeing puts on industrial’s and mid caps. All of this disappears out the window if some grand scale fiscal policy gets announced – but we all know how long something like that takes in this day and age.

What has monetary policy done for you lately?

Monetary policy has dominated our thoughts in financial markets for longer than I care to remember now, at first no one really knew what quantitative easing was. Then slowly but surely we all learnt that all it simply meant was that the FED and respective central banks around the world were prepared to underwrite risk in order to calm the waters and hopefully propel us out of what was a financial shock of large magnitudes.

To not give the central banks any credit in actually providing a very meaningful safety blanket in a time of great stress is to be at the very least lacking in imagination. It’s true we cant say for certain what would have happened had the US banks not been “saved” or if AIG’s liabilities had not been explicitly underwritten. To say that the market would have cleared and found a way is in a way half true – it would have …….eventually – but no one has any kind of idea what kind of wrecking ball would have obliterated the global economy had these ostensibly civil servants not stepped in.

How it was managed in terms of fairness was of course horrible, you could count on one hand the amount of bankers who can be easily accused of largesse and ignorance whose lives are worse now than they were back then. The public did bail out the institutions and those in charge of those institutions paid very little in terms of penalties excluding Iceland.

But, eight years on we are still dealing with the hangover from the Global financial crisis GFC, but in my opinion things are a lot BETTER than they “could” have been. Had these civil servants not stepped in you can assume that we would still be in the eye of the storm of the credit crunch.

If you remember what the credit crunch was, as it is not mentioned much nowadays – it was a large scale withdrawal of people & institutions circulating or “lending” cash to those with ideas for how to put that cash to work. It was a point blank reversal of the economic engine that spurred growth in the first place. On the contrary now we are in a position where liquidity is probably the highest its ever been yet no one wants to borrow.

No one wants to borrow is of course a silly thing to say – companies will borrow but sadly for appallingly wrong reasons, money is cheap now relative to history, when something is cheap in my opinion it has lost its value or more importantly it loses its power. Money has always been power and therefore borrowed money was usually put to good use, to generate more money and therefore more power. Now money is cheap and abundant – so why not just piss about it with it. Using borrowed money to fund buybacks or any kind of financial engineering to bloat your share price is the largest manifestation of this. Not only are you putting money to work in a very inefficient way but you are also wasting the opportunity to invest and grow.

So QE although in theory should be credited with at least a very valiant attempt by  central banks to free up funding for the whole economy to function properly in practice it had unintended consequences that almost rendered it useless. Maybe you could say that in practice it delayed the market clearing process and that remains to be seen.

How did QE help the average man on the street however, or more important how did monetary policy help the average man on the street?  Well for starters a lot of the people who were laid off through the GFC have been hired back. US employment numbers are back to where they were roughly before the GFC. This is not to say that all those who were laid off have been re-employed on similar terms, maybe they are under employed or maybe they are simply working for flat or lower wages than before. When I look around for other signs of benefit to the economy their is only one real sector where i can see a standout benefit.

Zero or close to zero rates have helped in allowing the consumer in the US in particular to get themselves back on track. US auto sales are performing considerably stronger than normal. A lot of US autos are sold on finance agreements, its considerably easier when rates are near zero to tempt in buyers with better deals now than before, also when those zero % finance deals are complimented by cheaper gasoline prices it gives the consumer a lot of confidence that they can afford this new car over the next X period of years.  See below chart in blue the 25y average sales per month of autos, and now see 2016, on average its a 14% pickup in demand, over the 5y average its even bigger.

FYI today’s sales numbers are approx 25% higher than during the period of the cash for clunkers programme enacted by the US govt to in an effort to help the US auto industry back in ’09.

 

What has monetary policy done for you lately though? We are all sitting here obsessing over if/when the FED will next raise rates. This is doing no one any good. The FED’s communication policy has become a little redundant and now working counterfactual to its original intentions. Instead of giving businesses and consumers guidance on the path of rates and clarity of thought we now are stuck in this “will they wont they ” scenario that feels never ending.

What all this is saying is that our obsession with monetary policy is coming to an end, it is in fact the only exit strategy I can think of  and that is a sharp transition to fiscal policy. The timing couldn’t be better – for better or worse whether you like either candidate or not the US will have a new president in circa three weeks. It’s time for some shock and awe tactics from the so called leader of the free world.

In such a divided and frankly bizarre election campaign the only real takeaway message has been that its time governments started listening to what the people want. In any normal realm DT would not have got this far and certainly Bernie Sanders could not have threatened the DNC leadership by advocating ostensibly socialism.  Certain candidates have done very well to get this far by using just usual standard political gesticulating. HRC’s message has not been particularly radical but by hook or by crook she is where she is. DT has got there by going full populist and appealing to the base desires of the electorate, promising a return to days of old for the american worker.

None of this will happen without FISCAL POLICY. Its time to think big, go big or go home.

QE for the people is a bad terminology and advocates in its simplest form a straight deposit of cash into the public’s bank account. I couldn’t think of a more useless or fruitless endeavor. People may think they just need extra money in their bank account but really they will just do what companies have shown to do and that is piss it up against the wall on a larger tv or a new set of curtains etc etc. none of which is creating anything of value.

In order to make something stick people need to see money being spent around them, this starts a process of creativity and engineering a new economy. People need to be exposed to the potential for opportunity in order to take risks. Fiscal policy can be described as easily as employing someone to dig up a hole and fill it in again, but when you embark on large scale infrastructure projects or at the very least in the US cases regenerating and repairing previously built infrastructure you set in motion a chain reaction of mini economies or micro businesses popping up to take advantage or service the grand plan.

Look at Apple and its IOS infrastructure- they created the infrastructure and the people generated a micro economy around it, sure apple probably benefits the most but so have hundreds and thousands of other people who have piggybacked onto the infrastructure to create a living for themselves.

Why is the timing right? Regime change always helps, commodities in general – the building blocks for large scale infrastructure are back to lowest levels in quite some time, see the Bloomberg commodity index (heavily weighted by oil obviously) which by the way will change fierce quick if something like this got announced ( be long base metals).

 

 

In Summary not just because I’m bored of hearing about it or talking about it,  Monetary policy has had its day in the sun and will always remain relevant but its certainly time for us all to think FISCAL policy. If half the pressure that was put on central banks over the years to “do something” was applied to your local or federal government I wonder how the world will look by the time the next presidential cycle rolls around.

 

A few thoughts from the sidelines

Let me start by saying I have no horse in the race if UK chooses to leave or remain in the EU. I am Irish and currently residing in Switzerland. It is unlikely that Ireland will leave the EU in my lifetime as we have a history of voting for pro EU treaties (sometimes we just keep voting until the “correct” answer is given!). You could say that indirectly I have a horse as Ireland has enjoyed strong reciprocal trading relationships with the UK since we settled our differences, however I don’t foresee any damage to that in the coming months regardless of outcome.

Once again however the media has played their usual role of flinging as much poo around the place in hope that something will stick but more importantly for them they will circulate their publications and boost ad revenue. A highly irresponsible way to decide an election but this is the world we live in.  This Brexit referendum is becoming quite emotional and aggressive as we hurtle towards the finish line and I would urge most to avoid the newspapers until this is done and take a more calculated approach to their decision.

You could read this and say I’m wrong about this or that, but at the end of the day this is how people come to decisions in a democratic environment, if you don’t agree with me or my beliefs that’s quite all right by me as it probably means I do not agree with your opinions, but democracy dictates that I have to live with them.

Personally I take a much more sombre approach and with the luxury of not actually having to cast a vote or make a decision I have looked at it from both angles dispassionately.

I believe the notion that has been propagated that if Brexit occurs the UK will be shut out from trade with the EU is utterly false. Yes for a period after the vote their will be a bit of chaos as both importers and exporters seek clarification on where they stand and the terms of trade may suffer on both sides for a while as creditors and debtors will demand payment up front rather than take any risk in the long term. This will of course lend to even more sensational headlines. However, once the dust has settled I tend to believe that people who seek to do business with each other will continue to do so no matter what the set up.

In the interest of fairness I also believe the Brexit camp view that if successful they would enter some kind of Utopian world whereby there exports would suddenly start flying off the shelves again is also utter nonsense. Global trade is not a new phenomenon- the same opportunities and pitfalls will exist on June 24^th as did on June 22^nd, and it will be up to UK business to adapt and refine products for the market place just like they do know. The notion that it would eliminate inefficiencies and not have to conform to EU rule surrounding products is also crazy as you will still be looking to sell products in to the EU block or did you think you were just going to ignore the world’s largest trading bloc?

It is not in the interest of the EU to block transactions with the UK or impose tariffs etc when a considerable number of the member countries have UK as one of their most important trading partners. More importantly if they do such an exercise and are seen to “punish” the UK for simply exercising a democratic freedom that would seem to me as a very foolish endeavor and would certainly turn a few more heads into thinking maybe this EU thing isn’t for us either.

Consider the below tables and see how many EU members you can spot in the top 10 nations that export to the UK, more importantly see who is Number one. So Mr. Schauble can throw around passive aggressive comments all he likes but I’m pretty sure the top brass at Volkswagen, BMW and Daimler to name but a few and all the unions that are associated with these organisations might want him to soften his stance a little.

I also reject the notion that In the case of Brexit house prices would collapse 30% as some have been quoted – or I think the chancellor himself picked a number of 10-18% out of his arse at some point. I reject this on a couple of levels.

• No one, and I mean no one has a clue what will happen in the event of Brexit let alone pick how much house prices may or may not fall by
• House prices in the UK have risen steadily over the last 30 years to a point where it is supremely difficult for the average person to get on the ladder so to speak, would it be such a bad thing if house prices fell a little?
• The widely accepted notion that house prices will fall is in my opinion false as in the most recent period of say last ten years growth has largely been fuelled by overseas money entering the UK market due to many factors – rule of law, diversifying revenue streams and most importantly getting their money out of a potentially volatile and dictatorial regime overseas. I cannot see why this would stop, if anything I think it would pick up (don’t underestimate the amount of Anti –EU sentiment out there in Europe itself).
• If I were a wealthy European (and I am almost certainly not!) I wouldn’t think twice about moving a considerable % of my money into UK assets for diversification purposes. Personally I don’t like property as in investment but plenty around me do.

 

On the issue of the Pound and what might or might not happen to its value I again am totally agnostic or unperturbed.

First of all do not for one second listen to an investment bank who will absolutely be on the front line to benefit from volatility in the pound surrounding this referendum. They get paid to stir the pot and create volatility and will always be on the front line to mop up the blood spill after all is said and done.

Currencies have a way of confounding everyone and also proving everyone both right and wrong on different time frames. Overall I believe the pound will actually get stronger as I genuinely believe there would be more capital inflows into the UK on a case of Brexit, but in the event of a rapid depreciation I think this would provide a nice necessary crutch for UK exporters to fall back on in the potential chaotic scenarios that may exist following the referendum.

Having a look at the UK top exports nothing screams to me as majorly price elastic, UK is not China and does not produce cheap goods that are easily substituted in my humble opinion. Demand for capital type goods will always be there and if anything may slightly tick higher while buyers try to take advantage of a slightly weaker currency thereby allowing the pound to find a natural level.

 

In respect to immigration it’s a tricky one and really has become quite the dominant theme throughout the whole campaign. It’s a tricky subject as I only have my own experiences to reflect on in a bubble type environment. I was an immigrant in the UK, worked with many different nationalities from around EU also. However as I was told by a rather racist cabbie once “oh yes mate but you are the good kind of immigrant”. Now this guy was actually referring to my skin tone and we needn’t go down that road but really the subject of immigration is a highly divisive class issue. No one had a problem with me in my job because I got paid well and contributed large amount of revenue to Her majesty, also I attained my role not because I provided my labour cheaper than the closest UK person but rather because I was better. However the further down the added value chain you go in terms of industry, immigration becomes a highly emotional issue.

I can understand how those in low added value positions can be upset at their jobs been taken by the cheaper alternative, especially if that cheaper alternative happens to be from a different country. The problem itself is actually way more complicated than a simple in or out referendum in my view. And if Cameron really wanted to avoid Brexit I think he could have gone a lot further in the issue of immigration a few years ago and we probably would not be having this referendum at all.

I am a firm believer in free movement of labour. I have been an immigrant in that respect all my life and I have contributed to the country I lived in all through that as well in a positive manner. I currently work in an office with a large number of different nationalities and we get along just fine. Complaining about immigration is like harking back to the days when you could go out have a few pints a bag of chips and still have change for the bus fare home. THOSE DAYS ARE GONE. We all now exist in a more globalised community – learn to engage with it and not fight it. If your job is being replaced by a cheaper means of production well I’m sorry to tell you that is always the case – so has mine and I have had to adapt and deal with it.

It is not immigration that is causing you angst it is a host of other factors that has led to this situation whereby your skills are not valued. Therefore you must change your skills. If you cannot change your skills there are reasons for that too, but it absolutely not the fault of immigrants. Just putting a cap on immigrants or banning them altogether is not going to bring you back to prosperity.

In summary as I always do I congratulate you for reading this far (most don’t!). Do I believe that Brexit is a good thing or bad thing? I think that Brexit will not cause the Armageddon like scenarios been thrown around in the press with reckless abandon. Do I think it’s the right choice for the UK, yes I probably do. More because I personally do not like what the EU is becoming, I like what it once was – but I do not buy into attempts for further political ties in the future. Europe is a diverse region with many different cultural approaches to life- a one size fits all attitude simply doesn’t work in my opinion.

I like free trade

I like free movement of capital and people

I like that a common currency has eliminated a lot of hassle and made cross border transactions easier and set a relative level of prices.

I do not like the thought of a more united Europe politically or the bureaucracy that one would expect from any organisation as large as the EU bloc.

I believe in allowing countries who democratically elect their own government to be able to allow them to govern in the best way for that country, Brexit does not guarantee this would happen either For what it worth.

I do not believe that it is wise to have a governing power of un-elected representatives deciding the fate on many issues from a central point.

Take it from me standing at 6ft 5 and sadly approx. 15 stone – “One size fits all” is almost never the case.

Do I think Brexit will happen ? Probably not, I haven’t witnessed many events that I can think of where the majority vote to really change things – usually the status qou wins out by a smidgen. It has been hard for Brexiteers to give any kind of concrete idea of what life would look like the next day should they win as they do not possess a crystal ball. Such a scenario does not lend well to people voting as even if they are fed up with their current situation people often do not want to take the risk that it might get worse (even if they think it will get better)

What is a bear market squeeze?

“I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description [“hard-core pornography”], and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.”

Justice Potter Stewart

The famous quote above is a favorite of mine when attempting to explain what is a bear market. Its a very hard thing to define and most people will disagree with you on any number of points, but after a few years in this industry  “I know it when i see it” is all i can really offer.

Given recent events in two notable markets both equities and Oil I thought it might be good to discuss the notion of what many may have heard the term a bear market squeeze. If that term leaves you confused never fear I am here to shed a little light.

A bear market squeeze can be as grizzly as it sounds – especially if you are short. It is the process whereby prices rise at a ferocious rate AFTER a large sell off. Just when you least expect it and things look like Armageddon is really happening they often pop up as if from nowhere leading many to scratch their head in raw utter confusion.

As I aim this blog at those not in the financial industry, chances are many of you have never bought a share in your life consciously ( they have probably been bought on your behalf without you knowing if you contribute to any sort of collective pension plan but let’s keep this simple).

If you have never bought a share in your life it’s highly likely you certainly have not shorted any shares either. Shorting is a foreign concept to many – I personally remember being explained the process on one of my first days in a back office of a large investment bank and assumed my manager was lying to me.

How can you sell something you don’t own? Is usually the first question that arises. In brief here is the process.

• A Large investment vehicle Investor A will purchase shares for indefinite periods of time with a long term horizon for investments. They wish to make it a little more attractive to just buying shares and staying long. Therefore they “lend” the shares to an investment bank or some kind of agent for a fee.
• That agent now has inventory (say VODAFONE SHARES ) that they can “lend” out to customers who wish to go short the stock. i.e. profit from a movement lower in the price.
• Investor B “borrows” the shares from the Agent bank and pays a fee for that privilege (usually 20-50bps of the notional amount annualized). They can now “deliver” shares to whoever bought them from her and not be held accountable for a settlement failure.
• When Investor B decides that they have made enough profit/loss on their short sale they go back into the market and buy back the required amount of shares to flatten off their position and deliver them back to the agent bank whom they borrowed from in the first place and hey presto Investor A still has the original amount of shares in the first place.

Seems pretty easy right – wrong. The market as a whole especially in equities is often geared to being long shares not short them. It’s fair to say that more POWER exists on the long side, i.e. more institutions are geared towards buying shares than selling them. A lot are even explicitly mandated that they cannot sell short shares.  Its also more expensive to short shares, as discussed above there are fees to pay just for the privilege to short and these are subject to demand/supply also therefore the worse the stock the more likely you will pay a higher cost to short therefore reducing your return on the trade. This creates a process whereby it can be very dangerous to short shares and it should really be left to the professionals.

So back to the original thoughts on what is a bear market squeeze? Its easier to explain it in terms of something more familiar. Many of you may have bought a house, tried to, thought about it or at least engaged in the process in some shape or another all too varying different outcomes.

In this case if you are a first time buyer you can consider yourself “short” the property market and anyone looking to sell is “long” the property market. Think of what you see around you and what you experience.

Property market is definitely a market whereby the longs have the power as the shorts need to get a house or a place to live and there are plenty of extraneous factors that can go into squeezing the price of a house higher. When you are short the housing the market here are a number of factors that are squeezing you.

• Lack of new supply
• Lack of available credit
• Poor wages that do not enable saving for a deposit
• Cash rich investor’s ability to move much quicker than you
• Sellers of property have time on their side and can drag out the process often for a long time while you burn cash renting
• Potentially aggressive selling tricks from estate agents
• A motivated competing bidder
• And the worst one is information asymmetries – whereby you are dealing on very little information, usually only what you can see in front of your face. Competing bids or offers are all done in anonymous fashion therefore you have no way to know where you stand.

These are just a few factors that I am sure you have experienced at some point and I have not even talked about macro factors in the overall economy that may affect decisions. Either way when you think about these things and what drives prices higher its not all that different from financial markets – its just happens a lot quicker.

Recently, in last two weeks we have experienced a very strong squeeze in both oil and equities – lets have a think why.

In the oil market the producers of Oil are “Long” and the customers are “Short” by design. Producers make it and customers need it. Oil has been trading lower now for some time witnessing prices not seen for 12-13 years. If you are short by design then it’s not the worst place for you to step in and buy some, especially lets say if you are an industrial producer, airline etc who buys in bulk. Also there is a recency bias that affects your decisions. This time one year ago oil was trading +80% higher than it is now – this time two years ago oil was trading roughly 220% higher than it is now- talk about a bargain !! When you put these things in context and look at the design of the market its easy to see why someone would want to try and lock in low prices and therefore the market will squeeze. The best explanation for this is one of my favorite quotes

“the cure for low oil prices , is low oil prices “

Im not saying that we have seen the lows in the oil price, on the contrary I believe in the power of trends and therefore expect to see pressure on oil prices again relatively soon but nothing goes down in a straight line in financial markets.

In equities it’s a little more complicated – the recent squeeze of circa 10% off the recent lows left many scratching their head including me. There are pros and cons to owning equity in this current market environment and on a very basic level here are some of them. A little obvious as to my thoughts on the situation here!

In a bear market squeeze the below list will be weighed up amongst other things and investors will get comfortable with some things while struggling with others but the result is that after a hefty drop in prices ( the cons ) more people were focusing on the pros for a period of time, and if volume of selling drops then the result can be a rapid rise in prices that leaves everyone wrong-footed.

Pros

• Equities produce cash yields in the form of dividends- if the price of a stock that used to offer a 5% dividend yield reduces in value then its potential dividend yield gets more attractive ( assuming you hold everything constant i.e. the ability of the company to pay a divi in the first place)
• Following on from this point bond yields, often considered the “safer” investments are rapidly losing attractiveness all around the world due to very low and sometimes negative yields- i.e. you receive almost NO return or In some cases you are actually paying for the privilege to lend someone money!!
• If (and this is a BIG IF) the overall market returns to growth the value of the equity will rise at a rapid pace providing a very good return and there.

Cons

• The overall market is dangerously geared to monetary policy from the respective central banks – think about this for a second – investors all over the world are making huge investment decisions based on what a handful of economists who have had some but very little luck in “fixing” the global economy since the GFC.
• The diminishing returns from the seemingly forever stimulus plans are becoming apparent and certainly worrying.
• Politically around the globe things are changing – i.e. regime changes bring about instability – the US presidential election is looking like the biggest circus to date.
• The world is almost certainly oversupplied with oil which has curtailed official inflation figures
• Rapid changes In technology are breaking previous industries and having an impact on incumbents margins in a real way.
• These changes in technology are also leading to an increasingly marginalised workforce who either need to adapt or die – adapting is a very difficult thing for the majority.
• The current trend would suggest that lower prices are inevitable for now ( not a prediction just an observation)
• China the once mighty growth engine of the world “appears” to be slowing down and there are strong concerns over their banking systems leverage both visible and in the “shadows.”
• Concern over European banks capital buffers has flared up again – also the ability for them to grow their business models is highly curtailed in the new regulatory limelight
• Oil companies are obviously suffering
• Commodity markets often a signal for growth around the world are still languishing around the lows with no real visible natural buyer in sight – metals, energies particularly.
• Two regime changes of enormous importance to be witnessed this year in the US- the presidential cycle and monetary policy cycle (recent fed hike to be continued or not?

 

Bear markets are a weird and wonderful thing- they are without a doubt the most interesting periods of time to be involved in financial markets, the sell offs are devastating to investors but the resulting bear market squeezes can be just as devastating if you have over played your hand on the short side and leads to some very tricky decisions.

Beatings WILL continue until morale improves

This week we got a clear example of how central bankers will continue to beat us until the morale (inflation) improves.

In a previous post I applauded the governor of the BOJ Kuroda for his actions taken towards the end of last year by not increasing his QQE (quantitative & qualitative easing programmer) but actually promising incentives for management of companies who invest in their people and innovation. In this author’s opinion a far better use of time and effort, as it actually touches on blending monetary policy with fiscal policy.

“What I did like recently was Kuroda attempt to throw a twist into his QQE (quantitative and qualitative) programme by saying that he will invest roughly $3bln into companies who invest in human capital. This is important, it is a signaling mechanism to say that the BOJ is behind companies who not only hire more but invest in their people to incentivize them to work more or more importantly innovate more. Once this message filters down appropriately to the top/middle management in Japanese companies who are probably invested in the company they are going to push for more hiring, better wages and hopefully empowering their employees to be more innovative.”

This week saw a far more direct and tried and tested approach. However we must remember just because it is tried and tested does not mean it will work.

Kuroda has now moved the BOJ to negative interest rates or NIRP. Not content with a near ZIRP for approx. 16 years, Kuroda now feels that had that just been a tiny bit lower inflation would have achieved the magic 2% mark that central bankers seem to repeat like a religious mantra so oft.  The best quote I read from a money manager in japan was that the carrot has been abandoned and now we are working with the stick.

 

Japan is renowned in the macro world for being the “widow maker”- i.e. plenty of macro fund managers have gone broke over the years betting on a return to form of inflation and growth not seen since the magic 80’s in Japan when they arguably dominated the scene for consumer electronics in a fast changing world. The below shows the inflation rate in japan over time and what’s more striking is that around the time they adopted the ZIRP policy  while there may have been periods of above zero inflation there were also plenty of periods of deflation.

 

So Kuroda has now resorted back to usual tricks by central bankers. Instead of trying to foster a culture change of risk taking and “animal spirits” he is just going to try and force money to float around the system by charging institutions for extra reserves held at the BOJ. I am not sure why Kuroda thinks that this move will have any effect greater than the already very loose monetary policy that has been shown not only in Japan but also around the world.

But let’s look at what potentially triggered such a decision and whether Kuroda has shot an intentional arrow or merely just reacted aggressively to current events.

What where big headlines in Japan less than a week ago was the resignation of the minster for Economy Akiri Amari for alleged dubious practices regarding brown envelopes. This, he has of course not admitted too but doing the honorable thing and not allowing suspicion to fall on the party. The very next day Mr. Kuroda who up until a week ago had denied contemplating lowering interest rates through the zero barrier suddenly had a change of heart. This would certainly seem like a strategy to divert headlines away from the scandal and allow us all too simply forget about Mr. Amari’s alleged transgressions. It seems a little too coincidental to me but would also caveat by saying I doubt Mr Kuroda would make such a rash decision. So this has been a tool (or arrow) in his arsenal for some time and he has just been waiting for the right time to do it must be the only explanation.

Why then, is now the right time outside of the reason above? Again the obvious answers don’t cover Kuroda in glory either.

Recent movements in markets have seen what is known as “RISK OFF” this is a general term that I have discussed before (here). As most of the market was unwinding their foolish “ carry trades” which is when you borrow a low yielding currency and invest in a high yielding currency the Yen found itself being in an awkward position for the BOJ. In a regime when you are desperately trying to devalue your currency and the rest of the market cannot see beyond their red flashing PNL on their screens. The best evidence of this is the AUDJPY cross or if you want to be super sexy (risky) you could have borrowed Yen and invested in equities just because leverage is fun right?

USDJPY was fast approaching a level of ¥115/6. i.e ¥115-¥116 Yen to the USD. I work as a trader and can spot areas of price levels that if broken can cause enormous amounts of volatility and pain (in the financial sense), If little old me can spot these obvious areas you can be dam sure the BOJ and all its army of advisors etc can also and put ¥115/6 as a line in the sand. An implicit put if you will. And by the way it’s not rocket science, look at chart attached below and tell me that ¥115/6 level is not important. It may not look like much to you know but imagine how many people, traders, highly levered options traders, structured products,fund managers, algos, quant finance models, businesses etc etc draw these “lines in the sand”. When a line in sand breaks, there are reactions, just ask the FX traders back in the day who used to make a great living (some still do) “running the stops”

Kuroda has come out and defended the ¥115/6 level with the only thing he could use to ensure it would hold- negative deposit rates. A move so bold that it forces everyone in the market to respect (for a while). Why do I think this is such a poor strategy? It reduces the BOJ to nothing more than a technical analyst, developing monetary policy according to charting techniques. Don’t get me wrong I’m a firm believer in TA just not so sure I would like my monetary policy to be dictated by it.

Also, now the market knows it weakness. It knows how to force a decision out of Kuroda. The Master –servant relationship is a complicated one in macro finance. Sometimes the market is beholden to the Central bank and sometimes the central bank is beholden to the market. Kuroda I believe now is firmly in the hands of the market, it may appear the other way but not so. When the market wants something it knows how to get it- fundamentals be dammed.

Where have we seen this type of behavior before? I.E negative rates for a currency. Well one that is close to my experience is of course Switzerland. The Swiss currency has had negative rates for some time now (Dec/Jan 2015).

Now you would assume that if this was an effective tool of monetary policy that inflation should be around the magic 2% mark in Switzerland, right? Wrong? The official Swiss inflation rate is even worse than the Japanese rate, and what you may note is that the below chart shows negative inflation or deflation throughout a period where oil prices were trading around the $100 mark so, don’t just say the very lazy and defeatist comment of…… “ Yes, but oil …………….”

 

In a race to devalue currencies all around the world the Swiss central bank (SNB ) commonly known as the world’s biggest hedge fund did the only thing they could do to devalue their currency. Pegging it to a level didn’t work EURCHF ( 1.20) to hold back the tide of those who rush into buying CHF in times of strife, so they famously abandoned it and all hell broke loose as the leverage in the system in that particular pair unwound itself. Now the USDCHF is back to the very level it was before that move, EURCHF is not owing to the ECB’s concerted campaign to drive the Euro lower, but USDCHF has found its way back and is looking to go lower higher ( implying a weaker CHF ). Why is this? Negative rates are such a drag man. Is inflation any higher in Switzerland? No, arguably its lower.

So Kuroda had me last year with some policies and now he has lost me. His negative rates may succeed in devaluing the currency and (therefore assisting in debt reduction strategy which is a whole other blog post) but he will not succeed in achieving anything close to a 2% inflation level.

And while this goes on it seeks to develop the idea that central banks are indeed out of carrots (arguably they had never had any in the first place) so the stick will be used in Japan and every other major economy around the globe ( US & EU ) until morale improves.