Thursday, 28 June 2012

Mind Of The Market II: All-Is-Well Syndrome, A Habit Of Misplaced Hope

In a chaotic world, a barrage of mirages can, sometimes, be confused for reality. In an environment of sustained negative developments and events, it seems somewhat paradoxical for misplaced hope to find an audience.

The second part in the Mind Of The Market series (Part I, here) will focus on recent elections in Greece and France, and the culture of all-is-well and misplaced hope that pervades market participant positioning. Paradoxically even as mainstream media resonates with negative undertones, participant actions paint another story.

Greeks came, voted a second time, and all seemed well. Again. For a disaster seemed averted. Greeks avoided Tspirageddon and offered the reins to a pro-bailout coalition led by New Democracy and PASOK, to steer them through the new phase in a never-ending saga.

The flight of deposits that had begun from Greek coffers into banks in stronger EU countries (run-rate approx. EUR 800 mm per day) seemed like a costly hedge to those that prudently went through the process. Money started trickling back into Greek banks, post elections and 'clarity'.

All is well.

Or, is it?

When The Mouse Garnered More Attention Than The Elephant
June 17, 2012 was a big day for voters. While global media and market participants were transfixed on developments in Greece, fretting about the possible victory of Tspiras' Left; a potentially far more important election transpired in France. Surprisingly, few seemed to notice, or care.

30-day search volume, a rough proxy for 'mindspace':

There was a collective sigh of relief when Left-centric Alexis Tspiras' Syriza lost to Right-leaning opponents in Greece. Over at France, the Socialists, under Francois Hollande, managed to achieve an absolute majority. Unlike Greece, where New Democracy had to jostle with PASOK to put together a government, France achieved a significant Socialist-dominated leadership, unlikely to face major opposition in implementation of policy.

In another queer development, a Party promising anti-austerity was voted to power (France), and a Party promising anti-austerity was shown the door (Greece). 

The Promise Of The Impossible...

A quick summary of Francois Hollande's election campaign agenda is insightfully oxymoronic.
  • Anti-austerity and growth-stimulating platform 
  • Reduce French budget deficit to 3% next year (current deficit: 4.5%) and eliminating it by 2017, although no clear road-map was enunciated. The Finance Minister insisted that targets would be met 'without austerity'
  • Reduce retirement age from 62 to 60 years
  • Creation of 60,000 new teaching jobs over the next 5 years 
  • Raise minimum wage by more than inflation and make it tougher for businesses to lay off workers
New jobs shall be created, working hours slashed, wages raised, lay-offs are tougher, pro-spending policies figure prominently; and yet, budget deficit is expected to be on the way down. Market participants seem to be placing an inordinate amount of faith in Hollande's ability in pulling off this Supermanesque feat of reconciling mutually exclusive objectives.

Hollande's pro-spending/stimulus stance is more likely to increase deficits than to decrease it. Especially, when the levers that would contribute to slashing the deficit are weakly understood. The whispering debt meter is likely to grow louder with time.    
...Yet Hope Runs High: France, A 'Safe' Haven

A look at market participant attitudes towards France over June is illuminating. Despite the slew of dark clouds on the horizon, largely thanks to the political impossibilities propounded by Hollande, market participants gleefully lapped up new bond issues by France. Reuters news runs:
French bond yields hit record low at auction - Jun 7, 2012

French yields fall at debt auction, demand firm - Jun 21, 2012

Yield on France's 50-year bond, due in 2060, fell to 3.27%. This was down from 3.34% in Nov '10, when the EU crisis was less intense than the present day. In the first bond auction after Hollande's Socialists assumed power, market participants accumulated new French bond issues. Bid-to-cover (a measure of participant demand) ran at close to 2.5x.

Yields began touching new lows (bond prices and yields move in opposite directions) and new issue appetite was healthy. When little had changed for the better and with the path of least resistance still pointing to more pain.

Hope floats eternal.

All is well.   

Greece: The Lair Of Liars & Wonders Of Short-Term Memory

While slightly dated, the chart captures the pre- and post- Euro situation in Greece. The (susiciously) reducing deficits leading up to Euro adoption reversed post-adoption. Much of this could be attributed to the benefits of cheaper sources of financing (common currency). Debt piled on and Cindrella had a ball. Until the party ended.  

Rumbles From The Past: Greece, 1990s
Barring a brief interlude in the early 1990s, PASOK - a Party associated with unbridled populism, a love for spending and tolerance for corruption - was at the helm of affairs throughout much of the 1990s and early 2000s, a critical time as Greece proceeded to adopt the common currency. In 2004, Greece admitted that it had fudged accounts to gain access to the Euro. Of course, that PASOK had presided over Greece when this activity was underway was deemed unworthy of mention. 

Voters exhibit an odd sense of history. Few remember, or question, the true reasons for their present quagmire but selectively remember the PASOK-promoted pay rises that they were beneficiaries of. Self-interested, rational beings indeed. Unsurprisingly, now, this same group is expected to lend support to their decades-old rivals - New Democracy - in forming a government and in steering Greece through trying times.

The Greece stock market roared its approval on pre-election rumours of pro-bailout faction assuming power.

Inertia Of Lying
Ahead of the critical EU Summit over the next few days, the Greek Prime Minister miraculously goes down with an eye problem, while nausea incapacitates the Finance Minister. Replacements shall make their way to the Summit, requesting renewed assistance from the EU powers-that-be.

The health 'issues' are likely to recur, at appropriate moments in this dynamic drama.

But, all is well.

A Habit Of Misplaced Hope

Time to gauge the pulse of the market. One would be forgiven for thinking all was indeed, hale and well. For a major disaster (Euro-imperilling government in Greece) was averted. All was/is, of course, well with France.

Cross-asset class behaviour leading up to Greece and France elections:

Risk-off sentiment prevailed generally, as market participants dived for cover in US Treasuries and bought protection to hedge against events in Europe (widening European CDS). Risk-off posturing continued with equity markets around the globe sauntering flat-to-down. Commodities reflected the sentiment, with dual-personality Gold being bid, even as Oil and Copper were shunned.

Post elections?

Built-in pessimism morphed into hope. The unwind began, as participants cycled out of US Treasuries, European CDS tightened and equities were bid. Oil and Copper continued to signal something amiss but few paused to ponder. The most significant change manifested in Volatility, which compressed materially post the weekend election events, a sign of return to 'normalcy'.

To sum up, little has changed for the better in the weeks post-elections. If anything, woes of varied character and intensity continue to confound Spain, Italy, Greece, France and Germany. This union is in disunion; on banking union, fiscal union, political union. The form of the Euro-wide bailout fund, European Stability Mechanism (ESM), remains shrouded in indecision and no clear path exists. Meanwhile, voices for Euro-defection and bailout requests (classic Game Theory responses) have picked up.

Market participants learnt all about tail-risks in the aftermath of the subprime crisis and Lehman Brothers. Few years since, tail-risks do not seem like tails anymore. The Black Swan event now would be a miraculous cure to the world's ills, or, the more likely outcome; the emergence of a new Order.

Until then, all is well.   ?

Monday, 11 June 2012

Mind Of The Market - I : Pavlovian Conditioning, Paradoxes & The Psychology Of Herding

In what should evolve into a multi-part series, Mind of the Market will endeavour to peer under the hood of the largest laboratory of human psychology in the world; the financial markets. Where frigid numbers and emotive participants spar enthusiastically in an elaborate and often bewildering drama-in-motion. Where apparitions and reality merge so finely as to be mostly indistinguishable. Where paradoxes and circular relationships reign supreme, frequently, and fervently, questioning the very essence of rationality and cause-and-effect.

Part I addresses the dynamics of Pavlovian Conditioning and market participant response to stimuli in investment decision-making. Intriguing paradoxes and the behaviour of asset prices - a cause (and consequence) of market participant response - is considered concomitantly. Finally, the psychology of herding closes Part I.

Pavlovian Conditioning and Asset Price Behaviour
When Ivan Pavlov discovered his lasting contribution to humanity - Classical Conditioning experiment on dogs - humankind was probably offering years of daily corroboration of the phenomena of Conditioning. An excerpt of the key theme of his study:
Conditioning is usually done by pairing the two stimuli, as in Pavlov’s classic experiments. Pavlov presented dogs with a ringing bell followed by food. The food elicited salivation, and after repeated bell-food pairings the bell also caused the dogs to salivate.
The table below broadly aggregates typical market participant response to event stimuli (information, emotional state and expectations):

Equities and commodities chime along lock-in-step, while sovereign credits adorn the character of a recession/bad news asset class ('safe' havens). Gold appears a near all-weather choice that is spurned during good times. The broad matrix, by no means sacrosanct, reasonably captures market participant psychology to macro stimuli.

Some Intriguing Paradoxes 

The Psychology Of Buying - Sovereign Credit

Mountain of Debt + New Debt = Increasing Debts-appeal
Amidst the ebb and flow of the financial crisis, new debt issued by USA, with a burden already as big as its GDP (and rising), has found enthusiastic buyers. Over the past two decades and change years, US’ debt grew 6-fold even as GDP grew 3-fold. Debt is now nearly 100% of GDP versus 50% in 1987. Back in 1987, US 10-year Treasury yielded 9.5% and inflation (CPI) was 4.5%, for a real return of +5%. Cut to the present, US 10-year Treasury yields were close to multi-century lows (c.1.5%) recently, while inflation (CPI) was c.2.5%, for a real return of -1.0%. 
Despite mounting debt burden and negative real yields, market participants gravitated towards US Treasuries. Negative real yields can be somewhat tolerated if there is a reasonable chance of greater depreciation in the currency of the marginal foreign buyer (if, say, a foreign investor makes (!) -1% by way of real yield and the US$ appreciates 6% relative to her currency, she would make 5%). 
Foreigners added ~$650 billion to their US Treasury holdings between Mar-11 and Mar-12 for negative real yields and since they hold close to half of US Public Debt ($11 trillion Public Debt, $15.7 trillion Total Debt, at last count), it is instructive to enter the mind of a foreign buyer, to discern their thinking.

Foreign holders of US Treasuries are exposed to risks on two fronts, (a) asset risk (risk of principal repayment and negative real yield) and (b) currency risk (US$ depreciation). The two largest foreign holders of US Treasuries - China and Japan - suffer from low/no real coupon and a gaping abyss if and when the US$ depreciates relative to their currencies (ignoring US insolveny risk, to keep things sane). The JPY is already feeling the heat thanks to JPY appreciation; while the Yuan, owing to the managed peg, has managed to stave off the eventuality, for now. But a gradual appreciation looks likely, for various reasons, and were it to materialise, these foreign buyers will be minus some big notes from their Treasury chests.

In the past, at the first signs of 'risk', the JPY, CHF, Gold and sovereign credits found many seeking shelter. In a vastly changed world today, similar protection is being sought. Ironically, in the shelter with the weakest foundation.

Classic Pavlovian Reaction overlaying rationality.

The Psychology Of Selling - Equities
Beneath the macro stimuli lie camouflaged several layers of micro stimuli that impinge on participant emotions and asset prices. Daily/Weekly/Monthly economic data releases, quarterly earnings reports and a host of other information trigger Pavlovian Responses in market participants; who, akin to Pavlov's mongrels that were befuddled by cause and effect; cause gyrations in asset prices bearing little relevance to actual intensity of the stimulus.

A quarterly earnings report below expectations often triggers selling in the company stock, even if the quarterly timescale bears little relevance, either to the longer timescale, or to the long-term dynamics of the underlying business. Among the higher order reactions to this earnings miss might be sympathy selling of companies in the same business (extrapolation of the reasons behind Company X's woes to Company Y), and a bump up in price gyrations.

Fed with data minutiae, often by the minute, market participants feel a compelling urge to act out (disseminate) incoming information. A quarterly GDP growth, or a quarterly earnings, print coming above/below market expectations gnaws at participants, and sightings of their emotional response can be found in the behaviour of prices. That these numbers, highly questionable in some markets, and subject to ex-post revisions, trigger multi-order reactions is intriguing. 

Instances of Pavlovian Reactions often trouncing rationality.

The Psychology Of Multiple Personality Disorder - Gold
For a wonderfully insightful example of rapidly altering human risk perceptions, it is illuminating to cast some light on the behaviour of Gold over 2011. Grave signs of multiple personality disorder was witnessed in Gold, which was one of the few asset classes that closed the year on a celebratory note.

1H 2011: Gold rose as sovereign debt worries escalated
2H 2011: Gold fell as sovereign debt worries escalated…further 

Even as fear escalated over August through December 2011 on resurgence of EU sovereign crisis, Gold suddenly seemed to have fallen out of favour. What was being hoarded on the premise of fear was now being sold, when the same reasons were available in greater supply.
It was roughly a year in two halves for the Yellow Metal. The first half, where it held allure to market participants as an inflation hedge/doomsday investment; while in the second half, this relationship broke down as Gold began tracking market expectations of Central Bank Quantitative Easing (a.k.a money printing).

At some point in the flowing continuum of emotional reactions, perceptions tipped; the stimuli had changed. Expectations of, or the absence of, quantitative easing began guiding market participant perceptions towards the yellow metal. As expectations for further rounds waned, so did interest in Gold. Recently, possible reopening of monetary spigots instilled some vigour in Gold.

The Psychology Of Herding
From being conditioned to dive into the seemingly soothing arms of sovereign bonds in time of duress, to selling earnings misses (and buying earnings beats) in equities, to flipping commodities on the near-term prospects of economies; herding represents one of the most innate characteristics in market participants inhabiting the financial landscape.

Being social animals, the evolutionary urge for tacit acceptance by the majority is a compellingly strong force. Apart from acceptance, the social fallout of being in the wrong while in minority further assists in the building of crowds. The prospect of quick profits while chugging along with the many instills a sense of comfort. Pavlovian Responses are, sometimes, a necessary appendage in this scheme of things.

Trend-followers, algorithms or otherwise, attuned to picking up these developments seek to exploit the power of the herd, before everybody else. Being alone, as a trend-follower, is a wondrously alluring prospect but, unfortunately, a mutually exclusive possibility. The trend follower, additionally, is an implicit Long on the persistence of the prevailing bias.

The enthusiastic herding into sovereign credit today, as a reaction to fear, has driven real yields in several geographies into negative territory. A few years down the line, when the world appears a little different from today, where interest rates would have likely ticked up from today's historically low levels; a host of market participants might awaken to the true meaning of the word 'safety'. 

Another typical Pavlovian Response in the face of catastrophe would be likely at this point - denial.

Thus, at the court, both great and small
Behave alike, for all ape all.
– Jonathan Swift, Excerpt from The Logicians Refuted

Sunday, 3 June 2012

The Correction (& Persistence) Of Anomalies

During dreary journeys across the market landscape scouring for interesting opportunities, the investor occasionally stumbles upon an oasis. Of extreme anomaly. The sighting is generally a mirage, a ray of false hope; but in some instances, the manifestation is very real and extremely intriguing, especially so when the anomaly manifests across companies operating in the same business.

The anomaly was first highlighted here ('Over-priced anomalies in bear markets'), when discussing One Life Capital Advisors (Bloomberg: OCAP IN). Extreme pricing is generally either an outcome of mass euphoria/fear, or a flock of informed market participant presence. OCAP IN seemed to be in the latter category. The post also highlighted the case of peer, Brescon Corporate Advisors (Bloomberg: BFS IN), as an example of under-appreciation. 

For brevity, the scheme of things as on the date of writing (Dec '11) is reproduced:

Such cases of extreme pricing always pique my interest. The situation seemed too far removed from reality. Diligence corroborated my hunch on OCAP IN's ridiculous pricing, and it corroborated my hunch of under-pricing in the case of BFS IN.

A mid-market focused investment banking, debt restructuring franchise with a reasonably long history of operations and respectable brand value seemed to be completely unloved. The company small size ($3.5 mm market value) and low liquidity were partly the reasons. Competition from investors scouring this market segment is limited and severe anomalies sometimes manifest, as a result.

BFS IN was available for far less than its cash and liquid investments (including equities), even after allowing for diminution in carrying value of these investments. Essentially, market participants were assigning no value to the business, a relatively reasonable operating history; a clear anomaly. 

As sentiment picked up in the first quarter of 2012 on the back of renewed FII inflows, stocks of under-appreciated companies come under the spotlight. BFS IN benefited from this surge in sentiment and currently trades at a market value of c.$7 mm, a 100% gain in a few months. The current market value is equal to its cash and liquid securities. Market participants continue to assign little value to either the business or its franchise, which is reasonably strong in its focus area. The margin-of-safety has since compressed but the example illustrates the minimal force that is sometimes required to effect a meaningful correction in anomalies.

On the other hand, the persistence of over-pricing is another intriguing aspect. OCAP IN continues to enjoy a market value of c.$70 mm - 10x BFS IN's market value - which, given its competitive standing, operational history, franchise value, business size, makes for an Alice in Wonderland situation. Shorting isn't the easiest in India but even if one could, the wait and weight of pain would be excruciating.
The principal risk in unloved companies is (1) questionable numbers/management, (2) the absence of a catalyst that could allow restorative forces to act with rigour. (1) is within the realm of known-unknowns and can be tackled to a reasonable degree. (2) is more sketchy. Sometimes, the catalyst takes so long materialising as to be virtually useless for value emergence. The catalyst in this case was an uptick in sentiment. But insisting on fat discounts to true worth allows leeway for unknown-unknowns that might afflict the company under consideration.

I'm watching this one closely, as I continue on my journey across the market landscape.