Measuring the growth of global foreign exchange reserves was a popular macro-analyst pass-time during the pre-crisis low vol hey-days. This exersize was conducted to gauge the central demand for U.S. Treasuries. The simple conclusion from this analysis was that slowing official asset accumulation would result in declining demand and rising Treasury yields. This argument misses one crucial point.
The rapid ascension of official reserve assets was a result of the US current account deficit. The only scenario in which this deficit would have corrected was some combination of a rising US savings rate and falling investment. Thus, in the event of a sharp contraction of the trade gap, net issuance of various kinds of securities would have fallen as well. Clearly, in such a scenario, there would have been no pressure on yields to rise.
A cursory look at the US flow of funds data tells us that net issuance of various fixed income products is down sharply and the rising household savings are finding their way into the treasury market. Consequently, there seems to be no pressure on yields to rise even when foreign exchange reserve growth has slowed down (even in the face of mammoth issuance).
Tuesday, September 1, 2009
Thursday, August 20, 2009
BUYING GROWTH STOCKS WITH A SAFETY VALVE
For the most part, I do not have any investing bent (macro, quantitative, value, growth, momentum etc) because I feel that the market is just too dynamic and no philosophy really works all the time. Even so, I often find it hard to convince myself to buy growth stocks selling at high multiples. The problem is that one negative growth surprise and the consequent multiple contraction has the potential to destroy performance.
There are a lot of companies I really like, but the market adores them too; leading to pricey valuations. One such stock is Jain Irrigation. India has numerous and growing mouths to feed. The erratic monsoon this year has again reminded the nation that agriculture continues to be largely rain-fed. Micro-irrigation is the solution and Jain Irrigation is the leader that space. The market acknowledges this fact and rewards the company with premium multiples. That is where my problem starts. My solution to this quandary is to figure out a way to get out with minimal/controlled draw down if growth disappoints in the future.
To guard against precipitous downside, I tested a simple technical rule. I would own the stock only when it is trading above the 20-day moving average. The results (posted below) are somewhat encouraging.
Jain Irrigation Yearly Return Summary Statistics: Jan 1991 to Dec 2008
Jain Irrigation: Jan 1991 to Dec 2008 (Jan 1991 = 100)
Source: Bloomberg
There are a lot of companies I really like, but the market adores them too; leading to pricey valuations. One such stock is Jain Irrigation. India has numerous and growing mouths to feed. The erratic monsoon this year has again reminded the nation that agriculture continues to be largely rain-fed. Micro-irrigation is the solution and Jain Irrigation is the leader that space. The market acknowledges this fact and rewards the company with premium multiples. That is where my problem starts. My solution to this quandary is to figure out a way to get out with minimal/controlled draw down if growth disappoints in the future.
To guard against precipitous downside, I tested a simple technical rule. I would own the stock only when it is trading above the 20-day moving average. The results (posted below) are somewhat encouraging.
Jain Irrigation Yearly Return Summary Statistics: Jan 1991 to Dec 2008
Jain Irrigation: Jan 1991 to Dec 2008 (Jan 1991 = 100)
Source: Bloomberg
Friday, July 31, 2009
INDIAN EQUITIES STILL PRICED RIGHT FOR MEDIUM-TERM INVESTORS
IN MY VIEW, 10-YEAR COMPOUNDED ANNUAL REAL RETURNS SHOULD BE ABOUT 8% WITH AN UPWARD BIAS
On December 7, 2008, I held the opinion that Indian equities were attractively priced for investors with a medium-term horizon (SENSEX PRICED TO DELIVER ATTRACTIVE MEDIUM-TERM RETURNS). I point that out not to stake my claim for predicting the breathtaking Q2 2009 rally, but to highlight that buying at the right price is key to investment success.
Short-term returns are driven by ebbs and flow in risk appetite. Such moves can be hard to predict even for the most seasoned market watchers. Over longer-term however, valuation plays the dominant role in determining returns. Sharp valuation downdrafts are good entry points for investors willing to bear near-term volatility.
EQUITIES STILL PRICED TO BEAT BONDS OVER 5 to 10-YEARS
In my previous piece, I had valued the SENSEX based on a price to nominal GDP multiple. Viewed from the same lense, equities are no longer under-valued. Yet, the asset class is not exuberantly priced either. From current levels, investors could garner at least 8% real returns over the next 10-years. This forecast assumes mean historical valuations and real GDP growth of about 7% to 8%. Needless to say that this projection builds in a margin of safety.
Yet, we must invest fully cognizant of the fact that over the short-term there could still be another downdraft.
On December 7, 2008, I held the opinion that Indian equities were attractively priced for investors with a medium-term horizon (SENSEX PRICED TO DELIVER ATTRACTIVE MEDIUM-TERM RETURNS). I point that out not to stake my claim for predicting the breathtaking Q2 2009 rally, but to highlight that buying at the right price is key to investment success.
Short-term returns are driven by ebbs and flow in risk appetite. Such moves can be hard to predict even for the most seasoned market watchers. Over longer-term however, valuation plays the dominant role in determining returns. Sharp valuation downdrafts are good entry points for investors willing to bear near-term volatility.
EQUITIES STILL PRICED TO BEAT BONDS OVER 5 to 10-YEARS
In my previous piece, I had valued the SENSEX based on a price to nominal GDP multiple. Viewed from the same lense, equities are no longer under-valued. Yet, the asset class is not exuberantly priced either. From current levels, investors could garner at least 8% real returns over the next 10-years. This forecast assumes mean historical valuations and real GDP growth of about 7% to 8%. Needless to say that this projection builds in a margin of safety.
Yet, we must invest fully cognizant of the fact that over the short-term there could still be another downdraft.
Tuesday, July 14, 2009
FINANCIALLY ENGINEERING AN "ALL-WEATHER" EQUITY PORTFOLIO
In principle, any asset class or security can be levered up/down to create the desired risk return payoff. Based on this concept, two negatively correlated securities can be combined to achieve a given level of expected return with lower risk (defined in terms of standard deviation). Using this paradigm, I seek to configure a portfolio with the expected return of equities, but lower standard deviation: the "all weather equity portfolio".
Treasury yields/prices and equities are positively/negatively correlated (see exhibit 1). This property is particularly helpful in creating the "all the weather portfolio". During the 20th century, U.S. stocks and bonds generated yearly real returns of 6.7% and 1.6%, respectively. Assuming 2% inflation going forward, I construct the portfolio as follows:
1. Long U.S. Treasuries: 1.25
2. S&P 500: 0.5
3. Borrowing: -0.75
Effectively, I buy U.S. Treasuries on leverage to achieve equity like returns. I used ETFs to conduct this exercise for the period July 30, 2002 to June 11, 2009: TLT: + 20yr Treasuries and SPY. I assume leverage at 8.5% (the margin rate for a personal investor). Institutional investors can finance the bond portfolio cheaply in the GC-repo market. Finally, the portfolio is rebalanced every day.
The performance of the portfolio can be observed in exhibit 2. Importantly, while the S&P 500 rose about 5% during the period under consideration, the all weather portfolio was up 11%. At the peak of the price appreciation cycle, stocks were up about 74%, while our financially engineered portfolio climbed only 42%. This under performance in the bull market is a function of the high interest rate I used for assuming leverage. Interestingly, the all-weather portfolio reached its peak with 62% total return in December 2008 – a time when the equity only portfolio had failed to generate any return since inception.
Redoing the calculation with the GC-repo rate (average for the period: 2.54%), I get more favorable (and more realistic for institutional investors) results (see exhibit 2). In this case, the all weather portfolio keeps pace with equities in the up move, and protects downside during the market crash of 2008.
Exhibit 1. Positive Correlation: U.S. Equities vs. U.S. Treasury Yields
Exhibit 2. "All-Weather" Portfolio Performance: Institutional
Exhibit 3. "All-Weather" Portfolio Performance: Personal
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Exhibit 4. Daily Return Statistics
Geek Notes
For calculating the total returns of the all-weather portfolio, I used the average yield on the 30-year U.S. Treasury as a proxy for coupon. And, I credited this coupon return on a daily basis. This implies that the returns on the all-weather portfolio are somewhat over-stated due to daily compounding.
Source: Bloomberg
Dimson, Staunton and Marsh; Triumph of the Optimists
Bridgewater Associates
Treasury yields/prices and equities are positively/negatively correlated (see exhibit 1). This property is particularly helpful in creating the "all the weather portfolio". During the 20th century, U.S. stocks and bonds generated yearly real returns of 6.7% and 1.6%, respectively. Assuming 2% inflation going forward, I construct the portfolio as follows:
1. Long U.S. Treasuries: 1.25
2. S&P 500: 0.5
3. Borrowing: -0.75
Effectively, I buy U.S. Treasuries on leverage to achieve equity like returns. I used ETFs to conduct this exercise for the period July 30, 2002 to June 11, 2009: TLT: + 20yr Treasuries and SPY. I assume leverage at 8.5% (the margin rate for a personal investor). Institutional investors can finance the bond portfolio cheaply in the GC-repo market. Finally, the portfolio is rebalanced every day.
The performance of the portfolio can be observed in exhibit 2. Importantly, while the S&P 500 rose about 5% during the period under consideration, the all weather portfolio was up 11%. At the peak of the price appreciation cycle, stocks were up about 74%, while our financially engineered portfolio climbed only 42%. This under performance in the bull market is a function of the high interest rate I used for assuming leverage. Interestingly, the all-weather portfolio reached its peak with 62% total return in December 2008 – a time when the equity only portfolio had failed to generate any return since inception.
Redoing the calculation with the GC-repo rate (average for the period: 2.54%), I get more favorable (and more realistic for institutional investors) results (see exhibit 2). In this case, the all weather portfolio keeps pace with equities in the up move, and protects downside during the market crash of 2008.
Exhibit 1. Positive Correlation: U.S. Equities vs. U.S. Treasury Yields
Exhibit 2. "All-Weather" Portfolio Performance: Institutional
Exhibit 3. "All-Weather" Portfolio Performance: Personal
.png)
Exhibit 4. Daily Return Statistics
Geek Notes
For calculating the total returns of the all-weather portfolio, I used the average yield on the 30-year U.S. Treasury as a proxy for coupon. And, I credited this coupon return on a daily basis. This implies that the returns on the all-weather portfolio are somewhat over-stated due to daily compounding.
Source: Bloomberg
Dimson, Staunton and Marsh; Triumph of the Optimists
Bridgewater Associates
Monday, June 29, 2009
PERILS OF OVER-EMPHASIZING A FEW TURNING POINTS
GDS: Gross Domestic Savings (Fiscal Year)
GDCF: Gross Domestic Capital Formation(Fiscal Year)
Sensex year-end (Calendar Year)
Source: Bloomberg; RBI
It seems from this graph that the Indian equity market delivers sustained stellar returns when the gross domestic savings and capital formation rise significantly. This suggests that superior market moves coincide with periods of rising trend growth rate of the economy (for the logic please see my previous post). Careful statistical analysis, however, points to a positive but statistically tenuous relationship.
SENSEX RETURN = 20.90(0.0034) + 0.93*GDFC Y-o-Y%(0.2645)
P-values in the brackets.
R^2= 5%
The obvious conclusion is that economic growth is only one part of the puzzle. Valuation is important. Rapid growth which has already been discounted by the market will not help.
Friday, June 12, 2009
9% GROWTH IN THE FACE OF A GLOBAL RECESSION: DREAM ON; ANY EQUITY RALLY BUILT ON THIS THEME WILL FACE GROWTH DISSAPOINTMENT IN THE FUTURE
The India growth story is a strong one. India has the most important advantage: top quality human capital. Not many countries with comparable social parameters can boast of India’s success in some quarters of higher education.
My view of Indian Trend Growth Dynamics: With Infinite Supply of Labor on the Margin, Trend Growth Rate is Determined by Productive Capacity: Gross Domestic Capital Formation and Ultimately on Funding Sources = Gross Domestic Savings + Sustainable Level of Current Account Deficit
1. Exports pick up leading to an increase in capacity utlization. A surge in capital formation results, which increases the productive capacity of the economy.
2. Initially, the current account deficit widens as funding needs outpace domestic savings. Ultimately, savings pick up as the propensity to save is higher from profits than from wages. And also because at higher levels of income, there is more leg room to save.
3. The higher gross savings rate leads to a rise in trend growth in terms of sustainability of funding available to finance the higher level of capital expenditure.
4. The down-leg begins with a down-turn in exports which spills-over into capex through the capacity utlization route.
5. Consumption spending is stable and grows at the new trend rate, providing stability to the economic ascension.
6. The savings rate dips in the downturn.
Rising trend growth is the norm for the Indian economy. Yet, do not underestimate the importance of cyclical forces.
Figure 1. Since the Mid-80s, cycles in GDP growth have been closely related to perturbations in exports. I have calculated the cyclical component by treating a 5-year moving average of GDP growth as the trend.
Figure 2. Cycles in Gross domestic capital formation are intricately linked to external sector performance.
.png)
Figure 3. Private final consumption expenditure lends stability to the expansion.
.png)
Figure 4. Government final consumption expenditure runs counter to the cycle, implying a countercyclical fiscal policy.
.png)
BOTTOM LINE
India’s trend growth has risen in the last 5-years to around 7%-8% as the gross domestic savings rate has climbed to about 32% (assuming an ICOR of 4). In the next big capex cycle, the trend will rise to 9%-10%. But that is not likely to happen without a recovery in global demand. And we should not forget that the last 5-years were more an exception than the norm. Until then, 6%-7% is more likely to be the outcome. That's pretty good, but it is way below 9%.
Source: Handbook of Statistics, RBI
All data at constant prices.
GFCE: Government final consumption expenditure.
PFCE: Private final consumption expenditure.
GDCF: Gross domestic capital formation.
My view of Indian Trend Growth Dynamics: With Infinite Supply of Labor on the Margin, Trend Growth Rate is Determined by Productive Capacity: Gross Domestic Capital Formation and Ultimately on Funding Sources = Gross Domestic Savings + Sustainable Level of Current Account Deficit
1. Exports pick up leading to an increase in capacity utlization. A surge in capital formation results, which increases the productive capacity of the economy.
2. Initially, the current account deficit widens as funding needs outpace domestic savings. Ultimately, savings pick up as the propensity to save is higher from profits than from wages. And also because at higher levels of income, there is more leg room to save.
3. The higher gross savings rate leads to a rise in trend growth in terms of sustainability of funding available to finance the higher level of capital expenditure.
4. The down-leg begins with a down-turn in exports which spills-over into capex through the capacity utlization route.
5. Consumption spending is stable and grows at the new trend rate, providing stability to the economic ascension.
6. The savings rate dips in the downturn.
Rising trend growth is the norm for the Indian economy. Yet, do not underestimate the importance of cyclical forces.
Figure 1. Since the Mid-80s, cycles in GDP growth have been closely related to perturbations in exports. I have calculated the cyclical component by treating a 5-year moving average of GDP growth as the trend.
Figure 2. Cycles in Gross domestic capital formation are intricately linked to external sector performance.
.png)
Figure 3. Private final consumption expenditure lends stability to the expansion.
.png)
Figure 4. Government final consumption expenditure runs counter to the cycle, implying a countercyclical fiscal policy.
.png)
BOTTOM LINE
India’s trend growth has risen in the last 5-years to around 7%-8% as the gross domestic savings rate has climbed to about 32% (assuming an ICOR of 4). In the next big capex cycle, the trend will rise to 9%-10%. But that is not likely to happen without a recovery in global demand. And we should not forget that the last 5-years were more an exception than the norm. Until then, 6%-7% is more likely to be the outcome. That's pretty good, but it is way below 9%.
Source: Handbook of Statistics, RBI
All data at constant prices.
GFCE: Government final consumption expenditure.
PFCE: Private final consumption expenditure.
GDCF: Gross domestic capital formation.
Friday, June 5, 2009
VALUATION MATTERS: RISK-ADJUSTED RETURN PERFORMANCE: U.S. HIGH YIELD TRUMPS S&P 500; USING LEVERAGE TO ENGINEER SUPERIOR RETURNS GIVEN RISK CONSTRAINT
The S&P 500 has rallied almost 40% from the March 9, 2009 lows. U.S. HY (HYG) and U.S. IG (LQD) are up 28% and 8%, respectively.
Yet, risk adjusted performance tells a different story. And that is what really matters because any asset class/security can be levered up/down to provide the desired risk-return characteristics. Clearly, the investment with the highest ratio of mean to standard deviation would dominate in this framework.
Based on this criteria(see Figure 1), U.S. High Yield performed the best in the rally since March 9, 2009, followed by equities and U.S. IG.
Assuming that we could borrow at 10%(see Figure 1), it was possible to engineer a portfolio that would have outperformed stocks while commanding the same risk defined in terms of standard deviation.
The key message of the story is that valuation matters. At the March 9 lows, stocks were modestly undervalued, but U.S. High-Yield looked battered and offered better potential risk-reward characteristics.
Figure 1
Yet, risk adjusted performance tells a different story. And that is what really matters because any asset class/security can be levered up/down to provide the desired risk-return characteristics. Clearly, the investment with the highest ratio of mean to standard deviation would dominate in this framework.
Based on this criteria(see Figure 1), U.S. High Yield performed the best in the rally since March 9, 2009, followed by equities and U.S. IG.
Assuming that we could borrow at 10%(see Figure 1), it was possible to engineer a portfolio that would have outperformed stocks while commanding the same risk defined in terms of standard deviation.
The key message of the story is that valuation matters. At the March 9 lows, stocks were modestly undervalued, but U.S. High-Yield looked battered and offered better potential risk-reward characteristics.
Figure 1
Thursday, May 21, 2009
A SURVEY OF LIQUIDITY, RISK APPETITE AND GROWTH INDICATORS: WORST FEARS OUT OF THE WAY
1. Fed Funds-GC Repo Basis Narrowed
2. 3-Month Libor-OIS Basis Contracted
The FF-GC basis had widened significantly last year due to stress in funding markets and risk aversion, leading to a severe shortage of treasury collateral. This was one of the factors pushing 2-year swap spreads wider. This basis has normalized due to the Fed's pro-active policy measures and a significant increase in treasury supply. Another peg in the same equation was the LIBOR-OIS basis. Interbank cash markets were dis-functional due to counter-party risk concerns among banks. This was preventing the Fed's policy stimulus from flowing through into cash markets. Narrowing of both these spreads is good news for the transmission mechanism of monetary policy and ultimately, growth.
3. Baltic Dry Index Off the Lows
Is this a reflection of the Chinese stocking activity or a genuine pick up in growth? Hard to say, but the trend over the last couple of months does indicate that the world economy has most likely bottomed.
4. Oil Outperforming Oil Stocks
This was certainly the case early last year when oil rose to stratospheric levels. Equity investors questioned the sustainability of the move in the underlying commodity and were right. I would agree with stocks this time as well because a significant increase in oil price at this stage of the cycle will likely nip the incipient recovery in the bud.
5. Gold Stocks Outpacing Gold
Gold is a great bet going forward. What is the probability that global central banks will get it just right? Pretty low, in my view. Most likely, monetary authorities will be late in withdrawing the extraordinary stimulus, making inflation a real risk at some stage in the future.
6. VIX is Significantly Down from the Highs
When equities collapsed in early 2009, the VIX did not climb back to the post-Lehman levels. This indicates that investors are now more sanguine about the worst fears expressed during the last quarter of 2008.
Overall, I think that we now can invest as if we are in a standard recession. I had always thought that proactive policy measures would minimize the probability of the Great Depression tail event. That is what the markets are saying now and I concur wholeheartedly.
2. 3-Month Libor-OIS Basis Contracted
The FF-GC basis had widened significantly last year due to stress in funding markets and risk aversion, leading to a severe shortage of treasury collateral. This was one of the factors pushing 2-year swap spreads wider. This basis has normalized due to the Fed's pro-active policy measures and a significant increase in treasury supply. Another peg in the same equation was the LIBOR-OIS basis. Interbank cash markets were dis-functional due to counter-party risk concerns among banks. This was preventing the Fed's policy stimulus from flowing through into cash markets. Narrowing of both these spreads is good news for the transmission mechanism of monetary policy and ultimately, growth.
3. Baltic Dry Index Off the Lows
Is this a reflection of the Chinese stocking activity or a genuine pick up in growth? Hard to say, but the trend over the last couple of months does indicate that the world economy has most likely bottomed.
4. Oil Outperforming Oil Stocks
This was certainly the case early last year when oil rose to stratospheric levels. Equity investors questioned the sustainability of the move in the underlying commodity and were right. I would agree with stocks this time as well because a significant increase in oil price at this stage of the cycle will likely nip the incipient recovery in the bud.
5. Gold Stocks Outpacing Gold
Gold is a great bet going forward. What is the probability that global central banks will get it just right? Pretty low, in my view. Most likely, monetary authorities will be late in withdrawing the extraordinary stimulus, making inflation a real risk at some stage in the future.
6. VIX is Significantly Down from the Highs
When equities collapsed in early 2009, the VIX did not climb back to the post-Lehman levels. This indicates that investors are now more sanguine about the worst fears expressed during the last quarter of 2008.
Overall, I think that we now can invest as if we are in a standard recession. I had always thought that proactive policy measures would minimize the probability of the Great Depression tail event. That is what the markets are saying now and I concur wholeheartedly.
Monday, May 18, 2009
BUY AND HOLD?
The S&P 500 flirted with a "supposedly" important technical level – the 20-day moving average – on Friday. I decided to back-test the historical (May 19, 1982 to February 20, 2009) performance of two simple rules - trend-following and contrarian - based on this technical parameter.
Rule #1: Trend-following
Buy on the close, if S&P 500 > 20-day moving average
Liquidate on the close, if S&P 500 < 20-day moving average
Rule #2: Contrarian
Buy on the close, if S&P 500 < 20-day moving average
Liquidate on the close, if S&P 500 > 20-day moving average
To say the least, the results for the simple trend-following strategy are quite dismal. The order of return dominance (See Exhibit 1) over the entire back-testing period is the following:
1. Buy & hold: $1 invested in the S&P on May 19, 1982 would have grown to $6.71 by February 20, 2009 (7.37% average annual return).
2. Contrarian: $1 invested in the S&P on May 19, 1982 would have grown to $3.35 by February 20, 2009 (3.35% average annual return).
3. Trend-following: $1 invested in the S&P on May 19, 1982 would have grown to $2.00 by February 20, 2009 (2.63% average annual return).
However, there are important variations over different time periods. The trend-following strategy broadly outperformed until about 1998. Since then the contrarian rule held sway. Buy & hold proved the best across time intervals.
Exhibit 1: Value of $1 Invested in Different Strategies: May 19, 1982 to February 20, 2009
Exhibit 2: Relative Performance (Trend Following/Contrarian): May 19, 1982 to February 20, 2009
Source: Bloomberg
Rule #1: Trend-following
Buy on the close, if S&P 500 > 20-day moving average
Liquidate on the close, if S&P 500 < 20-day moving average
Rule #2: Contrarian
Buy on the close, if S&P 500 < 20-day moving average
Liquidate on the close, if S&P 500 > 20-day moving average
To say the least, the results for the simple trend-following strategy are quite dismal. The order of return dominance (See Exhibit 1) over the entire back-testing period is the following:
1. Buy & hold: $1 invested in the S&P on May 19, 1982 would have grown to $6.71 by February 20, 2009 (7.37% average annual return).
2. Contrarian: $1 invested in the S&P on May 19, 1982 would have grown to $3.35 by February 20, 2009 (3.35% average annual return).
3. Trend-following: $1 invested in the S&P on May 19, 1982 would have grown to $2.00 by February 20, 2009 (2.63% average annual return).
However, there are important variations over different time periods. The trend-following strategy broadly outperformed until about 1998. Since then the contrarian rule held sway. Buy & hold proved the best across time intervals.
Exhibit 1: Value of $1 Invested in Different Strategies: May 19, 1982 to February 20, 2009
Exhibit 2: Relative Performance (Trend Following/Contrarian): May 19, 1982 to February 20, 2009
Source: Bloomberg
Saturday, May 2, 2009
SYSTEMATICALLY TRADING GOVERNMENT BONDS USING SIGNALS FROM THE OVERNIGHT INDEXED SWAP MARKET
STATISTICALLY SIGNIFICANT AVERAGE PROFIT OF 1BP PER TRADE; BID-OFFER SPREADS COULD BE AN ISSUE*
A theoretical case is often made for the derivatives market responding faster than the cash segment to economic data and policy announcements. If this assertion is true, then signals from the synthetic space can be used to trade cash instruments.
In the Indian context, I tested this hypothesis using 5-year/10-year government security yields and the 5-year overnight indexed swap rates.
The results are encouraging. OIS rates lead the moves in the government securities market. There is evidence of a positive follow through (positive moves followed by positive, negative followed by negative). A simple trading rule designed to trade government securities generates statistically significant profits.
The back-testing exercise indicates average profits of about 1 basis point (t-statistic >5) per round trip. I have not accounted for bid-offer spreads. Yet, market makers can certainly exploit this empirical regularity (because they do not have to cross bid-offers).
Rule # 1: 5-year OIS and 5-year Gsec
Data: Daily closing yields from February 2, 2003 to April 29, 2009
Cross-Correlation Structure Suggests Positive Follow-through from Synthetic to Cash
Correlation (OIS (-1), Gsec (0)) = 0.22
Correlation (OIS (0), Gsec (0)) =0.50
Correlation (OIS (0), Gsec (-1)) = 0.01
Trading Rule
If Delta (5-year OIS Rate) > 0, then short 5-year government bonds
If Delta (5-year OIS Rate) <0,then buy 5-year government bonds
Delta: Daily close to close
Trade: Daily close to close
Performance Statistics*
Mean (bp): 1.1
Standard deviation (bp): 6.7
t-statistic: 6.6
No. of Positions: 1498
No. of loss-making positions: 624 (42%)
Maximum Gain (bp): 63.6
Maximum Loss (bp): 45.4
Rule # 2: 5-year OIS and 10-year Gsec
Data: Daily closing yields from July 23, 2001 to April 29, 2009
Cross-Correlation Structure Suggests Positive Follow-through from Synthetic to Cash
Correlation (OIS (-1), Gsec (0)) = 0.14
Correlation (OIS (0), Gsec (0)) =0.48
Correlation (OIS (0), Gsec (-1)) = 0.03
Trading Rule
If Delta (5-year OIS Rate) > 0, then short 10-year government bonds
If Delta (5-year OIS Rate) <0, then buy 10-year government bonds
Delta: Daily close to close
Trade: Daily close to close
Performance Statistics*
Mean (bp): 0.88
Standard deviation (bp): 6.9
t-statistic: 5.4
No. of Positions: 1801
No. of loss-making positions: 751 (42%)
Maximum Gain (bp): 76.5
Maximum Loss (bp): 79.9
* Performance statistics not adjusted for the duration of the security traded.
Source: Bloomberg; IMF Working Paper: Derivatives Effect on Monetary Policy Transmission
A theoretical case is often made for the derivatives market responding faster than the cash segment to economic data and policy announcements. If this assertion is true, then signals from the synthetic space can be used to trade cash instruments.
In the Indian context, I tested this hypothesis using 5-year/10-year government security yields and the 5-year overnight indexed swap rates.
The results are encouraging. OIS rates lead the moves in the government securities market. There is evidence of a positive follow through (positive moves followed by positive, negative followed by negative). A simple trading rule designed to trade government securities generates statistically significant profits.
The back-testing exercise indicates average profits of about 1 basis point (t-statistic >5) per round trip. I have not accounted for bid-offer spreads. Yet, market makers can certainly exploit this empirical regularity (because they do not have to cross bid-offers).
Rule # 1: 5-year OIS and 5-year Gsec
Data: Daily closing yields from February 2, 2003 to April 29, 2009
Cross-Correlation Structure Suggests Positive Follow-through from Synthetic to Cash
Correlation (OIS (-1), Gsec (0)) = 0.22
Correlation (OIS (0), Gsec (0)) =0.50
Correlation (OIS (0), Gsec (-1)) = 0.01
Trading Rule
If Delta (5-year OIS Rate) > 0, then short 5-year government bonds
If Delta (5-year OIS Rate) <0,then buy 5-year government bonds
Delta: Daily close to close
Trade: Daily close to close
Performance Statistics*
Mean (bp): 1.1
Standard deviation (bp): 6.7
t-statistic: 6.6
No. of Positions: 1498
No. of loss-making positions: 624 (42%)
Maximum Gain (bp): 63.6
Maximum Loss (bp): 45.4
Rule # 2: 5-year OIS and 10-year Gsec
Data: Daily closing yields from July 23, 2001 to April 29, 2009
Cross-Correlation Structure Suggests Positive Follow-through from Synthetic to Cash
Correlation (OIS (-1), Gsec (0)) = 0.14
Correlation (OIS (0), Gsec (0)) =0.48
Correlation (OIS (0), Gsec (-1)) = 0.03
Trading Rule
If Delta (5-year OIS Rate) > 0, then short 10-year government bonds
If Delta (5-year OIS Rate) <0, then buy 10-year government bonds
Delta: Daily close to close
Trade: Daily close to close
Performance Statistics*
Mean (bp): 0.88
Standard deviation (bp): 6.9
t-statistic: 5.4
No. of Positions: 1801
No. of loss-making positions: 751 (42%)
Maximum Gain (bp): 76.5
Maximum Loss (bp): 79.9
* Performance statistics not adjusted for the duration of the security traded.
Source: Bloomberg; IMF Working Paper: Derivatives Effect on Monetary Policy Transmission
Sunday, April 26, 2009
SHORT-END OF THE CURVES COMPLETELY OUT OF LINE WITH THE CYCLICAL REALITY; 2-YEAR GSECS OFFER PLUS 20% ROE POTENTIAL WITH 10:1 LEVERAGE OVER 1-YEAR
The short-end of both the OIS and the risk free curve is completely out of line with the cyclical reality. While this discrepancy has corrected quite a bit since April 5, 2009 (when I first highlighted the tremendous return potential), the market still seems to be discounting a pretty sharp reversal of monetary policy.
1-year OIS is trading at 3.77%
1-year OIS 1-year forward is trading at 4.62%
1-year Gsecs are trading at 4.19%
1-year Gsec 1-year forward is trading at 5.16%
While it is difficult to make a case for further rate cuts from current levels, I am prepared to bet that if there is a move over the next-year, it will be lower. And I remain confident that the RBI will keep the market flushed with liquidity. The call, therefore, will hug the reverse repo rate (on average) over the next one-year.
For the year starting May 2010, the outlook is slightly murky. Yet, at this stage I doubt that short rates will climb 150bp higher from current levels in a relatively short period of time. The market is pricing that the RBI will normalize policy quickly once signs of a rebound are well entrenched. I doubt that. Policy makers globally are unlikely to risk nipping an incipient recovery in the bud.
Given the above, I would buy 2-year Gsecs with 10% equity for 1-year. I expect this trade to earn a return on equity of more than 20%.
Sunday, April 19, 2009
GREEN SHOOTS AND CHERRY BLOSSOMS
NOT A GREAT DEAL OF DIRECTIONAL CONVICTION FROM HERE; CHASE THE RALLY VIA U.S. CREDIT
I missed the fast and furious global equities rally that started six-week back. While I do not have a great deal of directional conviction, I think risk-reward for jumping into the market at current levels is not great. Continued positive economic surprises would be harder to come by as economists revise forecasts based on the better than expected data flow. Even if good news graces the market, it is no longer oversold to cause the price action evidenced in March. On the other hand, investors could severely punish negative developments.
Yet, I continue to be long spread products: high-yield (HYG), high-yield loans (FFRHX) and investment-grade bonds (LQD). Credit has lagged equities and if this economic improvement is for real, there would be a sharp catch up rally. Battered valuations would limit downside in the event of a setback.
BANKING SYSTEM ISSUES: POTENTIAL FOR UPSIDE SURPRISES LIMITED GOING FORWARD: LONG = GOLDMAN SACHS AND MORGAN STANLEY; SHORT = CITI AND BANK OF AMERICA
The surge in equities began with the assertion of return to profitability by Citi and Bank of America. The earnings out so far have been better than expected, but the massive rally in financials (XLF: 77% up since March 9, 2009) has probably already discounted this outcome. Concerns remain (Goldman’s missing month, AIG payouts, concentration of revenues in trading, impact of the accounting rule change, credit issues in the loan book etc) and sustainability is the key question.
Investors continue to evaluate the likely outcome of the tug of war between a better competitive landscape and legacy assets. Lehman and Bear Stearns’ demise has left future profit streams (and talent to capitalize on this opportunity) on the table. In my view, strong securities focused franchises are in a better position to attract this talent and gain market share. The banks with huge loan books will continue face problems and this should become evident at some stage during the rest of the year (unemployment lags the cycle).
The next big event is the result of the stress tests. Debate rages on how the government should publish the outcome. Questions are already being raised about the reasonableness of the economic assumptions underlying this examination of the financial system. Any declaration of universal health will strip the exercise of credibility. The message so far is that the government will probably release bank level data with a plan for capital injection in some form for the institutions deemed weak. Whatever the outcome, it seems to me that disappointment is more likely than not. Also, the potential for negative surprises is higher for commercial banks with huge loan books.
The last factor is the success of the PPIP. My initial conclusion is that the program will be more potent in tackling the legacy securities issues. Loans are carried at amortized cost and even 6:1 leverage might lead to prices which might result in significant write-downs.
I missed the fast and furious global equities rally that started six-week back. While I do not have a great deal of directional conviction, I think risk-reward for jumping into the market at current levels is not great. Continued positive economic surprises would be harder to come by as economists revise forecasts based on the better than expected data flow. Even if good news graces the market, it is no longer oversold to cause the price action evidenced in March. On the other hand, investors could severely punish negative developments.
Yet, I continue to be long spread products: high-yield (HYG), high-yield loans (FFRHX) and investment-grade bonds (LQD). Credit has lagged equities and if this economic improvement is for real, there would be a sharp catch up rally. Battered valuations would limit downside in the event of a setback.
BANKING SYSTEM ISSUES: POTENTIAL FOR UPSIDE SURPRISES LIMITED GOING FORWARD: LONG = GOLDMAN SACHS AND MORGAN STANLEY; SHORT = CITI AND BANK OF AMERICA
The surge in equities began with the assertion of return to profitability by Citi and Bank of America. The earnings out so far have been better than expected, but the massive rally in financials (XLF: 77% up since March 9, 2009) has probably already discounted this outcome. Concerns remain (Goldman’s missing month, AIG payouts, concentration of revenues in trading, impact of the accounting rule change, credit issues in the loan book etc) and sustainability is the key question.
Investors continue to evaluate the likely outcome of the tug of war between a better competitive landscape and legacy assets. Lehman and Bear Stearns’ demise has left future profit streams (and talent to capitalize on this opportunity) on the table. In my view, strong securities focused franchises are in a better position to attract this talent and gain market share. The banks with huge loan books will continue face problems and this should become evident at some stage during the rest of the year (unemployment lags the cycle).
The next big event is the result of the stress tests. Debate rages on how the government should publish the outcome. Questions are already being raised about the reasonableness of the economic assumptions underlying this examination of the financial system. Any declaration of universal health will strip the exercise of credibility. The message so far is that the government will probably release bank level data with a plan for capital injection in some form for the institutions deemed weak. Whatever the outcome, it seems to me that disappointment is more likely than not. Also, the potential for negative surprises is higher for commercial banks with huge loan books.
The last factor is the success of the PPIP. My initial conclusion is that the program will be more potent in tackling the legacy securities issues. Loans are carried at amortized cost and even 6:1 leverage might lead to prices which might result in significant write-downs.
Sunday, April 12, 2009
BEST HINDSIGHT TRADES OF Q1 2009: LONG EMERGING MARKETS, LONG USD/YEN, SHORT U.S. FINANCIALS AND SHORT LONG-DURATION U.S. TREASURIES
The following are the key trends from a survey of global asset class performance year-to-date:
- Emerging market bonds as well as equities outperformed. The BRICs markets are back.
- Duration exposure in the
- The commodities downdraft seems to be over, suggesting that the global economy has bottomed and the inventory adjustment process is near its end.
- The U.S. dollar gained ground in 2009, building further on the rally that started in 2008. The yen performed poorly as Japanese export concerns finally caught up with the currency.
- Gold remains roughly unchanged buoyed by the twin forces of risk-aversion and the likely inflationary impact of the global policy moves.
- In line with the overall emerging market resurgence and commodity revival theme, materials led sectoral performance in the
Global Asset Class Performance (2009 YTD)
Source: Market Watch
Sunday, April 5, 2009
RISK-REWARD GREAT FOR DURATION EXPOSURE THROUGH HIGH QUALITY CORPORATE PAPER
I have been part wrong and part right as far Indian fixed income markets are concerned.
DURATION EXPOSURE DID NOT PAY OFF IN Q1 2009; THE SHORT-END LOOKS ATTRACTIVE
I underestimated the brute force of supply pushing government security yields higher. Overnight indexed swap rates climbed as market-players probably paid to hedge duration. Yields rose on corporate paper as well.
Yet, the current yield levels – particularly the short-end - seem totally out of line with the cyclical reality, even after accounting for significant fiscal stimulus led issuance. Persistent excess liquidity is likely to be the norm going forward. I am also confident that the Reserve Bank is unlikely to lift the reverse repo rate over the next year. Given this backdrop, the short-end seems very attractively priced.
Consider the following investment-buy 1-year Government securities financed in repo with a haircut of 10%. Based on the current 1-year spot rate (5.35%) and daily call funding at 3.5% over the next 1-year, the return on equity on this investment will be 22%.
On the OIS front, the 1-year spot rate 1-year forward is 4.78% currently. This implies almost a 100bp increase in the 1-year spot OIS over the next 12-months – a scenario that seems extremely unlikely to me. A clear trade here is to receive the 2-year OIS versus the 1-year (receiving the 1-year OIS, 1-year forward).
SPREAD DURATION EXPOSURE TO HIGH QUALITY CORPOARTE PAPER REWARDED HANDSOMELY; ABSOLUTE YIELD LEVELS VERY ATTRACTIVE
The yield on the FIMMDA Bloomberg 10-year AAA corporate bond index rose about 55bp point in the first quarter of 2009, but the spread over 10-year Government security yield declined to 172bp on April 3, 2009 from 284bp on December 31, 2008. This spread averaged 111bp since December 2001, with a standard deviation of 76bp. At this point, the risk-reward for spread duration exposure does not look that great, but absolute yield levels on a diversified basket of corporate paper look attractive. Clearly, this is the time to assume duration exposure through high quality corporate paper.
RBI ANNOUNCES PLAN TO BUY INR 800BN GOVERNMENT SECURITIES
The overall structure of interest rates cannot decline unless base risk free yields fall. And, RBI’s latest move indicates that the central bank is alive to this issue. From the perch of current yield levels, long duration exposure makes sense. The ultimate aim of policy-makers is to reduce borrowing costs for the industry and that is where long positions would be most rewarding.
Sunday, March 8, 2009
SHORTING GAMMA IN THE USD/INR OPTIONS MARKET
The premise for short gamma trades is that the options’ market consistently overprices the volatility of the underlying. This discrepancy can be interpreted as a risk premium that speculators demand from hedgers.
A simple test suggests that this hypothesis is true for the USD/INR options market. Also, this risk premium seems to be auto-correlated.
RESULTS FROM IMPLIED VERSUS REALIZED VOL TRADES
I took one-week implied vols and compared these with USD/INR’s realized volatility over the subsequent seven-days. I calculated the daily standard deviation of the exchange rate on a close to close basis (annualized by multiplying it with the square root of the number of trading days per year). Then I measured the difference between implied and realized vol over the period under consideration. Following are the results from this exercise for non-overlapping weekly periods (annualized):
Data: 1-week implied vols. from July 2003 to March 2009; USD/INR: Daily data from July 2003 to March 2009
Stdev: 3.5%
No. of trades: 294
Proportion of loss-making trades: 22%
Maximum: 18.7%
Minimum: -10.3%
THERE IS EVIDENCE OF MOMENTUM IN WEEKLY PERFORMANCE (VOL TERMS)
The serial correlation is about 0.52, suggesting the presence of momentum. Based on this result, I tested a historical scheme to go short gamma only if the last trade money. The results are the following (annualized):
Mean: 2.0%
Stdev: 3.3%
No. of trades: 228
Proportion of loss-making trades: 17%
Maximum: 18.7%
Minimum: -6.2%
Clearly, the performance improves on many fronts. The proportion of loss-making trades decline by 5% to just 17% and the maximum drawdown falls as well.
Sunday, March 1, 2009
REVIVAL IN GLOBAL RISK APPETITE IS KEY TO A SUSTAINABLE EQUITY RALLY AT HOME; RELATIVE INSULATION FROM GLOBAL WOES HAS NOT HELPED AND WILL NOT HELP
I have made the case in the past that Indian equities are cheap by historical norms, but still not at valuation extremes of December 2002. While current pricing is consistent with healthy returns over the medium-term (5-10 years), we are still not in an environment that would be conducive to a sustained revival in equity market fortunes. Indian indexes cannot and will not rally at variance with global risk appetite. Consider the following regressions:
Sensex Total Return (%) = 19% + 0.01 * U.S. HY Excess Returns
Data: 1990 to 2007; Yearly
U.S. High Yield Excess Returns: Return over duration matched treasuries in basis points on the Lehman Brothers U.S. High Yield Index
R-squared = 0.44
t-statistic (beta) = 3.58 (P-value:0.002)
Sensex Total Return (%) = 11% + 0.01 * U.S.$ EM Excess Returns
Data: 1993 to 2007; Yearly
U.S.$ Emerging Market Excess Returns: Return over duration matched treasuries in basis points on the Lehman Brothers U.S.$ EM Index
R-squared = 0.23
t-statistic (beta) = 1.99 (P-value: 0.06)
The key message is a positive relationship between Indian stock market variation and excess returns in U.S. spread sectors. When risk premium demanded by global investors climbs, all asset classes under-perform.
Another way to look at this phenomenon is that the Indian bourses will post significant and sustainable rallies only when foreign portfolio investors return in a big way.
I do not foresee a revival in global risk appetite in the near future. The incessant flow of bad news continues. Trouble in Eastern Europe, never ending issues in the banking system, and massive fiscal deficits; all continue to keep markets on the back foot.
All of the above does not rule out a 20%-30% rally from wherever the market bottoms in the current downdraft, but the sustainability of the upswing will be questionable and I will look to reduce risk as markets move higher.
Sensex Total Return (%) = 19% + 0.01 * U.S. HY Excess Returns
Data: 1990 to 2007; Yearly
U.S. High Yield Excess Returns: Return over duration matched treasuries in basis points on the Lehman Brothers U.S. High Yield Index
R-squared = 0.44
t-statistic (beta) = 3.58 (P-value:0.002)
Sensex Total Return (%) = 11% + 0.01 * U.S.$ EM Excess Returns
Data: 1993 to 2007; Yearly
U.S.$ Emerging Market Excess Returns: Return over duration matched treasuries in basis points on the Lehman Brothers U.S.$ EM Index
R-squared = 0.23
t-statistic (beta) = 1.99 (P-value: 0.06)
The key message is a positive relationship between Indian stock market variation and excess returns in U.S. spread sectors. When risk premium demanded by global investors climbs, all asset classes under-perform.
Another way to look at this phenomenon is that the Indian bourses will post significant and sustainable rallies only when foreign portfolio investors return in a big way.
I do not foresee a revival in global risk appetite in the near future. The incessant flow of bad news continues. Trouble in Eastern Europe, never ending issues in the banking system, and massive fiscal deficits; all continue to keep markets on the back foot.
All of the above does not rule out a 20%-30% rally from wherever the market bottoms in the current downdraft, but the sustainability of the upswing will be questionable and I will look to reduce risk as markets move higher.
Tuesday, February 17, 2009
IS THE DEFLATIONARY TRAIN UNSTOPPABLE? NOT REALLY
LITTLE HOPE FROM MONETARY POLICY
Monetary policy operates through the financial system and banks are capital constrained. Even if intermediaries could lend, consumer balance sheets are not looking great with significant decline in asset values and the resulting increase in leverage. Credit off-take for capex will be cautious given that consumer demand is imploding. Conventional monetary policy is not working and will not work.
DIRECT GOVERNMENT SPENDING IN ISOLATION WILL LEAD TO A FEEBLE RECOVERY WHICH IN ALL LIKLIHOOD WON’T BE SELF SUSTAINING
There will certainly be a first round effect of direct government spending. But in the current environment, I remain doubtful about the efficacy of the multiplier effect. Heightened uncertainty will mute the second round effect due to a rising propensity to save. In fact, I think tax cuts will likely fail completely.
BEST USE OF GOVERNMENT MONEY IS A CLEANUP OF FINANCIAL INTERMEDIARIES
I do not think that bad loans need to be restructured or forgiven outright. Debt relief might create a perverse effect as it will encourage people who are current on their payments to default (worsening the problem). And I can’t think of a way to negate this incentive problem.
The value of doubtful loans or securitized assets needs to be written down fully. Private sector needs to step in with valuation expertise to lend credibility to the exercise. Once the quantum of capital shortage is known, the government needs to inject equity directly. I do not see any problem with public sector ownership of financial institutions as long as there is explicit commitment to privatize at some future date. The authorities need to step in when market failure is apparent. Right now is not the time to ensure allocative efficiency. The first priority is to allocate, then ensure that it is done the right way.
Once trust returns in the financial system, banks need to focus on the developing world to fund projects. The world needs to return to normal. The wealthy save and lend, the poor borrow and invest to create factories, roads and bridges.
MEANWHILE MONETIZED DEFICITS ARE REQUIRED TO SIDESTEP THE DYSFUNCTIONAL POLICY TRANSMISSION AND PREVENT DEFLATIONARY EXPECTATIONS FROM GETTING ENTRENCHED
Given the complexity of the politico-economic process, this clean up will take time and the government needs to sidestep the normal economic process and spend by borrowing directly from the central bank. This will provide a floor to the economy and prevent deflationary expectations from gaining traction.
EVEN WHEN DONE RIGHT; THIS PROCESS WILL TAKE A LONG TIME AND THE DEVELOPING WORLD WILL TAKE THE LEAD IN GROWTH
The factories in Asia that catered to U.S. consumers will no longer be viable. Consumer preferences differ in the less developed economies due to cultural dissimilarity and income levels. No amount of monetary easing can create huge demand for certain luxury goods in countries such as India and China. Production structures in export oriented economies will need to undergo painful restructuring to cater to domestic demand.
IF MY IDEAL POLICY WORLD MATERIALIZES, DEVELOPING COUNTRY EQUITIES WILL OUTPERFORM OVER THE NEXT COMPLETE CYCLE
The world worked in the following way over the last 5-years: home prices climbed leading to a positive wealth effect on U.S. consumption. This demand spilt into the external sector resulting in a higher current account deficit. Similar housing booms in Spain, Ireland and U.K. also reflected in expanding trade deficits. Export oriented economies such as Japan, China, Rest of Asia, and Germany expanded rapidly. This synchronous global upturn led to spiraling commodity prices, transmitting the up-cycle to countries such as Russia, Chile, and Australia. International investors financed the burgeoning U.S. external gap by driving the dollar lower. Global central banks bought U.S. assets (treasuries and agencies) to prevent their currencies from appreciating to benefit from U.S. demand. This chain is broken. Implications are obvious.
Monetary policy operates through the financial system and banks are capital constrained. Even if intermediaries could lend, consumer balance sheets are not looking great with significant decline in asset values and the resulting increase in leverage. Credit off-take for capex will be cautious given that consumer demand is imploding. Conventional monetary policy is not working and will not work.
DIRECT GOVERNMENT SPENDING IN ISOLATION WILL LEAD TO A FEEBLE RECOVERY WHICH IN ALL LIKLIHOOD WON’T BE SELF SUSTAINING
There will certainly be a first round effect of direct government spending. But in the current environment, I remain doubtful about the efficacy of the multiplier effect. Heightened uncertainty will mute the second round effect due to a rising propensity to save. In fact, I think tax cuts will likely fail completely.
BEST USE OF GOVERNMENT MONEY IS A CLEANUP OF FINANCIAL INTERMEDIARIES
I do not think that bad loans need to be restructured or forgiven outright. Debt relief might create a perverse effect as it will encourage people who are current on their payments to default (worsening the problem). And I can’t think of a way to negate this incentive problem.
The value of doubtful loans or securitized assets needs to be written down fully. Private sector needs to step in with valuation expertise to lend credibility to the exercise. Once the quantum of capital shortage is known, the government needs to inject equity directly. I do not see any problem with public sector ownership of financial institutions as long as there is explicit commitment to privatize at some future date. The authorities need to step in when market failure is apparent. Right now is not the time to ensure allocative efficiency. The first priority is to allocate, then ensure that it is done the right way.
Once trust returns in the financial system, banks need to focus on the developing world to fund projects. The world needs to return to normal. The wealthy save and lend, the poor borrow and invest to create factories, roads and bridges.
MEANWHILE MONETIZED DEFICITS ARE REQUIRED TO SIDESTEP THE DYSFUNCTIONAL POLICY TRANSMISSION AND PREVENT DEFLATIONARY EXPECTATIONS FROM GETTING ENTRENCHED
Given the complexity of the politico-economic process, this clean up will take time and the government needs to sidestep the normal economic process and spend by borrowing directly from the central bank. This will provide a floor to the economy and prevent deflationary expectations from gaining traction.
EVEN WHEN DONE RIGHT; THIS PROCESS WILL TAKE A LONG TIME AND THE DEVELOPING WORLD WILL TAKE THE LEAD IN GROWTH
The factories in Asia that catered to U.S. consumers will no longer be viable. Consumer preferences differ in the less developed economies due to cultural dissimilarity and income levels. No amount of monetary easing can create huge demand for certain luxury goods in countries such as India and China. Production structures in export oriented economies will need to undergo painful restructuring to cater to domestic demand.
IF MY IDEAL POLICY WORLD MATERIALIZES, DEVELOPING COUNTRY EQUITIES WILL OUTPERFORM OVER THE NEXT COMPLETE CYCLE
The world worked in the following way over the last 5-years: home prices climbed leading to a positive wealth effect on U.S. consumption. This demand spilt into the external sector resulting in a higher current account deficit. Similar housing booms in Spain, Ireland and U.K. also reflected in expanding trade deficits. Export oriented economies such as Japan, China, Rest of Asia, and Germany expanded rapidly. This synchronous global upturn led to spiraling commodity prices, transmitting the up-cycle to countries such as Russia, Chile, and Australia. International investors financed the burgeoning U.S. external gap by driving the dollar lower. Global central banks bought U.S. assets (treasuries and agencies) to prevent their currencies from appreciating to benefit from U.S. demand. This chain is broken. Implications are obvious.
Sunday, February 8, 2009
CAN ECONOMIC DATA BE USED FOR EQUITY MARKET TIMING? MANUFACTURING ISM CALLING FOR A REVERSAL IN STOCKS ONE-YEAR DOWN
Most economic data is useless for the purpose of predicting markets. Asset prices discount the future economic outlook and are often used as leading indicators. Forecasting financial instrument returns therefore requires predicting the course of leading indicators – basically two steps ahead of the economy.
Yet, leading indicators (excluding asset prices themselves) could potentially be used to differentiate between a “bear market rally”/“false dawns” from a sustainable turn in the outlook. The big question is the following: if there is a divergence between stock returns and the underlying economic outlook defined by a leading indicator, do fundamentals prevail?
I used the manufacturing ISM as a proxy for the future economic outlook. The S&P composite monthly returns are positively correlated with coincident changes in the ISM. Also, the monthly divergence indicator does not add any value to intra-year investment decision-making. However, not all is lost.
The level of the ISM predicts 1-year forward S&P performance. The relationship is inverse and statistically significant. The current level of the ISM suggests a good 2009 for stocks.
ISM AND S&P 500 ARE COINCIDENT
Monthly equity returns covary positively with the change in ISM.
S&P Comp. = 0.60 + 0.15*ISM
Data: Monthly % Changes from January 1948 to December 2008
R^2 = 5%
t-statistic = 6.8
While this information is obvious and good to know, it does not help us too much in our market timing endeavor.
ISM AND S&P COMPOSITE DIVERGENCE INDICATOR NOT USEFUL
To test my divergence hypothesis, I conducted the following experiments:
1. If monthly return on the S&P is positive but the 3-month average (to filter out noise) change in the ISM is negative, I short the index.
Average monthly return: -0.72
Standard deviation: 3.32
No. of trades: 209
2. If monthly return on the S&P is negative but the 3-month average change in the ISM is positive, I go long the index.
Average monthly return: -0.13
Standard deviation: 3.71
No. of trades: 124
The results are disastrous and suggest that either there is momentum in monthly returns or that stocks predict the economy better than the ISM. The lead-lag structure of correlations indicates that S&P composite’s variations predict the future movements in the purchasing manager’s index.
Correlation (S&P (t), ISM (t)) = 0.24
Correlation (S&P (t-1), ISM (t)) = 0.19
Correlation (S&P (t), ISM (t-1)) = 0.02
While these results reinforce my belief in the futility of economic indicators in devising profitable trading strategies, all is not lost.
YEARLY RESULTS PRESENT A DIFFERENT PICTURE
There exists an inverse relationship between the level of the ISM and 1-year forward returns. The reason for this covariance, in my view, is that the current in point the cycle has implications for the likely evolution of the future economic landscape.
Medium to long-term, the invisible hand operates to correct deviations from equilibrium. For instance, high oil prices set into motion various forces to reverse the trend. At steeper valuations, new sources supply such as tar sands become viable. Certain alternative fuels also gain traction. Elasticity of demand also rises with time as people adjust behavior and switch to processes which economize on fuel. In addition, governments reinforce these processes by actual policy or pronouncements which affect expectations of economic agents.
Similarly, a high level of the purchasing manager’s index indicates a mature business cycle with incipient inflationary pressures. In a money targeting regime, rising money demand forces interest rates to rise, working to moderate the cycle. At economic extremes, public outcry makes the authorities more responsive - Central Banks reinforce market forces to increase the speed of reversion to equilibrium.
S&P = 40.63 – 0.60* ISM (t-1)
Data: Yearly from 1948 to 2008, ISM: levels; S&P Comp.: Changes
R^2 = 9%
t-statistic (beta) = -2.51
The coefficient of ISM is statistically significant at the 1% level. The latest manufacturing PMI reading indicates the possibility of solid returns (about 19%) over the next year.
As a next step, I tested the strategy of buying the index when ISM fell below 45. I only considered year-ends to get non-overlapping time intervals.
Mean: 19%
Standard deviation: 15%
Maximum drawdown: -14%
Maximum: 41%
Number of trades: 10
Importantly, 9 out 10 trades made money. The strategy of picking the bottom lost money in 2001. I also tested whether these results represent a chance outcome devoid of any economic significance. A t-test for the difference in mean reward of a buy-hold strategy and the one presented above point to superiority of the PMI based trading scheme and we can assert this with 95% statistical confidence.
THERE ARE ALWAYS CAVEATS; IS THIS TIME DIFFERENT?
Understanding of why the rule worked in the past can also highlight circumstances where it might fail. The only failure occurred in 2001. September 11 was an exogenous shock that severely dented confidence. Additionally, in early part of the decade, equities sported stratospheric valuations. Stocks are clearly no longer exuberantly priced.
The second caveat is that the equilibrating forces I mentioned earlier, fail to operate as hypothesized or there is a longer lag than usual. Indeed, there is reason to believe that this scenario could be relevant today. The transmission mechanism of monetary policy has been rendered dysfunctional by the financial sector crisis.
Yet, given that the authorities are willing to do everything possible to avert debt deflation, I think it is imprudent to bet for a significant decline from current levels. Not that another downdraft is not possible, just that it requires another Great Depression-like outcome. I would bet against that low probability scenario.
Data Source:
http://www.irrationalexuberance.com/
http://www.ism.ws/
Yet, leading indicators (excluding asset prices themselves) could potentially be used to differentiate between a “bear market rally”/“false dawns” from a sustainable turn in the outlook. The big question is the following: if there is a divergence between stock returns and the underlying economic outlook defined by a leading indicator, do fundamentals prevail?
I used the manufacturing ISM as a proxy for the future economic outlook. The S&P composite monthly returns are positively correlated with coincident changes in the ISM. Also, the monthly divergence indicator does not add any value to intra-year investment decision-making. However, not all is lost.
The level of the ISM predicts 1-year forward S&P performance. The relationship is inverse and statistically significant. The current level of the ISM suggests a good 2009 for stocks.
ISM AND S&P 500 ARE COINCIDENT
Monthly equity returns covary positively with the change in ISM.
S&P Comp. = 0.60 + 0.15*ISM
Data: Monthly % Changes from January 1948 to December 2008
R^2 = 5%
t-statistic = 6.8
While this information is obvious and good to know, it does not help us too much in our market timing endeavor.
ISM AND S&P COMPOSITE DIVERGENCE INDICATOR NOT USEFUL
To test my divergence hypothesis, I conducted the following experiments:
1. If monthly return on the S&P is positive but the 3-month average (to filter out noise) change in the ISM is negative, I short the index.
Average monthly return: -0.72
Standard deviation: 3.32
No. of trades: 209
2. If monthly return on the S&P is negative but the 3-month average change in the ISM is positive, I go long the index.
Average monthly return: -0.13
Standard deviation: 3.71
No. of trades: 124
The results are disastrous and suggest that either there is momentum in monthly returns or that stocks predict the economy better than the ISM. The lead-lag structure of correlations indicates that S&P composite’s variations predict the future movements in the purchasing manager’s index.
Correlation (S&P (t), ISM (t)) = 0.24
Correlation (S&P (t-1), ISM (t)) = 0.19
Correlation (S&P (t), ISM (t-1)) = 0.02
While these results reinforce my belief in the futility of economic indicators in devising profitable trading strategies, all is not lost.
YEARLY RESULTS PRESENT A DIFFERENT PICTURE
There exists an inverse relationship between the level of the ISM and 1-year forward returns. The reason for this covariance, in my view, is that the current in point the cycle has implications for the likely evolution of the future economic landscape.
Medium to long-term, the invisible hand operates to correct deviations from equilibrium. For instance, high oil prices set into motion various forces to reverse the trend. At steeper valuations, new sources supply such as tar sands become viable. Certain alternative fuels also gain traction. Elasticity of demand also rises with time as people adjust behavior and switch to processes which economize on fuel. In addition, governments reinforce these processes by actual policy or pronouncements which affect expectations of economic agents.
Similarly, a high level of the purchasing manager’s index indicates a mature business cycle with incipient inflationary pressures. In a money targeting regime, rising money demand forces interest rates to rise, working to moderate the cycle. At economic extremes, public outcry makes the authorities more responsive - Central Banks reinforce market forces to increase the speed of reversion to equilibrium.
S&P = 40.63 – 0.60* ISM (t-1)
Data: Yearly from 1948 to 2008, ISM: levels; S&P Comp.: Changes
R^2 = 9%
t-statistic (beta) = -2.51
The coefficient of ISM is statistically significant at the 1% level. The latest manufacturing PMI reading indicates the possibility of solid returns (about 19%) over the next year.
As a next step, I tested the strategy of buying the index when ISM fell below 45. I only considered year-ends to get non-overlapping time intervals.
Mean: 19%
Standard deviation: 15%
Maximum drawdown: -14%
Maximum: 41%
Number of trades: 10
Importantly, 9 out 10 trades made money. The strategy of picking the bottom lost money in 2001. I also tested whether these results represent a chance outcome devoid of any economic significance. A t-test for the difference in mean reward of a buy-hold strategy and the one presented above point to superiority of the PMI based trading scheme and we can assert this with 95% statistical confidence.
THERE ARE ALWAYS CAVEATS; IS THIS TIME DIFFERENT?
Understanding of why the rule worked in the past can also highlight circumstances where it might fail. The only failure occurred in 2001. September 11 was an exogenous shock that severely dented confidence. Additionally, in early part of the decade, equities sported stratospheric valuations. Stocks are clearly no longer exuberantly priced.
The second caveat is that the equilibrating forces I mentioned earlier, fail to operate as hypothesized or there is a longer lag than usual. Indeed, there is reason to believe that this scenario could be relevant today. The transmission mechanism of monetary policy has been rendered dysfunctional by the financial sector crisis.
Yet, given that the authorities are willing to do everything possible to avert debt deflation, I think it is imprudent to bet for a significant decline from current levels. Not that another downdraft is not possible, just that it requires another Great Depression-like outcome. I would bet against that low probability scenario.
Data Source:
http://www.irrationalexuberance.com/
http://www.ism.ws/
Sunday, February 1, 2009
TRADING GOVT. SECURITIES USING THE SENSEX; EQUITIES LEAD BONDS BY 7-MONTHS
POSITIVE RELATIONSHIP BETWEEN S&P 500 RETURNS AND 10-YEAR U.S. TREASURY YIELD CHANGES
There is a well known positive relationship between U.S. Treasury yields and the S&P 500 returns. There are two interpretations of this covariance. First, risk appetite is pro-cyclical. Likelihood of a strong economy results in allocation in favor of equities versus treasuries. Second, stocks discount the profit outlook that lies ahead and bonds the likely Fed actions. A recession implies earnings downgrades and Fed cuts. An upswing in aggregate demand has the opposite consequences.
10-year U.S. Treasury Yield = -0.41 + 0.88* S&P 500
Data: Monthly percentage changes - July 1990 to December 2008
R^2 = 2%
t-statistic (beta) = 2.02
NEGATIVE RELATIONSHIP BETWEEN SENSEX RETURNS AND 10-YEAR INDIAN GOVERNMENT SECURITY YIELDS
To test the relationship for India, I ran the following regressions:
MONTHLY DATA
10-year GOISEC Yield = -0.02 - 0.75* SENSEX
Data: Monthly percentage changes - January 2000 to December 2007.
R^2 = 10%
t-statistic (beta) = -3.03
10-year GOISEC Yield = -0.26 - 0.41* SENSEX
Data: Monthly percentage changes - November 1998 to December 2008.
R^2 = 2%
t-statistic (beta) = -1.79
DAILY DATA
10-year GOISEC Yield = -0.003 - 0.27* SENSEX
Data: Daily percentage changes – July 2002 to January 2009.
R^2 = 1%
t-statistic (beta) = -4.40
I experimented with different periodicity and time periods just to be sure of the robustness of the results. The message is clear. Contrary to economic logic, an inverse relationship exists between Indian government bond yield changes and equity returns.
THE MARKET THAT GETS IT RIGHT CAN BE USED TO TRADE THE ONE THAT GETS IT WRONG
In my view, the reason behind this counter-intuitive relationship is that different players dominate the landscape in stocks and bonds. Foreign institutional investors determine the rhythm of the SENSEX. Nationalized banks rule the roost in the government securities world.
Based on the above, it seems likely to me that equities get the economic outlook more correct on average. Firstly, international investors have much better access to research and have a keener eye on the global cycle. Secondly, there is the big question of incentives. FIIs are paid to get things right and have to face the music for wrong bets. That is certainly not the case at nationalized banks where there is only downside for assuming risk.
SENSEX GETS IT RIGHT ON AVERAGE
Empirical evidence supports my hypothesis. RBI’s research suggests (Business Cycles and Leading Indicators of Industrial Activity in India, RBI Occasional Papers (2003)) that the SENSEX leads industrial production by about 12-months.
BOND YIELDS LAG EQUITY RETURNS BY ABOUT 7-MONTHS
I ran simple regressions using various monthly lags for stock market fluctuations. The fit parameters work out best for the 7th month.
10-year GOISEC Yield = -0.83 + 0.16* SENSEX (-7)
Data: Monthly percentage changes - November 1998 to December 2008.
R^2 = 8%
t-statistic (beta) = 3.23
LAST YEAR WENT BY THE BOOK; WHAT ABOUT 2009
Given my assessment of the Indian economic cycle, I would not sell government securities with yields at current levels. I get the same message from equities. Issues related to the transmission mechanism of monetary policy can be sorted out only over long periods. For now, the RBI needs to respond with the tools at hand. The only thing that the Reserve Bank can do is to reduce base rates, flood the system with liquidity and hope that deposit/lending rates respond in due course.
Bloomberg is the source for all data.
There is a well known positive relationship between U.S. Treasury yields and the S&P 500 returns. There are two interpretations of this covariance. First, risk appetite is pro-cyclical. Likelihood of a strong economy results in allocation in favor of equities versus treasuries. Second, stocks discount the profit outlook that lies ahead and bonds the likely Fed actions. A recession implies earnings downgrades and Fed cuts. An upswing in aggregate demand has the opposite consequences.
10-year U.S. Treasury Yield = -0.41 + 0.88* S&P 500
Data: Monthly percentage changes - July 1990 to December 2008
R^2 = 2%
t-statistic (beta) = 2.02
NEGATIVE RELATIONSHIP BETWEEN SENSEX RETURNS AND 10-YEAR INDIAN GOVERNMENT SECURITY YIELDS
To test the relationship for India, I ran the following regressions:
MONTHLY DATA
10-year GOISEC Yield = -0.02 - 0.75* SENSEX
Data: Monthly percentage changes - January 2000 to December 2007.
R^2 = 10%
t-statistic (beta) = -3.03
10-year GOISEC Yield = -0.26 - 0.41* SENSEX
Data: Monthly percentage changes - November 1998 to December 2008.
R^2 = 2%
t-statistic (beta) = -1.79
DAILY DATA
10-year GOISEC Yield = -0.003 - 0.27* SENSEX
Data: Daily percentage changes – July 2002 to January 2009.
R^2 = 1%
t-statistic (beta) = -4.40
I experimented with different periodicity and time periods just to be sure of the robustness of the results. The message is clear. Contrary to economic logic, an inverse relationship exists between Indian government bond yield changes and equity returns.
THE MARKET THAT GETS IT RIGHT CAN BE USED TO TRADE THE ONE THAT GETS IT WRONG
In my view, the reason behind this counter-intuitive relationship is that different players dominate the landscape in stocks and bonds. Foreign institutional investors determine the rhythm of the SENSEX. Nationalized banks rule the roost in the government securities world.
Based on the above, it seems likely to me that equities get the economic outlook more correct on average. Firstly, international investors have much better access to research and have a keener eye on the global cycle. Secondly, there is the big question of incentives. FIIs are paid to get things right and have to face the music for wrong bets. That is certainly not the case at nationalized banks where there is only downside for assuming risk.
SENSEX GETS IT RIGHT ON AVERAGE
Empirical evidence supports my hypothesis. RBI’s research suggests (Business Cycles and Leading Indicators of Industrial Activity in India, RBI Occasional Papers (2003)) that the SENSEX leads industrial production by about 12-months.
BOND YIELDS LAG EQUITY RETURNS BY ABOUT 7-MONTHS
I ran simple regressions using various monthly lags for stock market fluctuations. The fit parameters work out best for the 7th month.
10-year GOISEC Yield = -0.83 + 0.16* SENSEX (-7)
Data: Monthly percentage changes - November 1998 to December 2008.
R^2 = 8%
t-statistic (beta) = 3.23
LAST YEAR WENT BY THE BOOK; WHAT ABOUT 2009
Given my assessment of the Indian economic cycle, I would not sell government securities with yields at current levels. I get the same message from equities. Issues related to the transmission mechanism of monetary policy can be sorted out only over long periods. For now, the RBI needs to respond with the tools at hand. The only thing that the Reserve Bank can do is to reduce base rates, flood the system with liquidity and hope that deposit/lending rates respond in due course.
Bloomberg is the source for all data.
Sunday, January 25, 2009
TREND-FOLLOWING TO PROSPERITY? DOUBTFUL
I made the case that Indian equities are now undervalued based on price to nominal GDP, but the market is still not trading at the extremes seen around 2002-end (SENSEX PRICED TO DELIVER ATTRACTIVE MEDIUM-TERM RETURNS)- those valuations imply a SENSEX level of about 7500. Where the final bottom lies will depend upon the evolution of global risk appetite based on the future course of economic and earnings data. Considerable uncertainty remains about whether policy stimulus will work given the continued problems in the banking sector. Absent any further shocks, I am leaning toward a scenario where the substantial fiscal response along with improvement in credit markets will lead to a feeble resurgence in late 2009 or early 2010. Markets will turn before that, but given the substantial uncertainty, I am looking for ways to avoid the downdraft should the recovery not materialize. To this end, I tested several technical rules that could help in playing this turning point profitably.
The results are preliminary, but based on monthly index data it does not seem that simple trend following strategies would be of great help. There is no statistical evidence of either momentum or reversal in monthly return data for the SENSEX and BSE-100. Market breadth – characterized by the advance/decline ratio - does not seem to have any predictive power either. The option market – call to put ratio - seems to have some contrarian relevance.
TREND IS YOUR FRIEND? NOT SURE
I tested for linear dependence in monthly returns for both the SENSEX and BSE-100 (April-2001 to March-2008). The results do not indicate any tendency for either momentum or reversal.
SENSEX
Return (t) = 1.9% + 0.06*Return (t-1)
BSE-100
Return (t) = 2% + 0.05*Return (t-1)
The regressions have low R^2 and the coefficients for lagged returns are not statistically significant. So a simple momentum strategy will not be of much help in our endeavor.
What about buying only when the monthly closing value exceeds the 12-month moving average? The results are no better than a buy and hold exercise.
12-month Moving-Average Strategy: Monthly Return Statistics
Mean: 2.5%
Standard Deviation: 7.0%
No. of Months: 61
Buy and Hold: Monthly Return Statistics
Mean: 2.6%
Standard Deviation: 6.8%
No. of Months: 71
Bottom-line, it does not seem that we can simply follow the market to prosperity.
WHAT DOES MARKET BREADTH TELL US? NOT MUCH
High breadth is a sign of a healthy market that is more likely to rise. To test this hypothesis, I regressed monthly returns with one month lagged advance to decline ratio (A/D) as the explanatory variable. The results are not encouraging.
Returns (t) = 2.6% - 0.002* A/D (t-1)
The regression explains about 9% of the variation in monthly returns and the coefficient of the A/D ratio is negative but lacks statistical significance. There does not seem to be any pattern in the residuals.
To take the analysis one step forward, I tested four trading schemes:
1.If the advance/decline ratio for the month is higher than that for the last month and current monthly returns are positive, go long the market, otherwise stay out.
Mean: 2.2%
Standard Deviation: 8.2%
No. of Months: 35
2.If the advance/decline ratio for the month is lower than that for the last month and current monthly returns are positive, go short the market, otherwise stay out.
Mean: -2.9%
Standard Deviation: 6.5%
No. of Months: 20
3.If the advance/decline ratio for the month is lower than that for the last month and current month returns are negative, go short the market, otherwise stay out.
Mean: -1.9%
Standard Deviation: 5.9%
No. of Months: 21
4. If the advance/decline ratio for the month is higher than that for the last month and current month returns are negative, go long the market, otherwise I stay out.
Mean: -0.15%
Standard Deviation: 9.1%
No. of Months: 6
Market breadth does not seem very helpful in improving investment performance.
OPTIONS MARKET A CONTRARIAN INDICATOR
If the call/put (measured by value) ratio trends higher, on average, traders expect the market to rise. I tested the predictability of this technical factor by regressing monthly returns of the BSE-100 on 1-month lagged call to put ratios on the NSE. I know that the exchanges are different, but cannot think of a reason why that should bias the results.
BSE-100 Returns (t) = 5.7% - 0.008 Call to Put Ratio NSE (t-1)
The R^2 is about 18%. The coefficient for 1-month lagged call to put ratio is negative and the p-value is 0.11. It seems that the options market gets it wrong on average and we can say this with about 90% confidence.
PRELIMINARY EVIDENCE NOT ENCOURAGING; FURTHER INQUIRY REQUIRED
There are obvious qualifiers to the above analysis: firstly, the data is not enough; secondly, I used only monthly data, it is possible that the indicators work for different periodicity; and finally, there might be non-linear dependence that our simple statistical techniques failed to decipher. The results are not conclusive, but do suggest that simple trend following strategies are not likely to help us negotiate the considerable uncertainty that clouds the investment landscape.
Source: HANDBOOK OF STATISTICS ON THE INDIAN SECURITIES MARKET 2008; SEBI
Monthly data from April 2001 to March 2008
The results are preliminary, but based on monthly index data it does not seem that simple trend following strategies would be of great help. There is no statistical evidence of either momentum or reversal in monthly return data for the SENSEX and BSE-100. Market breadth – characterized by the advance/decline ratio - does not seem to have any predictive power either. The option market – call to put ratio - seems to have some contrarian relevance.
TREND IS YOUR FRIEND? NOT SURE
I tested for linear dependence in monthly returns for both the SENSEX and BSE-100 (April-2001 to March-2008). The results do not indicate any tendency for either momentum or reversal.
SENSEX
Return (t) = 1.9% + 0.06*Return (t-1)
BSE-100
Return (t) = 2% + 0.05*Return (t-1)
The regressions have low R^2 and the coefficients for lagged returns are not statistically significant. So a simple momentum strategy will not be of much help in our endeavor.
What about buying only when the monthly closing value exceeds the 12-month moving average? The results are no better than a buy and hold exercise.
12-month Moving-Average Strategy: Monthly Return Statistics
Mean: 2.5%
Standard Deviation: 7.0%
No. of Months: 61
Buy and Hold: Monthly Return Statistics
Mean: 2.6%
Standard Deviation: 6.8%
No. of Months: 71
Bottom-line, it does not seem that we can simply follow the market to prosperity.
WHAT DOES MARKET BREADTH TELL US? NOT MUCH
High breadth is a sign of a healthy market that is more likely to rise. To test this hypothesis, I regressed monthly returns with one month lagged advance to decline ratio (A/D) as the explanatory variable. The results are not encouraging.
Returns (t) = 2.6% - 0.002* A/D (t-1)
The regression explains about 9% of the variation in monthly returns and the coefficient of the A/D ratio is negative but lacks statistical significance. There does not seem to be any pattern in the residuals.
To take the analysis one step forward, I tested four trading schemes:
1.If the advance/decline ratio for the month is higher than that for the last month and current monthly returns are positive, go long the market, otherwise stay out.
Mean: 2.2%
Standard Deviation: 8.2%
No. of Months: 35
2.If the advance/decline ratio for the month is lower than that for the last month and current monthly returns are positive, go short the market, otherwise stay out.
Mean: -2.9%
Standard Deviation: 6.5%
No. of Months: 20
3.If the advance/decline ratio for the month is lower than that for the last month and current month returns are negative, go short the market, otherwise stay out.
Mean: -1.9%
Standard Deviation: 5.9%
No. of Months: 21
4. If the advance/decline ratio for the month is higher than that for the last month and current month returns are negative, go long the market, otherwise I stay out.
Mean: -0.15%
Standard Deviation: 9.1%
No. of Months: 6
Market breadth does not seem very helpful in improving investment performance.
OPTIONS MARKET A CONTRARIAN INDICATOR
If the call/put (measured by value) ratio trends higher, on average, traders expect the market to rise. I tested the predictability of this technical factor by regressing monthly returns of the BSE-100 on 1-month lagged call to put ratios on the NSE. I know that the exchanges are different, but cannot think of a reason why that should bias the results.
BSE-100 Returns (t) = 5.7% - 0.008 Call to Put Ratio NSE (t-1)
The R^2 is about 18%. The coefficient for 1-month lagged call to put ratio is negative and the p-value is 0.11. It seems that the options market gets it wrong on average and we can say this with about 90% confidence.
PRELIMINARY EVIDENCE NOT ENCOURAGING; FURTHER INQUIRY REQUIRED
There are obvious qualifiers to the above analysis: firstly, the data is not enough; secondly, I used only monthly data, it is possible that the indicators work for different periodicity; and finally, there might be non-linear dependence that our simple statistical techniques failed to decipher. The results are not conclusive, but do suggest that simple trend following strategies are not likely to help us negotiate the considerable uncertainty that clouds the investment landscape.
Source: HANDBOOK OF STATISTICS ON THE INDIAN SECURITIES MARKET 2008; SEBI
Monthly data from April 2001 to March 2008
Monday, January 19, 2009
PERFORMANCE APPRAISAL
It is important to assess periodically what’s working and what’s not.
I will start with the trades with mixed results.
1. Long Indian bonds: I bought Indian bonds on December 14, 2008 (LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN). My prediction was that cash would outperform derivatives and within cash, I thought that a diversified basket of AAA corporate paper will swamp treasury returns. The market rallied. On December 28, 2008 (TACTICAL NOTES FOR EARLY 2009), I reiterated my buy call based on strong indications from authorities that rate cuts were imminent and that the likely easing was not priced in. The Reserve Bank cut the reverse repo rate by 100bp, but government securities sold off on fears of impending supply. On January 11, 2009, I built further positions given attractive valuations post the ascension in yields (SHARP SELL-OFF IN THE BOND MARKET UNIQUE OPPORTUNITY FOR INVESTORS; 10-YEAR GOVERNMENT SECURITY YIELD TO SETTLE BELOW 5% EVEN WITHOUT RATE CUTS). The market moved in my favor last week. Overall, the results are mixed.
I am still overweight Indian bonds because supply is really not an issue, in my view. Slackening private investment demand will create space for government bonds on bank balance sheets. I am also expecting the Reserve bank to reduce the reverse repo rate by at least 50bp in H1 2009
Now I will cover trades that made me money.
2. Long U.S. Dollar: Long USD/INR up 2.5% and long UUP up 2.9%. I shorted the INR versus the dollar on December 22, 2008 (INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER). The INR has weakened 2.5% since then (47.38 on December 22, 2008 to 48.77 on January 19, 2009). I bought UUP (DXY) on December 29, 2008 (TACTICAL NOTES FOR EARLY 2009). The U.S. dollar has gained ground in the first half of January. As discussed in the rationale for the trade, global central banks followed the Fed in the march toward ZIRP in early 2009. The end of the risk rally also helped the dollar.
3. Long U.S. Credit: Long HYG (U.S. high-yield) up 0.9% and LQD (U.S. Investment-Grade) up 1.0% (TACTICAL NOTES FOR EARLY 2009). The correct way to gauge the performance of spread products is after adjusting for returns from duration matched treasuries. I shall not make that adjustment because I consciously assumed duration exposure in addition to spread risk. Bear in mind, however, that TLH (10-20 year treasury ETF) is down 2.3% during the same period, underscoring the out-performance of corporate paper.
4. Long U.S. 10-year break-even inflation: (Long TIP versus TLH) up 1.6% (TACTICAL NOTES FOR EARLY 2009): 10-year breakevens are about 40bp wider now. Also, 5-year breakevens 5-year forward have gone up, but remain well below 2% - where the Fed seeks to anchor long-term inflationary expectations.
*******29-Dec-08**16-Jan-09***Change
TIP*****100.4******99.696******-0.7%
TLH*****122.68*****119.88******-2.3%
HYG*****75.29******75.99********0.9%
LQD*****100.58*****101.6********1.0%
UUP*****24.69******25.4*********2.9%
************22-Dec-08**19-Jan-09******Change
USD/INR******47.38******48.56**********2.5%
Source: MarketWatch;RBI
I will start with the trades with mixed results.
1. Long Indian bonds: I bought Indian bonds on December 14, 2008 (LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN). My prediction was that cash would outperform derivatives and within cash, I thought that a diversified basket of AAA corporate paper will swamp treasury returns. The market rallied. On December 28, 2008 (TACTICAL NOTES FOR EARLY 2009), I reiterated my buy call based on strong indications from authorities that rate cuts were imminent and that the likely easing was not priced in. The Reserve Bank cut the reverse repo rate by 100bp, but government securities sold off on fears of impending supply. On January 11, 2009, I built further positions given attractive valuations post the ascension in yields (SHARP SELL-OFF IN THE BOND MARKET UNIQUE OPPORTUNITY FOR INVESTORS; 10-YEAR GOVERNMENT SECURITY YIELD TO SETTLE BELOW 5% EVEN WITHOUT RATE CUTS). The market moved in my favor last week. Overall, the results are mixed.
I am still overweight Indian bonds because supply is really not an issue, in my view. Slackening private investment demand will create space for government bonds on bank balance sheets. I am also expecting the Reserve bank to reduce the reverse repo rate by at least 50bp in H1 2009
Now I will cover trades that made me money.
2. Long U.S. Dollar: Long USD/INR up 2.5% and long UUP up 2.9%. I shorted the INR versus the dollar on December 22, 2008 (INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER). The INR has weakened 2.5% since then (47.38 on December 22, 2008 to 48.77 on January 19, 2009). I bought UUP (DXY) on December 29, 2008 (TACTICAL NOTES FOR EARLY 2009). The U.S. dollar has gained ground in the first half of January. As discussed in the rationale for the trade, global central banks followed the Fed in the march toward ZIRP in early 2009. The end of the risk rally also helped the dollar.
3. Long U.S. Credit: Long HYG (U.S. high-yield) up 0.9% and LQD (U.S. Investment-Grade) up 1.0% (TACTICAL NOTES FOR EARLY 2009). The correct way to gauge the performance of spread products is after adjusting for returns from duration matched treasuries. I shall not make that adjustment because I consciously assumed duration exposure in addition to spread risk. Bear in mind, however, that TLH (10-20 year treasury ETF) is down 2.3% during the same period, underscoring the out-performance of corporate paper.
4. Long U.S. 10-year break-even inflation: (Long TIP versus TLH) up 1.6% (TACTICAL NOTES FOR EARLY 2009): 10-year breakevens are about 40bp wider now. Also, 5-year breakevens 5-year forward have gone up, but remain well below 2% - where the Fed seeks to anchor long-term inflationary expectations.
*******29-Dec-08**16-Jan-09***Change
TIP*****100.4******99.696******-0.7%
TLH*****122.68*****119.88******-2.3%
HYG*****75.29******75.99********0.9%
LQD*****100.58*****101.6********1.0%
UUP*****24.69******25.4*********2.9%
************22-Dec-08**19-Jan-09******Change
USD/INR******47.38******48.56**********2.5%
Source: MarketWatch;RBI
Sunday, January 11, 2009
SHARP SELL-OFF IN THE BOND MARKET UNIQUE OPPORTUNITY FOR INVESTORS; 10-YEAR GOVERNMENT SECURITY YIELD TO SETTLE BELOW 5% EVEN WITHOUT RATE CUTS
VICIOUS SELL-OFF IN INDIAN BONDS
The 10-year Government security yield rose from 5.25% on January 1, 2009 to close the week at 6.25%. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index rose 87bp from 8.11% on December 30, 2008. The 5-year OIS rates ascended to 4.94% from an all time low of 4.42% on January 2, 2009.
Real GDP growth will remain below trend not only in 2009 but also in 2010. Inflation will likely recede below 5%. Global central banks will maintain an easing bias in 2009. Given this backdrop, the Reserve Bank will cut the reverse repo rate by at least 50bp in the next 6-months. I view this sell-off as an opportunity. Risk free yields will decline, the curve will flatten and AAA corporate spreads will shrink significantly from current levels.
GLOBAL MONETARY CONVERGENCE CONTINUES: RISK IS OVER EASING TO COUNTERACT DYSFUNCTIONAL TRANSMISSION MECHANISM
The Bank of England reduced base rates by 50bp to 1.5% last week, the lowest level since 1694. Easing inflationary concerns imply that the ECB will follow suit sooner rather than later. The Fed’s minutes revealed a discussion on quantitative targets for preventing “deflationary dynamics”. The Bank of Korea slashed policy rates to 2.5%. Indonesia and Taiwan also cut by 50bp. Bottom-line, while there are signs that credit markets are unfreezing, big questions remain about the percolation of base liquidity into the broader economy. In all probability, monetary authorities will risk overshooting on the downside to counteract tighter lending standards and high spreads.
PERSISTENT EXCESS LIQUIDITY TO AID BONDS IN THE FACE OF A LARGE GOVERNMENT BORROWING PROGRAM
I predict consistently high reverse repo quantum in the foreseeable future. Please refer to my piece - LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN; December 14, 2008 - for details. The end-game will be a rising investment to deposit ratio. Despite rising issuance, slumping private investment demand will create space for government bonds in public sector bank balance-sheets.
10-YEAR GOVERNMENT BOND YIELD TO TRADE BELOW 5% EVEN WITHOUT FURTHER MONETARY EASING
In a scenario where the reverse repo rate remains at 4.0%, 1-year YTM (4.63% on January 9, 2009) will trade close to 4.10%. Low yields and large cash chests will lead to a chase for yield, resulting in shrinking term and credit spreads. The 1/10 spread closed Friday at 162bp and averaged 85bp since 2001. Based on data since 2001, the mean 1/10 spread measured slightly below 85bp when the 1-year yield-to-maturity set below 5.50% on average. These numbers emanate largely from 2002 and H1 2003 - a period characterized by economic circumstances not very different from the current reality. Thus, even without a rate cut I see the 10-year Government security yield falling below 5.00% in H1 2009. Most likely, there will be further cuts and 5.00% should be conclusively broken.
1-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 1/10 SPREAD
1YEAR YIELD***********1/10 Spread
4.00%-4.50%***********74bp
4.50%-5.00%***********77bp
5.00%-5.50%***********82bp
5.50%-6.00%***********111bp
6.00%-6.50%***********98bp
6.50%-7.00%***********99bp
7.00%-7.50%***********98bp
7.50%-8.00%***********38bp
8.00%-8.50%***********84bp
8.50%-9.00%***********89bp
9.00%-9.50%***********25bp
9.50%-10.00%***********91bp
HIGH QUALITY CORPORATE PAPER WILL OUTPERFORM TREASURIES IN 2009
The average yield on the FIMDA Bloomberg 10-year AAA corporate bond index averaged 106bp above 10-year Indian treasuries since December 2001. The current 10-year AAA corporate spread rests 2.4 sigma above the mean observed over the last 7-years. There is a high positive correlation between spreads (even in percentage terms) and the level of the yield curve measured by 10-year Government security yields. Bottom-line, the incremental return over treasuries will collapse significantly by the end of 2009.
10-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 10-YEAR AAA CORPORATE SPREAD
10YEAR YIELD***********AAA Spread
5.00%-6.00%************67bp
6.00%-7.00%************65bp
7.00%-8.00%************128bp
8.00%-9.00%************167bp
9.00%-10.00%***********154bp
TACTICALLY I AM SHIFTING MY ASSET ALLOCATION AWAY FROM EQUITIES TO BONDS
I view the current sell-off as an opportunity to build further long bond positions. The risk-reward from current yield and spread levels appears good. Also, I am reducing my equity index positions in light of continued bad economic news and possible downside surprises in the earnings season.
Bloomberg is the source for all the data used.
The 10-year Government security yield rose from 5.25% on January 1, 2009 to close the week at 6.25%. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index rose 87bp from 8.11% on December 30, 2008. The 5-year OIS rates ascended to 4.94% from an all time low of 4.42% on January 2, 2009.
Real GDP growth will remain below trend not only in 2009 but also in 2010. Inflation will likely recede below 5%. Global central banks will maintain an easing bias in 2009. Given this backdrop, the Reserve Bank will cut the reverse repo rate by at least 50bp in the next 6-months. I view this sell-off as an opportunity. Risk free yields will decline, the curve will flatten and AAA corporate spreads will shrink significantly from current levels.
GLOBAL MONETARY CONVERGENCE CONTINUES: RISK IS OVER EASING TO COUNTERACT DYSFUNCTIONAL TRANSMISSION MECHANISM
The Bank of England reduced base rates by 50bp to 1.5% last week, the lowest level since 1694. Easing inflationary concerns imply that the ECB will follow suit sooner rather than later. The Fed’s minutes revealed a discussion on quantitative targets for preventing “deflationary dynamics”. The Bank of Korea slashed policy rates to 2.5%. Indonesia and Taiwan also cut by 50bp. Bottom-line, while there are signs that credit markets are unfreezing, big questions remain about the percolation of base liquidity into the broader economy. In all probability, monetary authorities will risk overshooting on the downside to counteract tighter lending standards and high spreads.
PERSISTENT EXCESS LIQUIDITY TO AID BONDS IN THE FACE OF A LARGE GOVERNMENT BORROWING PROGRAM
I predict consistently high reverse repo quantum in the foreseeable future. Please refer to my piece - LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN; December 14, 2008 - for details. The end-game will be a rising investment to deposit ratio. Despite rising issuance, slumping private investment demand will create space for government bonds in public sector bank balance-sheets.
10-YEAR GOVERNMENT BOND YIELD TO TRADE BELOW 5% EVEN WITHOUT FURTHER MONETARY EASING
In a scenario where the reverse repo rate remains at 4.0%, 1-year YTM (4.63% on January 9, 2009) will trade close to 4.10%. Low yields and large cash chests will lead to a chase for yield, resulting in shrinking term and credit spreads. The 1/10 spread closed Friday at 162bp and averaged 85bp since 2001. Based on data since 2001, the mean 1/10 spread measured slightly below 85bp when the 1-year yield-to-maturity set below 5.50% on average. These numbers emanate largely from 2002 and H1 2003 - a period characterized by economic circumstances not very different from the current reality. Thus, even without a rate cut I see the 10-year Government security yield falling below 5.00% in H1 2009. Most likely, there will be further cuts and 5.00% should be conclusively broken.
1-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 1/10 SPREAD
1YEAR YIELD***********1/10 Spread
4.00%-4.50%***********74bp
4.50%-5.00%***********77bp
5.00%-5.50%***********82bp
5.50%-6.00%***********111bp
6.00%-6.50%***********98bp
6.50%-7.00%***********99bp
7.00%-7.50%***********98bp
7.50%-8.00%***********38bp
8.00%-8.50%***********84bp
8.50%-9.00%***********89bp
9.00%-9.50%***********25bp
9.50%-10.00%***********91bp
HIGH QUALITY CORPORATE PAPER WILL OUTPERFORM TREASURIES IN 2009
The average yield on the FIMDA Bloomberg 10-year AAA corporate bond index averaged 106bp above 10-year Indian treasuries since December 2001. The current 10-year AAA corporate spread rests 2.4 sigma above the mean observed over the last 7-years. There is a high positive correlation between spreads (even in percentage terms) and the level of the yield curve measured by 10-year Government security yields. Bottom-line, the incremental return over treasuries will collapse significantly by the end of 2009.
10-YEAR GOVERNMENT SECURITY YIELD Vs. AVERAGE 10-YEAR AAA CORPORATE SPREAD
10YEAR YIELD***********AAA Spread
5.00%-6.00%************67bp
6.00%-7.00%************65bp
7.00%-8.00%************128bp
8.00%-9.00%************167bp
9.00%-10.00%***********154bp
TACTICALLY I AM SHIFTING MY ASSET ALLOCATION AWAY FROM EQUITIES TO BONDS
I view the current sell-off as an opportunity to build further long bond positions. The risk-reward from current yield and spread levels appears good. Also, I am reducing my equity index positions in light of continued bad economic news and possible downside surprises in the earnings season.
Bloomberg is the source for all the data used.
Sunday, January 4, 2009
RBI EASES FURTHER; MORE ON THE WAY
NO SURPRISE
The Reserve Bank of India cut the reverse repo and the repo rate by 100bp each. The cash reserve ratio was reduced to 5.0% from 5.5%, releasing INR 200 billion of incremental liquidity.
ANOTHER ROUND OF CUTS LOOKS LIKELY
Even the optimists expect the global economy to bottom only in H2 2009. Indian manufacturing will remain hostage to poor export performance. Inter-sectoral linkages will pull the services sector down. Expect further cuts.
The Reserve Bank of India cut the reverse repo and the repo rate by 100bp each. The cash reserve ratio was reduced to 5.0% from 5.5%, releasing INR 200 billion of incremental liquidity.
ANOTHER ROUND OF CUTS LOOKS LIKELY
Even the optimists expect the global economy to bottom only in H2 2009. Indian manufacturing will remain hostage to poor export performance. Inter-sectoral linkages will pull the services sector down. Expect further cuts.
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