2008 Year End Thoughts Going Into 2009
THE FOLLOWING ARTICLE DOES NOT CONSTITUTE A SOLICITATION TO INVEST IN ANY PROGRAM OF CERVINO CAPITAL MANAGEMENT LLC. AN INVESTMENT MAY ONLY BE MADE AT THE TIME A QUALIFIED INVESTOR RECEIVES CERVINO CAPITAL'S DISCLOSURE DOCUMENT FOR ITS COMMODITY TRADING ADVISOR PROGRAM OR DISCLOSURE BROCHURE FOR ITS REGISTERED INVESTMENT ADVISER PROGRAMS. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
Given hindsight, my commentary from the end of 2007 now seems quaint when I wrote: “The long and winding year of 2007 has come to a close... In the annals of trading, this is one ‘vintage’ that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.”
Unfortunately, any hopes for a calm year was dashed back in January. 2008 is not a year on which even the most hardened veterans of the market shall look back gladly—it has turned out to be an Annus Horribilis. And as we approach the start of 2009, I can almost hear the sigh of relief of many for whom this December 31st could not come any sooner. Indeed, we have witnessed an unprecedented global meltdown of the financial system and experienced massive wealth destruction in these turbulent twelve months.
Nevertheless, in this storm Cervino Capital Management LLC managed to post a positive year for the Diversified Options Strategy keeping true to this programs mandate of absolute returns. As of the end of November 2008, the D1X program is up 2.94% and the D2X levered program is up 7.43%. And although our year-to-date performance is currently less than desired, for most of this year until the market crash in October, our rolling twelve month rate-of-return was above our stated objective.
This is no small feat given that many CTA option programs this year suffered through significant drawdowns greater than 50%, and some are no longer even trading. Our understanding is that many CTA option programs, even now, are sidelined waiting for the historically volatile market conditions to settle down.
Meanwhile, our more beta exposed investment advisory portfolios were not so lucky and while they generally outperformed the benchmarks and held very well for 3/4 of the year, they eventually cracked with everything else in this dramatic autumn. The relatively stable performance of the Diversified Options Strategy is therefore striking in the context of such a ravaging bear market, where no asset class was spared and practically no strategy worked.
So much for Modern Portfolio Theory… just ask the much praised Harvard University Endowment. Then again this is what bear markets do: wholesale asset price destruction. It is interesting to note that bear markets will do more damage to your portfolio than wars—just look at a long-term chart of the Dow. But more on asset performances and expected return later…
What makes this bear more ferocious and treacherous to trade than any other meltdown since the 1930s is in the way our capital markets became dysfunctional during this crisis. The Fed and the Treasury (and most of their counterparts around the globe) have been engaged in massive interventions via standard monetary policy decisions, quantitative easing, capital injections in an effort to stop a seemingly unstoppable predicament.
While I do not believe they had much of an alternative, such conduct (and the possibly avoidable lack of consistency) has created recurrent unintended consequences, many of which we will not even face until years from now. This environment of uncertainty has had the additional destabilizing effect of making markets practically untradeable and even more dysfunctional. One day we can short, the next we can’t; one day the Treasury will buy a certain asset class, the next it will not; and so on…. not an environment conducive to improved functionality and liquidity in the global markets.
As mentioned above, the alternatives to these policy choices were practically non existent but in the long term we may be seeding more problems than solutions. I have argued in previous writings that hyperactive monetary policy such as the one implemented by the Federal Reserve Bank in the last fifteen years is highly correlated with the increasing frequency as well as the increasing size of financial crises.
Is the tail wagging the dog? Quite possibly…
The obsession of the Fed and most politicians to erase the business cycle is the direct cause of this hyperactive monetary approach. However, if the result of trying to eliminate mild but recurrent recessions (frankly, a necessary and not so negative part of an efficient economic system) is the creation of cumulative imbalances that threaten the system at its core, then perhaps a different approach may be appropriate.
For more on my views of this topic, see "A New Qualitative Capitalism"
But enough about the past—what should we expect going forward? The current situation makes it extremely hard to forecast as we are not even sure exactly what kind of economic system we are going to operate in going forward: capitalism, socialism or statist? This is a question that no Western country has had to face in almost 40 years, and yet today it is at the core of an investor long term strategy.
I wrote extensively on the kind of new qualitative capitalism that I would like to see flourishing after this crisis, but I doubt I will get my wish. For the moment we are clearly going thru a socialistic phase rather unavoidable given the collective missteps of our bankers, leaders, and let us admit it, the “average Joe” at large.
While most pundits have been likening these times to those of the Great Depression, I think we are beginning to look more like Japan—a sad, long deflationary nightmare. Perhaps this is how all “fiat” economic systems must end. I am no fan of the gold standard but there must be a price to pay for unbridled credit creation and the promotion of a standard-of-living greatly superior to the long term rate of growth of GDP.
The bond market seems to agree with the Japanese analogy and it recently went parabolic from an already overpriced level. I have occasionally tried to take the other side of this trade in the past few months. My belief was that even in the event of a Japanese scenario, one systemic variable was completely different—the Japanese ran a trade surplus and most of their debt was held internally while we are in the opposite position.
On the positive side, we have another difference: the U.S. has historically been a more dynamic socio-economic system, and unless we forget completely our entrepreneurial spirit, we might just be able to turn things around a bit more quickly. However, such a quicker turn-around would likely spell “inflation emergency” with all the dire consequences for bondholders.
Another explanation for the parabolic moves of the bonds (especially the 30 year) might be clever alchemy from Ben and Hank. Lets say you were to triple your debt load, and at the same time control interest rates, would you not also try to massively reduce the cost of money? In the real world, if a creditor triples its debt/equity ratio its cost of servicing such debt would go up percentage wise and in absolute numbers. However, if you are the U.S. government you can drive interest rates down artificially to refinance your debt long term. Seemingly, the typical rules don’t apply to the world’s reserve currency.
The U.S. is able to pull this off by getting the Chinese to play along. And despite all protestations, they seem happy to oblige considering the massive capital gains they are being gifted with for their old positions.
All the same, going forward the yield on U.S. debt is not attractive, which typically results in a weaker currency. But since the Chinese renmimbi is practically pegged to the dollar, it too will be devaluated, which in a deflationary environment is not such a bad thing (especially when you don’t have to take the blame for it, when oil is at a 5 year low, and you are the low cost producer of the world and want to stay that way). Furthermore, with yields so low, this will allow Hank and Ben to make a nice little (well not so little) profit on all those preferreds they bought from the banks which pay around 8%.
And to think the U.S. sent Martha Stewart to the jailhouse for insider trading, go figure…
As far as equities, this 2008 was a landmark year in terms of exposing the limitation of equities as solid beta components of long term investment/savings accounts. While I do expect equities to perform much better in the next ten years than in the past ten, I also believe that 2008 was the year that the “buy and hold” mantra was finally killed.
This “black swan” data-point, in my view, changes the return expectation of this asset class in general, and it does so within the context of a much worsened volatility profile. What seems clear now is that the long term viability of a passive equity portfolio depends solely on a favorable valuation of the asset class in general—the more undervalued equities are, the longer the affordable time horizon the investor has, and the more passive he/she may be. On the other hand, the higher the valuations, the more active portfolio management must be. This relationship is direct and accelerates at the extremes points of valuation.
Beta portfolios and passive indexing as increasingly perpetuated by the industry have massively failed the test of reality. I believe investors will have to resort to a much more active asset allocation and /or to a much smaller equity allocation. And this does not take into consideration a secular shift toward socialism which would imply a significantly reduced forward return-on-earnings in equities.
Not to get too sour, a bright spot next year might end up being real estate. The convergence of steep price reductions in the last 18 months, the cumulative efforts of all government agencies to reduce mortgage rates and possibly alter the price discovery process of this asset class in general, and a surfacing interest by foreign buyers may just be that needed energy to stop the bleeding sooner than expected.
With respect to option trading, we think that as 2009 evolves, actual volatility will start to settle down while implied volatility will remain high for a longer period of time. This is an optimum environment for volatility arbitrage using options. And after 2008, we could all benefit from quieter markets. In the least, any unexpected turns in the market will not come as such a surprise after Annus Horribilis.
- Davide Accomazzo, Managing Director
Given hindsight, my commentary from the end of 2007 now seems quaint when I wrote: “The long and winding year of 2007 has come to a close... In the annals of trading, this is one ‘vintage’ that will be remembered for some time as the year re-introduced the concept of investing risk and volatility. Unfortunately, some trading programs didn’t survive, and surely, the remaining players are breathing a sigh of relief.”
Unfortunately, any hopes for a calm year was dashed back in January. 2008 is not a year on which even the most hardened veterans of the market shall look back gladly—it has turned out to be an Annus Horribilis. And as we approach the start of 2009, I can almost hear the sigh of relief of many for whom this December 31st could not come any sooner. Indeed, we have witnessed an unprecedented global meltdown of the financial system and experienced massive wealth destruction in these turbulent twelve months.
Nevertheless, in this storm Cervino Capital Management LLC managed to post a positive year for the Diversified Options Strategy keeping true to this programs mandate of absolute returns. As of the end of November 2008, the D1X program is up 2.94% and the D2X levered program is up 7.43%. And although our year-to-date performance is currently less than desired, for most of this year until the market crash in October, our rolling twelve month rate-of-return was above our stated objective.
This is no small feat given that many CTA option programs this year suffered through significant drawdowns greater than 50%, and some are no longer even trading. Our understanding is that many CTA option programs, even now, are sidelined waiting for the historically volatile market conditions to settle down.
Meanwhile, our more beta exposed investment advisory portfolios were not so lucky and while they generally outperformed the benchmarks and held very well for 3/4 of the year, they eventually cracked with everything else in this dramatic autumn. The relatively stable performance of the Diversified Options Strategy is therefore striking in the context of such a ravaging bear market, where no asset class was spared and practically no strategy worked.
So much for Modern Portfolio Theory… just ask the much praised Harvard University Endowment. Then again this is what bear markets do: wholesale asset price destruction. It is interesting to note that bear markets will do more damage to your portfolio than wars—just look at a long-term chart of the Dow. But more on asset performances and expected return later…
What makes this bear more ferocious and treacherous to trade than any other meltdown since the 1930s is in the way our capital markets became dysfunctional during this crisis. The Fed and the Treasury (and most of their counterparts around the globe) have been engaged in massive interventions via standard monetary policy decisions, quantitative easing, capital injections in an effort to stop a seemingly unstoppable predicament.
While I do not believe they had much of an alternative, such conduct (and the possibly avoidable lack of consistency) has created recurrent unintended consequences, many of which we will not even face until years from now. This environment of uncertainty has had the additional destabilizing effect of making markets practically untradeable and even more dysfunctional. One day we can short, the next we can’t; one day the Treasury will buy a certain asset class, the next it will not; and so on…. not an environment conducive to improved functionality and liquidity in the global markets.
As mentioned above, the alternatives to these policy choices were practically non existent but in the long term we may be seeding more problems than solutions. I have argued in previous writings that hyperactive monetary policy such as the one implemented by the Federal Reserve Bank in the last fifteen years is highly correlated with the increasing frequency as well as the increasing size of financial crises.
Is the tail wagging the dog? Quite possibly…
The obsession of the Fed and most politicians to erase the business cycle is the direct cause of this hyperactive monetary approach. However, if the result of trying to eliminate mild but recurrent recessions (frankly, a necessary and not so negative part of an efficient economic system) is the creation of cumulative imbalances that threaten the system at its core, then perhaps a different approach may be appropriate.
For more on my views of this topic, see "A New Qualitative Capitalism"
But enough about the past—what should we expect going forward? The current situation makes it extremely hard to forecast as we are not even sure exactly what kind of economic system we are going to operate in going forward: capitalism, socialism or statist? This is a question that no Western country has had to face in almost 40 years, and yet today it is at the core of an investor long term strategy.
I wrote extensively on the kind of new qualitative capitalism that I would like to see flourishing after this crisis, but I doubt I will get my wish. For the moment we are clearly going thru a socialistic phase rather unavoidable given the collective missteps of our bankers, leaders, and let us admit it, the “average Joe” at large.
While most pundits have been likening these times to those of the Great Depression, I think we are beginning to look more like Japan—a sad, long deflationary nightmare. Perhaps this is how all “fiat” economic systems must end. I am no fan of the gold standard but there must be a price to pay for unbridled credit creation and the promotion of a standard-of-living greatly superior to the long term rate of growth of GDP.
The bond market seems to agree with the Japanese analogy and it recently went parabolic from an already overpriced level. I have occasionally tried to take the other side of this trade in the past few months. My belief was that even in the event of a Japanese scenario, one systemic variable was completely different—the Japanese ran a trade surplus and most of their debt was held internally while we are in the opposite position.
On the positive side, we have another difference: the U.S. has historically been a more dynamic socio-economic system, and unless we forget completely our entrepreneurial spirit, we might just be able to turn things around a bit more quickly. However, such a quicker turn-around would likely spell “inflation emergency” with all the dire consequences for bondholders.
Another explanation for the parabolic moves of the bonds (especially the 30 year) might be clever alchemy from Ben and Hank. Lets say you were to triple your debt load, and at the same time control interest rates, would you not also try to massively reduce the cost of money? In the real world, if a creditor triples its debt/equity ratio its cost of servicing such debt would go up percentage wise and in absolute numbers. However, if you are the U.S. government you can drive interest rates down artificially to refinance your debt long term. Seemingly, the typical rules don’t apply to the world’s reserve currency.
The U.S. is able to pull this off by getting the Chinese to play along. And despite all protestations, they seem happy to oblige considering the massive capital gains they are being gifted with for their old positions.
All the same, going forward the yield on U.S. debt is not attractive, which typically results in a weaker currency. But since the Chinese renmimbi is practically pegged to the dollar, it too will be devaluated, which in a deflationary environment is not such a bad thing (especially when you don’t have to take the blame for it, when oil is at a 5 year low, and you are the low cost producer of the world and want to stay that way). Furthermore, with yields so low, this will allow Hank and Ben to make a nice little (well not so little) profit on all those preferreds they bought from the banks which pay around 8%.
And to think the U.S. sent Martha Stewart to the jailhouse for insider trading, go figure…
As far as equities, this 2008 was a landmark year in terms of exposing the limitation of equities as solid beta components of long term investment/savings accounts. While I do expect equities to perform much better in the next ten years than in the past ten, I also believe that 2008 was the year that the “buy and hold” mantra was finally killed.
This “black swan” data-point, in my view, changes the return expectation of this asset class in general, and it does so within the context of a much worsened volatility profile. What seems clear now is that the long term viability of a passive equity portfolio depends solely on a favorable valuation of the asset class in general—the more undervalued equities are, the longer the affordable time horizon the investor has, and the more passive he/she may be. On the other hand, the higher the valuations, the more active portfolio management must be. This relationship is direct and accelerates at the extremes points of valuation.
Beta portfolios and passive indexing as increasingly perpetuated by the industry have massively failed the test of reality. I believe investors will have to resort to a much more active asset allocation and /or to a much smaller equity allocation. And this does not take into consideration a secular shift toward socialism which would imply a significantly reduced forward return-on-earnings in equities.
Not to get too sour, a bright spot next year might end up being real estate. The convergence of steep price reductions in the last 18 months, the cumulative efforts of all government agencies to reduce mortgage rates and possibly alter the price discovery process of this asset class in general, and a surfacing interest by foreign buyers may just be that needed energy to stop the bleeding sooner than expected.
With respect to option trading, we think that as 2009 evolves, actual volatility will start to settle down while implied volatility will remain high for a longer period of time. This is an optimum environment for volatility arbitrage using options. And after 2008, we could all benefit from quieter markets. In the least, any unexpected turns in the market will not come as such a surprise after Annus Horribilis.
- Davide Accomazzo, Managing Director
posted by Cervino Capital Management LLC at 12/22/2008
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