Some clarifications on longer term forecasts

In response to people’s question about point 4 in long term forecast, I wrote:

China faces a fork in the road when it slows down. The entrenched interest may keep or grab more wealth, but that will make China either a Latin American countries in the 70s with government terrorism or have a revolution. Or the entrenched interest may step back and start the inevitable transition process and share some of the wealth with the rest of Chinese people. Now the GDP growth is 9-10%, of which investment grow at 13-14% whereas consumption grows at about 7%. In transition, say investment grows at 0% and consumption at 7%, that would make the overall 3-4% GDP growth. So if consumption is largely growth at similar speed like before, people would not notice as much on that aspect. The pain though will still be inevitable because China’s problem is structural. All the resources, especially people, will have to be relocated to service from export and investment driven industries. So lots of people will lose their jobs. The transition would need government monetary and fiscal policy to help.

In response to people’s question about HK vs. Mainland housing bubbles, I wrote

Yes, both will suffer in the longer term. It may be a 10 or more year downward adjustment. HK could have big downward adjustment because it is not only exposed to Chinese economic growth, but also US interest rate. So you could say that the real interest rate today in China is 0; both normal interest and inflation rates are about 6%. But the real rates in HK is about -4%: its exchange rate system require a peg of nominal rate to the US at 0% (due to the impossible trinity concept that I discussed at the BCIC meeting last Nov) while having about 4% inflation rate. So it is a housing bubble on steroids and could even worse than China. When either China slows down or US recovers some, its housing market may have worse adjustment than China. Of course if a lot of Chinese money gets scared in mainland, they may escape to HK to buy something here. That might provide some support from below.

On the money so far and longer term (5 year forecast)

Setp 8

To share my two cents about the near term, we will have sharp ups and downs. Some actions (QE3 or 2.5) from the Fed at the end of both Sept and Oct will probably hold the market around the current levels (could be up by more than 10%) till Nov. However, we are likely to have a recession toward the end of the year or at the start of next year, and that is when the big market tank will likely happen. I also attached my longer term predictions (5 year) at the very end. If we are patient enough, most, if not all, will pan out in a few years.

Aug 4

If you still remember that I mentioned that we will have another deflation scare latter this year at our dinner during your visit to Boston this spring, it is now in full force. It will probably last at least until after the third quarter when the Fed could have more political capital and will to do QE3 (The risk of US severe recession is still not too high though). In the meantime, which is still at least a couple of months ahead, we will have rocky downward market with sometimes sharp rallies. We should see a repeat of risky asset rally (globally) when the Fed finally comes out with QE3 again. It is opportunity to be had when that happens. 

Longer term forecast

n  China will face sharp slow down in growth in five years (say from 10% to 3%) for many years to come

n  Related emerging markets and commodity producers will suffer as well.

n  HK’s housing price will drop substantially

n  Chinese people may not suffer in their satisfaction

n  The world will not come to an end with the slowdown in China’s growth

n  Eurozone will not survive in the current form

n  The U.S. will become stronger in relative terms if it can get the political act together

Sorry for the absence

Sorry for having missing for the last few months. The last few months have been quite busy for me. It looks like to continue this way in the near future. I will try to post more whenever I get the chance.


My view has changed  since late October last year. At a meeting of Boston investment professionals early last November, I have already argued for the bull case in equity markets. The double dip risk is not there any more, at least not that noticeable. 

Then I also mentioned that there will be some large downside volatility in Chinese markets in particular when China starts to be pressed to fight inflation, mainly from its stubbornness to largely fix nominal exchange rate. I will give another five years of high growth for China and then its growth rate is likely to drop much below 5%, say 2-3 %, from there. That does not mean that Chinese people will suffer that badly in living standard, because the consumption related sector should have higher growth rates than the overall GDP. If Chinese governance still keep the real interest so low for too long, China will have an even bigger asset bubble, e.g., another doubling in housing price. This is probably the most likely scenario. It is politics, not economics, that determines policies. So this may be a period to speculate cautiously and make a few bucks. But then the fate of future growth rate will be even more miserable, maybe for decades to come. The demographics will add a huge drag to the growth rate too. 


Housing will probably bottom out this year in the U.S. It may not take off, but capital loss risk will become much smaller after the summer. I sold my house in 2007 and have not bought one since. I will think about buying now. 


As long as emerging markets keep enjoying higher growth rates than the developed markets, capital will keep flowing to where the growth rates are higher. However, in the short term, EM probably will be forced to fight inflation, because they generally try to keep exchange rates a bit too low to gain export edge. That tightening, which is completely involuntary, will drag the market momentum that were trying to go higher. In the medium term, they are still attractive. In the longer term (e.g., beyond five years), they are vulnerable because they are probably all too dependent on the China story (think commodities), and will have trouble adjusting when China really slows down sharply in its GDP growth. 

A Dynamic Future for Active Quant Investing

I recently put the following article written with my friend Rodney Sullivan on SSRN (I mentioned this effort in an earlier blog).  Without great surprise, this article should appear in Journal of Portfolio Management next year. 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679766

It is about our view on the future of active quant investing.  The current active quant investing model is fatally flawed, just like Euro being a flawed currency.  Take this analogy further, Euro may yet survive the current crisis, because it is more of a political tool to integrate Europe than a product due to economic rationale.  Without a unified fiscal authority, breaking down of cultural and language barriers to allow real free labor movements, it is a doomed currency, with the only uncertainty about its collapse being the timing.

The current active quant investing is similarly flawed.  They are mostly riding on some long-term trends unintentionally (e.g., small, value, and momentum).  If you take these long term trends away, they got little game going.  This means that some smart semi-active ETFs can easily replace them, with the same boom and bust cycle of performance.  This also means that clients should not have paid them that much for doing what they are doing today.

When they are against the trends, they have no clue what to do.  Even more strange is that in the last few years, I talked to quite a few quant firms and mentioned that they should incorporate some quantitative but not systematic analysis to turn around their performance.  Even though some of them made good offers to me, none of them is flexible about their investment approach.  I ended up not taking any of those offers because I thought they are doomed, at least in the long-term. 

Some of them did start to go down the direction that we discussed in the article.  Some of them are looking more into the macro level and try to incorporate more information there.  Even there, the only approach is systematic and pure quant, which essentially doomed the effectiveness of the macro push.

The above article provides a decent, yet somewhat incoherent, guide about how quants should change to make their long term business model viable.  Rodney was instrumental in moderating the tone of the article, but we still get some hate mails, and we understand there could be many more hatred out there.  I am good at making the piece more coherent, but I sometimes cannot hold my punches.  So the current state of the article may be the best constrained optimum, given the hate mails we have already got. In the next revision, we will try to make it more coherent yet still moderate enough, and also incorporate any comments we get.

What surprises me is how close minded many of the quants are.  Even if the article is completely garbage, there is no need to hate, especially given the sorry state of quants in the last few years (which I correctly predicted in early 2008).  At least be open minded and see if there is anything useful there.  I would do that myself.  Further, I am surprised that no one was flexible enough to at least allow me to have an alternative investment approach under their roof in the last couple of years.  Maybe the only alternative is to have a start up to run an independent show, even though that takes a lot of time and preparations.

Is the U.S. doomed if USD is debased?

There is a lot of fear out there, linking the recent weakness of USD to the long-term doom of the U.S.  Even if we do not consider that USD is still not below the level in 2007 on a trade-weighted basis (there was not much of this kind of discussion then), this fear is completely baseless.

We do not have to look far back into history to have so many countries seeing their currency depreciated at some point and then come roaring back to the top of economic form.  Among developed countries, Britain and Canada easily come to mind.  Was Britain cursed when the pound collapse under Soros attack?  One key reason for the recovery of many countries is export driven growth.  That aside, using currency to measure a country’s long-term prospect is misguided.  It is the economy, stupid ;=).  Whenever faster growth and fuller employment happen, either due to currency devaluing or not, the currency is likely to appreciate again. 

So in today’s U.S., anything that could help improve growth and employment, including devaluing USD, should be considered as a viable policy tool, and is likely to result in long-term appreciation of USD. 

My view on Mr. Market, maybe more to follow on this topic

Is market efficient? No.

Is market stupid? Many times.

Is it easy to beat the market? Not really.

Should investors react strongly and positively to Citi's earnings news?

Since one of my friends liked this entry, I will expand it a bit more here.


From WSJ today:

"The bank's third-quarter profit was $2.2 billion, up from $101 million a year earlier, with per-share profit of seven cents coming in just above analysts' estimates. The amount the bank set aside for credit losses fell. Revenue rose 2% from a year earlier, to $21 billion, but fell 6% from the second quarter."

The markets react strongly and positively to the positive earnings news from Citi.  It actually brought up the whole financial sector, and the whole markets.  However, if investors know something about earnings management, the earnings pattern of Citi smells like classical  accrual earnings management.

Generally, firms that announce earnings slightly beating zero threshold (e.g., 1 cent per share) or analyst estimates (e.g., if analyst consensus is 6 cents and the announced earnings is 7 cents) are found to be most likely to have managed/fudged earnings.  See Burgstahler, D., Dichev, I., 1997. Earnings management to avoid earnings decreases and losses. Journal of Accounting and Economics 24, 99-126 for further evidence.  The academic literature even find that firms may manage earnings just enough so that it is e.g., 0.5 cents about zero or analyst consensus.  When the number is rounded up, it becomes 1 cent more than zero or analyst consensus.  I am not sure if Citi is using this later roundup tools.

How could firms management earnings?  Generally, they could use either accrual or real earnings management (AEM and REM). In AEM, firms exploit the flexibility under GAAP to classify items differently.  For example, the following paper show the the main forms of accrual earnings management are as follows:

    * Unsuitable revenue recognition
    * Inappropriate accruals and estimates of liabilities
    * Excessive provisions and generous reserve accounting
    * Intentional minor breaches of financial reporting requirements that aggregate to a material breach.

See Healy, P. M. and J. M. Wahlen. 'A review of the earnings management literature and its implications for standard setting', Accounting Horizons, December 1999, pp. 365-383.

So the way that Citi has met and slightly beat earnings expectation is through the third forms above. Although I am not able to check extensively, this pattern makes me suspicious that as one of the masters of the Universe, Citi must know how to do it right so that the trace of earnings management may be less obvious.

Companies also do real earnings management, which include abnormal production to affect costs of goods sold expenses, along with timing sales recognition, R&D and advertising spending, and asset sales.  For example, company could cut the current period R&D expenses to meet earnings expectations.  They could also slash price and bring forward sales into the current period to management earnings.  They could try to realize gains on asset sales to boost up earnings.  Different from AEM, REM 1) involves changes in the timing or structuring of operations, investments, and/or financing transactions; 2) have cash flow consequences; 3) do not necessarily reverse automatically; and 4) are more difficult to detect because it is easily disguised as normal operating decisions.  In a survey of CFOs, the following paper finds that managers prefer to use REM.

See Graham, J., C. Harvey, and S. Rajgopal, 2005, The economic implications of corporate financial reporting, Journal of Accounting and Economics 40, 3-73.

A well known paper by Sloan shows that accrual earnings management can predict future returns.  Firms with more AEM to boost up earnings would subsequently outperform in stock prices.  The main explanation is that investors do not fully understand the impact of accruals and blindly react to the announced earnings numbers (which is partly fudged).  So if that is the case, Citi shareholders are likely to experience some relatively lower returns in comparison to stocks with similar risk/characteristics.  This accrual characteristic has been used by buy-side money managers extensively in the last ten years.

See Sloan, R., 1996, Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71, 289-315.

Similarly to Sloan 1996, I have a recent working paper in which I find that firms practicing more REM to increase earnings would suffer lower future stock returns.  See my paper "Real earnings management and subsequent stock returns: at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679832.  The paper has been presented at the annual meeting of Chicago Quantitative Alliance, a national organization of mostly buy-side researchers and portfolio managers this September.  It has made every top ten downloaded list that fits its category.  Part of the paper is likely to be in most every buy-side managers' toolkit in the future.