Tuesday, August 07, 2007

(Dis)location, (Dis)location, (Dis)Location

Attention US equity market peoples: if you haven't already noticed, you are experiencing a capital dislocation event. This (as you must already have seen) is not about the level OF the index, but the relative levels of what is INSIDE of the index. It is spelled d-i-s-p-e-r-s-i-o-n, and if you have not already been run over by it, then you are probably pursuing a dysfunction investment strategy, with an extremely low sharpe ratio, and BOTH LOW expected return, coupled enormous FUTURE tail-risk.

As described in my previous post, Q3 2007 to-date has seen the complete decimation of value and price-sensitive factors at the expense of growth, revision, surprise, and price-momentum based factors, BOTH on the tails and within the cross-section. What this means is that the better the short-term expectations AND (and this is the most important "AND") the higher the however-framed p4ice momentum, the greater the return (and vice-versa). So, things with lower quality AND low momentum (irrespective of valuation, and, in fact in spite of it) the more it seems to go down.

In my previous post I hypothesized why this might be so using a flight-to-quality and bad-beta framework implying aggregate distaste for co's whose earnings have a higher sensitivity to market-wide earnings and similar infatuation for those uncorrelated , typically aliasing high, growth, high earnings momentum, positive earnings change etc. which are hypothesized to be more sensitive to the rate of discount which, in the markets estimation, has been newly determined to be staying put, at worst, removing hypothetical uncertainty as to the present value of a dollar of optimistic future earnings.

But there is a another possibility, and I think it perhaps more likely. SOME VERY LARGE FUNDS ARE IN THE PROCESS OF DE-LEVERAGING/LIQUIDATING (EITHER FORCIBLY OR VOLUNTARILY), THE NAMES OF WHICH WILL BECOME APPARENT TO ALL SHORTLY. This means that they are having to buy-in their shorts presumably a combination of expected under-performers, most likely from the realm of the shitty, the overvalued, the large cap & cap-weighted ETFs or all the preceding, and sell/puke those generally smaller-cap alpha-generating things that are "cheaper" or exhibit characterstics of value that are likely to yield positive relative return in the future, AND THEY ARE SELLING THEM WITHOUT RESPECT TO PRICE OR VALUE BECAUSE THEY HAVE TO, either because investors have asked for their money back, or to meet margin calls elsewhere, or because their lenders have pulled their lines, and so on.

Make no mistake: This is a liquidation event, and it is of a magnitude much larger than seen in 04, 05, 06, or early 2007, and rapidly approaching that of 2002. While GS/Mark Carhart's $10 bn Alpha fund was down 8% in late July, IT IS LIKELY THAT THE LOSSES FOR HIS AND SIMILAR FUNDS IN AUG TO DATE WILL STAGGERING BY COMPARISON.

For those under-leveraged and under-exposed, this will be opportunity. For those investing in the typical beta fund with concentrated smaller-cap longs versus ETFs, with any kind of value bias, there will be no exit. The response by the end investors - particularly HNW retail who for the most part are absolutely clueless about risk, and generally feedback trading, the will be redemption PANDAEMONIUM as knaves digest the realization that oh-so-much is, in fact correlated to credit, and that their loss-tolerance is, contary to bluster and swagger, very small indeed.

Anyone care to take a guess or two as to "WHO" precisely is getting waterboarded by the market??!?


Anonymous said...

Fabulous blog (though I don't always understand all of your posts as your intelligence must be at least a standard deviation above mine)

I'm not completely convinced yet that this is the big dislocation you see it to be. Clearly some players are seen to be naked as the tide is going out, but I don't know how deep the silliness reaches inside some of these funds. Is the studipity really that far-reaching? I tend to think that we may see a correction in the S&P in the 15% range, but anything larger requires a significant ecomomic change. And the economy, at least for now, is weathering the housing decline.


James said...

Hey Cassandra,

I think you are 100 percent correct about whats going. The carnage is the small caps is massive. I'm seeing stocks literally collapse 40-50 percent in an hour for no real reason other than a massive arbitrage trade between small and big caps is blowing up in a lot funds faces. Check out MFLO yesterday. Apparently GS Global Alpha had backed tested there strategies for months with the use of a crays super computer and had concluded that VAR was infantismal for the fund to ever have a draw down of more than 12 percent in year. Something is very very wrong and there is a lot more risk than most people understand.

Anonymous said...

Can you recommend any book(s) to gain a better understanding of the quant content (factor returns, etc.) in your posts?
Frank White

"Cassandra" said...

James... What's a nice boy like you doing playing around in piece-'o-crap like MFLO?

Semi-stable, low-or no-growth with negative revisions are 10x fwd earns (and dropping like a stone. But things with growth and surprise and short-interest like (ISRG, AMZN, BWLD, CROX, GMCR, NILE)
are as expensive as they've ever been.

Call me a conservative dweeb, but I'd rather own a lowly leveraged grocery-anchored REIT like CDR earning a steady 10%, than things at wonderfully sexy things at 50x 2009.

Frank - Use the links on the site to wander round the quant guys as some offer good insights. Also, use the bilbiographies of the most cited academic papers and spend time reading them carefully. I've personally learned most of sensitivities (adn hence attention) the hard way - by getting slammed for ignoring r discounting risks or thinking I'm "hedged", only to get blind-sided.

The real problem in blindly hedging such risks is that the risk that will bite you in the future, will almost certainly NOT be the risk that kicked your ass in the recent past. And perhaps the only way to guard against such hidden, not-yet-seen risks is to be Andy-Grove paranoid and dream about risk-factor-sheep...

Charles Butler said...


The scenario you describe has folks not only dumping long positions, but buying back their index hedges. Might this be behind the apparent panic buying we see at certain slightly low-ish levels of the s&p, for example?


"Cassandra" said...

CB - the market is a big place. No doubt there is BOTH. Most vicious index short-covering have been iin R2000, but since many use ETFs as short whipping boy, trade unwinding sees sale of smallercap longs and cap-weighted buy-ins. Last2 days have seen vicious bi-polar squeezing in many of slaughtered shorts, but also continued jamming of high-momentum, high short-interest names (see CNQR NILE GMCR DEL). In Japan, the same is being seen with the shittiest and most-shorted names by foreign hedgies/IB prop books getting goosed for no reason. Profitable exits are rarely so disorderly. Puking and demand for liquidity is the reason. Goldman's Alpha fund denied its unwindin, but that doesn't mean their not deleveraging and they certainly wouldn't tell anyone if they did.

Many funds have quarterly/45-day notice periods, which mean 15 Aug. is deadline. I wonders whether some of it is overtly predaotry to trigger redemptions from competitors.

M.A.S said...