Sunday, December 23, 2012

In Search of the Holy Grail?

The December letter from Absolute Return Partners is another must read for institutional and retail investors. The letter, In Search of the Holy Grail, delves into the frustrating practice of predicting financial markets:
“It’s one thing to have an opinion on the macro, but something very different to act as if it’s correct.”    --Howard Marks, Oaktree Capital Management

It can be a frustrating, and rather futile, experience to be an economist. Financial markets do not always behave as if there is a connection between economic fundamentals and stock prices, a subject I touched on in the October 2012 letter. In fact, if you believe the findings of a recent Vanguard study, rainfall statistics provide more value than either trend GDP growth or trend earnings growth in terms of their ability to predict future stock market returns (chart 1 below, click on image).

Using U.S. market data going back to 1926, Vanguard analysed the predictive powers of a whole range of metrics. The rather depressing conclusion – at least from an economist’s point of view – is that we are pretty much wasting our time by assigning any value at all to what goes on in the real economy. Of all the metrics tested by Vanguard, only P/E ratios seem to explain some reasonable proportion of future (real) stock market returns, and that is only if you are prepared to take a very long term view (10 years in the Vanguard study).
What's even more depressing is how much time, money and effort is being wasted trying to predict the future using "sophisticated" economic models that invariably break down. Economists spend too much time sharpening up ("calibrating") their useless econometric models and not enough time understanding how the economy is constantly evolving and where the real risks to the system lie.

The ultimate failure lies with economics programs at universities. When I was studying at McGill University, all undergrads in honors economics had to take a course in history of economic thought taught by  Robin Rowley. Professor Rowley also taught honors econometrics, which he did by showing us how to critically examine all the spurious relationships which routinely get published in economic journals (later found out not just in economics but other fields as well, including medicine).

But it was the history of economic thought that I really enjoyed and the great contributions of Keynes, Tinbergen, Hicks, Hayek, Friedman, Kahneman, Tversky, Ricardo, Savage, Shackle, Simon, Stiglitz, von Neumann, Walras and many more. Rowley published a book with Omar Hamouda, Probability in Economics, going over these important contributions and how economics often ignores them.

Anyways, back to the Absolute Return Partners' December letter. Niels Jensen writes:
I have been writing the Absolute Return Letter since October 2003. At least 75% (I haven’t checked) of all those letters have focused on various aspects of the macro economy and a great many of them have gone on to make predictions on stock prices, interest rates, commodity prices and currencies. Have I been wasting my and, more importantly, your time during all those years?

I don’t think so, but my answer does require some clarification. At Absolute Return Partners, when structuring portfolios for our clients, we distinguish between three different time horizons – the very near term (the next few months), the medium term (from a few months to a few years) and the long term (many years). Most mutual funds, pension funds and insurance companies allocate the majority of their capital to the medium term, making it a very crowded space and the more crowded the space, the more efficient it usually is, and the more difficult it will be to generate alpha.

The short term is often ruled by more aggressive investors. Hedge funds dominate this space, frequently at the expense of private investors. The long term is the least crowded; it is in fact distinctly un-crowded in the current environment. As I have repeatedly pointed out over the past couple of years, one of the most noticeable implications of the financial crisis is the craving for liquidity. This has driven more capital than ever before towards the short and medium term, creating very attractive opportunities for those investors who can take a long term view.

Despite the findings of Vanguard and others I maintain my long held view that it is possible to identify long term economic trends which are likely to have a quantifiable impact on asset prices; however, the effect is only measurable over the very long term. Now, we cannot construct portfolios with only the long term in mind. If we did that, we would almost certainly go out of business before our ideas came to fruition.
Keynes said it best, "markets can stay irrational longer than you can stay solvent," but sometimes markets aren't irrational, just those reading them get distracted by all the noise, the latest being the fiscal cliffhanger.

This is why most hedge funds and active managers fell off the cliff this year, betting on something that never happened. They didn't read the macro environment right, and most have succumbed to hedge fund Darwinism.

As far as time horizons, think Jensen is wrong when he says pension funds have the same one as mutual funds. Not the ones in Canada. He should carefully read David Denison's last speech as the head of CPPIB.

Importantly, pension funds have a distinct advantage over mutual funds in terms of waiting out a crisis and they have an advantage over private equity funds too because they can sit on their private market investments longer, waiting to realize better returns.

Where I agree with Jensen is that post-2008 all funds, including pension funds, are paying close attention to liquidity risk, driving more capital into short and medium term horizons, creating opportunities for those investors who can take a longer term view. This is just another reason why market timing is a loser's proposition.

I will let you read the rest of the Absolute Return Partners' December letter, but sum up the findings and key observations below:
1. High yield has never looked more expensive when compared to equities (chart 17).

Chart 17: The U.S. earnings yield is now higher than the HY yield

2. Investors with an appetite for income should therefore consider high income equities as an alternative to corporate bonds but, at the same time, remind themselves that the companies they invest in need to have a balance sheet of sufficient quality to maintain and possibly even increase the dividend over time.

3. Investors interested in riding the buy-out wave (which is a forecast, not a fact), should focus at the value/quality end of the market where private equity funds are more likely to be active.

4. If investing in hedge funds, doing what more than half of all hedge investors do (i.e. investing in ‘vanilla’ strategies such as equity long/short) could very well lead to disappointment. Investing in more esoteric, less crowded, strategies is likely to lead to better results.
I warn institutional investors investing in "more esoteric, less crowded, strategies," be careful or you'll get hammered once again. The hunt for yield has revived structured credit funds and while some are delivering outstanding results, the space is attracting too many charlatans and rookies.

Moreover, the bond party is over and while macro risks still dominate, excellent L/S funds, many of which I track every quarter, are still posting great numbers and will continue doing so in 2013. When it comes to the hedge fund 'holy grail', be careful because today's big winners are often tomorrow's biggest losers.

Below, Lawrence Schloss, New York City's chief investment officer and deputy comptroller for pensions, talks about the city's pension fund strategy and investment in real estate, private equity and hedge funds. Schloss speaks with Deirdre Bolton on Bloomberg Television's "Money Moves."

And Bloomberg's Su Keenan reports that Third Point CEO Dan Loeb's bet on Greek debt has provided him with a $500 million payday. That was the best hedge fund trade of the year and kudos to Loeb and a few others for having the brains and balls to go through with it.