I said similar thing when I discussed why you may be interested in my blog.
"This is what you need to know: important people have no special monopoly on wisdom; and in times like these, when the usual rules of economics don’t apply, they’re often deeply foolish, because the power of conventional wisdom prevents them from talking sense about a deeply unconventional situation."
http://krugman.blogs.nytimes.com/2010/09/27/the-power-of-conventional-wisdom/
Monday, September 27, 2010
Monday, September 20, 2010
Defining Global Macro Quant Equity
In strictest terms, quantifiable information is that which investors can back test and assign a statistical significance level and then systematically implement. A broader definition would include that which is quantifiable but cannot necessarily be assigned statistical significance or systematically implemented. The broader definition is where I believe a new opportunity for global macro quant equity lies.
Most of self-ascribed quant equity investors today use only the first set of quantifiable information, and mostly from the bottom up perspective. My friend, Rodney Sullivan, and I have a new paper suggesting that quant investors should seriously consider applying a global macro approach that use the broader set of quantifiable information. This paper can be found at the SSRN. Both he and I have been keen to this approach for several years now. I summarize this paper by way of an analogy.
Before 2008, the quant ocean liners were faster the other ocean liners. In particular, the pure quant ocean liners have the most systematic implementation and strictly rely on the quantifiable information that can be back tested with statistical significance. They are the fastest of all. These pure quant ocean liners are our focus.
As a result of their success, the captains of the pure quant ocean liners hired many superb engineers and kept all of them under the deck tooling the ocean liners. These captains made the rule that no one should waste any time above the deck. This worked as long as the luck is on their side, i.e., the weather is great so that there are no icebergs, and all the undercurrents are flowing in the same direction as these ocean liners.
From 2008, the weather starts to change. Icebergs start to appear in the ocean and undercurrents start to turn against these ocean liners. If these captains or his crews have been above the deck, they would have noticed this. However, the under-the-deck rule prevents them from seeing that. These ocean liners almost all hit the first iceberg, suffering significant damage.
However, the captains of these ocean liners thought that this is just an anomaly and no iceberg will appear again. So he insisted that his men mostly continue doing what they did, with the under-the-deck rule still strictly enforced. What he and his crews did not know is that icebergs are popping up all around them this time, quite different from any difficult periods that they had before. And the undercurrents are totally against them. Soon enough, these ocean liners all hit icebergs again in 2009 and were severely damaged this time. Undercurrents were initially against them strongly, pushing them backwards substantially in 2009, but then showed no direction in 2010. With the engine sputtering and no clear direction of undercurrents, these ocean liners start to float with currents with no clear direction in 2010.
Should the pure quant ocean liners do something drastic about it? Just think about Euro. It is a flawed system that may survive for a while, but its death is certain under large standard deviation events unless backed by a united fiscal authority and active efforts to bring down the culture and language barrier (so that labor and capital could flow freely within the Euro Zone). The pure quant ocean liners are in the same situation.
The captains of some of these ocean liners did start to order his crews to do something different, under the pressure of their passengers. They gathered information about the history of the last two large iceberg accidents and maybe some smaller iceberg incidents in the past. They want to use the information to predict the positions of any future icebergs. This is a great improvement, and is part of what we advocate.
However, trying to predict future icebergs purely with the limited information faces insurmountable challenges. It is important to eliminate the under-the-deck rule so that the weather and current conditions can be taken into consideration in future navigation to avoid future icebergs even though those conditions cannot be back tested with an assigned significance level or systematically implemented. After all, even the best dedicated surveyors of these conditions such as George Soros could not necessarily produce a statistically significant track record of forecasting (To understand why this is the case, please see my earlier post on global macro investing: http://xlpartners.blogspot.com/2010/08/what-is-important-in-global-macro_4346.html). We also suggest that these captains should use all useful information instead of throwing some important information out.
Further, these captains never had any idea about the issue of undercurrents. These captains do not fully understand that even if their ocean liners seems to be tightly constructed with everything based on statistical significance and systematically implemented, these ocean liners frequently have serious unintentional biases. Some of these biases are persistent, e.g., small size, value, and momentum. Other biases are incidental and last for a period and then disappear.
When these unintentional biases are in the same direction as the undercurrents, like in the few years before 2008, they bring significant tail wind to the pure quant ocean liners. When these unintentional biases are in the opposite direction as the undercurrents, the pure quant ocean liners face substantial head wind.
The power of these unintentional biases is so large that many times most of the mileages covered by the pure quant ocean liners are due to this power. Understand and be mindful of these unintentional biases is important to both alpha generation and risk management. It is dangerous not to fully understand the unintentional bias while navigating the rough seas.
For one example of unintentional biases, I would refer to one discussion by Jeremy Grantham in his most recent quarterly report (see the last two paragraphs on p5)
http://www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdf
I have only read less than five reports of his ever due to the lack of time and their lack of short-term timing ability. However, I find that all the reports are extremely insightful, especially for funds serving long-term institutional investors.
A similar simple example is about small cap and value in different time periods. As mentioned above, the pure quant ocean liners persistently have these biases. In 2000, these segments are undervalued, which gives the pure quant ocean liners substantial tail wind in the last market down turn from 2000. In 2008, the same segments are quite overvalued, which gives the pure quant ocean liners substantial head wind.
So by global macro investing, we argue that the captains of these ocean liners need to add the top down quant models to systematically incorporate any global macro information that they can incorporate this way. These captains also need to use quantifiable fundamental global macro information even if they cannot systematically implement it. These reinvented ocean liners will be global macro quant equity ocean liners.
Most of the issues discussed above are in three papers that I wrote in the past. The first two papers are free for circulation if I am invited for presentation. Feel free to contact me at xli5@hotmail.com if you are interested in these papers. The last paper is only available for a handsome sum. If you are interested in the last paper, you can learn about the first paper before you decide about the third paper.
Li, Xi, 2007, Unintentional bets of pure quant investing, Working Paper, XL Partners, Inc.
Li, Xi, 2009, No religion in quant investing, Working Paper, XL Partners, Inc.
Li, Xi, 2008, Why does pure quant investing have unintentional bets, Working Paper, XL Partners, Inc.
Most of self-ascribed quant equity investors today use only the first set of quantifiable information, and mostly from the bottom up perspective. My friend, Rodney Sullivan, and I have a new paper suggesting that quant investors should seriously consider applying a global macro approach that use the broader set of quantifiable information. This paper can be found at the SSRN. Both he and I have been keen to this approach for several years now. I summarize this paper by way of an analogy.
Before 2008, the quant ocean liners were faster the other ocean liners. In particular, the pure quant ocean liners have the most systematic implementation and strictly rely on the quantifiable information that can be back tested with statistical significance. They are the fastest of all. These pure quant ocean liners are our focus.
As a result of their success, the captains of the pure quant ocean liners hired many superb engineers and kept all of them under the deck tooling the ocean liners. These captains made the rule that no one should waste any time above the deck. This worked as long as the luck is on their side, i.e., the weather is great so that there are no icebergs, and all the undercurrents are flowing in the same direction as these ocean liners.
From 2008, the weather starts to change. Icebergs start to appear in the ocean and undercurrents start to turn against these ocean liners. If these captains or his crews have been above the deck, they would have noticed this. However, the under-the-deck rule prevents them from seeing that. These ocean liners almost all hit the first iceberg, suffering significant damage.
However, the captains of these ocean liners thought that this is just an anomaly and no iceberg will appear again. So he insisted that his men mostly continue doing what they did, with the under-the-deck rule still strictly enforced. What he and his crews did not know is that icebergs are popping up all around them this time, quite different from any difficult periods that they had before. And the undercurrents are totally against them. Soon enough, these ocean liners all hit icebergs again in 2009 and were severely damaged this time. Undercurrents were initially against them strongly, pushing them backwards substantially in 2009, but then showed no direction in 2010. With the engine sputtering and no clear direction of undercurrents, these ocean liners start to float with currents with no clear direction in 2010.
Should the pure quant ocean liners do something drastic about it? Just think about Euro. It is a flawed system that may survive for a while, but its death is certain under large standard deviation events unless backed by a united fiscal authority and active efforts to bring down the culture and language barrier (so that labor and capital could flow freely within the Euro Zone). The pure quant ocean liners are in the same situation.
The captains of some of these ocean liners did start to order his crews to do something different, under the pressure of their passengers. They gathered information about the history of the last two large iceberg accidents and maybe some smaller iceberg incidents in the past. They want to use the information to predict the positions of any future icebergs. This is a great improvement, and is part of what we advocate.
However, trying to predict future icebergs purely with the limited information faces insurmountable challenges. It is important to eliminate the under-the-deck rule so that the weather and current conditions can be taken into consideration in future navigation to avoid future icebergs even though those conditions cannot be back tested with an assigned significance level or systematically implemented. After all, even the best dedicated surveyors of these conditions such as George Soros could not necessarily produce a statistically significant track record of forecasting (To understand why this is the case, please see my earlier post on global macro investing: http://xlpartners.blogspot.com/2010/08/what-is-important-in-global-macro_4346.html). We also suggest that these captains should use all useful information instead of throwing some important information out.
Further, these captains never had any idea about the issue of undercurrents. These captains do not fully understand that even if their ocean liners seems to be tightly constructed with everything based on statistical significance and systematically implemented, these ocean liners frequently have serious unintentional biases. Some of these biases are persistent, e.g., small size, value, and momentum. Other biases are incidental and last for a period and then disappear.
When these unintentional biases are in the same direction as the undercurrents, like in the few years before 2008, they bring significant tail wind to the pure quant ocean liners. When these unintentional biases are in the opposite direction as the undercurrents, the pure quant ocean liners face substantial head wind.
The power of these unintentional biases is so large that many times most of the mileages covered by the pure quant ocean liners are due to this power. Understand and be mindful of these unintentional biases is important to both alpha generation and risk management. It is dangerous not to fully understand the unintentional bias while navigating the rough seas.
For one example of unintentional biases, I would refer to one discussion by Jeremy Grantham in his most recent quarterly report (see the last two paragraphs on p5)
http://www.gmo.com/websitecontent/JGLetter_SummerEssays_2Q10.pdf
I have only read less than five reports of his ever due to the lack of time and their lack of short-term timing ability. However, I find that all the reports are extremely insightful, especially for funds serving long-term institutional investors.
A similar simple example is about small cap and value in different time periods. As mentioned above, the pure quant ocean liners persistently have these biases. In 2000, these segments are undervalued, which gives the pure quant ocean liners substantial tail wind in the last market down turn from 2000. In 2008, the same segments are quite overvalued, which gives the pure quant ocean liners substantial head wind.
So by global macro investing, we argue that the captains of these ocean liners need to add the top down quant models to systematically incorporate any global macro information that they can incorporate this way. These captains also need to use quantifiable fundamental global macro information even if they cannot systematically implement it. These reinvented ocean liners will be global macro quant equity ocean liners.
Most of the issues discussed above are in three papers that I wrote in the past. The first two papers are free for circulation if I am invited for presentation. Feel free to contact me at xli5@hotmail.com if you are interested in these papers. The last paper is only available for a handsome sum. If you are interested in the last paper, you can learn about the first paper before you decide about the third paper.
Li, Xi, 2007, Unintentional bets of pure quant investing, Working Paper, XL Partners, Inc.
Li, Xi, 2009, No religion in quant investing, Working Paper, XL Partners, Inc.
Li, Xi, 2008, Why does pure quant investing have unintentional bets, Working Paper, XL Partners, Inc.
Sunday, September 19, 2010
What is the next big number to watch?
To me, the next big number would be ISM to be announced on October 1. Given the contradictory number of ISM and regional surveys in the last couple of months, seasoned forecasters like David Rosenberg and Roubini.com have argued that it is highly likely that ISM will be corrected downward in the subsequent couple of months. Let's see if they are right in the first month after their forecasts.
Saturday, September 18, 2010
Academic literature and quant investing
I would be interested in any of your comments here. My experience is that most buy-side quant managers get most of their ideas from academic literature. There are different variations but the quant managers really do not have too much fundamental innovations of their own. However, the problem for quant managers and academic literature is that the academic literature really had nothing really new in the last 10 years. We got lots of papers published claiming substantial abnormal returns, but there is nothing really that have longer-term efficacy and relatively low correlation with the previously discovered ones. Maybe your experience is somewhat different?
The flation debate
There are extreme arguments on the both ends of the spectrum in the flation debate. Since I advocate T-bonds for the next six months, many may perceive me as a permanent deflationist. But I am not. All I argued was that in the short term the danger of deflation is clearly a magnitude greater than inflation. The reasons are listed in my earlier blog on the stimulus debate.
http://xlpartners.blogspot.com/2010/08/future-intellectuality-of-stimulus.html
For example, in a liquidity trap, which the U.S. have not faced for the past 70 years, no matter how much money you print, it would have no effect on inflation. Money will not become toilet paper, and they will hold value pretty well. The only exception is a catastrophic inflation shock like the oil crisis in the 1970s (I also mentioned this in the above-mentioned blog. In fact, I could have easily expanded each sentence in the above-mentioned blog to a couple of paragraphs, but I thought to save readers some pain).
The most likely scenario is that we will bounce around zero inflation for quite a few years. Whether we can get out the liquidity trap is more about politics than economics. If the two parties can unite, and if we can educate Americans about the very large numbers that I argued in the above-mentioned blog (another two trillion fiscal stimulus and Fed balance sheet totaling 10 trillion through inflation and exchange rate targeting), we will get out of the liquidity trap in no time. However, the political situation, and the lack of education on this aspect, makes liquidity trap the most likely scenario. Fed, for example, will only likely step in after deflationary scares (when we have mild deflation) and will likely take away the support prematurely before mild inflation can take root. A modern democratic society is nearly impossible to use the brutal liquidationist approach that Hoover initially adopted in the face of the market crash. However, the same society is likely to be balanced by the little Hoovers so that it cannot adopt drastic stimulus.
So my suggestion of investing in long-term T-bonds or shorting equities in the next six months is based on deflation scare, not permanent deflation.
http://xlpartners.blogspot.com/2010/08/it-is-still-not-too-late-to-join-party.html
Even if Fed would step in to save the market, they would only act when market is in real danger, and you probably should have taken profits before that time. I admit that I may have been somewhat early on this trade. Q4 2010 and Q1 2011 are the earliest periods that we are likely to have significant double dip scares in GDP growth. Later next year are the periods when we are likely to have significant deflation scares. I recommended this trade in early August because you would have thought that markets are not as short sighted or overly optimistic as they are now. In retrospect, it seems to me that the significant T-bond appreciation before September may also be partly due to some prominent hedge funds rewinding their losing bets against T-bonds. A few were actually closed due to this losing bet.
So if the U.S. could adopt more stimuli as I suggested, my recommended trade would hurt badly. I sincerely hope that the U.S. government could follow my policy recommendations, even if this will prove that my trade recommendations are wrong. Another reason to adopt the inflation approach is because it eliminates substantial amount of debt even at very low levels (e.g., 3%). Although morality is intuitively attractive, the reality teaches us that we have to forgive the debt anyway, either through defaults (either mass defaults as in the Great Depression or slow burn defaults as in the Great Recession) or inflation.
http://blogs.wsj.com/economics/2010/09/18/number-of-the-week-defaults-account-for-most-of-pared-down-debt/
However, the political gridlock are only likely to increase more after the mid-term election, and the cautious style of Obama proves that he is more of a politician than an idealist in comparison to FDR. Maybe we need another disaster before the U.S. can get a more idealistic president in the Oval Office.
For the longer term, it is crazy to me to only believe in extreme arguments on either end of the flation debate. I was quite concerned about inflation for a little while too. But the baseline scenario to me now is near zero inflation for a long while with relatively small inflation risks from potential catastrophic price shocks (e.g., disasters in food supply maybe due to further global warming or conflicts with Iran).
Some may argue that the U.S. is different from Japan in demographics, which reduces the deflation pressure. The birth rates and immigration are both higher in the U.S. The latter may not be of much help because fewer people would come to the U.S. due to the relatively stronger growth outside of the U.S. and because the potential escalating hostility against immigration due to the high unemployment.
BTW, I understand that PIMCO made some inflation hedges. The absolute number seems big, but it is tiny in comparison to PIMCO’s overall bond portfolios. I also understand that import price have jumped, but that is only for a month and the external exposure of the U.S. economy is very small, with imports only being around 16% of GDP. In fact, the U.S. probably has the lowest external exposure among developed countries and most large developing countries. I also understand that food and energy prices have increased, but that will take a while to affect the core price index, and they usually do not persist given the generally elastic supplies.
http://xlpartners.blogspot.com/2010/08/future-intellectuality-of-stimulus.html
For example, in a liquidity trap, which the U.S. have not faced for the past 70 years, no matter how much money you print, it would have no effect on inflation. Money will not become toilet paper, and they will hold value pretty well. The only exception is a catastrophic inflation shock like the oil crisis in the 1970s (I also mentioned this in the above-mentioned blog. In fact, I could have easily expanded each sentence in the above-mentioned blog to a couple of paragraphs, but I thought to save readers some pain).
The most likely scenario is that we will bounce around zero inflation for quite a few years. Whether we can get out the liquidity trap is more about politics than economics. If the two parties can unite, and if we can educate Americans about the very large numbers that I argued in the above-mentioned blog (another two trillion fiscal stimulus and Fed balance sheet totaling 10 trillion through inflation and exchange rate targeting), we will get out of the liquidity trap in no time. However, the political situation, and the lack of education on this aspect, makes liquidity trap the most likely scenario. Fed, for example, will only likely step in after deflationary scares (when we have mild deflation) and will likely take away the support prematurely before mild inflation can take root. A modern democratic society is nearly impossible to use the brutal liquidationist approach that Hoover initially adopted in the face of the market crash. However, the same society is likely to be balanced by the little Hoovers so that it cannot adopt drastic stimulus.
So my suggestion of investing in long-term T-bonds or shorting equities in the next six months is based on deflation scare, not permanent deflation.
http://xlpartners.blogspot.com/2010/08/it-is-still-not-too-late-to-join-party.html
Even if Fed would step in to save the market, they would only act when market is in real danger, and you probably should have taken profits before that time. I admit that I may have been somewhat early on this trade. Q4 2010 and Q1 2011 are the earliest periods that we are likely to have significant double dip scares in GDP growth. Later next year are the periods when we are likely to have significant deflation scares. I recommended this trade in early August because you would have thought that markets are not as short sighted or overly optimistic as they are now. In retrospect, it seems to me that the significant T-bond appreciation before September may also be partly due to some prominent hedge funds rewinding their losing bets against T-bonds. A few were actually closed due to this losing bet.
So if the U.S. could adopt more stimuli as I suggested, my recommended trade would hurt badly. I sincerely hope that the U.S. government could follow my policy recommendations, even if this will prove that my trade recommendations are wrong. Another reason to adopt the inflation approach is because it eliminates substantial amount of debt even at very low levels (e.g., 3%). Although morality is intuitively attractive, the reality teaches us that we have to forgive the debt anyway, either through defaults (either mass defaults as in the Great Depression or slow burn defaults as in the Great Recession) or inflation.
http://blogs.wsj.com/economics/2010/09/18/number-of-the-week-defaults-account-for-most-of-pared-down-debt/
However, the political gridlock are only likely to increase more after the mid-term election, and the cautious style of Obama proves that he is more of a politician than an idealist in comparison to FDR. Maybe we need another disaster before the U.S. can get a more idealistic president in the Oval Office.
For the longer term, it is crazy to me to only believe in extreme arguments on either end of the flation debate. I was quite concerned about inflation for a little while too. But the baseline scenario to me now is near zero inflation for a long while with relatively small inflation risks from potential catastrophic price shocks (e.g., disasters in food supply maybe due to further global warming or conflicts with Iran).
Some may argue that the U.S. is different from Japan in demographics, which reduces the deflation pressure. The birth rates and immigration are both higher in the U.S. The latter may not be of much help because fewer people would come to the U.S. due to the relatively stronger growth outside of the U.S. and because the potential escalating hostility against immigration due to the high unemployment.
BTW, I understand that PIMCO made some inflation hedges. The absolute number seems big, but it is tiny in comparison to PIMCO’s overall bond portfolios. I also understand that import price have jumped, but that is only for a month and the external exposure of the U.S. economy is very small, with imports only being around 16% of GDP. In fact, the U.S. probably has the lowest external exposure among developed countries and most large developing countries. I also understand that food and energy prices have increased, but that will take a while to affect the core price index, and they usually do not persist given the generally elastic supplies.
Saturday, September 11, 2010
Sharp Worded Me
Some readers of this blog may find that the blogs to be somewhat blunt, and sharp tongued. Well, I apologize if you are not used to the style. However, I feel that bluntness is the necessity of any blog. I may be wrong, but it seems to me that readers generally are more attracted by the sense of epic battles. Also, if you make ambiguous wordings and references, and going in circles in terms of logic, to avoid offending any one, you are likely to lose your readers. That would be a disservice to the readers, because they deserve a clear explanation. I will always try to be objective. This virtue should never be compromised. You can count on me that I will always be true to reasoning, recognize where I am wrong, and will not be affected by dogmatism and religion in anything. Remember this blog is called "Eclectic Investors ;=)"
In daily life or work life though, one should be much more tactical because bluntness may achieve exactly the opposite effects.
In daily life or work life though, one should be much more tactical because bluntness may achieve exactly the opposite effects.
A touching story told by the author of Harry Potter at Harvard Commencement
http://harvardmagazine.com/commencement/the-fringe-benefits-failure-the-importance-imagination
Please see the above link for a touching story that we as part of the humanity could all learn some. If you can not find some echos here, you may want to have some reflection on yourself and your life. My tears dropped when I read it, and I am not a very sentimental person.
Please see the above link for a touching story that we as part of the humanity could all learn some. If you can not find some echos here, you may want to have some reflection on yourself and your life. My tears dropped when I read it, and I am not a very sentimental person.
Friday, September 10, 2010
One-Legged China
In our last discussion, you insisted that Chinese export contribution to its GDP growth is at least 40% to 50%, far more than the 30% or so I mentioned. Here is a link to a BW article: Why the Export Slump Won't Doom China's Economy.
http://www.businessweek.com/globalbiz/content/apr2009/gb20090420_581968.htm
The authors stated that Chinese export counts 12% of GDP, contributes to 3% of the11~12% GDP growth. I largely agree with them. Are their data wrong? If they were grossly wrong, then your bearish arguments about China and bullish arguments about the US long bond would carry a lot more weights. Would you mind pointing out the Chinese economic data sources that you use and deem reputable?
I do not remember that he actually mentioned 30%, and I mentioned current account surplus, instead of export. And my common sense tells me that Chinese export is far greater than 12% of GDP. It is also such a laughable article that Business Week, a seemingly respectable Magazine, seems only to be able to serve the entertainment purposes today.
So now let’s look at the numbers by comparing the GDP growth rate and current account balance using data from IMF. The idea here is that if current account surplus as a percentage of GDP is about half of the GDP growth, then current account surplus contributes to about half of China’s GDP growth.
The data seem to even surprise me. The first graph shows the GDP growth rate, and current account balance as a percentage of GDP, whereas the second graph shows the later divided by the former. The graphs, especially the second one, say that almost all the Chinese GDP growth is from current account surplus in recent years (from 2005), hence my blog title “one-legged China.”
Since the 2009 number from IMF is just an estimate, we probably should obtain the final number instead. However you calculate it, my argument stands. For example, a Google search shows that the media generally quotes a 2009 current account surplus of about USD 290 billion for China. If you divide that by the Chinese GDP of about USD 4.5 trillion, that is about 6.4%. So current account surplus would be about half of Chinese GDP growth.
And pay attention that this is not always the case. Current account balance was negative for many times in earlier years, and current account surplus was never as large share of GDP growth as it is now.
People like Steve Roach still argue that it would be a smooth cruise for China to switch from export driven growth model to domestic consumption driven growth model (see The new lesson for resilient Asia, Financial Times, June 8, 2010). I hope that these people would finally come to senses about the reality of the one-legged China and the difficulty, along with the grave danger, facing China and the world in this transition process. Even if China starts the transition process voluntarily soon, it could easily take China more than a decade, with significant bumps in between. If China still drags its own feet while the world all suffers from diminishing demand, any sensible Americans should vote for trade war by the end of next year with unemployment likely staying around 10%. Those who argue today that it is a silly idea to blame East Asian countries for any problem facing the United States are themselves blind. Those who still make the same argument by the end of next year are just stupid.
And if you would like to challenge me on facts, you should bring your facts and data, instead of asking me to prove against some entertainment story ;=).
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