Insight

The US markets display classic sell-off and recovery patterns

From April to July most equity markets were in decline before the big sell-off of August.  The exceptions were the large US indices (S&P500, Dow Jones and the Nasdaq) which traded sideways over this period before also selling off.  The subsequent August to November movements illustrate the three month cycle that Camomille models.  While we don’t aim to predict the peak before the sell-off, we are confident that once a sell-off occurs, we can map the recovery thanks to our in-depth understanding of human behaviour and how numerous biases can affect the trading behaviour of market participants.

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Month 1: Sell-off

The sell-off for all markets was sharp and generally lasted about a month to the end of August before retracing 50% of the decline.  The various reasons and explanations for the sell-off are incidental to our strategy.

Month 2: Consolidation

This was followed by a somewhat volatile yet range bound period of a month.  The consolidation was shocked somewhat by the Volkswagen scandal at the end of August but a combination of loss aversion and the ability of investors to ‘rationalise’ the pain of the initial sell-off predicated market consolidation.

Month 3: Recovery

Finally two months after the first signs of the sell-off, the markets retested lows before recovering into the third month.

By the end of month three (November) a recovery was seen in all markets although the extent of this recovery varied by region.

A global view

With the exception of the Russell 2000 (small cap index) the other US indices (S&P500, Dow Jones and Nasdaq) all regained beginning of August levels, shutting out media narratives regarding China growth concerns and the future of US interest rates

European and EM indices followed the same sell-off, consolidation and recovery time pattern as the US but only recovered 60% of the decline in the third month.

 

Sell off, consolidation and recovery pattern of markets, August 2015

SPX Index (S&P 500 Index) INDICE


Is there any trend in the speed of market recoveries?

Camomille’s strategy is based on the sell-off, consolidation and recovery pattern of markets with each stage taking approximately a month.  A question we are regularly asked is whether technology, high frequency trading or QE have impacted the speed of recovery.

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Using the 14 global equity indices we include in our model and data from 1980 to 2014, we have studied how long it takes for markets to recover following a sell-off (typically being a fall of between 5% and 10%).

How many markets recover in two or three months?

First of all we looked at what percentage of markets recover to the level of the prior peak by our buy and sell dates (being on average two and three months after the fall).

Recoveries to buy and sell dates
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For both series, recovery time has remained consistent, with an average of 38% of markets recovering within two months and 54% recovering within three months.

Stability of recovery days

Next we looked at the stability of the recovery days over time.  The graph below shows the average recovery days of those markets that did so by our buy and sell dates.

Average days to recovery for those that recover within 2 and 3 months
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Once again there is no significant trend since 1980 in recovery days, despite various technological advancements, development of high frequency trading and the introduction of QE.

Evolution of recoveries

Finally we looked at the evolution (5 year increments) of how markets recover over our cycle.
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On average 54% of markets recovered within three months varying between 40% and 65% depending on the time period.  Significantly there is no trend over time to this pattern.

Conclusion

In conclusion we have established that recoveries over the two and three month time periods have been consistent since 1980 with no evidence of a trend change, and as such there is no evidence that technology, HFT or QE has had any impact on these recovery times.

Should you require more detailed analysis where we expand our recovery parameters, include the 1970’s and split results regionally we would be pleased to provide.  Please email [email protected].


The risk and rewards of diversification

Regardless of how financially sound a company is or how strong a reputation it has, it is not immune from single event shocks or unsystematic risk.

In September, Volkswagen’s cheating of US emission tests resulted in the stock plunging 45%. Occurring at what was a sensitive time for markets this led to a global contagion with the DAX being impacted by 8% and the MXWD by 6%.

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Whilst the indices have largely recovered Volkswagen still lags significantly. The magnitude of this fall demonstrates the dangers of concentration. Diversification is normally positive but in Volkswagen’s case its global diversification is negative since the problem product (‘emissions’) is not diversified. Although the issue arose in the US the fact that the problem is global makes it financially serious.

In June, Nestlé suffered serious reputational risk as noodles manufactured and sold in India were alleged to have excessive lead content. In this situation Nestlé SA fell 8% and the SMI 6%. These recovered to previous levels.

The difference between these two companies, which both operate in over 150 countries, is that Nestlé has over 2,000 brands covering almost every food and beverage category compared to Volkswagen that has only 12 brands, all of which are vehicles with ‘emissions’.

We have no doubt Volkswagen will survive this unsystematic shock, as has BP plc, following their oil-spill in 2010, but it highlights the dangers of single stock risk.

At Camomille in building our portfolio we seek to diversify as much as possible, thus eliminating unsystematic risk and spreading systematic risk. We use equity indices to reduce single stock risk and allocate our risk globally between developed and emerging markets to reduce country and regional risk. We further diversify equity systematic risk by incorporating a commodity component (gold and oil).

Systematic & Unsystematic Risk Chart


CFA UK Behavioural Finance Conference 2015

The CFA UK inaugural behavioural finance conference was well attended, unsurprising given the growing interest in behavioural finance and its applications within investment management.

The behavioural bias mentioned by every speaker was overconfidence, with heavy referencing of work by Daniel Kahneman throughout. Arman Eshragi of Edinburgh University included a quote from Kahneman that were he to eliminate one single behavioural bias, it would be overconfidence.

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There were various intriguing examples of overconfidence provided, most interestingly perhaps from Benjamin Kelly at Blackrock who discussed the narrow confidence intervals we all exhibit with wild guesses, never mind experts making predictions or forecasts on their specialist subjects. Arman Eshragi produced academic research suggesting past performance, particularly good performance, boosts active share in the following period, suggesting overconfidence. His research also found solo managers with a 3% higher active share than teams.

Priming and herding were also covered, with Colin McLean, CEO of SVM, providing an interesting example using a fan chart of Bank of England inflation forecasts. It showed that regardless of current inflation, forecast inflation has been persistently centred around 2%. As well as evidence of anchoring, perhaps this also provided evidence of herding (or groupthink). Benjamin Kelly used a very interesting example of the tendency of analysts in morning meetings to make their forecasts or predictions relative to the first forecast provided by the group, resulting in clusters around that first prediction.

Colin McLean quoted Dunning (2014) “Humans process information in a way that not only reflects beliefs, but also reinforces them”, cutting to the core of behavioural finance. As Emily Haisley from Barclays Wealth mentioned, the key to avoiding behavioural biases is by empowering what Daniel Kahneman labelled our analytical, slow System 2, to control for our instinctive, fast System 1, leading to better choices and ultimately better outcomes.

Benjamin Kelly noted this process of correcting for biases involves evaluating our processes rather than our outcomes. The best example is stock-picking. Writing a checklist of why we have bought a stock, and sticking to these principles when deciding subsequent action, can help us make more informed choices. Whether the investment makes or loses money is not as important as whether we conducted the correct analysis. Emily Haisley spoke of the importance of removing reference point dependence and loss aversion (prospect theory). By asking ourselves the question “If I were to invest money today would I buy this stock” it removes the shackles derived from our cost price, and the fear of crystallising losses. Long term, good processes lead to good outcomes.

Perhaps the most interesting trend I have observed from these conferences and talks is from the questions posed by the audience, specifically cultural implications. On each of the last two occasions, the questions have surprised the speaker. This is evidence of the growing interest in cultural relevance in behavioural finance, which we at Camomille see as important.

For further information about Camomille’s research in this area read our research paper Evolutionary Psychology, Neuroscience and Culture here.


Seasonality: Why it can make sense to ‘Sell in May and go away’

“Sell in May and go away” was first coined over 50 years ago in the FT and is discussed and thought about every year by many in the market. Its validity as a strategy varies depending on the motives of who is arguing it and the assumptions behind treatment of costs, dividends and interest.

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What is certain is that if you take any index the gross returns in the December to May period will exceed those in the June to November period. Bouman and Jacobsen (2002) in The Halloween Indicator, “Sell in May and Go Away”: Another puzzle found evidence of this going back 300 years.

Although not the case every year a quick look at markets this year shows the saying to hold.

At Camomille where we run a strategy that seeks to maximise the time value and utilisation of risk we cannot ignore that it is optimal to rebalance risk from the summer period to the winter period. For this reason in the summer period we reduce the size of our long positions by 30% and increase the size of our short positions by 10% to improve risk adjusted returns.

Seasonality blog


‘Fear index’ added to model capturing times of greatest stress

Camomille has successfully traded the VIX futures contract since its introduction over 10 years ago. Many fantastic opportunities existed in the term structure of the contract allowing medium dated term trades to be entered into for zero and exited for up to 2 points with low overall risk. Changes in the shape of the curve and high margining has made the previous return profile less attractive though.

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However using the concepts developed in our systematic model, mapping the sell-off, consolidation and recovery pattern of markets, we find that the movement in the VIX is not only as predictable after a sell-off as equity indices but historically even more profitable.

Why

  • The VIX is a fear indicator. Although the negative correlation between the S&P and VIX is significant its beta is low. When the S&P sells off it is certain that the VIX will rise, however the magnitude of the rise is digital. A 5% fall in the S&P can create either a 30% move in the VIX on one occasion or a 60% move on another. On average the VIX moves 5 times as much.
  • The VIX is mean reverting. Once the S&P has sold off it can either stay low for a longer period of time or recover. The VIX however will quickly revert back to lower levels in both instances.
  • The term nature of the VIX contracts gives significantly positive carry by going short.
    The execution of the VIX trade typically happens earlier in our cycle so represents an efficient use of capital and spread of risk.

In our modelling we find that the win ratio for VIX trades is 75% versus 60% for the S&P, with the expected size of the recovery from the VIX some 3 times greater and potential profits per trade 8 times superior.

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Richard H. Thaler: Misbehaving

Given the contribution of Richard Thaler’s work in researching our strategy at Camomille, the enthusiasm for his new book, Misbehaving was exceeded only by the opportunity to attend an interview with the man himself at The Royal Society of Medicine.

Thaler began by recalling some stories that laid the framework in his mind for questioning classic economic theory, in particular the assumptions around human decision-making.  Initially he made a list of apparently erroneous behaviour, without a clear idea of what it meant, or what to do with it.  It wasn’t until he came across Daniel Kahneman and Amos Tversky that he realised much of the work they were doing at that time on Prospect Theory explained his ‘list’ of behavioural anomalies.  Biases such as loss aversion, mental accounting and framing appeared to fill in his gaps.  A long collaboration followed that would provide the foundations for a huge rise in the reach and popularity of Behavioural Economics, establishing a legitimate, coherent challenge to the  assumptions that had been the foundation of economic models to date.

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Central to Thaler’s narrative is his antipathy for ‘Econs’ as he calls them; fictitious individuals that exist in economic models, but not in the real world.  Behavioural Economics would serve to replace ‘Econs’ with actual people.  The primary difference between ‘Econs’ and ‘us’ is  that whilst we are subject to emotions that warp some of our behaviour leading to conventionally irrational decision-making, ‘Econs’ do not suffer in this way.  They are unemotional, perfectly rational and able to assess with total precision the utility to be gained from any given decision or choice they make.

The discussion progressed from economic theory to the broader, practical successes that have emerged from a more accurate understanding of how individuals actually perceive choice and how they make decisions.  His greatest achievement has been the overhaul of pensions in the US, where automatic enrolment and the prompted option to sign up to automatic future contribution increases has led to more effective savings behaviour; individuals are far more prudent when it comes to future decisions than they are with decisions today, much like starting a diet next week, or giving up smoking next year, both of which are far easier than committing at present.

He was also keen to clarify that he is not a supporter of automatic organ donor enrolment, contrary to popular belief, instead promoting the virtues of prompted choice.  He highlighted the issue with the former, in that the family still needs to be consulted after death, and they would now have no idea whether the donor in question actually wanted to be a donor at all, or was just automatically enrolled.  Making such decisions at such a traumatic time is suboptimal to say the least.

He also discussed the human propensity to overweight small outcomes.  A trait insurance companies capitalise on to the tune of $27bn a year in the US via extended warranties.  His advice was simply: “Don’t buy extended warranties!”

More recently Thaler has been involved with the Behavioural Insights Team which has been assisting the UK government since 2010, further evidence that the relevance of Behavioural Economics reaches far beyond finance, and will become a critical tool to policy makers in addressing issues ranging from healthcare and financial stability all the way to social inequality

For further information on Camomille’s study of Behavioural Economics or the implications of the field on our investment approach, please email [email protected].


Gold added to Camomille’s model

To further enhance the risk return profile of our investment strategy, we have added gold to the investment universe making it the second commodity to feature, together with our oil allocation.

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From 1975 when gold was free to float and daily pricing available it has returned some 4.8%pa with much volatility and many years trading below previous highs (notably 1980).   In our model we expect gold returns of some 6% (before any leverage we apply) and without the huge drawdowns.  It has achieved this by avoiding the market during the long declines but still capturing upside.

Governed by behavioural biases such as ‘herd mentality’, the responsiveness of gold to our sell-off, consolidation and recovery cycle has been high with a win ratio of 66%, sortino ratio of 1.5 and volatility less than 10%.  As well as being a good source of alpha in terms of these ratios additional benefits are further diversification of our model incorporating a larger commodity component to complement the existing equity allocation.  The result is a lower correlation to equity markets and no correlation to CTA trend following funds.

Gold captioned-Camomille


FT Camp Alphaville

It was without surprise that the agenda at this year’s Camp Alphaville was changed at the last minute to incorporate a panel on Greece.  While temperatures soared to see the hottest July day on record, consensus was icy, with a managed exit perhaps the best scenario for Greece in the long term. There was also little enthusiasm for the future of the Eurozone itself given the inherent issues these events have uncovered. The only winners were seen as being parties like UKIP and their promotion of Brexit.

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Next, Steve Keen looked at the importance of debt to GDP as a warning sign of financial crashes, a measure he accuses governments of ignoring, instead focussing on inflation and unemployment.  He argued that capitalism drives an endless cycle of de-leveraging followed by leveraging, with booms and crashes unavoidable, advocating a shift from a debt to equity based economy. He predicted a China crash within two years.

One of the liveliest discussions of the day was between Dan Crum and Daniel Yu from Gotham City Research who advised that short-selling is not necessarily being pessimistic about a company but rather being “optimistic about justice”.  From Gowex to Quindell, Yu highlighted that it’s his intellectual curiosity that drives his research before revealing Myriad Group as his next subject, which at the time of writing was down 30%.

Shamed Enron CFO, Andrew Fastow talked about Business Ethics (ironic). He covered his role in the Enron saga, proceeding to examine how tricky ethics can actually be and uncovering many accounting shenanigans still being pulled by some of the biggest corporations in the world. He also used a clever story about a group of ethics graduates which showed just how malleable people’s ethical principles can be.

Overall, speaker consensus at the event was negative. Little hope on Greece and Europe, pessimism over China, and a fundamental flaw in how government’s monitor and intervene in economies. On top of that, a rather sobering insight into flawed accounting regulations, complex rules, and their part in encouraging unethical behaviour by humans who ultimately cannot resist bending the rules for personal gain or to single-mindedly appease shareholders.

It came as little surprise that the most optimistic speaker all day was the professional short seller.