• 19 Apr 2012 at 7:10 PM

Risk-On, Risk-Off, Risk-Of-Firing

Oh, the world. Go read Jeremy Grantham’s GMO quarterly letter; as always it’s pretty fun. Then go read this HSBC report that Paul Murphy wrote about on Alphaville. These are things you probably know already but are worth remembering. First, Grantham:

The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!

You probably knew that, though the numbers were new to me.* This though seemed like a useful breakdown: Read more »

  • 21 Feb 2012 at 6:46 PM

The Smart Indexes Are Even Worse Than The Dumb Ones*

You may have heard that the Dow hit 13,000 today before subsiding to a shameful 12,965.69. You may not have heard this, or cared, because the Dow is for morons, being a price-weighted index of thirty semi-random companies that, gah, aren’t even “industrial” any more.** There are alternative theories but those theories are wrong:

Joe Weisenthal in defense of the Dow has been noting its very high correlation with other, broader, more sensible indexes. I see this as further undermining the Dow’s legitimacy. If it’s very different methodology were leading to some kind of meaningfully different result, then we could perhaps argue that it’s adding value in some kind of way. But instead what’s going on is that the Dow’s creators are hand-picking which stocks to include in the index specifically with an eye toward constructing an index that mirrors the other, better indexes out there. Apple and Google, for example, aren’t in the Dow and aren’t doing to get in any time soon because their very high share prices would skew the index in weird ways. This just goes to show that the Dow’s creators already “know” the right answer (from looking at the S&P 500 and the Wilshire 5000) and then are trying to assemble an index to create the predetermined result.

Maybe! An alternative theory is maybe suggested by [Occam’s razor and] this piece from the Journal this weekend about index funds that I just loved and so am now going to inflict on you at unnecessary length: Read more »

Goldman Sachs has a piece of research out today on ETFs, billed as sort of “ETFs for dummy portfolio managers who need to start understanding them.” It’s worth a read if you can get it, with a decent overview of questions that it is probably possible to think too hard about, like whether 400% short interest in many big ETFs is worth freaking out about (short answer: nah).

Particularly useful is a cautious but intelligent stab at the question of whether increased correlations are being driven by increased ETF use:

A substantial debate exists among investors about the cause of increased correlation. Namely, are correlations high simply because the environment is dominated by the macro? Or, are they due to the increasing use of index-level products, such as ETFs and futures? And most importantly, how do these forces interact? Given the nature of the cause-and-effect relationship of the two sides of this debate, we find our highest value in becoming more granular in our approach to these questions by specifically focusing our work on sector-based observations rather than index-level ones.

For those who like charts, here are two charts: Read more »

If you read only one thing about ancient fire management methods and modern volatility, it should be this report by Chris Cole of Artemis Capital Management.

There is much goodness here that others have discussed. But perhaps the most interesting for the current world is the move from positive to negative serial correlation in stock prices over time. (Positive serial correlation means that stocks are more likely to go up the day after an up day, negative that they’re more likely to go down on the day after an up day, and zero that yesterday’s performance is not predictive of today’s.) Serial correlation peaked in 1971, floated around zero-ish from 1980 to 2000, and is now strikingly negative:

As Cole says: Read more »

Goldman Sachs Portfolio Strategy Research has a fascinating research piece out today on equity correlation markets. It does good work as a piece of research because (1) if you like equity derivatives, it’s got all sorts of fun charts and technical stuff and (2) if you don’t, it’s got a hard sell: trade equity corr with Goldman!

There are many market participants that are affected by the level of equity correlations but are not yet trading correlation actively. So far, the market has been primarily one-way; banks selling correlation and hedge funds and proprietary trading desks buying it for the positive carry. We believe that the correlation market can become a new area in which institutional investors could add alpha.

The equity correlation market, which is pretty niche-y, lets investors bet on how dispersed the returns of stocks will be in the future. And the trade to make now, Goldman thinks, is to sell correlation, which “appears attractive,” meaning that current implied correlation is much higher than they think realized correlation will be in the future: Read more »

Correlations between and among asset classes tend to go way up in periods of stress, and so it should come as no surprise that Biblical events have, um, correlated with record correlations among stocks. Here’s the chart from Goldman’s David Kostin:

Really high correlations make trading really easy! All you have to do is get the right direction, then it doesn’t matter what stocks you pick. So how’d everyone do?

Not so great. The Wall Street Journal talked to Credit Suisse:

Based on one-month trailing movements, S&P 500-index stocks have a correlation of 80%, even higher than the 73% peak reached during the crisis in late 2008, says Ana Avramovic of Credit Suisse.

The impact is felt by everyone from small investors to the most sophisticated hedge-fund managers, who often go long and short different stocks rather than bet on market direction. Indeed, Ms. Avramovic points out that hedge funds tend to perform better when correlation declines and suffer when it increases.

CNBC, on the other hand, has been reading Goldman’s Kostin, whose own headline is “Hedge funds outperform in correlated sell-off.” He explains:
Read more »

Zero Hedge points out this awesome chart in an otherwise kind of back-test-eriffic Stanford paper on credit-equity correlation trading:

The chart graphs 2003-2010 investment grade credit spreads (left axis) versus the S&P (bottom axis), with the size of the circles corresponding to the level of the VIX volatility index and the colors distinguishing the year of the observations.
Read more »