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Guarding Your Tail

September 3, 2013 Leave a comment

It didn’t seem when dawn broke in New York today as if the stock market would spend some time during this first post-summer session fighting to record a positive mark on the close. The S&P opened up 1% higher, partly because Chinese economic data was modestly stronger-than-expected, but mostly because hot money types sought to use the thin overnight session to try and create the impression that returning investors were flocking to buy “these cheap levels.”

But whatever the proximate cause of the overnight rally, it was met immediately with selling and three hours later the indices were flirting with unchanged on the day before a late charge produced a +0.4% finish for the S&P. I don’t think the turnaround had anything to do with the fact that Israel fired ballistic missiles into the Mediterranean as a test of anti-ballistic-missile technology last night – that information was known when we walked in, although there was some confusion about whether the U.S. was involved or not and whether it was supposed to be secret or not.

Indeed, the whole U.S. market seems far more interested in whether the Employment number this Friday is 160k or 180k than whether the U.S. or Israel attacks Syria, prompting a response from Iran and/or Syria on Israel and generally provoking the situation in the Middle East like a Mentos candy dropped into Diet Coke. This is why 10-year notes were down on the day, despite the fact that the terribly low float outside the Fed means any flight to quality could be explosive.

The odds of a flight to quality may be low, but the expected payoff is (probability of event) * (value given that event happens), the latter of which is quite high. This is one reason I would be more comfortable being cautiously long bonds at this point. I guess the counterargument is that any taper will have a disproportionate effect on the sectors with less float, but I would think that should be mostly priced in by now. Well, perhaps the Syrian conflict is priced in as well…after all, little is likely to happen very soon, unless Congress acts quickly to validate the President’s request for authorization of military action. The President doesn’t seem to be looking for a quick answer and would probably like the whole issue to just go away, so probably the most likely event is still that nothing happens in Syria that impacts U.S. interests very much.

But do keep in mind that the part of the value of a particular strategy that comes from a particular state of the world is, as I said above, (probability of the state of the world) * (value given that state of the world happens).[1] For many financial options, the value of the option is determined not by the likely or median outcome, or even the distribution of likelihood of outcomes around the strike price of the option, but rather the outcomes in the tail, where there is very low likelihood and very high value. These are all “unlikely” events, in the sense that their independent probabilities are less than 50% and in most cases markedly less:

  • a hot war in the Middle East,
  • an abrupt taper from the Fed, or a decision from the Fed to increase purchases,
  • Merkel’s party loses the vote and is unable to form a pro-Euro coalition,
  • the Yen suddenly collapses,
  • the US borrowing ceiling isn’t extended without fierce brinkmanship (in mid-October, the US won’t be able to pay for everything it wants to pay for, although it will still have plenty to make debt service and entitlement payments and so is not in even remote danger of an actual default unless the Treasury simply refuses to direct its ample revenues to debt service),
  • …and others.

How does your asset allocation perform under each of these scenarios? Are there tails you have unhedged? If so, then you are doing what hedge funds have been doing for the last couple of decades: selling implicit options, earning a better return today as long as a bad event doesn’t hit. In hedge fund land, we talk about being short implied credit or liquidity options, but even retail investors have this sort of position on. What happens to your portfolio if oil goes to $200, or the US suddenly drops into recession, or the Euro breaks up over the weekend? What about if inflation goes from 2% to 6%? (Interesting fact: over the last 100 years, inflation accelerated by at least 4% from one year to the next fully 10% of the time. And the probability that inflation is over 10%, given that it is over 4.5%, is 37%…so in other words, the inflation tails are very long).

Don’t ask me for answers about what you should do in these cases – my purpose in these articles is not to distribute free answers to intricate questions that depend on your personal situation. My purpose is to present the question, and the question is, have you thought about how your portfolio will perform in the case of unlikely events?

If not, spend some time doing so. My fundamental belief is that a 70% or 80% equity position is almost never the right answer for any investor. If you are sufficiently wealthy that you could lose that 80% and have it not affect your lifestyle, either now or in the future, then you truly can plan for the long haul and ignore such risks (although even then I would not ignore valuations because you can add to your long-term returns by paying attention to them). For everyone else, “long term” is probably 10 years or less, and severe impairment of the portfolio does not admit to a certain 10-year cure. Just ask the people who had most of their retirement assets in Enron, or for that matter in the NASDAQ circa March 2000.

Watch your tail. The next month or two will be interesting.


[1] Technically, this is only true if all of the enumerated states of the world are distinct. To the extent that they are not, a covariance structure comes into play…for our purposes you can think of each separate event as creating option value, but you can’t simply sum those values.

Shifting Regimes And Those at Risk of Toppling

October 9, 2012 3 comments

Equities weakened today, while commodities strengthened (and especially energy commodities). Although it is only one day’s trading, this messes around a little bit with the popular themes at the moment regarding why stocks are so high despite widespread expectations for a lackluster Q3 earnings season.

One theme has it that the stock market is doing well because the economy had been looking pretty good, especially with Friday’s positive (although not terrific) Employment Report, even if Q3 turns out to be disappointing. After all, stocks are supposed to discount the future, not the past, right? In line with that theme, today’s pullback might represent a weakening of sentiment about global growth. The IMF revised downward its forecast for global growth to 3.3% this year (and advanced economies only 1.3%).  However, if that’s the reason then surely commodities ought to have suffered as well, especially gasoline. On the contrary, gasoline rose 2.6%, with November RBOB coming within $0.60 of a contract high set in March.

Another theme is that quantitative easing has been levitating stocks, despite weak fundamentals. But that doesn’t hold water either, since quantitative easing ought to be pushing commodities higher at least as much as it is pushing equities (which, after all, tend to trade with weak multiples in high-inflation regimes). The chart below (source: Bloomberg) shows the last year’s trading in the S&P, gold, and the DJ-UBS generally, normalized to October 10th = 100. While all three of these markets have rallied since the first implementation of the “soft” Evans rule back in June, stocks have clearly outpaced the markets that traditionally respond best to monetary largesse. So stocks are not likely up here because of QE, although that excuse probably helped over the last month.

It could, of course, be an equity-specific reason…like high valuations and probably unsustainable gross margins…but that doesn’t play well in Peoria so even though it is the simplest answer, it probably isn’t one the majority of analysts will put forth. It would be bad for business!

More subtle is the possibility that the inflation regime is moving from one that is accommodative to equity valuations (low, stable inflation) to one that is less accommodative. A ‘regime shift’ in inflation expectations is consistent with the way that inflation markets are trading – although breakeven inflation weakened very slightly today, 10-year BEI have rallied back to near all-time highs after the set back in the second half of September. It isn’t that the regime shift has happened today, and I’m not claiming that, but that it may be in the process of happening as the stock market is looking and acting toppy while inflation markets are showing some vibrancy.

It is hard to say why regime shifts happen, and the econometrics doesn’t tell you why – it just gives you ways to measure it and model it after the fact. It may be something incalculably complex, or something as easy as a news story that causes investors to reassess the context of the risks they are taking. A story, for example, about the rapidly rising prices in Iran and the collapsing rial.

It is hard to measure just exactly what inflation is in Iran. The latest figures from the central bank are from April, and show that inflation in the first four months of the year was running at a 44% annualized rate. But from all accounts, this has accelerated recently, and the behavior of consumers in the article linked to above smacks not of 3% monthly inflation, but of a much higher rate.

The reason that some people are calling this ‘hyperinflation’ is because the black market exchange rate for Iranian rials has apparently collapsed (I personally am not in touch with the black market so I have to take that on faith). The official rate, shocker of shockers, hasn’t changed much; since February you’ve been able to get about 12,350 rials for the dollar (see chart, source Bloomberg).

Now, whether or not the exchange rate is 12,000 IRR/$ or 40,000 IRR/$ isn’t as important to the average Iranian as the exchange rate of IRR for stuff – that is, the price level. This fact has led to some analysts making the rather wacky claim that inflation isn’t really that bad since the exchange rate doesn’t really matter to most Iranians. According to the story linked to here,

The politically-important lower-classes…are shielded from devaluation of the dollar because their day to day lives don’t even involve dollars. Salehi-Isfahani told Business Insider, “The Iranian currency is very worthwhile for poor people. They go to work, they get their daily wage, they go buy their chicken and bread, and they get the same that they got the day before.”
That’s crazy. If prices are changing for the upper class, I can’t think of how the lower class could possibly be insulated from those price changes. Economies just don’t work that way. If there is one exchange rate for one set of goods and another exchange rate for a different set of goods, it implies a changing exchange rate between those goods, unless there is to be arbitrage. So, to make up an example: perhaps the price of an egg is table in rials, except that a few months ago it was enough to buy bus fare and now you can trade it for a car, because both can be exchanged for enough rials to equal $1. See anything absurd about that? The relative prices matter, and you can’t stop barter, and therefore you can’t have different exchange rates in different parts of the economy without completely screwing up the economic system – probably worse than if you just let the inflation do its thing, which would at least not destroy the relative prices of goods to each other.

Moreover, the anecdotal stories don’t point to a low level of inflation, whether it’s called “hyperinflation” or not. Any way you slice it, when inflation is 40%+ whatever wealth you have saved up for a rainy day is vanishing quickly, and in Iran this is undermining an already unpopular regime (although probably not quickly enough for Israel!).

The simple realization is: when inflation starts getting out of control (and wonder of wonders, M1 money supply in Iran has risen at roughly a 34% per annum pace since 2007), all your stored-up wealth had better be in real things, or you won’t have any stored-up wealth. This is more true at 60% inflation than at 6% inflation, but even 6% inflation will halve the real value of your wealth in less than a decade. In that context, in context of the mere risk of such an outcome, I’ve wondered for a long time why more investors don’t look to protect a bigger portion of their portfolios with inflation-linked solutions. Maybe that regime is finally shifting (the inflation expectations regime, that is, not the Iranian regime) as we have an example that we can see today, rather than harkening back to the 1970s.

Incidentally, if you’re thinking about inflation investing, you may be interested in the following item. In the August “Beyond the Numbers,” a publication put out by the Bureau of Labor Statistics, there was an article entitled “Consumer Price Index data quality: how accurate is the U.S. CPI?” If you know any of those people who grouse and grumble about hedonic adjustment (the net effect is almost zero) and about the substitution of chicken for steak (the BLS makes no such adjustment, which is an ‘upper level’ substitution; the BLS only suggests that if the price of Purdue chicken goes up you might buy a different brand of chicken), then suggest this piece to them. It describes and addresses some of the biases in the CPI and how the BLS deals with them. Those that take the time to read this (relatively brief) piece will understand a lot more about how the number is actually computed, as opposed to how some hacks claim it is computed, and hopefully such an understanding will open up a wider universe of potential investments in the ‘inflation control’ toolbox.

Central Bank Groupthink

September 19, 2012 7 comments

Lest anyone be confused about the unanimity and collective will of central banks globally on the question of how aggressively to pursue a dovish monetary policy, the Bank of Japan on Wednesday surprised even the Japanese finance minister by increasing the size of its own quantitative easing program. After many years of pursuing a half-heartedly dovish monetary policy, the BOJ is now fully on board with asset purchases that will total some $1 trillion. Why not? The Fed’s aggressive asset purchases moved core inflation from 0.6% to 2.3% before a recent softening – and a rise in core inflation is what Japan has been working on for years. Five-year inflation swaps in Japan now are quoted around 0.80%, indicating that at least some investors think the BOJ’s stated policy of provoking 1% inflation has some chance of being achieved.

It is no surprise that there is great intellectual exchange between the economists at all of the central banks. While this can be a good thing (after all, Japan finally caught on that they can’t kill a rhino with a flyswatter), it is also dangerous in that it provokes groupthink. Since the Fed has clearly lost any of its monetarist leanings, in favor of an experimentalist “anything but Friedman” (ABF) philosophy, this isn’t really a good thing. If I have to groupthink – and, after all, it is hard to resist that tendency when one is in a group – I want to groupthink with Albert Einstein and his colleagues; I don’t want to groupthink with the cast of “Jersey Shore.”

Despite this obvious fanning of the inflationary flames, inflation breakevens softened again today and commodity prices slipped a bit further. The latter was mainly due to energy prices, as Crude has now dropped over 8% this week. The trigger for this correction has been the statement from the Saudis that they’ll supply lots of oil to the market, and a surprising rise in crude oil inventories. But the Saudis frequently boast that they can pump all they want, and crude oil inventories are highly variable. It seems odd to me to have what amounts to a negative “Middle East unrest premium,” but some too-smart-by-half observers speculated today that the chance of an attack of Israel on Iran has lessened since the moon will be waxing soon and providing too much light for a nighttime attack. Um…let me say that I’m just reporting this idea, not supporting it. I think if the dollar continues to weaken, oil prices will continue to rise. That basic relationship has held for most of a decade now. The chart below (Source: Bloomberg) shows the dollar index versus the front NYMEX Crude contract, weekly closes, for the last six years or so (the last point is Friday’s). The simple R2 is about 0.57.

While aggressive monetary easing from other central banks will help support the dollar, the Fed is still by far the most aggressive central bank. If the crisis continues to recede, then the dollar’s safe haven bid will continue to fade. I’m not so sure of the former, but I don’t want to bet on dollar strength here with the Fed dedicated to providing unlimited quantities of reserves.

In other economic news, and not at all unrelated to that, today’s Existing Home Sales figure was the strongest since 2009-2010, at 4.82mm units. Inventories of existing homes rose slightly, but still remain around 2003-2005 levels rather than the 2006-2011 levels. To be sure, there is plenty of shadow inventory still around, but these levels of existing home inventories have historically been low enough to allow home price appreciation.

In fact, as weird as it sounds housing has gone from being a systematic drag on core inflation to being a supportive factor in core inflation going forward. The levels of inventory should help support home price dynamics going further, but we needn’t look far into the future. Over the last year, the 9.5% rise in the median existing home sales price compares more favorably with the rates of 2002-2005 than it does to the 2006-2011 experience (see chart, source Bloomberg).

So don’t look now, but we’re in the midst of a home price rally. This is remarkable given the difficulty, still, of securing a home mortgage compared to the crazy days of the early ‘Aughts. Yes, perhaps the crazy credit terms followed the bubble’s inflation, rather than preceding and causing it. But if that’s true, then we’d have to lay the blame for the bubble more directly on the central bank’s doorstep.

Well, re-inflating the housing bubble is after all one of the things the Fed is unabashedly trying to do. Rising home prices frees trapped homeowners and solves the problem of underwater mortgages. It is just one way that inflation saves a lot of grief for policymakers.

Existing Home Sales is not the only place we see signs of percolating housing prices and warnings of continued buoyancy of housing CPI (Owners’ Equivalent Rent of Residences has been up at a 2% pace over the last year, actually higher than core CPI for the first time since 2009. Prior to that, y/y OER had been higher than core for all but one month of the period 1993-2009.[1]

This upward pressure on housing inflation will continue. I have previously documented the connection between rents and OER, which has suggested that OER could be headed to over 3% soon. The connection between rents and Owners’ Equivalent Rent is obviously pretty close, but here is another way of looking at the same thing. The chart below (source: Bloomberg) shows OER versus the National Multi Housing Council’s “Market Tightness” index, lagged four quarters. Tight housing conditions, no surprise, lead higher rents.

This regression is not as tight as the one between rents and OER, but the R2 is still about 0.48 since 2003. Moreover, the current level of the Market Tightness index points to an OER over the next year just a bit above 3%.

The final piece of the puzzle that you need to know is this: OER is 23.5% of the overall CPI, and roughly 30.7% of core inflation. Throw in “Rent of primary residence,” which is in fact direct rents, and the total is 29.9% of overall CPI and 39% of core. If housing inflation is returning, then there are two possibilities: either we are entering another housing bubble, which I think would be unprecedented (have we ever had back-to-back bubbles in the same asset class?), or else this rise will be accompanied by a rise in other prices so that nominal home prices will be rising while real home prices do not (or not as much). Either way, it looks like the Fed is getting what it wanted – and I wonder only how long it will take before people realize this isn’t an accident.


[1] In another sign ignored by those who believe there is a conspiracy (by the government, the Masons, or maybe the Knights Templars) to lower CPI, the BLS adjusts the value of the housing stock for wear-and-tear in a negative quality adjustment that has the tendency of pushing up inflation by just about the same amount that the oft-reviled positive quality adjustments push down inflation.

The Downside Of Healthy Banks

March 15, 2012 7 comments

For the third day in a row, equity volume was passable, near 800mm shares. That’s the best 3-day performance, volume-wise, since early February. What does it mean, on a day that stocks rallied another 0.6%? Bulls will say that it is supportive, showing that the rally is gaining adherents and some of the sidelined cash is returning to the market. Bears will say that it looks like retail is finally chasing the market higher.

I don’t know which (if either) of these is true, but either way the market has the support right now of solid, if unspectacular, economic fundamentals. Empire Manufacturing came in at 20.21, Initial Claims fell to 351k, and Philly Fed printed 12.5: all three releases were as good or better than expectations.

Bonds had sold off in the overnight session before rallying back and managing to fall only a smidge, with yields +1bp on the day.

Commodities were generally strong, but the energy sector fell with gasoline off -1.8%. Energy traders were a bit rattled by a Reuters story that the UK and the US had agreed to coordinate releases from strategic stockpiles. Spot Crude dropped $2 instantly. In a way, it is an odd reaction because there are only two reasons to announce a release of reserves now. The first possibility is that it is a political gambit by the Obama Administration to take away a talking point from the Republicans, pushing gasoline prices (ironically, only a week or so after the President said that a plan to lower gasoline prices to $2.50 – proposed by candidate Gingrich – was a ‘phony, election year promise.’) But if the main point was political, then why involve the UK when any important domestic effect would be driven by a release of US stockpiles?

Possibility two is that a behind-the-scenes discussion on releasing stockpiles in the event of hostilities in the Middle East was taking place. This isn’t as much of a stretch to consider as you might think; the current naval deployment map shows that in addition to two aircraft carriers already present in the Gulf region, the U.S. has newly moved a big-deck amphibious warfare ship into the region; also, two other carriers recently put to sea, with one halfway to the Mediterranean already. The Administration’s denial of the Reuters story, which caused prices to rebound warily, was also phrased curiously, with White House press secretary Carney saying that “It is inaccurate…that any kind of agreement was reached.” “Inaccurate” seems a bit wishy-washy if what he meant was that there were no discussions being had, or that the report was outright false.

If there is any chance of hostilities near-term, of course, it would be stupid to release reserves before shots were fired, because then prices would still spike on news of combat. Any agreement would presumably concern a co-ordinated stockpile release to be announced after fighting commenced. This is not a prediction of war – I am even less qualified to comment on that than on many other things people bash me about. I am simply saying that I am raising my antennae as a result of this curious combination of events.

Any prospective rise in oil prices, as well as the lagged effect of energy price increases which have already happened, is additive to whatever numbers are reported tomorrow in the BLS’s CPI report. The consensus estimate is for a rise in headline inflation of 0.4% and 0.2% on core inflation, keeping the year-on-year measure of headline at 2.9% but allowing the year-on-year core reading to slip to 2.2% from 2.3%.

I don’t think we will actually get a downtick in core inflation. If core is only 0.17% month/month, then it will be sufficient to sustain the 2.3% year/year print (which was really 2.27%), so to get a downtick to 2.2% you either need 0.15% or 0.16%, or month/month needs to surprise by coming in at only 0.1%. In fact, last February core CPI rose 0.20%, so in order to get an uptick only a +0.27% monthly print is necessary.

It has been 15 consecutive months that we have watched year-on-year core inflation rise, the longest such streak since the mid-1970s. If we get a clean, unrounded 0.2% rise in Core CPI, it should be enough to set a record by edging year-on-year core inflation higher for a sixteenth consecutive month. A downtick is possible tomorrow, but I believe we will set a record.

Record or not, the underlying reasons for being concerned about inflation are just not going away. The latest data on Commercial Bank Credit show that the “wall of money” that was safely in sterile reserves a few months ago continues to leak out. The year-on-year rise in commercial bank credit has finally surpassed 5%, the first time it has returned to the “normal” 5-10% range since the crisis began (See Chart below, source St. Louis Fed).

So if 9%-10% M2 growth, where year-on-year growth in that metric has been for the last 32 weeks, doesn’t bother you because of the decline in M2 velocity, the acceleration in commercial credit growth should cause at least a mild discomfort. Yes, banks are healing – and while that is mostly good news, the flip side of healthy banks is recovering money velocity.

From Sizzle to Simmer, Overnight

Have we forgotten how to trade anything except Europe?

Bonds today were unchanged. The S&P ended with a gain of 0.02% after trading in a 6-point range all session. Volume barely cracked 600mm shares, easily the quietest Monday of the year and barely exceeding the 599mm shares printed on the slowest day of the year so far, February 24th. It bears reminding that, with the exception of the day after Thanksgiving and the week between Christmas and New Year’s Day, the equity market hadn’t seen a day with only 600mm shares traded since at least 2004 (the data provided by Bloomberg only go back to 2005). And now we have two of them in the span of slightly more than two weeks.

We are only days removed from the most-threatening period of financial disruption since at least 2008, and that assumes that we are removed from that period. It is not clear yet when the next shoe will drop, but one seems likely. Will it be Portugal, with 13.3% ten-year-notes? Spain, which just unilaterally announced that it will not deliver a deficit/GDP ratio this year that it had previously agreed to? (They said they preferred 5.8% to the 4.4% they’d told the EU). Or Greece again, for any of ten different reasons?

Let’s revel in the calm, I suppose. If Europe can go from sizzle to simmer for a few weeks, attention will turn soon enough to the Middle East where Syria, Iran, and Israel/Gaza all offer compelling story lines. Any one of these stories is probably not enough to move markets, but any overlap in the stories (Iran expresses overt support for Hamas in Gaza, for example) could have non-linear effects in the market – that is, energy markets may suddenly care.

On Tuesday, the FOMC is meeting, but there are no expectations for anything more than token tweaks to the official statement and certainly no hint of any change in policy on the horizon. The market will be quiet and thin, less because the FOMC is meeting than because hey, the NCAA bracket won’t fill itself out! (Plus, the NFL free agency period begins…with the NFL today taking a page from the Troika and instituting an NFCAC, changing rules retroactively to seize $46mm in salary cap space from Washington and Dallas and distributing it to other teams. But I’m not bitter.)

In principle, the 8:30ET release of Retail Sales (Consensus: +1.1%/+0.7% ex-autos) could trigger some volatility, but I honestly don’t expect it.

It isn’t just that the market is thin. Thin markets can be volatile and whippy as moderate-sized flows push prices around. It’s that the market is thin and investors and traders are remarkably noncommittal, so it is thin and lethargic. I don’t know what that indicates, exactly. It could indicate that investors are very conservatively positioned, so that there is a lot of “potential energy” when they come off the sidelines. But it could just as easily mean that investors are fully committed to their favorite strategy, and will run for the hills if it stops working. I’ve seen both kinds of markets, and they are not easy to distinguish a priori.

I am not one who changes positions just because nothing is happening, however. I remain bearish on fixed-income, bearish on equities (although with the success of the Greek tender I am not adding any more to put positions), and bullish on commodities. I don’t expect to win all three of those bets.

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