Evidence Investing

Check this out...  [I encourage you to read it, but at least look at the graphics]

Thanks to the Petersen Foundation for this.
Make no mistake, there is no greater threat to our country and our way of life than this! My advice: vote out of office any politician who votes to raise the debt limit or votes to increase entitlements or votes for unfunded spending.

To add to the research on analyzing housing prices by Disposable Income (see my previous post for US, UK, Canada, Australia analysis), we now get a look at China.  As you might have heard, there is a lot of talk in the business press about a bubble in China, specifically real-estate.

Check out the China chart:

From Political Calculations:

We see that a very close coupling from 1999 through 2003.  However, in 2003 a deviation from the established trend occurred and a new linear trajectory emerged, which continued through 2007.

That tells us is that something happened, most likely in late 2003, to set housing prices on a higher growth rate trajectory. Since that new trajectory is linear, we surmise a change in overall economic conditions, which suggests that China's housing market was not in a bubble.

That observation is contradicted by what we see next. In 2008, housing prices plunged while average disposable incomes were barely changed. This outcome suggests that a bubble indeed existed in the Chinese housing market from 2003 through 2008.

Finally, in 2009, we see both housing prices and disposable incomes surging upward, as the Chinese economy responded to its government's massive stimulus programs initiated in reaction to the worldwide economic crisis of 2008.

What we would hypothesize from these observations is that whatever bubble exists in China extends far beyond the nation's housing market, which has actually responded rationally to those conditions. We would then conclude is that what China has really dealing with is an economic bubble that extends across many sectors of its economy. We also find that the rapid resurgence of housing prices in 2009 suggests that China may now have formed a true housing bubble in addition to its overall economic bubble.

Like all economic bubbles, they will end. It's just a matter of when and how.

Alright, now that I have got at least something under my belt for each of my topic areas, we can move on to the EVIDENCE for asset rotation (or Tactical Asset Allocation…TAA), which is the real meat and potatoes of this blog.

One quick think I wanted to bring up: you may hear the term Strategic Asset Allocation.  This refers to the following:  “Strategic asset allocation describes the practice of creating a portfolio with a constant or fixed mix of assets designed to fit the investment parameters of the investor.  A key assumption is that those parameters will remain relatively stable over the long term.  In other words, if the investor's long term objectives and risk tolerance are best served by a 60% equity and 40% fixed income portfolio, determined by risk tolerance and return goals, then that will be set as their target portfolio until their return objectives and risk tolerance change significantly. (source)

Tactical Asset Allocation: Uses some sort of prediction model to periodically alter the consistency of a portfolio on an active basis; that is, periodically adjusting holdings and weights of diverse assets based on the current prediction model output.  In other words, when your model tells you a down-turn in equity may be near, your system will allocate toward bonds.

Look at this summary table:

For more on this, check out this excellent short article from UBS.

”Wait,” you say, “I thought you said you hate prediction and you don’t believe you can tell the future!!”  True, but with some caveats: I don’t believe in paying for someone’s opinion on what is going to happen in the future, and I don’t believe that the markets can be predicted well. I do believe you can have a basic idea where trends are leading and when markets are broadly over/under valued, etc…USING ANALYSIS BACKED BY REAL EVIDENCE!

So let get right down to it and start to answer our core questions:

1. What’s the evidence behind TAA, in general?
2. What prediction models work and are evidence based?

In order to answer this best, we need to first talk about our prediction models and then we can see how they fit into the overall TAA frame work.

There are a multitude of prediction models out there, as I am sure you know.  And, despite their claims, only a very few manage to ever beat the market and even fewer (if any) can beat the market on a long-term ongoing basis.  And, that is our goal, by the way: to beat the market.  If you don’t believe you can beat the market, there is no point in trading (commission costs), studying and analyzing (time/opportunity costs)…you might as well throw your money in an index fund and hit the golf course!  (look for a future post on the logic and evidence for an against ‘beating the market’)

So, there are three types of prediction models that I will deal with (so far) in this blog:

1. Momentum
2. Selected Technical Analysis (Moving Averages)
3. Yield Curve

Why these three? Because they have the most supporting evidence, of course!  J

In reality, these are the only prediction models that I have run across that have been significantly studied and which are supported by rigorous and numerous research studies.  If we discover more, we will be sure to let you know…

I am going to devote many future posts to each of these models, so I am just going to give you the definitions of each today…

1. Momentum Investing: An investment strategy that aims to capitalize on the continuance of existing return trends in the market. The momentum investor believes that large increases in the price of a security will be followed by additional gains and vice versa for declining values. (Investopedia)
2. Selected Technical Analysis (Moving Averages)-based Investing:  An investment strategy that aims to capitalize on the continuance or change in directional price movements, as defined by a moving average of asset price.  The moving average investor believes that moving averages have predictive qualities and that assets tend to trend on one side of their moving average, and that a moving average cross-over is significant.
3. Yield Curve Investing:  An investment strategy that aims to capitalize on the positive consequence of changes in the yield curve for assets.  The yield curve investor believes that the yield curve has predictive qualities and that some assets do better in certain yield curve environments.

Next time, we will start in on the evidence for momentum.  

Note: the following is from Bloomburg, and I include it not for politics sake but as a comment to my Big Play on bonds.

Check this out:

Obama Pays More Than Buffett as U.S. Risks AAA Rating

(click to read the whole story at Bloomburg)

March 22 (Bloomberg) [edited] -- The bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama.

Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity.

 Former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.

“It’s a slap upside the head of the government,” said Mitchell Stapley, the chief fixed-income officer in Grand Rapids, Michigan, at Fifth Third Asset Management.

America will use about 7 percent of taxes for debt payments in 2010 and almost 11 percent in 2013, moving “substantially” closer to losing its AAA rating, Moody’s said last week.

“It’s a manifestation of this avalanche, this growth in U.S. Treasury supply which is under way and continues for the foreseeable future, and the comparative scarcity of high-quality credit,” particularly in shorter-maturity debt, said Malvey, whose Lehman team was ranked No. 1 in fixed-income strategy

Last year’s $2.1 trillion in borrowing by the government exceeded the $1.08 trillion issued by investment-grade companies, the biggest gap ever, Bloomberg data show. Malvey said the last time he can recall that a corporate bond yield traded below Treasuries was when he was head of company debt research at Kidder Peabody & Co. in the mid-1980s. 

While Treasuries are poised to make money for investors this quarter, they are losing momentum. [Treasuries] are down 0.43 percent in March after gaining 0.4 percent last month and 1.58 percent in January, Bank of America Merrill Lynch indexes show.

President Obama’s budget proposal would create bigger deficits every year of the next decade, with the gaps totaling $1.2 trillion more than his administration projects, the nonpartisan Congressional Budget Office said this month. Publicly held debt will zoom to $20.3 trillion

To start off my options posts, I just wanted post some (very) basics.  If you don’t have a good handle on what options are and the basics of how they work, READ THIS FIRST.

If you do know something about options…or even if you know a lot, take a quick look at these two pages so you can use them as a quick reference source in the future. 

                PowerOpt Options Explanations                               Forbes Options Explanations

Also, take a look at this chart:

Just to realize what is available when it comes to options.  A lot, isn’t it?  Each one of these strategies can based on what kind of risk you want to take, your opinion about where you think the market is going.

While it’s nice to know you have all these strategies at your disposal, the thing that bothers me most is that in order to do well, you really have to have an opinion about where the market is going…And if you remember, that is what I really try to avoid: No one really knows where the market is going.

So, while we will look at several different option strategies as time goes on, I am going to focus on the strategies that require the least knowledge of future price movement.

Based on other things laid out in this blog, I feel like we can have a very basic idea of if we are in a bull or bear market, in general (much more to come on this).  Obviously, smaller (but still very significant/devastating) interim reversals of the overall trend can occur and be really difficult to handle.

So, what I am interested in are the best strategies (lowest risk) for markets with 1) largely sideways movement and markets 2) which we feel like we have some vague idea of the overall trend.   Frankly, if I have to be any more specific about future price movement to make money/avert my losses, I’m really not interested.  SO, that kind of rules out simple buying puts or calls, for the most part.

In fact, while I will talk about credit spreads, I really am going to stick with covered calls, covered puts, married puts, and other strategies along these lines.   

What I am going to talk about is how to maximize these strategies and how to implement these in a overall portfolio. 

Ok, so sorry about the trite overview and the lack of evidence and substance, but I thought it important to tell you where we will be going in this section.

So taking another angle on our look at the housing real estate market...   Price-to-Rent Ratio.

From the good people at CalculatedRisk comes a excellent article and a even more excellent graph (yes, I love pictures).  Based on the brainy but understandable letter to the SF fed regarding the housing bubble in 2004 by economist John Krainer (which you can find here and I suggest you read if you have a chance), the price-to-dividend ratio used to value equities in finance can be applied to the housing market in by way of the Price-to-Rent Ratio.  

Krainer says, "The finance paradigm holds that an asset has a fundamental value that equals the sum of its future payoffs, each discounted back to the present by investors using rates that reflect their preferences. For stocks, the payoffs requiring discounting are the expected dividends. This approach can extend to housing by recognizing that a house yields a dividend in the form of the roof over the head of the occupant. The fundamental value of a house is the present value of the future housing service flows that it provides to the marginal buyer. In a well-functioning market, the value of the housing service flow should be approximated by the rental value of the house."

Makes sense doesn't it?  So lets look at the graph:

Pretty interesting, huh?   So we can use this information in a couple of ways.  
1) Historically speaking 0.9 is the approximate average ratio for this market.  And right now we seem to be about 10% above the historical average...which (surprisingly?) corresponds with the data from my previous post on housing prices.  Nice!

2) We should really keep an eye on this particular metric in the future for bubbles (which you know are going to happen again sometime, somewhere).

I warned you there would be some of this...ENJOY!

What is ‘Rotation’?  Well, it’s the methodical or systematic redeployment of portfolio capital into different asset classes over time based on some underlying (proven) theory.  The goal is to decrease volatility and increase Sharpe Ratio and total return.

My specifically, in the context of this blog, I am referring to asset rotation, sector rotation, or tactical asset allocation (TAA). 

Investopedia gives a fairly clean rudimentary definition (slightly modified): the TAA strategy allows portfolio managers to create extra value (ostensibly ‘beat the market’) by taking advantage of dynamic situations in the marketplace through active management of which asset classes the portfolio capital is deployed at any given time.  In other words,  you periodically and actively adjust the mix of assets as markets rise and fall and the economy strengthens and weakens. 

 TAA models exist to help investors identify and participate in outperforming sectors of all markets (usually via the stock market).  This is critical!  The way I like to think of it is that in any given economic climate or situation, there is at least one asset some where that is making money and increasing in value.

 Think of the two recent bear markets, generally from 2000 through 2002, and 2007 until March of 2009. During both of these periods, equities (the S&P) declined more than 50%, yet bonds were profitably during this time.  Gold has been profitably during many recessions as well...as well as a host of other sectors or asset classes.  The bottom line is that there is always money to be made somewhere, no matter what is happening to the economy or business cycle.    

 The key is finding which assets to actually be in at any given time…  Easier said than done, right?  Absolutely.  While TAA’s premise is not all that earth shattering (be in assets that make money), certain aspects of it are fairly revolutionary to many investors.  First, it is a radical departure from the buy-and-hold dogma often touted by the investment community for so-called ‘individual and unsophisticated investors.’  Secondly, TAA will steer investors into what may be the uncharted waters of alternative investments, such as commodities, real estate, etc.  Thirdly, by way of regular portfolio adjusting, we can see that trading costs (friction) can be an issue. 

So at this point there are two elephants in the room:

1. Where’s the evidence to prove that TAA is better than buy and hold
2. How do you determine when and where to switch asset classes

 No doubt these are the critical issues…but have faith, we will get to the answers of both of these questions very shortly.  Stay tuned.

I think its fair to assume that most people would agree that we are not out of the woods yet, but I get the feeling that people are getting ansy... to buy at these 'cheap, cheap prices.'  Just how much lower can housing/real estate prices go??  Well, to look at that question, I would like to show a really excellent bit of research done by Ironman at his top-quality blog (PoliticalCalculations). 

We can look at housing prices related to the past to try to get a handle on this, but the problem is that there are so many factors (inflation, jobs, supply/demand, etc, etc) that it makes it a really tough multi-varient problem to figure out a housing price predictor that works half way decent...

In his post (A Better Method for Detecting Housing Bubbles), he says: 

"But what would be a better method for determining whether house prices might be in a bubble? Is there a way to detect a bubble forming in its earliest stages?

We think we've developed a better method, which is in part based upon our observations of age and income driven spending. What we found is that personal spending for housing was a very strong function of personal income.

That observation gives us an alternative way to determine how much Americans of a given income spend on housing and given the strong correlation between income and housing expenditures, we can substitute personal income in place of the measure of rent used by the federal government. We can then plot non-inflation-adjusted house prices against that personal income, which would give us insight into not just whether house prices have decoupled from the economic fundamentals supporting them, but when as well.

We did just that with median house prices and median household income in the United States since 1967.  What we find from our chart is that the U.S. housing bubble clearly began in 2000, with a distinct deviation away from the two otherwise linear trends that we observe in the data."

Look at the graph below showing a chart of this analysis for US home prices (CLICK TO ENLARGE):

And here for a similar chart using UK data:

And here it is for Australian data:

And here it is for Canadian data....BUT only up until 2006:

Now before you go on, be sure you clicked on each one to see them in their full glory...

Isn't it amazing how clear those trend lines are???  You dont see that very often in financal or economic data...

First, lets focus on the US chart:  the main thing to see is that we are still about $15,000 above the long term trend line.  Or about 7.5% above.  While it could be said that people may be used to paying more of their income for housing...I would say that that argument really doesnt hold water: if anything people living through this real estate debacle are going to be less willing to risk their money on real estate.  Now that people have seen and felt how far prices can fall, its my opinion they will be more concervative in the future.    Also, I am interested on the effects of our high unemployment on median income (obvious, isn't it?) and how this may allow for even more declines in pricing.

England shows nearly the same pattern as the US, having started the bubble at the same time. They also seem to be on a similar tragectory.   It'll be interesting to watch.

Australia: they appear to have managed this much better.  They have a much smaller bubble and, more importantly, appear to be back on track.  Good for them!.

Canada:  Incomplete data.  The way its drawn there shows a possible change in trend (due to changes in tax policy, etc, etc?) or perhaps just the upswing in the bubble phenom.   Bottom line is that we cant say yet for Canada...until we get data for 2007  through to the present.

So, what does all this mean:  In my opinion, we here in the US are still in a housing price buble with at least 7% to 10% decreases yet to come...but we may be getting close!