Growth & Momentum Everywhere

March 26, 2015

In 2009, Clifford Asness, Tobias Moskowitz and Lasse Pedersen published a paper titled “Value and Momentum Everywhere”. The rationale behind their analysis was simple – value bias investing generates returns that are lowly, or even negatively correlated with a “momentum” style of investing. Value investors invest in stocks that are fundamentally cheap, whereas momentum investors allocate capital on the basis that what has gone up should continue to go up. Diversifying your portfolio across stocks exhibiting a value profile and those that have had strong momentum behind them will likely generate better risk-adjusted returns than investing in either of these styles in isolation. The sweet spot is in finding stocks that combine both styles. This is perhaps why Apple has been a hedge fund darling for so long; it has been showing lower than average cash flow, earnings and sales multiples when compared to competitors and the broader market while enjoying a powerful momentum that has propelled its share price up by a factor of 25 in 10 years.

Intuitively, this approach makes sense – if a stock is cheap and starts to go up, perhaps it is on its way to correct its cheapness. If this is the case, it should outperform its peers and the broader market once this is corrected for. In addition, financial practitioners know that sources of diversification in equities are rare, and anything that lowers the risk of one’s portfolio while keeping its expected return constant is worth having. In combining value and momentum, a portfolio manager can have his or her cake and eat it too, in theory.

Sadly, this beautiful concept finds substantial limitations in everyday investing. We find that value as a style works well, but only if the investment window reaches several years – at least according to professor Robert Schiller at Yale.  He argues that the minimum window of value investments should be 8 years, with better results for those willing to invest over a period twice as long. Besides, value only offers a long-term premium when applied to very small stocks as pointed out by Israel and Moskowitz at AQR Capital, a large US-based asset management firm run by Asness himself.

Along with Kent Daniel, a scholar at the Kellogg School of Management, we find that the growth style of investing combines much better with momentum than with value to generate excess returns. Consider this, a portfolio of the stocks that rank highest according to momentum and value metrics has generated 100 bps of excess performance over the S&P500 in the last 10 years. This, however, comes with a larger maximum drawdown of -55.5% vs. 52.6% for the S&P500. By contrast, a growth and momentum portfolio of 10 stocks has beaten the S&P500 by an average of approximately 18 percentage points per annum over the same period. This also comes with a lower maximum drawdown (-41.8%).

Beyond the real-world shortcomings of combined value and momentum investing, at MONOGRAM we believe that the prism through which Asness and his colleagues look at these issues is indicative of the faulty way the financial community addresses these issues. We believe that drawdown, and not volatility, is the true measure of risk. This is because our investors care much more about the risk of losing a large chunk of their capital (“drawdown risk”) than the day-to-day capital markets turnings (“volatility”). With no offense to Mr. Asness, since combining value and momentum reduces the volatility of a portfolio without reducing its drawdown risk, it is of little practical interest to us. Momentum does that alone, as an enormous amount of literature has repeatedly shown, and we see little upside in polluting its benefits by combining it with a value filter.


Should we fear a strong US Dollar?

March 18, 2015

Towards the summer of 2014, the US Dollar, measured against a trade-weighted basket of currencies, started to rally. Fast-forward 9 months and this move has become parabolic, with US currency trades at a 12-year high and on course to record its best quarterly return since 1992. Part of this strength is attributable to the weakness of two of the US’s main trading partners – Japan and Europe. Both the Bank of Japan and the European Central Bank are in the midst of a massive-scale money printing program, a combined $120bn-a-month exercise, whose goal is to stimulate growth and boost exports through the depreciation of their own currency. In contrast, the US Federal Reserve has indicated that it might be considering an increase in interest rates, thus making dollar-denominated assets relatively and increasingly attractive.

Yet at 0.24% for one year, the yield on US government bonds is hardly mouth-watering. But in a world flirting with deflation this is almost as good as it gets for a safe asset since, according to JPMorgan, approximately 16% of global government bonds with maturity higher than 1 year trade at a negative yield. Buy a Danish or a Swiss bond and you are sure to get less than what you paid for when they mature. From a currency standpoint, American assets are therefore attractive. However, since a strong Dollar is an impediment to the competitiveness of US businesses, investors have reduced their US holdings mostly in favour of European assets. According to Merrill Lynch, the cumulative flow out of US equities has amounted to $50bn so far this year. Unsurprisingly, European equities have outperformed US equities by no less than 16 percentage points in 2015.

This rationale makes sense on paper, but as Thomas Huxley, a British biologist contemporary of Darwin once said – “the great tragedy of Science is the slaying of a beautiful hypothesis by an ugly fact”. This holds true for the hypothesis where a strong US Dollar is bad for US equities since a simple regression of monthly US stock returns against the performance of the US Dollar since 1980 shows that American equities trade completely independent to the performance of the Dollar. While it is true that the recent past (the last 3 to 5 years) shows a degree of negative correlation, two time series can be strongly negatively correlated while evolving in the same direction. This is what has happened to the USD and US equities – they have both gone up. In another exercise, we observed the average annual performance of US equities against that of the US Dollar by quintile and see results that are completely consistent with previous findings.


Asian borrowers in trouble

March 13, 2015

With the US dollar trading close to a 12-year high, over-leveraged Emerging Market currencies look very vulnerable. This is because Emerging Market financial assets (read debt levels) have approximately doubled since 2008. Asian countries in particular have pilled foreign debt at an accelerating pace with the year-on-year debt growth for the Asian block now reaching 35%.

From the perspective of an Asian investor, leverage makes sense. Borrowing large amounts of money in a depreciating currency means less capital to pay back at maturity. And low interest rates (US rates have been close to zero for 6 years) make for negligible interest payments. Asian countries have gorged on this bonanza and the jury is out as to whether this is going to result in a painful indigestion.

The moment of truth might be near. The US dollar is powering ahead as the US Federal Reserve (the “Fed”) has indicated that its next monetary policy move will be restrictive, not accommodative. The Fed is remarkably lonely here as 9 countries have lowered their main interest rate since the beginning of the year already.  Yesterday again, the Korean Central Bank reduced its key rate to a historical low of 1.75% and the Chinese are considering a similar move. With comparatively fewer dollars and more of other currencies in the system, the value of the greenback has to go up.  This is exactly what is happening, and this is happening quick- the USD trades 10% higher than at the end of 2014.

At MONOGRAM we are staying away from Emerging Market stocks, since a forced de-leveraging caused by a strong dollar will certainly translate into substantial downside in domestic equities. But should the going get tough, these assets will probably trade low enough to present a bargain. Until then, we prefer the safety of the US market.


Euro capital flight could be good news for North America and the UK

March 12, 2015

This week the European Central Bank started its Quantitative Easing Program (“QE”), which boils down to an attempt to increase the amount of money in circulation while lowering interest rates, thus, on paper, boosting the economic activity of the region. As QE means more Euros in the global system, the Common Currency should underperform its peers. This debasement process has largely been anticipated by financial market operators, who have been selling the Euro and buying European stocks en masse. At time of writing, the Euro is 11% lower than at the beginning of the year, while European stocks are 14% higher.

Meanwhile European corporations as well as households have accumulated large balances of cash since 2008, which sit idle on account rather than being recycled back into the economy for productive usages. This, in turn, is a reflection of various structural effects, including the aging of the European population:  older people generally enjoy higher savings because they have accumulated more wealth than younger people. Increasing inequality also pushes the average savings rate up, as Keynes teaches us that propensity to consume is lower for richer people.

The pressure is mounting on these large cash balances to find a better home than European assets, which become less attractive by the day compared to foreign bonds, stock and real investments. This is because QE means that foreign currencies are likely to increase against the Euro while foreign assets in general, and bonds in particular, generally offer a better yield than domestic ones. Good European “signatures” such as the German government or the best corporations, already borrow at zero percent or even less (“lend us EUR 100, we will give you back EUR 100 in 10 years”), and with a massive new buyer in town these rates have little chance to increase any time soon.

The outflow or European money towards foreign assets (mostly bonds) has started (EUR 300bn over the last three months, net), and is accelerating. Deutsche Bank estimates that no less than a net EUR 10 trillion (yes, EUR 10.000 billion!) should exit the Eurozone by the end of the decade. In practice, this means that for every 10 Euros of wealth created, approximately 1 Euro will be sent abroad.

Where is all this cash going? Mostly to bonds in the US, Canada, and to a lesser extent the UK. Over the long run, this means (even) lower bond yields in these countries, and perhaps higher equity valuations. These jurisdictions are therefore better off for European QE too. In the meantime, investors looking for a bargain should stay clear of European bonds, where the upside is almost inexistent and where currency risk is high.