THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
The second quarter of 2009 is winding down and it is time for some retrospective analysis and a few forecasts. In the addition to the written commentary below, I've also recorded a video for MarketDNA, a blog which I maintain for the benefit of my Pepperdine University MBA students.
The S&P 500 rallied an additional 15% in Q2 with a practical absence of any meaningful pullbacks. Not unexpectedly this rally occurred alongside a weakening USD. This inverse correlation has proven almost necessary in the last few years to justify any meaningful increases in equity prices. In this particular circumstance, the weakening dollar reflected the so-called “reflation trade” when economic and monetary stimuli are injected massively into the economy improving demand but also creating inflation expectations.
Stocks and commodities as well tend to react favorably in this context and so they did. Inflationary expectations were not missed by bond traders who continued to unwind the overly aggressive long positions accumulated at the end of last year and in the face of growing government supply, yields started to increase.
The inflation/deflation debate is at the core of any economic forecast for the foreseeable future. We believe it is undeniable that some level of inflation will be the legacy of this dislocating economic period but we do not believe it is an issue at the moment.
The economic recovery seems very sloppy and certainly uneven. Unemployment rates are still growing (albeit normally a lagging indicator) and based on historical comparisons should continue to rise significantly. The most positive scenario would be a shift in the engines of growth from the US to the emerging markets, a move that would spur international economic growth and new found incentives to increase productivity. However, emerging markets, as exciting as they may be in the long term, just don’t have the critical mass or the proper balance between domestic demand and exporting policies, to be able to drive the rest of the world out of this malaise.
Economic numbers out of China seem foggy at best, manipulated at worst; Russia is completely dependent on energy prices and those are a function of global recovery (a circular relationship); Brazil and India could help but in due time and not in the short term. In terms of equity prices, emerging markets did outperform US stocks and for long term portfolios, I still think they represent a good bet and should be on everyone’s radar.
At this juncture, the problem is identifying whether equities in general are still undervalued and then identifying selective opportunities. The P/E ratio of the US market is now at best indicating fair value and not anymore any undervaluation; this is true of TTM ratios, forward looking ratios and CAPE ratios as well. Another negative seems to be the increased selling interest on the part of corporate insiders who were actually big buyers around the March lows. The stock/bond ratio also indicates overbought equities compared to bonds (even though such extreme was recently alleviated). Overall, the US market does not seem to be a compelling buy at the moment and that should skew investors’ attention toward more selective ideas and strategies.
MLPs continue to be high on the list for the income and the inflation protection built into their business model. Also the tax advantage may come in handy as this administration may move toward increases in dividend and capital gains taxes. Of course the increase in Treasuries yields reduces the competitiveness of MLPs distributions; however, the spread remains attractive.
Option trading was not as profitable as expected in Q2 as a persistent lower implied volatility versus statistical volatility made derivative arbitrage more difficult. Lower volume in options also increased the cost of trading and made this quarter a non-event. Looking forward we think an increase in volatility is likely and a more aggressive two-way trading environment may be developing which would be beneficial to our strategy.
One last comment on increasingly strange intraday trading dynamics; many professional players have noticed that while the financial system has returned to some level of stabilization, on an intraday level market dynamics feel strange and maneuvered. Many theories are circulating including the never ending conspiracy explanations. We are not sure concrete manipulations are indeed occurring but it is clear that many intraday moves are nonsensical; one possible explanation may be that in the absence of a coherent and general investment thesis as you would normally experience during normalized times, computer trading and quant based algorithms take over distorting logical intraday supply-demand relationships. The increase weight of institutional trading in dark pools and supplemental liquidity programs may be significantly distorting intraday internals. This is something for the regulators to investigate but in the meantime it is another new issue that has to be incorporated into any market analysis.
- Davide Accomazzo, Managing Director
Monday, July 6, 2009
Commodity “Roll Yield” a Fictional Return?
This article, originally published by Opalesque Futures Intelligence (Issue 5, April 7, 2009), is an extract from the paper, “Term Structure and Roll Yield: Not Your Father’s Backwardation.”
Half the lies they tell about me aren't true. --Yogi Berra
Term Structure and Roll Yield
Question: if something is stated repeatedly as fact, does that make it necessarily true? We no longer believe the sun circles the earth, but that idea was once conventional wisdom.
A similar issue faces investors who use passive commodity indexes. In a recent Financial Times story, “Steep ‘contango’ forces traders to adapt commodities plans”, we are told that investors in commodity index products “obtain a separate return, known as the roll yield, as they shift their positions each month from the expiring futures contract into the following month.” This idea is so commonly asserted that it is accepted as fact—but is it?
The problem is that empirical tests using a variety of models have produced inconsistent conclusions as to whether there is in fact positive expected returns from speculating in the futures market. This is vexing to financial institutions who sell products structured around commodity benchmarks such as the S&P GSCI or DJ-AIG, and who need to “market” a structural source of return in what is essentially a zero-sum game.
Notably, ten years ago mainstream thinking about commodities was largely negative. Thomas Schneeweis and Richard Spurgin in their 1996 paper, “Multi-Factor Models in Managed Futures”, stated that the low level of investment in managed futures was due to the fact that investors required both a theoretical basis and supporting empirical results. In other words, prevailing wisdom at the time was against speculation in commodities.
The industry’s marketing solution came in the form of a series of studies over the past decade of which the most cited is “Facts and Fantasies about Commodity Futures” written by Gary B. Gorton and K. Geert Rouwenhorst, two Yale University academics. After their paper was referenced by Jim Rogers in his book Hot Commodities, the concept and theory of the roll yield became well established in the investor mindset.
Our working paper “Is Managed Futures an Asset Class; The Search for the Beta of Commodity Futures” nonetheless, takes issue with Gorton and Rouwenhorst’s conclusions.
To begin with, the roll yield is derived from a simplified definition of backwardation and contango based on what Hilary Till, co-editor of Intelligent Commodity Investing, describes as the “term structure of the futures price curve.” Nowadays, backwardation is commonly defined as conditions when “the futures price is below the current spot price” and contango as conditions when “the futures price is above the current spot price.”
However, this paradigm is not in line with the original definition of normal backwardation as described by John Maynard Keynes (1923, 1930), and related phenomena identified by Nicholas Kaldor (1939) and Holbrook Working (1948, 1949). Classically, backwardation and contango correlate the futures price to the “expected future spot price,” which is an unknown, to be discovered in the future, at the time the futures converges with the spot.
This difference in assumptions is not insignificant. The conundrum is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in forward contracts. They are simply agreements which commit delivery of an asset at some place/point in time. So how does rolling contracts yield positive expected returns?
Rolling the Futures Contract Backward
Futures and forward contracts, unlike securities, are instruments with a finite life and terminate on pre-specified dates when the futures contract converges with the spot price. At that point the spot price is discovered and delivery of the underlying cash commodity is made between commercial participants.
A wheat futures contract, for example, has delivery contracts for March, May, July, September and December. For this reason, and as a matter of practice, most speculators do not allow their positions to enter the delivery period, and a perpetual long futures position requires a trader to “roll the contract” from one contract month to the next.
A close look at the studies written by proponents of the roll yield reveals use of a model or algorithm that results in a fictional trade. Rather than rolling the futures contract forward, they in effect roll the futures contract backward to provide “proof” for their thesis. This is facilitated with the assumption that the “expected future spot price” is a pre-determined static constant, which it is not.
As a real world example, let’s assume that a trader goes long a March futures contract at $100. The trader subsequently rolls that contract in sixty days by selling it at $120, and simultaneously reenters the long position via a July futures contract at $121. Sixty days later the trader exits the position altogether by liquidating the July contract at $111.
The long March futures contract trade results in a $20 realized gain and the long July futures contract trade results in a $10 realized loss. Using a simple method for calculating rate-of-return of an investment, the net gain of $10 is divided into the original $100 March futures contract price, resulting in a 10% return. This is straightforward and logical.
By contrast, the model for calculating the roll yield is complicated and arguably illogical. The following example is based on formulas conventionally used by researchers to calculate roll yield as documented by Till (2007) in Intelligent Commodity Investing (chapter 3, pages 73-78).
Let’s assume a trader goes long a March futures contract at $100, and then sixty days later sells the March contract at $120. The net gain of $20 is then divided into the original investment of $100 resulting in a 20% return. This is referred to as the “spot return.”
Now at the time the trader purchased the March futures contract, assume that the July futures contract was trading at $90. The algorithm for calculating the roll yield then subtracts this $90 July futures contract price in the past from the current $120 March contract liquidation price. This is called “excess return” and the net gain of $30 is then divided into the $90 July contract price for a 33% return.[1]
The “arithmetic” roll yield is calculated by subtracting the spot return of 20% from the excess return of 33%, which results in a supposed 13% return to the investor. Obviously, this mathematical trick mixes up past and present prices, and creates roll yield out of an imaginary transaction that is impossible to duplicate in the real world.
Admittedly, models are an abstraction from reality. Expecting such models to be exactly right is unreasonable, and it is generally understood that neoclassical economic models have inherent limitations. Ergo, we must be careful not to follow models over a cliff.
As noted by Robert Greer in his paper What is an Asset Class, Anyway?, the inherent problem with investing in commodities as an “asset class” is that they are not capital assets but instead consumable, transformable [and perishable] assets with unique attributes.
By definition, any commodity trading facilitated for financial rather than commercial reasons is speculation. Further, derivatives are risk management tools, fundamentally different from the “rising tide raises all ships” concept of the capital formation markets.
Investors should recognize that commodity markets are more complex than what many proponents would have you believe. In truth, the “zero-sum conundrum” makes it impossible to isolate a persistent source of return without that source eventually slipping away.
----------------------------
COMMODITY RETURN SOURCES
* Spot Return - Gain or loss from changes in the underlying spot prices. When the spot price of the commodity rises, the value of the futures contract tends to rise.
* Collateral Return - Interest on the deposit required to trade derivatives.
* Strategy Return - Some analysts refer to a return derived from how one weights and rebalances the components of a commodity index.
* Roll Return (focus of article) - Generated by owning a futures contract for a time, and subsequently selling that contract and buying a longer dated contract on the same commodity.
[1] Hilary Till cites the following with respect to excess returns: “As explained by Shimko and Masters, the convention in calculating excess returns is to treat the futures investment as being fully collateralized based on the second-nearby price.” D. Shimko and B. Masters, 1994, “The JPMCI—A Commodity Benchmark.”
References
Keynes, John Maynard (1930). “A Treatise on Money, Volume II: The Applied Theory of Money” London: Macmillan, 1930, pp. 142-147.
Greer, Robert J. (1997). “What is an Asset Class, Anyway?” Journal of Portfolio Management, Winter, 86-91.
- Mack Frankfurter, Managing Director
Half the lies they tell about me aren't true. --Yogi Berra
Term Structure and Roll Yield
Question: if something is stated repeatedly as fact, does that make it necessarily true? We no longer believe the sun circles the earth, but that idea was once conventional wisdom.
A similar issue faces investors who use passive commodity indexes. In a recent Financial Times story, “Steep ‘contango’ forces traders to adapt commodities plans”, we are told that investors in commodity index products “obtain a separate return, known as the roll yield, as they shift their positions each month from the expiring futures contract into the following month.” This idea is so commonly asserted that it is accepted as fact—but is it?
The problem is that empirical tests using a variety of models have produced inconsistent conclusions as to whether there is in fact positive expected returns from speculating in the futures market. This is vexing to financial institutions who sell products structured around commodity benchmarks such as the S&P GSCI or DJ-AIG, and who need to “market” a structural source of return in what is essentially a zero-sum game.
Notably, ten years ago mainstream thinking about commodities was largely negative. Thomas Schneeweis and Richard Spurgin in their 1996 paper, “Multi-Factor Models in Managed Futures”, stated that the low level of investment in managed futures was due to the fact that investors required both a theoretical basis and supporting empirical results. In other words, prevailing wisdom at the time was against speculation in commodities.
The industry’s marketing solution came in the form of a series of studies over the past decade of which the most cited is “Facts and Fantasies about Commodity Futures” written by Gary B. Gorton and K. Geert Rouwenhorst, two Yale University academics. After their paper was referenced by Jim Rogers in his book Hot Commodities, the concept and theory of the roll yield became well established in the investor mindset.
Our working paper “Is Managed Futures an Asset Class; The Search for the Beta of Commodity Futures” nonetheless, takes issue with Gorton and Rouwenhorst’s conclusions.
To begin with, the roll yield is derived from a simplified definition of backwardation and contango based on what Hilary Till, co-editor of Intelligent Commodity Investing, describes as the “term structure of the futures price curve.” Nowadays, backwardation is commonly defined as conditions when “the futures price is below the current spot price” and contango as conditions when “the futures price is above the current spot price.”
However, this paradigm is not in line with the original definition of normal backwardation as described by John Maynard Keynes (1923, 1930), and related phenomena identified by Nicholas Kaldor (1939) and Holbrook Working (1948, 1949). Classically, backwardation and contango correlate the futures price to the “expected future spot price,” which is an unknown, to be discovered in the future, at the time the futures converges with the spot.
This difference in assumptions is not insignificant. The conundrum is that for every buyer of a commodity futures contract there is a seller—sine qua non, there is no intrinsic value in forward contracts. They are simply agreements which commit delivery of an asset at some place/point in time. So how does rolling contracts yield positive expected returns?
Rolling the Futures Contract Backward
Futures and forward contracts, unlike securities, are instruments with a finite life and terminate on pre-specified dates when the futures contract converges with the spot price. At that point the spot price is discovered and delivery of the underlying cash commodity is made between commercial participants.
A wheat futures contract, for example, has delivery contracts for March, May, July, September and December. For this reason, and as a matter of practice, most speculators do not allow their positions to enter the delivery period, and a perpetual long futures position requires a trader to “roll the contract” from one contract month to the next.
A close look at the studies written by proponents of the roll yield reveals use of a model or algorithm that results in a fictional trade. Rather than rolling the futures contract forward, they in effect roll the futures contract backward to provide “proof” for their thesis. This is facilitated with the assumption that the “expected future spot price” is a pre-determined static constant, which it is not.
As a real world example, let’s assume that a trader goes long a March futures contract at $100. The trader subsequently rolls that contract in sixty days by selling it at $120, and simultaneously reenters the long position via a July futures contract at $121. Sixty days later the trader exits the position altogether by liquidating the July contract at $111.
The long March futures contract trade results in a $20 realized gain and the long July futures contract trade results in a $10 realized loss. Using a simple method for calculating rate-of-return of an investment, the net gain of $10 is divided into the original $100 March futures contract price, resulting in a 10% return. This is straightforward and logical.
By contrast, the model for calculating the roll yield is complicated and arguably illogical. The following example is based on formulas conventionally used by researchers to calculate roll yield as documented by Till (2007) in Intelligent Commodity Investing (chapter 3, pages 73-78).
Let’s assume a trader goes long a March futures contract at $100, and then sixty days later sells the March contract at $120. The net gain of $20 is then divided into the original investment of $100 resulting in a 20% return. This is referred to as the “spot return.”
Now at the time the trader purchased the March futures contract, assume that the July futures contract was trading at $90. The algorithm for calculating the roll yield then subtracts this $90 July futures contract price in the past from the current $120 March contract liquidation price. This is called “excess return” and the net gain of $30 is then divided into the $90 July contract price for a 33% return.[1]
The “arithmetic” roll yield is calculated by subtracting the spot return of 20% from the excess return of 33%, which results in a supposed 13% return to the investor. Obviously, this mathematical trick mixes up past and present prices, and creates roll yield out of an imaginary transaction that is impossible to duplicate in the real world.
Admittedly, models are an abstraction from reality. Expecting such models to be exactly right is unreasonable, and it is generally understood that neoclassical economic models have inherent limitations. Ergo, we must be careful not to follow models over a cliff.
As noted by Robert Greer in his paper What is an Asset Class, Anyway?, the inherent problem with investing in commodities as an “asset class” is that they are not capital assets but instead consumable, transformable [and perishable] assets with unique attributes.
By definition, any commodity trading facilitated for financial rather than commercial reasons is speculation. Further, derivatives are risk management tools, fundamentally different from the “rising tide raises all ships” concept of the capital formation markets.
Investors should recognize that commodity markets are more complex than what many proponents would have you believe. In truth, the “zero-sum conundrum” makes it impossible to isolate a persistent source of return without that source eventually slipping away.
----------------------------
COMMODITY RETURN SOURCES
* Spot Return - Gain or loss from changes in the underlying spot prices. When the spot price of the commodity rises, the value of the futures contract tends to rise.
* Collateral Return - Interest on the deposit required to trade derivatives.
* Strategy Return - Some analysts refer to a return derived from how one weights and rebalances the components of a commodity index.
* Roll Return (focus of article) - Generated by owning a futures contract for a time, and subsequently selling that contract and buying a longer dated contract on the same commodity.
[1] Hilary Till cites the following with respect to excess returns: “As explained by Shimko and Masters, the convention in calculating excess returns is to treat the futures investment as being fully collateralized based on the second-nearby price.” D. Shimko and B. Masters, 1994, “The JPMCI—A Commodity Benchmark.”
References
Keynes, John Maynard (1930). “A Treatise on Money, Volume II: The Applied Theory of Money” London: Macmillan, 1930, pp. 142-147.
Greer, Robert J. (1997). “What is an Asset Class, Anyway?” Journal of Portfolio Management, Winter, 86-91.
- Mack Frankfurter, Managing Director
Tuesday, May 12, 2009
1st Qtr 2009 Review and Shifting Outlooks
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
A continuation of the general volatility experienced last year has continued into the first and second quarter of 2009—this is unsurprising. Most markets continue to see large daily swings even though, as far as the S&P 500 is concerned, the intraday ranges seem to have abated since the very destabilizing days of October and November 2008.
Within this environment of ongoing economic and social instability, Cervino Capital’s Diversified Options Strategy managed to book positive performance for the first quarter.
That said, the markets have been frustrating these last few months. What started out as panic selling into March 9th has evolved into a V shaped rebound which has taken the S&P 500 up about 39% from the lows with practically no retracements. The Nasdaq did even better with a 50% run concentrated in its high betas representatives: AAPL, GOOG and RIMM.
In the interim, the US dollar is back on the forefront of the global economic debate as the Chinese are again making waves for the substitution of the greenback as the world reserve currency. The Chinese suggest the new global currency should be modeled after the IMF Special Drawing Rights. Such an idea does not seem to have a chance to become reality anytime soon and such a proposal looks to be more a veiled way by the Chinese to demand additional global policy power in general.
Nevertheless, this renewed debate brings up the future relative value of the dollar. As long as markets remain destabilized the dollar should retain a bid, yet an improving macro situation will ultimately hurt it. In that case, the dollar and commodities will reflect inverse correlation.
It is within this dollar context that commodities are indicating a potential global economic resurgence as crude, copper, aluminum and platinum have started to build a base and move higher. Yet at this juncture, I believe commodities are less relevant an economic indicator, as policy and time remain in my view the two main drivers of any future economic renaissance.
Meanwhile, credit spreads in the corporate bond world (where the Federal Reserve Bank has not intervened) are still historically high and provide competition to equities as an investment choice. LIBOR, commercial paper and other credit measures look better strictly due to the Federal Reserve intervention. In effect, the Federal Reserve is now producing prices for many asset classes and instruments: ABS, MBS, CP, mortgages, Treasuries and so on.
From a macro perspective, there is a case to be made that equity markets may have found a significant bottom—significant being defined as a multi-month trend change. Many analysts have been calling for the formation of a generational market bottom. And it is true that some of the long term valuation metrics have become much more attractive than in the last 20 years (eg, cyclically adjusted P/E ratio, gold/S&P 500 ratio). However, while the market may have looked attractive below 700 it is certainly not as exciting above 900. I believe that a long term bottom will be more function of future global policy (especially a rejection of protectionist forces) and necessary time for the deleveraging process to take its course.
Add to this a shift in the domestic political-economic environment, and that any potential recovery will be cobbled by many fundamental factors (consumer balance sheet repair, commercial real estate loan refinancing, shadow foreclosure inventory, etc.), there is a strong argument that the current situation is not conducive for multiples expansion in equities.
It is within this structural context that we have approached this market. We had expected choppiness and inconsistent price action. Unfortunately, we were recently met with a constant and relentless upside momentum move which we are managing.
The key aspect to recognize about our strategy is that it excels in choppy markets, not momentum markets. We continue to believe that the long-term fundamentals will evolve into a sideways and range-bound market which we can take full advantage of.
- Davide Accomazzo, Managing Director
A continuation of the general volatility experienced last year has continued into the first and second quarter of 2009—this is unsurprising. Most markets continue to see large daily swings even though, as far as the S&P 500 is concerned, the intraday ranges seem to have abated since the very destabilizing days of October and November 2008.
Within this environment of ongoing economic and social instability, Cervino Capital’s Diversified Options Strategy managed to book positive performance for the first quarter.
That said, the markets have been frustrating these last few months. What started out as panic selling into March 9th has evolved into a V shaped rebound which has taken the S&P 500 up about 39% from the lows with practically no retracements. The Nasdaq did even better with a 50% run concentrated in its high betas representatives: AAPL, GOOG and RIMM.
In the interim, the US dollar is back on the forefront of the global economic debate as the Chinese are again making waves for the substitution of the greenback as the world reserve currency. The Chinese suggest the new global currency should be modeled after the IMF Special Drawing Rights. Such an idea does not seem to have a chance to become reality anytime soon and such a proposal looks to be more a veiled way by the Chinese to demand additional global policy power in general.
Nevertheless, this renewed debate brings up the future relative value of the dollar. As long as markets remain destabilized the dollar should retain a bid, yet an improving macro situation will ultimately hurt it. In that case, the dollar and commodities will reflect inverse correlation.
It is within this dollar context that commodities are indicating a potential global economic resurgence as crude, copper, aluminum and platinum have started to build a base and move higher. Yet at this juncture, I believe commodities are less relevant an economic indicator, as policy and time remain in my view the two main drivers of any future economic renaissance.
Meanwhile, credit spreads in the corporate bond world (where the Federal Reserve Bank has not intervened) are still historically high and provide competition to equities as an investment choice. LIBOR, commercial paper and other credit measures look better strictly due to the Federal Reserve intervention. In effect, the Federal Reserve is now producing prices for many asset classes and instruments: ABS, MBS, CP, mortgages, Treasuries and so on.
From a macro perspective, there is a case to be made that equity markets may have found a significant bottom—significant being defined as a multi-month trend change. Many analysts have been calling for the formation of a generational market bottom. And it is true that some of the long term valuation metrics have become much more attractive than in the last 20 years (eg, cyclically adjusted P/E ratio, gold/S&P 500 ratio). However, while the market may have looked attractive below 700 it is certainly not as exciting above 900. I believe that a long term bottom will be more function of future global policy (especially a rejection of protectionist forces) and necessary time for the deleveraging process to take its course.
Add to this a shift in the domestic political-economic environment, and that any potential recovery will be cobbled by many fundamental factors (consumer balance sheet repair, commercial real estate loan refinancing, shadow foreclosure inventory, etc.), there is a strong argument that the current situation is not conducive for multiples expansion in equities.
It is within this structural context that we have approached this market. We had expected choppiness and inconsistent price action. Unfortunately, we were recently met with a constant and relentless upside momentum move which we are managing.
The key aspect to recognize about our strategy is that it excels in choppy markets, not momentum markets. We continue to believe that the long-term fundamentals will evolve into a sideways and range-bound market which we can take full advantage of.
- Davide Accomazzo, Managing Director
Epilogue: In the Beginning There was Alpha
Hear then, o Economidae, nymphs of the streams
Of infinitely discussed yet discounted prophets,
Of the story which I sing: the epic of men
And women locked in the battle of egos and coherence,
Precision and relevance, the song for all ages
And peoples to hear and revere the great and poor
Deeds of this tribe of malcontents and heroes...
Of infinitely discussed yet discounted prophets,
Of the story which I sing: the epic of men
And women locked in the battle of egos and coherence,
Precision and relevance, the song for all ages
And peoples to hear and revere the great and poor
Deeds of this tribe of malcontents and heroes...
--The Walrasiad, Prologue
Epilogue:
In the beginning, Man created the markets. The markets were without form and void, and darkness was over the faces of analysts. And Man said, “Let there be Alpha,” and there was Alpha. And Man saw that Alpha was skeptic. So Man created Beta from Alpha so that he may have faith. Thus it was that Beta evolved from the aggregate of individual Alpha decisions.
In time Man affirmed that Alpha is only a derivative of Beta and not unto itself. Thus it was Alpha’s fate to be banished to the farthest corners of the market where it thrived little noticed in the wilds of commodities and forex, and strange unknown strategies.
And so it came to be that Beta ruled the markets for many generations and organized itself around the concept of rational agents and equilibrium. And those who claimed to be Alpha were really leveraged Beta or Alpha corrupted by money flows into exotic Beta. And Man saw it was good.
But alas, Man was not happy in his greed and sought more leverage and converted evermore Alphas from the wilds with the trap of untold assets under management. And thus, Beta's down-fall did come about, as Man did not recognize that faith and greed is cause for disequilibrium. Soon the wisdom of crowds became the madness of crowds, and all was chaos in the markets.
This was the way of the markets when the few remaining Alphas, the true skeptics, whose only heresy was to saith that economic agents are irrational and the natural order of the markets is disequilibrium, returned from banishment and did cause great wealth for their kind.
Thus it was that “true” Alpha in its actions restored the equilibrium. From then on it was said by Man that Alpha seeks madness in the wisdom of crowds and wisdom in the madness of crowds.
Hence, price discovery is yin-yang, as is wave-particle duality. In truth, all Man's philosophies reveal this dichotomy as Man is trapped in the observer effect, prisoners of the box in which Schrodinger placed his cat. Ergo, the universe is akin to True Beta and just a huge mechanism for price discovery on a quantum level. And Man saw that creative destruction was good.
In time Man affirmed that Alpha is only a derivative of Beta and not unto itself. Thus it was Alpha’s fate to be banished to the farthest corners of the market where it thrived little noticed in the wilds of commodities and forex, and strange unknown strategies.
And so it came to be that Beta ruled the markets for many generations and organized itself around the concept of rational agents and equilibrium. And those who claimed to be Alpha were really leveraged Beta or Alpha corrupted by money flows into exotic Beta. And Man saw it was good.
But alas, Man was not happy in his greed and sought more leverage and converted evermore Alphas from the wilds with the trap of untold assets under management. And thus, Beta's down-fall did come about, as Man did not recognize that faith and greed is cause for disequilibrium. Soon the wisdom of crowds became the madness of crowds, and all was chaos in the markets.
This was the way of the markets when the few remaining Alphas, the true skeptics, whose only heresy was to saith that economic agents are irrational and the natural order of the markets is disequilibrium, returned from banishment and did cause great wealth for their kind.
Thus it was that “true” Alpha in its actions restored the equilibrium. From then on it was said by Man that Alpha seeks madness in the wisdom of crowds and wisdom in the madness of crowds.
Hence, price discovery is yin-yang, as is wave-particle duality. In truth, all Man's philosophies reveal this dichotomy as Man is trapped in the observer effect, prisoners of the box in which Schrodinger placed his cat. Ergo, the universe is akin to True Beta and just a huge mechanism for price discovery on a quantum level. And Man saw that creative destruction was good.
- Mack Frankfurter, Managing Director
Monday, December 22, 2008
2008 Year End Thoughts Going Into 2009
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Given hindsight, my commentary from the end of 2007 now seems quaint when I wrote: “The long and winding year of 2007 has come to a close... In the annals of trading, this is one ‘vintage’ that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.”
Unfortunately, any hopes for a calm year was dashed back in January. 2008 is not a year on which even the most hardened veterans of the market shall look back gladly—it has turned out to be an Annus Horribilis. And as we approach the start of 2009, I can almost hear the sigh of relief of many for whom this December 31st could not come any sooner. Indeed, we have witnessed an unprecedented global meltdown of the financial system and experienced massive wealth destruction in these turbulent twelve months.
Nevertheless, in this storm Cervino Capital Management LLC managed to post a positive year for the Diversified Options Strategy keeping true to this programs mandate of absolute returns. As of the end of November 2008, the D1X program is up 2.94% and the D2X levered program is up 7.43%. And although our year-to-date performance is currently less than desired, for most of this year until the market crash in October, our rolling twelve month rate-of-return was above our stated objective.
This is no small feat given that many CTA option programs this year suffered through significant drawdowns greater than 50%, and some are no longer even trading. Our understanding is that many CTA option programs, even now, are sidelined waiting for the historically volatile market conditions to settle down.
Meanwhile, our more beta exposed investment advisory portfolios were not so lucky and while they generally outperformed the benchmarks and held very well for 3/4 of the year, tey eventually cracked with everything else in this dramatic autumn. The relatively stable performance of the Diversified Options Strategy is therefore striking in the context of such a ravaging bear market, where no asset class was spared and practically no strategy worked.
So much for Modern Portfolio Theory… just ask the much praised Harvard University Endowment. Then again this is what bear markets do: wholesale asset price destruction. It is interesting to note that bear markets will do more damage to your portfolio than wars—just look at a long-term chart of the Dow. But more on asset performances and expected return later…
What makes this bear more ferocious and treacherous to trade than any other meltdown since the 1930s is in the way our capital markets became dysfunctional during this crisis. The Fed and the Treasury (and most of their counterparts around the globe) have been engaged in massive interventions via standard monetary policy decisions, quantitative easing, capital injections in an effort to stop a seeminglyy unstoppable predicament.
While I do not believe they had much of an alternative, such conduct (and the possibly avoidable lack of consistency) has created recurrent unintended consequences, many of which we will not even face until years from now. This environment of uncertainty has had the additional destabilizing effect of making markets practically untradeable and even more dysfunctional. One day we can short, the next we can’t; one day the Treasury will buy a certain asset class, the next it will not; and so on…. not an environment conducive to improved functionality and liquidity in the global markets.
As mentioned above, the alternatives to these policy choices were practically non existent but in the long term we may be seeding more problems than solutions. I have argued in previous writings that hyperactive monetary policy such as the one implemented by the Federal Reserve Bank in the last fifteen years is highly correlated with the increasing frequency as well as the increasing size of financial crises.
Is the tail wagging the dog? Quite possibly…
The obsession of the Fed and most politicians to erase the business cycle is the direct cause of this hyperactive monetary approach. However, if the result of trying to eliminate mild but recurrent recessions (frankly, a necessary and not so negative part of an efficient economic system) is the creation of cumulative imbalances that threaten the system at its core, then perhaps a different approach may be appropriate.
For more on my views of this topic, see "A New Qualitative Capitalism"
But enough about the past—what should we expect going forward? The current situation makes it extremely hard to forecast as we are not even sure exactly what kind of economic system we are going to operate in going forward: capitalism, socialism or statist? This is a question that no Western country has had to face in almost 40 years, and yet today it is `t the core of an investor long term strategy.
I wrote extensively on the kind of new qualitative capitalism that I would like to see flourishing after this crisis, but I doubt I will get my wish. For the moment we are clearly going thru a socialistic phase rather unavoidable given the collective missteps of our bankers, leaders, and let us admit it, the “average Joe” at large.
While most pundits have been likening these times to those of the Great Depression, I think we are beginning to look more like Japan—a sad, long deflationary nightmare. Perhaps this is how all “fiat” economic systems must end. I am no fan of the gold standard but there must be a price to pay for unbridled credit creation and the promotion of a standard-of-living greatly superior to the long term rate of growth of GDP.
The bond market seems to agree with the Japanese analogy and it recently went parabolic from an already overpriced level. I have occasionally tried to take the other side of this trade in the past few months. My belief was that even in the event of a Japanese scenario, one systemic variable was completely different—the Japanese ran a trade surplus and most of their debt was held internally while we are in the opposite position.
On the positive side, we have another difference: the U.S. has historically been a more dynamic socio-economic system, and unless we forget completely our entrepreneurial spirit, we might just be able to turn things around a bit more quickly. However, such a quicker turn-around would likely spell “inflation emergency” with all the dire consequences for bondholders.
Another explanation for the parabolic moves of the bonds (especially the 30 year) might be clever alchemy from Ben and Hank. Lets say you were to triple your debt load, and at the same time control interest rates, would you not also try to massively reduce the cost of money? In the real world, if a creditor triples its debt/equity ratio its cost of servicing such debt would go up percentage wise and in absolute numbers. However, if you are the U.S. government you can drive interest rates down artificially to refinance your debt long term. Seemingly, the typical rules don’t apply to the world’s reserve currency.
The U.S. is able to pull this off by getting the Chinese to play along. And despite all protestations, they seem happy to oblige considering the massive capital gains they are being gifted with for their old positions.
All the same, going forward the yield on U.S. debt is not attractive, which typically results in a weaker currency. But since the Chinese renmimbi is practically pegged to the dollar, it too will be devaluated, which in a deflationary environment is not such a bad thing (especially when you don’t have to take the blame for it, when oil is at a 5 year low, and you are the low cost producer of the world and want to stay that way). Furthermore, with yields so low, this will allow Hank and Ben to make a nice little (well not so little) profit on all those preferreds they bought from the banks which pay around 8%.
And to think the U.S. sent Martha Stewart to the jailhouse for insider trading, go figure…
As far as equities, this 2008 was a landmark year in terms of exposing the limitation of equities as solid beta components of long term investment/savings accounts. While I do expect equities to perform much better in the next ten years than in the past ten, I also believe that 2008 was the year that the “buy and hold” mantra was finally killed.
This “black swan” data-point, in my view, changes the return expectation of this asset class in general, and it does so within the context of a much worsened volatility profile. What seems clear now is that the long term viability of a passive equity portfolio depends solely on a favorable valuation of the asset class in general—the more undervalued equities are, the longer the affordable time horizon the investor has, and the more passive he/she may be. On the other hand, the higher the valuations, the more active portfolio management must be. This relationship is direct and accelerates at the extremes points of valuation.
Beta portfolios and passive indexing as increasingly perpetuated by the industry have massively failed the test of reality. I believe investors will have to resort to a much more active asset allocation and /or to a much smaller equity allocation. And this does not take into consideration a secular shift toward socialism which would imply a significantly reduced forward return-on-earnings in equities.
Not to get too sour, a bright spot next year might end up being real estate. The convergence of steep price reductions in the last 18 months, the cumulative efforts of all government agencies to reduce mortgage rates and possibly alter the price discovery process of this asset class in general, and a surfacing interest by foreign buyers may just be that needed energy to stop the bleeding sooner than expected.
With respect to option trading, we think that as 2009 evolves, actual volatility will start to settle down while implied volatility will remain high for a longer period of time. This is an optimum environment for volatility arbitrage using options. And after 2008, we could all benefit from quieter markets. In the least, any unexpected turns in the market will not come as such a surprise after Annus Horribilis.
- Davide Accomazzo, Managing Director
Given hindsight, my commentary from the end of 2007 now seems quaint when I wrote: “The long and winding year of 2007 has come to a close... In the annals of trading, this is one ‘vintage’ that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.”
Unfortunately, any hopes for a calm year was dashed back in January. 2008 is not a year on which even the most hardened veterans of the market shall look back gladly—it has turned out to be an Annus Horribilis. And as we approach the start of 2009, I can almost hear the sigh of relief of many for whom this December 31st could not come any sooner. Indeed, we have witnessed an unprecedented global meltdown of the financial system and experienced massive wealth destruction in these turbulent twelve months.
Nevertheless, in this storm Cervino Capital Management LLC managed to post a positive year for the Diversified Options Strategy keeping true to this programs mandate of absolute returns. As of the end of November 2008, the D1X program is up 2.94% and the D2X levered program is up 7.43%. And although our year-to-date performance is currently less than desired, for most of this year until the market crash in October, our rolling twelve month rate-of-return was above our stated objective.
This is no small feat given that many CTA option programs this year suffered through significant drawdowns greater than 50%, and some are no longer even trading. Our understanding is that many CTA option programs, even now, are sidelined waiting for the historically volatile market conditions to settle down.
Meanwhile, our more beta exposed investment advisory portfolios were not so lucky and while they generally outperformed the benchmarks and held very well for 3/4 of the year, tey eventually cracked with everything else in this dramatic autumn. The relatively stable performance of the Diversified Options Strategy is therefore striking in the context of such a ravaging bear market, where no asset class was spared and practically no strategy worked.
So much for Modern Portfolio Theory… just ask the much praised Harvard University Endowment. Then again this is what bear markets do: wholesale asset price destruction. It is interesting to note that bear markets will do more damage to your portfolio than wars—just look at a long-term chart of the Dow. But more on asset performances and expected return later…
What makes this bear more ferocious and treacherous to trade than any other meltdown since the 1930s is in the way our capital markets became dysfunctional during this crisis. The Fed and the Treasury (and most of their counterparts around the globe) have been engaged in massive interventions via standard monetary policy decisions, quantitative easing, capital injections in an effort to stop a seeminglyy unstoppable predicament.
While I do not believe they had much of an alternative, such conduct (and the possibly avoidable lack of consistency) has created recurrent unintended consequences, many of which we will not even face until years from now. This environment of uncertainty has had the additional destabilizing effect of making markets practically untradeable and even more dysfunctional. One day we can short, the next we can’t; one day the Treasury will buy a certain asset class, the next it will not; and so on…. not an environment conducive to improved functionality and liquidity in the global markets.
As mentioned above, the alternatives to these policy choices were practically non existent but in the long term we may be seeding more problems than solutions. I have argued in previous writings that hyperactive monetary policy such as the one implemented by the Federal Reserve Bank in the last fifteen years is highly correlated with the increasing frequency as well as the increasing size of financial crises.
Is the tail wagging the dog? Quite possibly…
The obsession of the Fed and most politicians to erase the business cycle is the direct cause of this hyperactive monetary approach. However, if the result of trying to eliminate mild but recurrent recessions (frankly, a necessary and not so negative part of an efficient economic system) is the creation of cumulative imbalances that threaten the system at its core, then perhaps a different approach may be appropriate.
For more on my views of this topic, see "A New Qualitative Capitalism"
But enough about the past—what should we expect going forward? The current situation makes it extremely hard to forecast as we are not even sure exactly what kind of economic system we are going to operate in going forward: capitalism, socialism or statist? This is a question that no Western country has had to face in almost 40 years, and yet today it is `t the core of an investor long term strategy.
I wrote extensively on the kind of new qualitative capitalism that I would like to see flourishing after this crisis, but I doubt I will get my wish. For the moment we are clearly going thru a socialistic phase rather unavoidable given the collective missteps of our bankers, leaders, and let us admit it, the “average Joe” at large.
While most pundits have been likening these times to those of the Great Depression, I think we are beginning to look more like Japan—a sad, long deflationary nightmare. Perhaps this is how all “fiat” economic systems must end. I am no fan of the gold standard but there must be a price to pay for unbridled credit creation and the promotion of a standard-of-living greatly superior to the long term rate of growth of GDP.
The bond market seems to agree with the Japanese analogy and it recently went parabolic from an already overpriced level. I have occasionally tried to take the other side of this trade in the past few months. My belief was that even in the event of a Japanese scenario, one systemic variable was completely different—the Japanese ran a trade surplus and most of their debt was held internally while we are in the opposite position.
On the positive side, we have another difference: the U.S. has historically been a more dynamic socio-economic system, and unless we forget completely our entrepreneurial spirit, we might just be able to turn things around a bit more quickly. However, such a quicker turn-around would likely spell “inflation emergency” with all the dire consequences for bondholders.
Another explanation for the parabolic moves of the bonds (especially the 30 year) might be clever alchemy from Ben and Hank. Lets say you were to triple your debt load, and at the same time control interest rates, would you not also try to massively reduce the cost of money? In the real world, if a creditor triples its debt/equity ratio its cost of servicing such debt would go up percentage wise and in absolute numbers. However, if you are the U.S. government you can drive interest rates down artificially to refinance your debt long term. Seemingly, the typical rules don’t apply to the world’s reserve currency.
The U.S. is able to pull this off by getting the Chinese to play along. And despite all protestations, they seem happy to oblige considering the massive capital gains they are being gifted with for their old positions.
All the same, going forward the yield on U.S. debt is not attractive, which typically results in a weaker currency. But since the Chinese renmimbi is practically pegged to the dollar, it too will be devaluated, which in a deflationary environment is not such a bad thing (especially when you don’t have to take the blame for it, when oil is at a 5 year low, and you are the low cost producer of the world and want to stay that way). Furthermore, with yields so low, this will allow Hank and Ben to make a nice little (well not so little) profit on all those preferreds they bought from the banks which pay around 8%.
And to think the U.S. sent Martha Stewart to the jailhouse for insider trading, go figure…
As far as equities, this 2008 was a landmark year in terms of exposing the limitation of equities as solid beta components of long term investment/savings accounts. While I do expect equities to perform much better in the next ten years than in the past ten, I also believe that 2008 was the year that the “buy and hold” mantra was finally killed.
This “black swan” data-point, in my view, changes the return expectation of this asset class in general, and it does so within the context of a much worsened volatility profile. What seems clear now is that the long term viability of a passive equity portfolio depends solely on a favorable valuation of the asset class in general—the more undervalued equities are, the longer the affordable time horizon the investor has, and the more passive he/she may be. On the other hand, the higher the valuations, the more active portfolio management must be. This relationship is direct and accelerates at the extremes points of valuation.
Beta portfolios and passive indexing as increasingly perpetuated by the industry have massively failed the test of reality. I believe investors will have to resort to a much more active asset allocation and /or to a much smaller equity allocation. And this does not take into consideration a secular shift toward socialism which would imply a significantly reduced forward return-on-earnings in equities.
Not to get too sour, a bright spot next year might end up being real estate. The convergence of steep price reductions in the last 18 months, the cumulative efforts of all government agencies to reduce mortgage rates and possibly alter the price discovery process of this asset class in general, and a surfacing interest by foreign buyers may just be that needed energy to stop the bleeding sooner than expected.
With respect to option trading, we think that as 2009 evolves, actual volatility will start to settle down while implied volatility will remain high for a longer period of time. This is an optimum environment for volatility arbitrage using options. And after 2008, we could all benefit from quieter markets. In the least, any unexpected turns in the market will not come as such a surprise after Annus Horribilis.
- Davide Accomazzo, Managing Director
Steamrolling Over Option Trading Programs
[Originally published October 21, 2008 on SafeHaven and MarketOracle.]
"In days of old, seers entered a trance state and then informed anxious seekers what kind of mood the gods were in, and whether this was an auspicious time to begin a journey, get married, or start a war. The prophets of Israel repaired to the desert and then returned to announce whether Yahweh was feeling benevolent or wrathful. Today The Market's fickle will is clarified by daily reports from Wall Street and other sensory organs of finance. Thus we can learn on a day-to-day basis that The Market is "apprehensive," "relieved," "nervous," or even at times "jubilant." On the basis of this revelation awed adepts make critical decisions about whether to buy or sell. Like one of the devouring gods of old, The Market -- aptly embodied in a bull or a bear -- must be fed and kept happy under all circumstances. True, at times its appetite may seem excessive -- a $35 billion bailout here, a $50 billion one there -- but the alternative to assuaging its hunger is too terrible to contemplate."
--Dr. Harvey Cox, Atlantic Monthly (1999)
Has the options trading model blown up?
Investor interest is options programs is a study in contrarian behavior. During the 1990s there was a great deal of aversion to the strategy of writing options. This began to change after 2003 when the S&P 500 bull market and the VIX bear market provided a “goldilocks” environment for naked option writing. The result was a proliferation of CTAs offering such programs by the end of 2006.
The irony is that low volatility going into 2006 created increasingly dangerous conditions to engage in option writing. In order to maintain return expectations from prior years, a CTA had to increase risk by either moving the strike price closer to the underlying price, and/or increase the number of positions.
Conventional wisdom at the time was that these programs were uncorrelated to the underlying market. As a result, there was a flood of investor interest in option programs seeking 20+ percent returns. Then came the subsequent transition to higher volatility since February 2007 which has yet again chastened many investors.
There is an old saying when it comes to options trading—it is like picking up nickels and dimes in front of a steamroller. It turns out many players offering option programs in 2005 and 2006 were relatively new to the space, untutored in the violence of short “gamma” as happened during 1998, 2001 and 2002.
So what distinguishes one option program from another, as well as risky trading from less risky trading? The answer is qualitative, but the trick is to produce “risk-adjusted returns,” in which positive returns are generated while mitigating volatility and exposure to risk. In options trading, this is a difficult feat.
First, investors need to recognize that there is a direct correlation between leverage and return with any managed futures program. A program which produces a 30% return is not necessarily better than a program which produced a 15% return. In fact, these returns could be produced by exactly the same trading programs with one using twice the leverage as the other for the same size account. The key is risk-adjusted returns.
One of the crucial factors which provides for consistent absolute returns in option writing/premium capture strategies is “theta,” or time decay. Consequently, the most important responsibility for a trader to manage is the risk of positions in his/her book, which should be considered liabilities until expiration.
A standard strategy is to write options far out-of-the-money, with the idea that the probability such options will go into-the-money by expiration represents a low probability event. In this strategy, traders will “white knuckle” their positions with expiration the only true stop loss. Investors are required to suffer high intra-month equity volatility in their accounts with the expectation that if the options eventually expire out-of-the-money, any unrealized losses plus premium written will be earned.
Risk of ruin is high with this kind of approach, and there is a tendency for the “deer in the headlight” syndrome. If traders do cover such positions, thereby booking large “painful” losses, they will often “roll” the contract to another strike price in the hope that the market won’t reach that subsequent level.
This kind of strategy has worked reasonably well for many option programs, with some using variations of the strategy to mitigate risk and equity volatility by utilizing bull spreads and/or calendar spreads.
The critical question in this current environment is if implementing routine trading strategies is still viable or more importantly, is it prudent? There are rumors that certain CTA option programs have utilized more margin than the agreed-to account size. This situation, in my opinion, represents irresponsible trading.
The bulk of investment performance is typically a function of strategy and risk taken. Yet the complexity of human behavior can never be fully modeled. Therefore, a discretionary common sense approach is needed—one which balances the quantitative with the qualitative in order to manage cycles of volatility.
Traders like to talk about how they provide “alpha” or skill-based returns. Alpha is a byproduct of “beta,” which is often referred to as a benchmark. In alternative investments, one can think of beta as the core strategy and alpha as the tactical overlay in response to changing market conditions.
This is the strength of discretionary trading—the ability to tactically adapt to changing conditions.
Unfortunately, the ‘quality of returns’ is a difficult concept to quantify. My recommendation is not to analyze how well traders have performed in normal market conditions, but how they have performed under stressful market conditions such as February 2007, March 2008 and now during October 2008.
Where does option trading go from here?
The seeds of the economic crisis we currently find ourselves is founded on the ‘forward contract exclusion’ from Section 2(a)(1)(A) of the Commodity Exchange Act of 1936. From this loophole in the Act, and various court cases since 1936, as well as the CFTC’s 1992 exemptive order issued under then-chairperson Wendy Gramm, evolved the unregulated over-the-counter (OTC) derivatives market. It is this history, along with deregulation built into the Commodity Futures Modernization Act of 2000, which allowed for the exponential growth of the $50-$60 trillion credit default swaps (CDS) market.
But for the ISDA and its former CEO, Robert Pickle, previous market crises such as the Orange County and Metalgesellschaft derivatives debacles in 1994, as well as the implosion of Long-Term Capital Management in 1998, should have long ago forced OTC derivatives onto exchanges such as the CME.
The persistency of frozen credit market conditions in the face of multiple central bank, treasury and government actions/interventions is cause for great alarm. Meanwhile, the Sword of Damocles overhanging this crisis has always been the CDS market. Draconian as it may be, some are calling for international action to declare credit default swaps null and void. But could this fear be overblown?
Fear culminated in panic last week as the market eyed Friday’s Lehman Brothers CDS auction in New York. The average price at the auction was below 10 cents, and worry was that financial institutions worldwide would have to face a bill of as much as $400 billion leading to significant writedowns.
It turns out, however, that the net payouts that CDS sellers have to make on defaulted Lehman Brothers debt is only a small fraction of the amount of insurance that was written. According to the DTCC, the “multilateral” calculations it performed on swaps tied to Lehman “indicate that net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range.”
This is excellent news as it proves to the market that net exposure on CDS transactions is substantially less than the $50-$60 trillion nominal figure often cited, which in fact references the “underlying” bonds and loans being protected. In other words, contract offsets greatly reduced overall market exposure.
Meanwhile, there has been an announcement that the CME Group will launch by the end of November the first electronic trading platform that is fully integrated with a central counterparty clearing facility for the CDS market. At the same time, the G-7 has pledged to do everything in their power to prevent any more Lehman Brothers-style failures of systemically important financial institutions.
Nevertheless, there will be more dislocations to come. Concern now is focusing on insurance companies and automakers. At the same time, the cost of protecting Dubai’s debt surged last week as concerns mounted about potential investment losses in the Emirate and the refinancing of up to $22 billion of debt.
Meanwhile, Standard & Poor’s stated that GM and Ford may go bankrupt, which is just one indication that substantial damage has been done to the “real economy.” Further, expectation is that unemployment will increase causing a feedback loop into lower consumer spending and reduced earnings for companies.
All this leads to the idea that the US stock market is susceptible to a long malaise where the predominant trend will be wide ranging sideways action. Yet, after we turn this page in market history, systemic risk will also have been greatly reduced, and it is unlikely we will see the VIX at 60+ again for a generation.
Current volatility as of today makes any attempt at establishing option positions very risky/expensive. However, once the market finds technical support, the setup is one where there will be greater implied volatility than the actual volatility as exhibited by the market. This is a perfect environment for arbitrage.
So for option traders who survived and proved their mettle in managing risk, investors should recognize that markets over the next few years will likely be “in the zone” for these programs.
- Mack Frankfurter, Managing Director
"In days of old, seers entered a trance state and then informed anxious seekers what kind of mood the gods were in, and whether this was an auspicious time to begin a journey, get married, or start a war. The prophets of Israel repaired to the desert and then returned to announce whether Yahweh was feeling benevolent or wrathful. Today The Market's fickle will is clarified by daily reports from Wall Street and other sensory organs of finance. Thus we can learn on a day-to-day basis that The Market is "apprehensive," "relieved," "nervous," or even at times "jubilant." On the basis of this revelation awed adepts make critical decisions about whether to buy or sell. Like one of the devouring gods of old, The Market -- aptly embodied in a bull or a bear -- must be fed and kept happy under all circumstances. True, at times its appetite may seem excessive -- a $35 billion bailout here, a $50 billion one there -- but the alternative to assuaging its hunger is too terrible to contemplate."
--Dr. Harvey Cox, Atlantic Monthly (1999)
“To fly an airplane it must fly ‘in the zone.’ Too slow and
you stall and lose control; too fast and the wings come off.”
This is what Captain Dan Ryder, a former Navy fighter pilot who also served as Underway Command Duty Officer on U.S.S. Nimitz, explained as we sailed around Santa Cruz Island in a 37’ Tartan. That conversation took place the weekend before the “bailout” vote, and it has stuck with me ever since.
Since then world equity markets have plunged in a dive that hasn’t been seen since the Great Crash of 1929 stoking fears that we may be headed for the worst recession since the 1930s. Amid mounting fears that the frozen credit markets pose an imminent danger, the pressure for a coordinated rescue by the world’s economic policymakers has become acute. As stated in this weekend’s Financial Times in a telling quote, “Five years ago central bankers seemed almost omnipotent; now they seem scared.”
No doubt sentiment has materially changed since October 2006 when equity markets were in the midst of an extended bull run and the VIX, also known as the fear gauge, was hovering in a range between 10 and 12. For comparison, on Friday October 10th, the VIX hit an all time record intraday high of 76.94—that is 7 times higher than 2 years ago, and almost 3.5 times greater than levels for the VIX just a month ago. [Since writing this article, the VIX has hit 80 two times.]
The importance that volatility plays in options trading should not be underestimated. In fact, it is the key factor which drives how much premium can be charged/received when purchasing/writing options.
Low volatility makes for a difficult environment to write options and capture premium in a risk adverse manner. Like an airplane flying too slow, volatility during much of 2006 and through February 2007 was too low. This became apparent on February 27, 2007 when the VIX spiked nearly 100% and several option writing programs collapsed, giving back two or three years of accrued profits in a day.
Since that date volatility began to rise with the VIX trending higher. But this presented another problem for many CTA option writing programs—the transition from low volatility to higher volatility can be treacherous. Nonetheless, a group of these programs managed the transition, and arrived at what could be considered the “sweet spot” or “zone” for premium capture—a VIX ranging between 20 and 30.
This is the average range for the VIX from 1997 through 2003. But to gain insight into volatility spikes during this time period one must look back to three events. The first event was during the summer of 1998 with the implosion of Long Term Capital Management when the VIX reached 45. The second event was after 9/11/2001 when the VIX spiked to 44. This was followed by a VIX high of 45 during the 2002 bottom. However, each of these readings is far below a VIX of 70+ reached this past Friday.
More recently, since February 2007 the VIX has spike above 30 several times: first on 8/16/2007 when it closed at 30.83, then on 11/12/2007 at 31.09, followed by a spike on 1/22/2008 with a reading of 31.01. But the most memorable day was March 17, 2008 when the Federal Reserve Bank financed JP Morgan’s takeover of Bear Stearns in a controversial deal. The VIX spiked to 32.24 and market pundits debated on whether the Fed overreacted, or had helped us narrowly avert a crisis due to systemic counterparty risk.
We got our answer on September 14, 2008, when in one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself to Bank of America, while Lehman Brothers filed for bankruptcy protection and hurtled toward liquidation after it failed to find a buyer. That event set off the domino effect when on September 18th, the Fed provided AIG with an $85 billion loan in return for a government stake of 79.9 percent and effective control of the company—an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system.
It’s been downhill ever since with the largest financial “bailout” in United States history causing an existential crisis amongst those who hold to purest free market ideology. Yet, even with its passage—noting that financial market “rescues” have precedence in U.S. history dating back to Alexander Hamilton—the deterioration in the markets has not stopped (yet, as of this writing).
It is a classic case of the road to hell paved with good intentions. Every action that central banks, the treasury or governments have taken so far to try and stem the bleeding has been dismissed by the markets. And last week it seemed that the metaphorical wings of market volatility finally came off.
With the VIX above 50, much less given its rise above 70, market conditions have become extremely imprudent to trade. This is the conclusion that we came to, resulting in our liquidating positions.
Since then world equity markets have plunged in a dive that hasn’t been seen since the Great Crash of 1929 stoking fears that we may be headed for the worst recession since the 1930s. Amid mounting fears that the frozen credit markets pose an imminent danger, the pressure for a coordinated rescue by the world’s economic policymakers has become acute. As stated in this weekend’s Financial Times in a telling quote, “Five years ago central bankers seemed almost omnipotent; now they seem scared.”
No doubt sentiment has materially changed since October 2006 when equity markets were in the midst of an extended bull run and the VIX, also known as the fear gauge, was hovering in a range between 10 and 12. For comparison, on Friday October 10th, the VIX hit an all time record intraday high of 76.94—that is 7 times higher than 2 years ago, and almost 3.5 times greater than levels for the VIX just a month ago. [Since writing this article, the VIX has hit 80 two times.]
The importance that volatility plays in options trading should not be underestimated. In fact, it is the key factor which drives how much premium can be charged/received when purchasing/writing options.
Low volatility makes for a difficult environment to write options and capture premium in a risk adverse manner. Like an airplane flying too slow, volatility during much of 2006 and through February 2007 was too low. This became apparent on February 27, 2007 when the VIX spiked nearly 100% and several option writing programs collapsed, giving back two or three years of accrued profits in a day.
Since that date volatility began to rise with the VIX trending higher. But this presented another problem for many CTA option writing programs—the transition from low volatility to higher volatility can be treacherous. Nonetheless, a group of these programs managed the transition, and arrived at what could be considered the “sweet spot” or “zone” for premium capture—a VIX ranging between 20 and 30.
This is the average range for the VIX from 1997 through 2003. But to gain insight into volatility spikes during this time period one must look back to three events. The first event was during the summer of 1998 with the implosion of Long Term Capital Management when the VIX reached 45. The second event was after 9/11/2001 when the VIX spiked to 44. This was followed by a VIX high of 45 during the 2002 bottom. However, each of these readings is far below a VIX of 70+ reached this past Friday.
More recently, since February 2007 the VIX has spike above 30 several times: first on 8/16/2007 when it closed at 30.83, then on 11/12/2007 at 31.09, followed by a spike on 1/22/2008 with a reading of 31.01. But the most memorable day was March 17, 2008 when the Federal Reserve Bank financed JP Morgan’s takeover of Bear Stearns in a controversial deal. The VIX spiked to 32.24 and market pundits debated on whether the Fed overreacted, or had helped us narrowly avert a crisis due to systemic counterparty risk.
We got our answer on September 14, 2008, when in one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself to Bank of America, while Lehman Brothers filed for bankruptcy protection and hurtled toward liquidation after it failed to find a buyer. That event set off the domino effect when on September 18th, the Fed provided AIG with an $85 billion loan in return for a government stake of 79.9 percent and effective control of the company—an extraordinary step meant to stave off a collapse of the giant insurer that plays a crucial role in the global financial system.
It’s been downhill ever since with the largest financial “bailout” in United States history causing an existential crisis amongst those who hold to purest free market ideology. Yet, even with its passage—noting that financial market “rescues” have precedence in U.S. history dating back to Alexander Hamilton—the deterioration in the markets has not stopped (yet, as of this writing).
It is a classic case of the road to hell paved with good intentions. Every action that central banks, the treasury or governments have taken so far to try and stem the bleeding has been dismissed by the markets. And last week it seemed that the metaphorical wings of market volatility finally came off.
With the VIX above 50, much less given its rise above 70, market conditions have become extremely imprudent to trade. This is the conclusion that we came to, resulting in our liquidating positions.
Has the options trading model blown up?
Investor interest is options programs is a study in contrarian behavior. During the 1990s there was a great deal of aversion to the strategy of writing options. This began to change after 2003 when the S&P 500 bull market and the VIX bear market provided a “goldilocks” environment for naked option writing. The result was a proliferation of CTAs offering such programs by the end of 2006.
The irony is that low volatility going into 2006 created increasingly dangerous conditions to engage in option writing. In order to maintain return expectations from prior years, a CTA had to increase risk by either moving the strike price closer to the underlying price, and/or increase the number of positions.
Conventional wisdom at the time was that these programs were uncorrelated to the underlying market. As a result, there was a flood of investor interest in option programs seeking 20+ percent returns. Then came the subsequent transition to higher volatility since February 2007 which has yet again chastened many investors.
There is an old saying when it comes to options trading—it is like picking up nickels and dimes in front of a steamroller. It turns out many players offering option programs in 2005 and 2006 were relatively new to the space, untutored in the violence of short “gamma” as happened during 1998, 2001 and 2002.
So what distinguishes one option program from another, as well as risky trading from less risky trading? The answer is qualitative, but the trick is to produce “risk-adjusted returns,” in which positive returns are generated while mitigating volatility and exposure to risk. In options trading, this is a difficult feat.
First, investors need to recognize that there is a direct correlation between leverage and return with any managed futures program. A program which produces a 30% return is not necessarily better than a program which produced a 15% return. In fact, these returns could be produced by exactly the same trading programs with one using twice the leverage as the other for the same size account. The key is risk-adjusted returns.
One of the crucial factors which provides for consistent absolute returns in option writing/premium capture strategies is “theta,” or time decay. Consequently, the most important responsibility for a trader to manage is the risk of positions in his/her book, which should be considered liabilities until expiration.
A standard strategy is to write options far out-of-the-money, with the idea that the probability such options will go into-the-money by expiration represents a low probability event. In this strategy, traders will “white knuckle” their positions with expiration the only true stop loss. Investors are required to suffer high intra-month equity volatility in their accounts with the expectation that if the options eventually expire out-of-the-money, any unrealized losses plus premium written will be earned.
Risk of ruin is high with this kind of approach, and there is a tendency for the “deer in the headlight” syndrome. If traders do cover such positions, thereby booking large “painful” losses, they will often “roll” the contract to another strike price in the hope that the market won’t reach that subsequent level.
This kind of strategy has worked reasonably well for many option programs, with some using variations of the strategy to mitigate risk and equity volatility by utilizing bull spreads and/or calendar spreads.
The critical question in this current environment is if implementing routine trading strategies is still viable or more importantly, is it prudent? There are rumors that certain CTA option programs have utilized more margin than the agreed-to account size. This situation, in my opinion, represents irresponsible trading.
The bulk of investment performance is typically a function of strategy and risk taken. Yet the complexity of human behavior can never be fully modeled. Therefore, a discretionary common sense approach is needed—one which balances the quantitative with the qualitative in order to manage cycles of volatility.
Traders like to talk about how they provide “alpha” or skill-based returns. Alpha is a byproduct of “beta,” which is often referred to as a benchmark. In alternative investments, one can think of beta as the core strategy and alpha as the tactical overlay in response to changing market conditions.
This is the strength of discretionary trading—the ability to tactically adapt to changing conditions.
Unfortunately, the ‘quality of returns’ is a difficult concept to quantify. My recommendation is not to analyze how well traders have performed in normal market conditions, but how they have performed under stressful market conditions such as February 2007, March 2008 and now during October 2008.
Where does option trading go from here?
The seeds of the economic crisis we currently find ourselves is founded on the ‘forward contract exclusion’ from Section 2(a)(1)(A) of the Commodity Exchange Act of 1936. From this loophole in the Act, and various court cases since 1936, as well as the CFTC’s 1992 exemptive order issued under then-chairperson Wendy Gramm, evolved the unregulated over-the-counter (OTC) derivatives market. It is this history, along with deregulation built into the Commodity Futures Modernization Act of 2000, which allowed for the exponential growth of the $50-$60 trillion credit default swaps (CDS) market.
But for the ISDA and its former CEO, Robert Pickle, previous market crises such as the Orange County and Metalgesellschaft derivatives debacles in 1994, as well as the implosion of Long-Term Capital Management in 1998, should have long ago forced OTC derivatives onto exchanges such as the CME.
The persistency of frozen credit market conditions in the face of multiple central bank, treasury and government actions/interventions is cause for great alarm. Meanwhile, the Sword of Damocles overhanging this crisis has always been the CDS market. Draconian as it may be, some are calling for international action to declare credit default swaps null and void. But could this fear be overblown?
Fear culminated in panic last week as the market eyed Friday’s Lehman Brothers CDS auction in New York. The average price at the auction was below 10 cents, and worry was that financial institutions worldwide would have to face a bill of as much as $400 billion leading to significant writedowns.
It turns out, however, that the net payouts that CDS sellers have to make on defaulted Lehman Brothers debt is only a small fraction of the amount of insurance that was written. According to the DTCC, the “multilateral” calculations it performed on swaps tied to Lehman “indicate that net funds transfers from net sellers of protection to net buyers of protection are expected to be in the $6 billion range.”
This is excellent news as it proves to the market that net exposure on CDS transactions is substantially less than the $50-$60 trillion nominal figure often cited, which in fact references the “underlying” bonds and loans being protected. In other words, contract offsets greatly reduced overall market exposure.
Meanwhile, there has been an announcement that the CME Group will launch by the end of November the first electronic trading platform that is fully integrated with a central counterparty clearing facility for the CDS market. At the same time, the G-7 has pledged to do everything in their power to prevent any more Lehman Brothers-style failures of systemically important financial institutions.
Nevertheless, there will be more dislocations to come. Concern now is focusing on insurance companies and automakers. At the same time, the cost of protecting Dubai’s debt surged last week as concerns mounted about potential investment losses in the Emirate and the refinancing of up to $22 billion of debt.
Meanwhile, Standard & Poor’s stated that GM and Ford may go bankrupt, which is just one indication that substantial damage has been done to the “real economy.” Further, expectation is that unemployment will increase causing a feedback loop into lower consumer spending and reduced earnings for companies.
All this leads to the idea that the US stock market is susceptible to a long malaise where the predominant trend will be wide ranging sideways action. Yet, after we turn this page in market history, systemic risk will also have been greatly reduced, and it is unlikely we will see the VIX at 60+ again for a generation.
Current volatility as of today makes any attempt at establishing option positions very risky/expensive. However, once the market finds technical support, the setup is one where there will be greater implied volatility than the actual volatility as exhibited by the market. This is a perfect environment for arbitrage.
So for option traders who survived and proved their mettle in managing risk, investors should recognize that markets over the next few years will likely be “in the zone” for these programs.
- Mack Frankfurter, Managing Director
Thursday, October 2, 2008
3rd Qtr 2008 Review and Nonno's Mistake
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
At the end of WWII, my grandfather looked around and, devastated by the surrounding destruction and by the fall of an ideology he believed in, decided to sell for a song the family fortune, buildings, land and businesses. In my business, we would say he sold the lowest downtick as Italy went on to rebuild its infrastructures and to become at its height the fifth most industrialized country in the world.
In my career as a money manager and a speculator, I often race in my mind to this memory to remind myself that crisis breeds opportunities… as long as you don’t put yourself in the position to sell the lowest downtick, and as long as you don’t let ideologies run your decision making.
The financial crisis we have been fighting for the last year is the product of many practical distortions and ideological falsities, which Congress has loudly reminded us in its pathetic bickering over the rescue package. However, from the ashes of crisis, true and real recoveries take shape and opportunities are created. The life of an investor is about dodging, covering, attacking, covering again, retreating and attacking once more; always making sure that any losses that may come his/her way will not be terminal.
Our financial system has been under duress for over a year now and our posture at Cervino has been constantly adaptive to the difficult market conditions: we dodged, covered, and also attacked when visibility allowed. Such visibility is still very limited and therefore size and posture must be tuned accordingly. Flexibility and under-leverage are still in my opinion the name of the game until confidence is restored in the system, until people will feel safe about storing, lending, investing their money in financial institutions.
So what are we doing collectively to restore such confidence?
Treasury Secretary Paulson provided a plan that, admittedly vague, tries to address the liquidity issue most banks have been facing: leveraged balance sheets loaded with illiquid asset backed securities (affected by a collateral decreasing in value). Paulson proposed for the US Government to practically be the market maker of these complex securities, allowing the government to purchase such illiquid assets and hold them until better times, thereby backstopping the vicious spiral of lower prices forcing additional liquidation which in turn generates even lower prices.
Initially, Congress and the American people balked at the price ($700 billion) of the rescue package and the idea of rescuing fat bankers. Without spending too much time to point out that everyone is to blame in this disaster: politicians, many homebuyers, regulators and certainly bankers.
As I mentioned earlier ideologies are never good starting points for investment decisions. The rescue package is aimed to help all of us by providing stability, that in times of massive dislocations such as this, only the government can provide.
I believe in free markets and in free enterprise, but I also must be honest and pragmatic about the fact that even before this mess markets were neither free nor fair. The complexities of our society make it impossible to run a system completely free and fully meritocratic—that is just the way it is. No doubt, I keep a copy of “Capitalism and Freedom” by Martin Friedman on my nightstand but I recognize that our financial and social system is more complex than just shouting slogans like so many false free marketers (media pundits, politicians and regular Joes) have a tendency to do.
The real problem with the Paulson plan is not ideological or an issue of fairness, but with its execution if signed into law. The key to the plan is the pricing of assets, assets that in some cases have been constructed in complex and opaque ways. Price the asset too high and the tax payer will end up with a loss, price it too low and the plan will not succeed. Pricing these assets correctly is difficult but not at all impossible. After all about 95% of all mortgages are performing, and 75% of subprime mortgages are also still performing; even allowing for a haircut to cover increases in defaults and some additional decrease in the value of the collateral, most of this paper is worth more than the forced liquidation prices we are witnessing.
We may ask if this is the case, why is it that private equity is not aggressively buying them? The answer is “reflexivity.”
The uncertainty of the situation and the shakiness of the financial system make it hard for an investor to step in at this point. As a result, a vicious circle is now in full play. That is why the system must be stabilized. The uncertainty of the regulatory environment and the opaqueness of these markets are additional reasons why new investors are on the sideline. Stability and clarity must be the foundations of any rescue plan.
This is not the first time a banking crisis of this nature occurs (and certainly it will not be the last) and it is curable. Think of the banking crisis that happened in Sweden twenty years ago. Then, like now, a real estate bust caused the Swedish banking system to practically go bankrupt. The government purchased shares in its banks to recapitalize them and years later sold them at a nice profit. Sweden in the immediate aftermath of the crisis saw its unemployment numbers rise from 2% to 10% and a painful reduction in income occurred as well. However, while the crisis lasted three years, the recovery lasted fifteen years and Sweden produced a GDP growth more than 3% in average, double the rate produced by its European partners.
The idea to recapitalize the banks should also be part of the Paulson plan. George Soros has been very vocal about this lately to the extent that he thinks this should be the main element of any rescue package. I believe a combination of a transparent market making facility and a recapitalization package would go a long way to stabilize the situation.
Another element that increased instability and forced liquidation is the accounting rule FAS157 or “fair value pricing.” FAS157 requires marketable securities to be marked to market on the holder’s balance sheets. However, fair value of long maturity and illiquid securities such as Mortgage Backed Securities and Asset Backed Securities is not reflected by its market price since now there is practically no market.
In this situation, fire-sale prices become the pricing benchmark which ends up exacerbating the crisis. Changing or suspending FAS157 is a little like changing the rules in the middle of the game and it should not be done without a proper solution on how to price these securities. Most of these assets should be priced based on their cash flow and based on realistic assumptions on the price of the collateral. A few of these securities, the so called toxic waste, might prove more challenging.
Ultimately, a global approach is needed. Governments, central bankers, regulators and sovereign wealth funds should all participate in the solution of what is the most frightening crisis the financial world has experienced since the Great Depression. When credit markets completely freeze like it is now happening (the spike in the TED spread reflected a seven standard deviations move) the issue is not bailing out bankers or safeguarding taxpayers money, the issue becomes survival of the economic system that all of us used and have benefited from since the industrial revolution.
From a trading perspective, we stress again that size and posture must be adjusted for the level of volatility which in many regards is unprecedented. Time horizon also must be either really short or really long. In our absolute return programs we have shrunk our time horizon and we have also reduced size. While in our longer term portfolios, we are looking to start positioning in specific and strategic sectors maintaining a very long term horizon.
We think the dollar rally may have more to go as the deleveraging process continues and requires dollars to be repurchased to pay off the debt (not to mention that none of the currencies is on an absolute level strong). As far as US Bonds is concerned, we still expect them lower due to their historically low yields especially in the context of a rising deficit. Additionally, we don’t expect the commodities to resume their rally any time soon due to the deflationary environment and the large outflow of speculative funds. This includes gold as well with the caveat that in a panic situation, it still represents the strongest flight to safety.
In conclusion, we expect equities to be volatile for a while but we also think that the risk reward ratio is tilting in favour of being long for time horizons that are either very short or very long. However, should the credit markets fail to unlock, all bets are off.
Arrivederci
-Davide Accomazzo, Managing Director
At the end of WWII, my grandfather looked around and, devastated by the surrounding destruction and by the fall of an ideology he believed in, decided to sell for a song the family fortune, buildings, land and businesses. In my business, we would say he sold the lowest downtick as Italy went on to rebuild its infrastructures and to become at its height the fifth most industrialized country in the world.
In my career as a money manager and a speculator, I often race in my mind to this memory to remind myself that crisis breeds opportunities… as long as you don’t put yourself in the position to sell the lowest downtick, and as long as you don’t let ideologies run your decision making.
The financial crisis we have been fighting for the last year is the product of many practical distortions and ideological falsities, which Congress has loudly reminded us in its pathetic bickering over the rescue package. However, from the ashes of crisis, true and real recoveries take shape and opportunities are created. The life of an investor is about dodging, covering, attacking, covering again, retreating and attacking once more; always making sure that any losses that may come his/her way will not be terminal.
Our financial system has been under duress for over a year now and our posture at Cervino has been constantly adaptive to the difficult market conditions: we dodged, covered, and also attacked when visibility allowed. Such visibility is still very limited and therefore size and posture must be tuned accordingly. Flexibility and under-leverage are still in my opinion the name of the game until confidence is restored in the system, until people will feel safe about storing, lending, investing their money in financial institutions.
So what are we doing collectively to restore such confidence?
Treasury Secretary Paulson provided a plan that, admittedly vague, tries to address the liquidity issue most banks have been facing: leveraged balance sheets loaded with illiquid asset backed securities (affected by a collateral decreasing in value). Paulson proposed for the US Government to practically be the market maker of these complex securities, allowing the government to purchase such illiquid assets and hold them until better times, thereby backstopping the vicious spiral of lower prices forcing additional liquidation which in turn generates even lower prices.
Initially, Congress and the American people balked at the price ($700 billion) of the rescue package and the idea of rescuing fat bankers. Without spending too much time to point out that everyone is to blame in this disaster: politicians, many homebuyers, regulators and certainly bankers.
As I mentioned earlier ideologies are never good starting points for investment decisions. The rescue package is aimed to help all of us by providing stability, that in times of massive dislocations such as this, only the government can provide.
I believe in free markets and in free enterprise, but I also must be honest and pragmatic about the fact that even before this mess markets were neither free nor fair. The complexities of our society make it impossible to run a system completely free and fully meritocratic—that is just the way it is. No doubt, I keep a copy of “Capitalism and Freedom” by Martin Friedman on my nightstand but I recognize that our financial and social system is more complex than just shouting slogans like so many false free marketers (media pundits, politicians and regular Joes) have a tendency to do.
The real problem with the Paulson plan is not ideological or an issue of fairness, but with its execution if signed into law. The key to the plan is the pricing of assets, assets that in some cases have been constructed in complex and opaque ways. Price the asset too high and the tax payer will end up with a loss, price it too low and the plan will not succeed. Pricing these assets correctly is difficult but not at all impossible. After all about 95% of all mortgages are performing, and 75% of subprime mortgages are also still performing; even allowing for a haircut to cover increases in defaults and some additional decrease in the value of the collateral, most of this paper is worth more than the forced liquidation prices we are witnessing.
We may ask if this is the case, why is it that private equity is not aggressively buying them? The answer is “reflexivity.”
The uncertainty of the situation and the shakiness of the financial system make it hard for an investor to step in at this point. As a result, a vicious circle is now in full play. That is why the system must be stabilized. The uncertainty of the regulatory environment and the opaqueness of these markets are additional reasons why new investors are on the sideline. Stability and clarity must be the foundations of any rescue plan.
This is not the first time a banking crisis of this nature occurs (and certainly it will not be the last) and it is curable. Think of the banking crisis that happened in Sweden twenty years ago. Then, like now, a real estate bust caused the Swedish banking system to practically go bankrupt. The government purchased shares in its banks to recapitalize them and years later sold them at a nice profit. Sweden in the immediate aftermath of the crisis saw its unemployment numbers rise from 2% to 10% and a painful reduction in income occurred as well. However, while the crisis lasted three years, the recovery lasted fifteen years and Sweden produced a GDP growth more than 3% in average, double the rate produced by its European partners.
The idea to recapitalize the banks should also be part of the Paulson plan. George Soros has been very vocal about this lately to the extent that he thinks this should be the main element of any rescue package. I believe a combination of a transparent market making facility and a recapitalization package would go a long way to stabilize the situation.
Another element that increased instability and forced liquidation is the accounting rule FAS157 or “fair value pricing.” FAS157 requires marketable securities to be marked to market on the holder’s balance sheets. However, fair value of long maturity and illiquid securities such as Mortgage Backed Securities and Asset Backed Securities is not reflected by its market price since now there is practically no market.
In this situation, fire-sale prices become the pricing benchmark which ends up exacerbating the crisis. Changing or suspending FAS157 is a little like changing the rules in the middle of the game and it should not be done without a proper solution on how to price these securities. Most of these assets should be priced based on their cash flow and based on realistic assumptions on the price of the collateral. A few of these securities, the so called toxic waste, might prove more challenging.
Ultimately, a global approach is needed. Governments, central bankers, regulators and sovereign wealth funds should all participate in the solution of what is the most frightening crisis the financial world has experienced since the Great Depression. When credit markets completely freeze like it is now happening (the spike in the TED spread reflected a seven standard deviations move) the issue is not bailing out bankers or safeguarding taxpayers money, the issue becomes survival of the economic system that all of us used and have benefited from since the industrial revolution.
From a trading perspective, we stress again that size and posture must be adjusted for the level of volatility which in many regards is unprecedented. Time horizon also must be either really short or really long. In our absolute return programs we have shrunk our time horizon and we have also reduced size. While in our longer term portfolios, we are looking to start positioning in specific and strategic sectors maintaining a very long term horizon.
We think the dollar rally may have more to go as the deleveraging process continues and requires dollars to be repurchased to pay off the debt (not to mention that none of the currencies is on an absolute level strong). As far as US Bonds is concerned, we still expect them lower due to their historically low yields especially in the context of a rising deficit. Additionally, we don’t expect the commodities to resume their rally any time soon due to the deflationary environment and the large outflow of speculative funds. This includes gold as well with the caveat that in a panic situation, it still represents the strongest flight to safety.
In conclusion, we expect equities to be volatile for a while but we also think that the risk reward ratio is tilting in favour of being long for time horizons that are either very short or very long. However, should the credit markets fail to unlock, all bets are off.
Arrivederci
-Davide Accomazzo, Managing Director
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