Right and wrong

Thursday, July 10, 2008

One of the refreshing things about this business when you run risk is that you have a very clear criterion of right and wrong: your P/L. Now, for a (M)acro (M)an, it is the medium-term evolution of his P/L that is the statistically significant criterion in determining the accuracy of his views. As he has explored in the past, short-term swings for even the most astute of traders are largely random.

That said, on a short term horizon Macro Man's decision to cover some more of his equity short was clearly wrong, given the meltdown in the US last night. In many ways, of course, being wrong is not unexpected. Macro Man's style is to scale into positions as conditions become more favourable to his views, and scale out as conditions become less favourable (more on this below.) Whilst employing such a strategy, it is highly likely that some profit-takes will go offside.

Still, Macro Man cannot help but laugh at what passes for analysis these days. Yesterday, he received a Bloomberg message from a large bank before the US open, trumpeting that one of their analysts was looking for a 10-15% bounce off the lows in banks stocks.

Mind you you, this came the day after a $4.19 rally in the BKX. Hmmmmmm. When Macro Man did a bit more digging, this call became even less insightful. Measured off of Monday's low, the BKX had already rallied 10.1% from its lows. Gee, thanks for the heads up there. Of course, yesterday the BKX rallied another half a buck and then collapsed. So while this chap may have technically been right in analyst world, under the more exacting microscope of a P/L one cannot help but think that his call would have been proven disastrously wrong.
In any event, Macro Man stands by his view that conditions are making equity shorts less comfortable to hold. Intraday volatility has risen dramatically, particularly in comparison to close/close volatility. Frankly, Macro Man isn't whether this heralds a bounce or collapse. To get a flavour for how this choppiness relates to historical precedent, he constructed a "choppiness index" for Eurostoxx, which compares the average daily range with relatively recent price history.

He calculated this index back to the beginning of 2001. When he ran the numbers, he found that the recent price action has been in the 99.5th percentile of choppiness over the past seven and a half years. Yowsah! No wonder it's been so confusing!
Although Macro Man hasn't performed an exhaustive study of how prior episodes of chop have resolved themselves, intuitively it makes sense that they would produce either countertrend moves (as directional positions are covered) or high-volatility continuations (as trend faders/Maginot Liners give up the ghost.)

How the present period of chop ends will likely depend on earnings season. Given that modern corporate earnings announcements are little more than a public exercise in creative accounting, Macro Man has little wish to go in with heavy positioning in one direction or another. Far better to flatten exposure and remain nimble, adjusting the view as fresh data emerges. And with that game plan in mind, even though yesterday's profit-take was the wrong thing to do in the micro term, from a more strategic perspective it was right.

Posted by Macro Man at 9:54 AM  


I would say your p/l represents your trading and bet-management ability, and not the delta of your being right or wrong in say, the economy, the trend etc.

In our trading team, we have several traders with trade ratios right wrong under 0.5, that are making a lot of money. If you run a VC for example your looking at having wrong 9 times of 10, but still make a shitload of money.

I do understand your argument, and I think your blog is great fun.


Anonymous said...
11:40 AM  

BR, I see what you're saying. I suppose that I would count "risk management", "sizing", and "timing" as factors that are just as important, if not more so, than getting the macro view right.

To use a sporting analogy, baseball games are decided by how many runs you score, not what your team's batting average is. There are some very productive players (Adam Dunn, for example)who have low batting averages. There are other productive players (Ichiro, for example) who have very high batting averages but hit few home runs. The superstars (Ted Williams, for example), hit for both a high average and hit a lot of home runs.

I suppose that as a manager of traders, you just have to try and avoid hiring too many Mario Mendozas.

Macro Man said...
1:02 PM  

Nicely explained and long post on how the right decision was made with the wrong result. In poker we say "bad beats". On to the next one!

ryansoh said...
2:00 PM  

why o why doesn't fx move--i blieve the dxy has been in something like a 3% range for 5 months--given the foreign ownership stake in the GSEs debt (and what the heck how about some you go getter and S&P or Moodies jumping the gun and puttng US and or GSE debt on credit watch for downgrade) hurting the buck???

Anonymous said...
2:39 PM  

Anon, the only thing I can suggest is positioning. I mean, why isn't that universally acknowledged turd, the NZ dollar, going down? Sure, Mrs. Watanabe and carry monkeys are buying it....but I can only assume the reason it's drifting up is because so-called directional punters are already short.

Macro Man said...
2:47 PM  

Would that not also include the AUD? ... USD/AUD at 0.95ish has short written all over it if you ask me.

Nice explanation by the way MM of your trading considerations. I am learning more from this site on trading and positioning than I could EVER imagine learning in some flashy course at the business school.

As Anon @ 2.39 I am also wondering what migh kick off some real action in FX land.


CV said...
5:30 PM  

Is there any reason to believe that the $5 increase in the price of oil before the 2:30 close was anything other than a very successful attempt to crack equities?

Anonymous said...
7:55 PM  

CV, just curious what is your reason for shorting AUD/
AUD correlation with commo esp. oil has been very tight and get tighter recently, so, shorting aud is basically a putn on crude, or atleast a flattening out in crude prices.

AUD fundamentally should be traded off copper/ gold/ coal/ steel prices, as the export at elevated prices, and still continued demand for these products from accommodative eM's is improving Aussie terms of trade.
At relatively high core inflationary pressures, and even though economy is weaknening, the chances of RBA cutting rates right now are nil, and at least 25bps is in the car in next 6 months, USD remains under pressures against AUD.
OR, crude corrects somewhat and AUDUSD can finally head lower, I'd look to short .9800

Anonymous said...
8:02 PM  

If brevity is the soul of wit, cv has become wit's deity.

BR, there's a major difference betweem VC, where all that's required is a rough estimate of the upside of each company and the success rate of the industry and global macro, where one is determining large themes where probabilities are poorly-defined. (in Macro Man's baseball analogy, global macro is betting point spread on teams composed of rookies). There's a general idea of the upside, but no number for the industry success rate.

MM, I had the very interesting experience of watching my pretty good track record undergo some reversion to the mean. In Jan-Feb, I beat the market by 8 percentage points, but have done dead even or down a couple since then. Here are some of the global macro story divergences from reality that I see:
1. Excessive fear on emerging market bonds. Cripes, the USG may have to default on Fannie and Freddie and we're worried about *Brazil*?
2. Excessive discounting of alternative energy relative to oil. If fear of war with Iran is driving oil prices, what does anyone think will happen to substitutes in the event oil hits $300/barrel?
3. Misunderstanding of stagflation. It is noted that official inflation is not very high. But as long as growth is running below inflation (and not in deep recession), prices of inflation-resistant assets should continue to rise simply because they are the better of many bad bets. This is especially true considering that US interest rates are negative, while risk is growing.

Always interested in your take on these things.

Charles of MercuryRising

Anonymous said...
8:05 PM  

(oops. When I wrote my comment, cv's comment was blank. Now I see that it has appeared, making my own comment incomprehensible.)

Charles of MercuryRising

Anonymous said...
8:08 PM  

Charles, I wouldn't characterize the market's attitude towards emerging market fixed income as "excessive fear."

In Asia, people are paying rates/short bonds because inflation is high, rising, and an acknowledged problem, and interest rates are negative.

In S Africa and Turkey, people have been selling bonds because of upside inflation surprises and questionable CB credibility.

In Mexico, people have sold bonds/paid rates because inflation (including inflation expectations) continues to surprise top the upside.

And in Brazil, market rates have risen because inflation/expectations have firmed, domestic demand is very strong, and the CB has suggested they'll do what it takes to get on top of inflation. Everyone I know, including me, is sort of waiting til the music stops to receive Brazilian rates. Some appear to have started already.

As for alternative fuel sources, I suppose it depends on what you mean. Uranium had a huge bull run over the last few years which has been partially unwound. It should eventually turn back up. As to the other alternatives (solar/wind/tidal, etc), you can't reallty trade 'em except through companies, and that is more for a micro man. And while nat gas may have lagged oil, it's at least moved in the same direction.

On inflation, a majority of people still view the world the the prism of cost-push inflation via labour markets, and thus view the current scenario as ultimately deflationary. I come out on the other side, believing that globalization will push up the price of food and energy so much that there will HAVE to be pass through in the West.

I've yet to find a satisfactory way to play that for the long term, however, which can reside in my book with its shorter-term risk parameters.

Macro Man said...
8:39 PM  

The best and most concise summary of the problem with wind energy was posted by a reader on Vic Niederhoffer's website yesterday:


Vic is a permabull, I know...there are occasionally some very insightful posts that show up there.

D said...
11:17 PM  

I don't discount the inflation in emerging markets, MM. But is it being measured accurately in the US (and some other developed countries)? And will those emerging markets running CA surpluses choose to revalue their currencies, which will revalue bonds denominated in local currency?

If there is a systemic mismatch of reality and expectations in the US, or if the EM decides to let their currencies rise while the US runs low interest rates, then emerging market risk may be relatively mispriced, and due for a correction.

As for alternative energy, I would respectfully differ with your definition of macro. There are ETFs that allow one to invest without getting into the micro level. Granted, the micro level is not recondite when shopping for ETFs, but they allow one to invest on a macro hypothesis (i.e., what will be the rate of substitution between oil and other energy forms?) without worrying so much about individual company performance.

Anyway, these differences in viewpoints and expectations are what makes a trade... and an interesting conversation.

Charles of MercuryRising

Anonymous said...
11:30 PM  

d, I would dispute Gifford's figures. See, for example www.doe.gov/news/4855.htm for realistic estimates of the cost of solar.

This is actually an overstatement, since the cheapest way to produce solar energy doesn't require solar panels, just polished metal and water. As for capacity, as T. Boone has pointed out, within five years, we could replace the generating capacity represented by nat gas with wind and/or solar. The gas so saved would be available for transportation.

The time for alternative energy is here.

IMHO, of course.

Charles of MercuryRising

Anonymous said...
11:38 PM  

$8/(W)att is the installed cost...

The figures distributed by the DOE include financing of 4%, 1% annual operating cost, and capital depreciation over 20 years.

I suppose the US and everyone else in the world can just tack that up front expense onto their national/public revolving credit line...right?

Here's the unabridged version of your source:


D said...
12:32 AM  

d, the source you cite states that the cost of power from trough plants is expected to be 11-14 cents/kWh. Nevada's Solar One is being financed privately and is expected to be profitable. PG&E is purchasing power from Mojave at 10 cents/kWh. This is consistent with other estimates of breakeven. I don't have precise figures, but it certainly sounds to me as if private companies think that they can make money at ca. 10 cents/kWh.

Furthermore, coal is heavily subsidized by the fact that externalities are not included in the price. If they were, coal would be prohibitively expensive. Solar's price, by contrast, will fall as th technology proves itself and financing rates drop. Utilities don't pay much for financing as these things go. Four percent is below market rates, but not by a huge amount.

--Charles of MercuryRising

Anonymous said...
8:51 AM  

"why isn't that universally acknowledged turd, the NZ dollar, going down?"

Hey, watch it! That's my currency you are insulting (yes, I am short it :) ). Let's see what happens when rates start falling (maybe just a few weeks from now).

"the chances of RBA cutting rates right now are nil, and at least 25bps is in the car in next 6 months,"

What? A hike? Sez who? The median forecast (on Bloomberg) calls for the rate to remain at 7.25 percent through 09q1. I own the Australian dollar (against the New Zealand dollar - mostly to cut the carrying cost), but a serious commodity correction would crush it.

"I come out on the other side, believing that globalization will push up the price of food and energy so much that there will HAVE to be pass through in the West."

I'm not so sure. Not too long ago, I read that eliminating fuel subsidies in Asia would lead to demand destruction equal to three million barrels a day of crude (THAT would send prices lower). The system has too many complexities to confidently predict how things will turn out, but a "real" recession certainly has a good deal of deflationary potential.

Anonymous said...
12:21 PM  

Mercury Rising, I mean Global Warming pundit...

The figures you are quoting are amortized over 20+ years with assumptions that are far from reasonable. I am not opposed to people with the means adopting grid independence via solar power, but it is clearly a discretionary expenditure. Europe, USA, Japan do not have discretionary dollars to deploy such an infrastructure.

We can revisit this subject in another 20 years and see what nanotechnology has produced in the way of tubes to see if it is economical. Until that time, the uber-recession upon us will take care of the price of oil in due time.

D said...
5:15 PM  

d says, "The figures you are quoting are amortized ..."

No, d, the figures I cited are what electricity is apparently being sold at.

But 20 years sounds like a good time out period.

--Charles of MercuryRising

Anonymous said...
1:32 AM  

I give up explaining the numbers...the days of thin air money are behind us.

D said...
12:01 AM  
sosoy said...
10:31 AM  

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