Monday, December 11, 2006
Ouch. There’s no other word to describe it. Over the last 24 hours, virtually everything that could have gone wrong, has. The dollar bet has gone from super to supine, courtesy of Friday’s inexplicable late-day dollar surge that has thus far followed through on Monday. The DAX, meanwhile, has handily beaten the S&P over the last few days, taking the spread trade (un) comfortably into negative territory.
Macro Man was not particularly surprised that the dollar corrected; after all, December 2004 and 2005 saw corrections from the underlying trend. What was surprising was the manner in which it corrected, with seemingly bullish, Voldemort-driven price action swiftly reversing into a free fall. Ultimately, this could be a healthy phenomenon, shaking out a few weak dollar shorts and setting the stage for acceleration of dollar weakness into year end. Perhaps tomorrow’s Fed meeting could be a catalyst if Jeffrey Lacker returns to the ‘on hold’ fold and the statement is perceived as dovish.
However, the losses prompted Macro Man to put on the thinking cap over the weekend. What is the appropriate ‘default’ setting for a macro portfolio? After all, it is pretty difficult to scratch out 10% in pure prop trades without taking sufficient leverage to risk substantial drawdowns. The recent press accorded to Goldman’s Absolute Return Tracker suggests that it should be possible to create an underlying beta portfolio on top of which to lay a series of portable alpha prop trades.
Of course, there is an argument to be made that that is what many hedge funds currently do, without the portable alpha overlay. Nevertheless, if one can develop a passive strategy that generates a consistent return, it provides a handy tailwind from which to leverage one’s particular area of expertise.
An obvious starting point is equities, which are more volatile than bonds or currencies and deliver higher nominal returns. Macro Man’s interest was piqued by a recent debate about the utility of P/E ratios in market timing. Macro Man decided to investigate a relatively naïve market timing strategy based on S&P 500 trailing PE ratios.
The essence of the strategy is to be fully invested in US equities when they are relatively attractive, and out of the market when they are not. Macro Man used trailing S&P 500 p/e ratios since 1986 (the earliest available in Bloomberg), inverting them to generate a trailing earnings yield reading. He then compared this earnings yield with the prevailing yield on 10 year Treasuries. The initial analysis seemed to suggest that when Treasury yields are substantially higher than earnings yields, equities underperform. When the difference is smaller, equities seem to do OK. What is curious is that Treasury yields are currently priced at a discount to earnings yields, a clear anomaly over the past 20 years!