Quant-ry
Today, even as J-Pow (who replaces J-Yell) is grilled over the partisan coals, the melt-up in Bitcoin remains the major focus of the financial world. Why would anyone pay attention to dreary Senate Fed confirmation hearings when they are too busy opening a Coinbase account and choosing a cold wallet solution? The value proposition of blockchain, like the value proposition of the internet back in 2001, is being indiscriminately being priced into the cryptocurrency market at an astonishing rate.
Financial innovation is the focus of a new land grab, and the first mover advantage is huge. We can worry about valuation later. Bitcoin is a strategic asset.
Meanwhile, back in asset management land, active managers are still struggling to regain the ground lost to passive index strategies . The recent recovery in active market performance is a minor victory after a long stretch of underperformance that resulted from fund managers' tilt towards "value" based and "growth-at-a-reasonable-price" strategies. Passive portfolios still dominate fund flows. Uber is ordering driverless Volvos, while investors are buying driverless portfolios.
As shown below, traditional alpha factors have been a drag on relative performance in this cycle. The charts are relative performance lines of the "momentum" factor iShare ETF relative to both "value" and "growth" factors. Except for the Trump election head-fake a year ago, the winning trade has been momentum.
How can a strategy that is seemly derived by investing like a dog chasing its' tail be winning? Don't valuations matter? Are valuations and earnings irrelevant? Is Amazon EVER gonna report a profit ??
For answers, we have to go back to the heyday of active management in the 1990's when investors paid attention to things like estimates, and more particularly estimate revision and earnings surprise. Quant-based strategies dominated the active management landscape as accessibility to computer generated data on earnings estimates improved and were translated into models that shaped a generation of analysts and PMs. I have always argued that quant doesn't "work" in the tails of the cycle. This part of the cycle has not been friendly to the earnings model-based crowd.
In the latest Financial Analysts Journal (I'm still reading them!), an article by Feng Gu and Baruch Lev argue that the efficacy of earnings-based models has been diminishing for years. They argue that because corporate earnings are not adjusted for the creation of "strategic assets" the income statement is not the place to look for guidance on stock performance.
The type of assets that Netflix, Google and Amgen have created are good examples. The capital spent to create these assets must be expensed in the current period, while the "value" of these assets are realized over a long period. The earnings of these companies are less important to investors than the metrics of 'subscriber growth', 'click-through rates' and 'IP portfolio pipeline'. 'Strategic assets' are the new 'estimate revision'.
Tesla and its' rock-star CEO Elon Musk is the poster boy for aggressive risk taking and the creation of disruptive strategic assets. The stock couldn't care less about earnings as it steamrolls over the value-obsessed hedgies like David Einhorn who have been short for years. Although the shiny-coin tricks of self-landing rockets and "insane" sports cars reminds me of the price-to-press-release era in the dot-com boom, it's hard to dismiss the game-changing success of Tesla. In bull markets, sometimes we need to check our brains at the door and just buy.
Combine that with the low interest rate, tight risk premia environment fomented by the 'risk-put' of dovish central bankers and you have the makings of a sustainable bull market in the pricey companies that have dominated over the last four years. No wonder quant managers have struggled as they wait for their out-dated models to be rewarded. I believe it will take a blow-off and subsequent bear market cleansing for the momentum preference to abate. Godot may arrive sooner.
So as the yield curve slowly sinks into the flattest shape in years, and the economy chugs along, we are cautiously staying with the momentum trade. The FED can only control the front end of the curve. The ECB and BOJ have the long end in their control. What could possibly go wrong? Stay tuned.
Risk Model: 4/5 Risk On
Last week saw a recovery in the Junk bond market that prompted a quick reversal in the AAII Bull/Bear ratio to the positive. The only fly in the ointment is the elevated RSI of the $XIU, resulting from the recent surge in energy stocks and strong bank performance. Oil looks like a crowded trade, with the widely telegraphed OPEC agreement looking like a sell-on-news event and seasonality is still negative.
The bank earnings parade kicked off by $BNS on a down note (ouch!!) as trading profits disappointed. In Canada, more choppy sideways trading is likely. Tax loss selling and profit-taking is likely before a Santa comes down the financial chimney to rally the market.