World financial markets to Japan Central Bank: 有難うございます。

Just as the QE tap gets closed by the Fed earlier this week, the Bank of Japan steps up to the plate with another JPY 10trn (around USD 130bn) of stimulus.  Queue financial markets back to all-time highs:

Doumo arigatou, Kuroda-san.  Cancel crash.  Source: thinkorswim by TDAmeritrade

My favourite quote on this, from Bloomberg:

“Markets don’t really seem to care about what kind of stimulus we get or where it’s coming from, as long we get something,” said Teis Knuthsen, chief investment officer at Saxo Bank A/S’s private-banking unit.

Once again, the dip-buyers win: even if you pulled out at the death cross, you were out of the market for all of about 1 week before you got back in (missing out on about 0.5% of appreciation along the way).  Guess we just keep going until it stops working!

Fed ends QE; Treasuries rally?

From what I can tell, the Fed basically announced exactly what the market expected: no more $xx billion of price-insensitive demand for Treasuries and MBS per month; a better economy noticed; and rates will stay low for a considerable time.

So this is how the US Treasury Bond futures market waved farewell to QE:

Hurrah! Less demand going forward! Wait…what? Source: thinkorswim by TDAmeritrade

One would (naively) think the end of considerable, price-insensitive, demand would cause prices to fall.  And…no.  Must be that the event-risk of what the Fed could have said came to naught, so life is OK again.

On the plus side, bonds seem to be back to the ‘anti-equity’ trade: equity futures are off since the announcement.  Better keep those long positions in bonds, then…

What trading strategy suits you? Putting the woo-woo in systematic trading…

I just finished Mechanical Trading Systems by Richard Weissman, which focuses on (who’d have thought) design and use of systematic trading strategies.  The usual mix of momentum, mean reversion and intraday strategies are all here.

What I found more interesting was the author’s pairing of the strategies with trader personality.  The thesis is that certain types of strategy suit different people.  This goes along with my earlier post about return skew: though there are several ways to make money trading, the manner in which returns come can be hard for a person to stomach.

In sum:

• Momentum: the ‘no vacation’ strategy.  Most trades lose (a small amount of) money, but a few home runs make up for all the losses and then some.  Key is that the home runs are completely unknowable, so you must be in the market at all times.  How do you feel about losing trades 5, 6, 7, 9, etc. times in a row?  Would you keep rolling with the strategy?  How do you keep faith it’s not broken?
• Mean reversion: made for contrarians.  Benjamin Graham’s Mr. Market becomes over exuberant and depressed without end; your job is to be greedy when others are fearful.  Going against the crowd can be tough, particularly when you’re too early to the trade.  Trade returns tend to be more winners than losers, so that’s some compensation.
• Intraday: the ‘quick minded’ strategy.  Basically either of the two approaches above (though most go for mean reversion in the intraday context), but with a much-compressed time scale.  Same sorts of emotional issues apply, but with the added stress of needing to make multiple decisions per day (and needing plenty of caffeine).  In my mind, this is where automating the trading becomes absolutely necessary.

As I mentioned before: all these are ways to make a buck.  The question is whether you, as a person, can handle the consistent losses (momentum), the discomfort of going against the crowd (mean reversion), and/or a very stressful lifestyle (intraday).

On a completely tangential note, it was interesting to see the slippage schedule used in the 2008 book was $100 per futures contract, per side.  The market is a lot cheaper these days…

Quick read: Ritholtz on math errors, leading to tax policy

He doesn’t go into wonk-ville, but Mr Ritholz hits on a topic very much on my radar these days: US tax policy vis-a-vis expats.

As a newly-naturalised dual British/American citizen, I now have a legitimate choice whether to give back my US passport.  Why would I do this?

Well, the answer is mainly around taxation: the US’s IRS is unique among developed countries in not giving a *&^% where the US citizen is or how he makes money; the IRS gets its share.  Thanks to a double-taxation treaty between the US and UK, I only pay the higher of the two tax bills each year; that ends up being the UK (but surprisingly, not by much; and for the extra tax, I get free healthcare!!).  However: what if, someday, I end up wanting to live in a nice island community; perhaps one with a super-low tax rate?  Don’t worry about low taxes; you’ll still owe the full US rate to the IRS.  Some of these same islands may not have double-tax treaties, in which case you’ll owe both countries.

The UK is much more sensible with taxation, at least in terms of only taxing citizens if they’ve UK earnings and/or resident in the UK.  If you’re a Brit living in America, you don’t owe the UK Inland Revenue for your US earnings.

So…maybe one day I’ll have a great passive income stream.  Maybe that income stream will pay the bills for living in a low-cost, high-sun environment.  Then I’d consider giving up my US passport.

End soapbox.

Let’s party like it’s 2007… Fannie and Freddie return to power

I was interested in this article by the Economist over the weekend.  In the latest ‘WTF?’ moment I’ve had when reading the financial/economic news, various US Government agencies have evidently removed the more stringent requirements on what qualifies as a government-guaranteed mortgage.  Remember the heady days of 2007 and before, when ‘stated income’ (a.k.a. ‘liar loans’) and < 5% deposit mortgages were the order of the day?  Welcome back, I guess.  In another ‘WTF’ moment, evidently banks no longer need to have ‘skin in the game’ for RMBS they’ve structured from Fannie/Freddie mortgages; they can go back to underwriting mortgages to whomever they please, confident Fannie/Freddie will guarantee the loans for structuring.  Again, back to the fun times!

The only somewhat relieving factor this time around is the US Government’s explicit ownership of Fannie and Freddie.  I mean, the Government/taxpayer were on the hook for the costs of mortgage blow-up in 2008; at least this time the taxpayer gets a 100% profit sweep.  It just makes explicit what has been common knowledge for a VERY long time: US taxpayers like people owning homes so much, they’re willing to subsidise each other’s purchases through the tax system.

Plan B = Fail

Hello from my iPhone.

It may be the middle of London, but apparently we are just fine without broadband Internet. No doubt thanks to some well intentioned construction crew, the local area must go without. For eight hours and counting.

My original Plan B for my trading portfolio, using a laptop at the local watering hole, has been scuppered by the area outage.

Note to self: lease virtual server space with better uptime. Move trading systems to the cloud. Access when needed.

Lesson learned.

End the Fed? Not too hasty…

I’m a big fan of Vonetta Logan and her Nailed It! segment on tastytrade.  In a somewhat similar vein to the Daily Show or Last Week Tonight, Vonetta doses her segments with enough humour to be able to hold attention for a fairly boring topic.

Last week’s Nailed It was about the Fed, including ways to improve oversight of their regulatory responsibilities and open market operations.  Yes, generally a boring topic.  The segment points out some generally known (though not universally agreed-upon) areas of Fed policy:

• No Congressional oversight of open market ops: the Fed can buy and sell Treasuries and such as it pleases.  The bank’s leverage ratio (about 77 to 1, according to Vonetta, quoting Fed docs) is WAY above that required of too big to fail banks.
• Regulatory capture: Fed regulators are generally considered too lacking in knowledge and courage to stand up to those banks they are meant to govern.
• Punishment of savers/retirees/’pure market’ folks: the continuing unconventional policies of QE and forward guidance are keeping interest rates too low (hurting savers and pensioners) and volatility artificially deflated (hurting ‘pure market’ folks).

Vonetta has a few, rather uncontroversial, remedies for the situation.  I encourage anyone to watch the segment to get the full scoop.

In the meantime, I’ve heard a lot of folks grumbling about the Fed, for similar reasons to the above.  This got me thinking…has the Fed been acting outside its mandate?  Has the group made markets worse for us?  I can immediately think of a few reasons why the Fed is doing a good job, all things considered:

• Small interest > capital loss: yes, the unconventional policies mean 30-year Treasuries yield less than 3%.  But, having worked in the financial services industry during 2008, I’m very familiar with stories such as the failing banks of several nations (Ireland, Iceland, Spain, Portugal, Greece, Cyprus,………) and the bailed out banks of several other nations (England, France, Germany, US, …….).  The downward economic spiral of that time meant real rates needed to be very negative, to adjust for sticky wages and the like.  The Fed has done what it can to make real rates as negative as possible, which (in theory, though I like Paul Krugman’s use of IS-LM liquidity trap framework) is as much as it can do.
• Regulatory capture is not a Fed issue.  It’s a general issue:  suppose you made $x million per year creating RMBS and related derivatives, or came up with the credit modelling to value said derivatives.  It’s now 2008, and everything has blown up; what will you do now?  In one corner is the regulators, who need to understand what the hell just happened; provided they don’t want to arrest you, they want you to help them figure out the mess.  You can earn a government salary for that – maybe $100k or 200k.  OR you could go work for the same bank, or a hedge fund, and pick up the gems from the crap; you’d probably still earn $x millions.  Which do you choose?  There should be no question that bank regulators, who could never be paid as much as the people they are regulating, would much rather ‘play nice’ and increase their (very small) chance of getting hired by the banks they regulate.  It’s simple economics, and it goes on in probably every regulated industry there is (e.g. see all the examples of Congressmen/regulatory heads becoming industry lobbyists).  This isn’t the Fed’s fault; it’s general greed.
• Low interest rates?  Choose equities!  so the Fed is to blame both for returns being too low (interest rates too low for savers/pensioners) and for returns being too high (equity market gains of 100%+ since 2009).  Macro hedge funds can’t make money due to weird markets.  Options volatility has been too low.  Hmmm.  There seems to be a solution in all of this, which the Fed has telegraphed for a long time: take on more risk; particularly equity risk.  The Fed has helped ensure the stock markets have fully recovered the losses from 2008, so patient investors haven’t been harmed in the process.  Now that we’re back to black…maybe the Fed should step away?

OK, enough soap box.  I’m more sanguine about the Fed’s policies in the past several years, if only because I very clearly remember the utter fear and uncertainty whether the Fed could do enough to save the economy in 2008.  It did; it has.  The more relevant question going forward is: how dependent have we all become on unconventional policies to stabilise confidence in financial markets?  Will the end of QE, and the beginning of ‘normal markets’, mean even fewer individual investors?  If so, I’m even more fearful of the pension situation.

Quick note to self about the portfolio: mental accounting bias

In a word: fungibility.  Many folks are fans of compartmentalising their portfolios: this amount for housing; this amount for retirement; this amount for kids schooling.  There’s a behavioural investment bias associated with this, called mental accounting.  If memory serves me correctly, the CFA curriculum has a somewhat hand-wavy approach to this bias:

1. Mental accounting is suboptimal.  The portfolio is all fungible; money is money.  Creating silos can inhibit portfolio return, because it’s possible that more assets are kept in safer or less diversified holdings than if the portfolio was considered as a whole.  So CFA-designated financial advisors: don’t silo your clients’ portfolios.
2. But…. most people have real difficulty thinking of his/her portfolio as a whole.  It can be scary to think about (say) the kids’ college money being put into risky investments better left for long-duration retirement funds.  In order to sate clients’ needs to ‘see’ certain silos within their portfolios, the financial advisor might relent to this approach.

I think a big area of discussion related to this concept is ‘the emergency fund’ of cash.  Suppose the following, silly example:

• Single person, aged 35, with annual living expenses of $25,000 p.a.
• Has a job earning $50,000 p.a., so is saving a fair chunk.
• Due to lottery winnings/inheritance/previous stock options/etc., the person has a $1,000,000 portfolio.
• Conventional emergency fund thinking: stash away 3-6 months of living expenses (e.g. $7-12,000) in cash at all times.
• Total portfolio thinking: keep only necessary liquidity in cash (maybe $2,000, say).  Remainder is put in a portfolio of various assets, with a total return objective.  If bad times happen job-wise, liquidate some of the portfolio.

Which do you feel is better for this person?  What about your own situation?  Hmm…

How would you like your returns skewed?

There have been several times in the past where I’m explaining ‘XYZ strategy’ to someone (hopefully they asked me beforehand), and the concept of skewness comes up.  A couple examples:

• Several (successful) strategies lose far more frequently than they win.  It’s not always like playing the lottery…
• Sometimes ‘the sure thing’ trade, which has made money every day, suddenly blows up.

Thus loops in the concept of skewness – how big are losses relative to gains?  On the lottery side, you’re almost certainly going to lose  USD 1 on a game with a (highly improbable) gain of USD tens of millions.  But other examples abound in financial markets:

• Long-only (just about) anything: this is a negatively skewed strategy.  Most months/years you will have a gain, but some months will be TERRIBLE.  Don’t think about the little correction we just had…think about 2008.  It can take years to recoup the losses from long-only: for example, notice that the NASDAQ is still about 10% below its 2000 peak.
• Venture capital: this is a positively skewed strategy, in its most basic form.  The VC fund manager selects (say) 10 companies at an early stage of development.  Financials don’t really mean much at this stage – they could do anything.  The hope is that, out of 10, there will be 1 big winner and maybe a few small winners.  The others are expected to be written off.  So, one gain outweighs the many.
• Volatility selling: this is a classic negatively skewed strategy.  VERY negatively skewed, epitomising ‘picking up pennies in front of a steam roller’.  After premium selling funds lost about 50-70% in 2008 (or went completely bust), several actually hit high water marks in the past couple years.  So it’s a sustainable, if nerve-wracking, strategy.  By the way, insurance products and market making are roughly the same as option premium writing, in terms of performance characteristics.
• Momentum trading: a classic positively skewed strategy.  Frequently momentum is classed as ‘long volatility’, which it is…kinda.  More long gamma…but anyway.  This is a ‘pain trade’, in that most of the time you’re losing money as markets oscillate back and forth and you’re trading with the trend.  Only occasionally do the big trends come; you can’t really forecast them, and you MUST be in the market when they come.  Otherwise this is a losing strategy.

I leave you with the following track records, harvested from Altegris’s managed futures website.  Interesting place to learn about volatility and momentum offerings.

Classic volatility selling strategy characteristics: nice, steady gains punctuated by large losses. Source: http://www.managedfutures.com

Classic example of a higher-geared momentum fund. Notice how the fund spends most of its time below high water mark; this is broken up with infrequent, large gains. Source: http://www.managedfutures.com

Extra credit: those seeking more technical info on return skewness, and particularly how the time-variance of skewness is a function of strategy design, should look at this wonkish paper.

Vol drag ahoy!

Now that markets have (somewhat) calmed, let’s see how the old vol drag play has worked thus far:

For those new to this: VXX tracks changes in the VIX index, by buying short-term VIX futures.  UVXY is meant to return 2x the daily return of VXX; again, this is achieved by buying (I’m guessing double) the same futures.  Because VIX futures tend to be in contango, buying futures is a generally losing proposition unless volatility is spiking (e.g. the past month).  Because geometric returns (which is the price series of UVXY) are generally lower than arithmetic returns (which is each day’s return of UVXY versus VXX), the former’s price series should lag the 2x mark.

So what’s happened over the past month: VXX up 21%, UVXY up 31%.  Total drag of about 10% in a month.

On a side note, look how vol drag can work in UVXY’s favour.  When the VIX was increasing just about every day (e.g. beginning of period until 13 Oct), geometric returns were higher than arithmetic due to compounding.  At the peak, end-13 Oct, gains in VXX and UVXY were 45% and 97%, respectively.  It was only when volatility really came off that the effects of vol drag become obvious.  The impact of VIX futures in backwardation also was a positive for UVXY vs VXX for the period, but that’s another conversation.