Tuesday, November 15, 2011

While Europe Fiddles, TMM Correlate and Disperse

The most remarkable thing about Europe is that, as we posted last week, trying to get something positive out of the Eurocrats is impossible. What is sadder still is that throughout the whole of the crisis TMM have not felt such a level of resignation that the Eurozone is about to collapse. This morning the number of folks leaving the stadium thinking it’s all over is at stampede levels. Whether they are right or they are wrong is immaterial at the moment the crush can still kill. Now if you are listening, dear Eurocrats, we are at the point where even YOUR ivory towers are cracking. So how about you do something to restore a little CONFIDENCE? Because that is all it will take to stop this unwind of leverage that is causing all classic money multipliers to dry up within the zone and which you seem so adamant not to compensate with policy change. Though last spring was and then last summer was, NOW is the time for action.

TMM think that’s all we can do really as our bit to make things better. A couple of years back we adopted the ethos of only worrying about things we could change, which actually led to a less depressing life and a new liberation. So, despite the deafening roar of icebergs against hulls, we are going to look at something else to try and take our minds off it.

TMM thought it would be worth discussing some other stuff – namely equity correlation and its cousin, dispersion. One of the sustained features of this crisis is high volatility (both realized and implied) leading to progressively higher levels of equity correlation which makes trading individual stocks much less rewarding. If you regressed the returns of individual S&P equities over the last few years as such:

Return =β*S&P Return + β*Sector Return+residual

You’d probably find that the R-squared or predictive capacity of this regression was strong to quite strong – and probably a lot more strong than in the period prior to 2006. This poses a couple of obvious questions:

  1. Why bother doing any work on individual stocks if its all RORO and sector risk
  2. Why bother paying CEOs squillions when their value add seems utterly indifferent between one another?

So when there really isn’t much dispersion to speak of the stuff worth fighting over is macro – spreadsheets, cash flow models and sensitivity tables can take a hike. Its all positioning, economics, and broad based sector sensitivities. This likely explains why some very large funds have done very well over the last few years – the richest pickings have been in things that trade a lazy few billion a day and thus its possible to be very big indeed without being too big (or too weird) for the market.

Volatility and correlation have moved in lockstep and trended higher, arguably since 2007:

There is a pretty clear reason for this and that is that most of the aggregate risk out there is systematic in nature. Back in the 80s or 90s you might have worried about the likes of Microsoft eating your lunch, today the larger concern for corporate is a wholesale breakdown in the banking system, sovereign credit, or the like. Basically, trading DM is like trading EM used to be because like EM did back then DM has a leverage problem.

TMM think that following some – any - resolution of the Euro Crisis that is about to change. Why? Because while deleveraging is continuing, it is slowing in the US and there is a lot of noise - and one letter in Caixin - calling for normalization of interest rate policy in China. Once Europe falls into line (possibly with a few members dropping out) the new reality will be priced in and we can get over crisis phobia and move onto the mediocrity of cyclical growth. Not to mention that most Central Bankers worth their salt know that, “yeah, you know, we probably should keep an eye on that stuff” with the notable exception of the completely discredited JCT/Greenspan faction. To that end the tsunamis of macro volatility are going to get progressively less forceful and micro forces will reign.

This can only mean one thing: TMM are going to have to spend more time talking about industry or intra-industry macro rather than good ol’ Indices-Govvies-FX macro. And that means that the big gains will be made out of disruptive business models and technology – largely the latter combined with the former. You couldn’t manage the resurgence of the horse and buggy in the 1920s if you tried but great tech works best when married with great design as the late Steve Jobs showed on a few occasions. To that end what is TMM looking at?

Consumer: So banal it barely merits a mention but suffice to say if your 15 year old daughter buys everything online guess what – in 20 years high street is going to be gutted. TMM think that longer term physical retail franchises are going to struggle vs online stores in the Amazon fulfillment chain.

REITS and Property: On a related point if high street gets demolished then we will need a lot more warehouse and logistics centres but not much in the way of retail malls.

Energy: Two stylized facts about energy generation have held for some time. One is that the bigger you go the lower your capital costs and cash costs. The second is that coal (and high carbon emissions) are cheapest and best. TMM think this is unraveling fast, firstly due to super-efficient combined cycle gas turbines but perhaps even more so due to the efforts of Bloom Energy. Solar is getting a nice run based upon how cheap it is getting but distributed and scalable gas generation from solid oxide fuel cells is getting pretty silly cheap too.

This poses another really tricky question: if you look at retail power prices for most places the $/kWh bakes in a lot of maintenance capital expenditure on power lines, cables etc. But what happens when power usage starts to go off a cliff because major point users of power go for their own production on site? Well, you get the Bloomberg subscription model problem: as people get fired, you have ot charge more per subscription to get cover your fixed costs. And that to TMM makes grid companies and the conventional grid sound like things that could be due for a major shakeup. Utilities as defensive? TMM are not so sure in the longer term, and it’s that kind of “she’ll be right mate” complacency that is the source of the worst portfolio management accidents.

Finance: If everything gets moved onto exchanges by regulators, what would Interactivebrokers not be able to do better than most investment banks? Indeed.


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Thorium238 said...

forgive me if this has been said before; as i see it there are 3 theme reasons for why we are where we are in Europe in no particular order:1 the politicians still do not understand or are so scared of the electorates that they don't want to risk going to the next and obvious stage of Union. 2 Germany is behaving like any other sensible Euro sceptic anglo saxon country and saying; yes we will help but only when "you" have put your house in order and when it's in our national interest to do so; given that they will have to pay this seems reasonable to me, and clearly Mangler dosen't think we are there yet. 3 Germany has realised that Eurozone does not work as it is waiting for it to self destruct so it can walk away either to a new Dmk or narrower Euro of fiscal and money policy like minded economies, now here is the big leap, could this explain why the Bundesbank (sorry i mean ECB)is so reluctant to get involved?

Either way the outcome is binary and if you really must have a position, volatility is telling you "make mine a small one please"

Lemmiwinks said...

distributed and scaleable?
why does something have to be distributed if it is scaleable?

abee crombie said...

agreed on the Highstreet.. especially in China and other EM countries. Internet leaves the middle man in a tougher spot..

Momo stock picking still works, IMHO

Charles said...

As far as energy and "She'll be all right mate" is concerned, the real nasty surprise could be that we realize that we actually have to scoop out CO2 from the atmosphere. Current costs for that kind of remediation are estimated at 200$ a ton. If the corresponding liability is allocated to CO2 emitting power producers, even if one is a super-efficient-fuel-cell-of-the-future-powered utility, one is broke. This is asbestos^100.

Jim said...

The OECD has Leading Indicators All Pointing Down


"Composite leading indicators (CLIs) for September 2011 continue pointing to a slowdown in economic activity in most OECD countries and major non-member economies. Compared to last month’s assessment, the CLIs point more strongly to slowdowns in all major economies. In Japan, Russia and the United States the CLIs point to slowdowns in growth towards long term trends. In Canada, France, Germany, Italy, the United Kingdom, Brazil, China, India and the Euro area, the CLIs point to economic activity falling below long term trend."


Charles said...

The beginning of this post reminded me the classic quote of Keynes
"Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."

Guys (and maybe Gals), if you are only fair-weather pilots, are you really worth 2 and 20 ?

Secret--Sauce said...

Stampedes can also have positive outcomes. I can remember one in particular that led to the end of festival seating, albeit at a very high cost. But then there are those like 2008 - nothing to say and nothing to hear. Let's just pray, we won't get fooled again.

Just to play devil's advocate, on retail I would point out that that meme has been atwitter for at least a decade. To be sure, Amazon has laid low many a big box retailer and book store, but I would be reluctant to take the story to its logical condition: That retail will be completely placed by the Borg. For starters, there is some portion of the population that will not buy online. Second, many of those that will need to touch and feel the products at a store first and then look for a price online.

Thus, while thus far the analysis has (rightly) focused on online cannibalizing the retail channel, at some point it's important to recognize that there is also a symbiotic relationship; the absence of retail would hurt online sales.

Therefore, the issue is entirely one of price, i.e., not "Sears is worthless," but "what is Sears worth"? I suspect in the stampede to throw retail in the dustbin of history there will be value to be found.

At any rate individual stocks and sectors can fun - index ETFs are soul-suckers. But that's just my opinion, I could be wrong.

Anonymous said...

"A couple of years back we adopted the ethos of only worrying about things we could change, which actually led to a less depressing life and a new liberation."

Very well put... sometimes I feel like the black guy in the green mile, carrying all the worlds economic policy failures on my shoulders, trying to absorb the diseases and create a better world.

Chris of Stumptown said...

Cpmppi reminds me of Franklin Roosevelt's "Arsenal of Democracy" address.

Cpmppi: "Though last spring was and then last summer was, NOW is the time for action."

FDR: "Let not the defeatists tell us that it is too late. It will never be earlier. Tomorrow will be later than today. Certain facts are self-evident."

Personally, I don't see much that interests at current prices. My guess is that they may be very different in 12 months. So no reason to invest, spend time at the beach instead.

Chris of Stumptown said...

Q: why distribute and scale both
A: IP communications has too much lag with too much handshaking.

Anonymous said...

Does anyone else get the feeling the stock markets are expressing unwarranted trust towards European leaders?

I mean the bonds are tanking... And we get this:


ECB is literally determined to kill Euro. I can't believe we're ruled by these morons.

Secret--Sauce said...

Just watched Brian Eno on Colbert - great show. But Team Macro Mod, Secret Affair? Seriously?

Polemic said...

Im sorry secret-sauce, Mod we were not, but that does not mean we will stand back and have the undoubted stupendousness of the film Quadrophenia ( we trust you have seen it) or even the anthemic "time for action" by Secret Affair questioned or sullied in anyway on these hallowed pages ..

you aren't related to secret affair are you secret sauce?

Leftback said...

Sounds like Macro towel-chucking by TMM. Not that single stocks aren't an amusing diversion, of course. But isn't this typical of range trades? Usually we have the summer doldrums but this year it was different. Relax, things will start making sense again at some point. Tell you what, though, a lot of people have taken their ball home and are done for the year, absent big moves or obvious catalysts...

Secret--Sauce said...

The secret sauce has indeed been spread far and wide, but guys on Vespas typically do not fall within the splatter pattern.

That said, we did feign a fondness for Erasure to please a filly or two as a young man but nowadays the old man got all the money.

Polemic said...

Not towel chucking by us LB, in fact the towel chucking appears to have been today by a lot of balance sheet books in European "everything" bonds. Even Finland!

Its more a resignation that just that the constant debate about europe has become so binary ( as thorium says above) that there is little discuss apart from the "will they, won't they". European bonds melt, equities have got bored of that game already and FX appears to give no more than one hoot about it either.

French spreads may have blown out but actual yields in 10yr france are only back to their normal levels of spring/summer. If it's internal spreads that matter then we have another reason to model this as fannie/freddy 2008 vs USTs redux we have mentioned before.
Agree that its wind down period now.
bored with it all and want a break

Amplitudeinthehouse said...

TMM, you find'em , and I'll try and time'em...don't about the fats cats, theres always Happy Valley.

Anonymous said...

USD poised for major move, equities oblivious. We could be On Like Donkey Kong.

Nickolai said...


Illustration to your point on retail