The ASX lays another egg: The case for algorithmic trading

2015 was another poor year for the Australian stock market with the S&P 200 (excluding dividends, at time of posting this article) falling by 3.9% (after a return of only 1.1% in 2014).

The market’s current level is the same as it was back in April/May of 2006! This means that if you have been invested in an index fund over that period, your returns have only been dividends of perhaps 3-4% per annum. It’s a completely lost decade.

You have to feel sorry for people invested in super funds that are largely exposed to the Australian stock market because they are simply not going to have sufficient funds to retire on at those sorts of rates of return.

The commodities boom effectively concealed a lot of the weaknesses of the Australian market which are now becoming very apparent to all and sundry.

While the Australian market is fine for trading, I do have a number of issues with long-term investments in this market, namely:

1.    The market has very few quality companies;

2.    The corollary to the above is that there are a significant amount of listed companies that could only be described as absolute junk (how some of these companies were allowed to list is incomprehensible to me);

3.    The market is very heavily weighted to banks and resource companies – when these sectors do badly their weighting in the market all but ensures the All Ordinaries and S&P 200 will also do badly. You simply can’t allow your financial future to be beholden to the iron ore price and how people are feeling about a few large banks – it’s crazy;

4.    We compensate the executives of these listed companies with world class remuneration packages for (in many cases), absolutely mediocre (or worse) performances;

5.    There is a reasonably high level of insider trading that is very rarely prosecuted, the cases that have been prosecuted concern absolutely blatant breaches of the law by naïve individuals which made their detection very easy;

6.    Australian institutional investors are very skittish, they have absolutely no patience and their highly reactive trading often hurts the market (unnecessarily);

7.    A result of point 6 is that we now have a bi-polar market, we have a few “hot” sectors that people are willing to pay anything for and we have everything else that they want to avoid like the plague. You can only get growth from the “hot” (or faddist) companies, so everyone crowds into these companies, setting the stage for the inevitable bust;

8.    In common with many markets around the world, we have auditors giving a clean bill of health to some companies that are in dire financial circumstances. (All I can say is thank God for litigation funders for keeping both auditors and companies honest, because no one else is standing up for the shareholder in quite the way they do. It’s a very sad reflection on regulators that litigation funders often have to essentially do their job for them);

These days I don’t always expect to make large capital gains, I’m just looking to get a reasonable return through dividends.

The long-term buy and hold approach contrasts very starkly with my algorithmic trading. Some statistics for 2015 on my algorithmic trading are provided below:

 

Annual return	9.39%
Risk adjusted return	17.4%
Winning trades	64.3%
Losing trades	35.7%
Profit ratio of winning trades to losing trades	3.43
Sharpe ratio of trades	0.89

 The table only represents long trades (not shorts) and excludes any dividends received. The risk adjusted return is adjusted based on actual exposure to the market, which in this case was only 54%.

As you can see, it’s vastly superior to the index performance (or the index hugging fund managers).

The program responsible for the above performance is only 51 lines of code. One of the most important components of that code is the trend indicator.

Determining trend direction is notoriously difficult, I tried many different things (all unsuccessful) before somehow developing something that appears to work.

To give you an example, the last long trade for 2015 occurred on 24 June when Ansell (ANN) was bought at an average price of $24.74, this trade was closed on 21 July at an average price of $25.94, a profit of 4.85% (before brokerage) for 27 days (not exactly high frequency trading, but a good trade).

After this trade, the program stopped signalling any long trades, and this was just as well as the market took a very steep dive through August and is yet to recover.

As I write this, conditions are still not conducive for trading long. But that of course is the beauty of the long/short trader, you simply switch to shorting. When conditions change again to favour the long side, I will go back to trading long. I will occasionally have both long and short positions open, but this is rare for me.

I recently attended a presentation given by a long/short fund that has had some reasonable success over the years. The presenter put up a list of the top 10 ASX listed stocks by market capitalisation and said something like: “I feel very sorry for long only Australian fund managers, can you imagine trying to make a profit out of that?”

In global markets, the population growth and industrialisation that fuelled markets for the entire 20^th century will not continue to anywhere near the same extent and this is likely to render buy and hold strategies anachronous and further contribute to the rise of the algorithms.

Blackmores is now an LSD deal

Robert Ringer wrote a book in the 1970s titled Looking out for Number One. The book was unintentionally hilarious in certain parts, but certainly enjoyable, and one thing I do remember was his description of “LSD deals”. This is a business deal that only someone who was taking the mind altering drug LSD would find attractive.

Which brings me to Blackmores (BKL.AX). I have long been a fan of this company, I was buying the shares at around $13.85 back in 2009, you can see the post I wrote at the time here: http://thestockscribe.blogspot.com.au/2009/01/blackmores-and-campbell-brothers-why-i.html

Last Thursday (29 October), Blackmores briefly traded at over $200 per share. Roughly 14 times the average price that I had bought at.

Human psychology is always interesting when it comes to trading markets. Most people are wired to lose money because they simply can’t stop themselves from doing stupid things. They listen to the media, they listen to no-nothing “experts”, they jump on popular fads and they follow the herd. Over time, you are almost guaranteed to lose money doing this.

I’ll put it to you as a long-time Blackmores shareholder (who is now completely out of the company), that most of the smart money has exited the company at current prices. How could they not? How often have you made 11-14 times on your money in the space of 6 years? In all probability, it’s now the real dumb money that is buying the shares. What a wise person does in the beginning, a fool does in the end. Just my opinion.

And it doesn’t matter if Blackmores goes up even further from here, the point is, anyone buying the shares now is playing a very dangerous game because the stock is priced for absolute perfection, one misstep and that share price will plummet like a lead balloon.

When I was buying my Blackmores shares back in 2009, no one wanted to know the company, it was about as popular as dog turd. And that was great, because that is how I make large amounts of money. Now, they can’t get enough of it at insane price levels (may be they are all on LSD, I don’t know).

It’s true that the devaluation of the Australian dollar and the insatiable Chinese buying of their products (mostly by Chinese in Australia, not Chinese in China) has turned things around for Blackmores in a big way. However, the company is now demonstrating a classic reflexive process.

Reflexivity was a concept discussed by George Soros in his iconic book: The Alchemy of Finance. I will quote from this book:

There is bound to be a flaw in the participants’ perception of the fundamentals. The flaw may not be apparent in the early stages but it is likely to manifest itself later on. When it does, it sets the stage for the reversal of the prevailing bias. If the change in bias reverses the underlying trend a self-reinforcing process is set in motion in the opposite direction. What the flaw is and how and when it is likely to manifest itself are the keys to understanding boom/bust sequences.

A couple of years ago, Blackmores’ sales declined dramatically (something completely forgotton now), but make no mistake, at some point it can happen again. But that is the manifestation of the flaw that George Soros refers to in the above quote.

Insurance Australia Group (IAG) and Berkshire Hathaway

There’s been some staggeringly misinformed comment regarding Berkshire Hathaway’s partnership and equity stake with IAG (announced on 16 June 2015). 

Commonwealth Bank analyst, Ross Curran asked Mike Wilkins (IAG’s Chief Executive) and Nick Hawkins (IAG’s CFO) one of the most naively stupid questions I’ve ever heard. He asked whether IAG had given Berkshire 20 percent of its business in exchange for the 3.7 percent equity stake that Berkshire made in IAG!

Let’s get a few things straight.

Firstly, the equity stake that Berkshire took in IAG is completely incidental to the much more important partnership arrangement that the two companies have entered into (they just happen to have been announced at the same time which somehow managed to confuse both analysts and media alike). They could have entered into the latter agreement without Berkshire taking any equity interest in IAG, it doesn’t matter because that has nothing to do with their arrangement. It just so happens that Buffett believes that IAG is a well-run, cheap company with a strong franchise that he was happy to pay $5.57 per share for (and don’t think for one minute that he would buy a stake in any company that he didn’t believe in, no matter what the size of that stake was).

For someone like Ross Curran to confuse this side equity deal with the fee-based partnership arrangement suggests to me that Ross isn’t the brightest analyst we’ve ever seen.  Hey Ross, a couple of billionaires called earlier, they want to buy 3.7% of the Commonwealth Bank and get your Board to give them 20 percent of your profits for the next 10 years– sound like a good deal for the bank Ross? No? Then how stupid do you think IAG are?

For some media outlets like the Australian Financial Review (James Thomson) to pick it up as if it was some great insight is laughable. On the other hand, one of the few analysts who does seem to have had a much sounder understanding of the implications of the deal was Jan van der Schalk at CLSA.

The really important deal was the ceding of 20 percent of IAG’s insurance premium to Berkshire in return for Berkshire paying 20 percent of the claims and also insurance operating costs plus what Buffett described as a large annual payment. In Buffett’s own words describing the payment: “substantial – a payment of a size that virtually no other insurance company in the world would pay, and that we have never paid before.”

Buffett is a person of great integrity, so I would accept his statement. However, because we do not know what the size of that payment will be, we simply don’t know who got the better deal and whether it is earnings dilutive etc. This is actually something that should have been mandatory for both parties to disclose.

The main points are as follows:

·        The equity deal that Berkshire did was completely incidental to the partnership agreement with IAG, anyone confusing the two is displaying their ignorance;

·        Notwithstanding the above point, the equity deal is a huge endorsement of IAG’s management and business model (make no mistake, Buffett wouldn’t touch 99 percent of ASX listed entities with a barge pole and nor should you);

·        IAG is not entering into this deal with Berkshire under distressed conditions (unlike for example Goldman Sachs did during the GFC), so there is no requirement to give Berkshire a great deal;

·        We do not know the details of the payments that Berkshire will make to IAG over the life of the agreement, so any earnings dilution calculations etc. undertaken by pseudo analysts are purely guesswork;

·        Buffett has basically put a floor under the IAG share price at $5.57, if it does go lower, you can buy at less than Berkshire (and personally, I’m happy to);

·        The benefits for IAG are the freeing up of significant capital and greater earnings stability (IAG has made underwriting losses in two of the past five years); and

·        Contrary to what some pundits have written, unless Berkshire never intends on repatriating its Australian dollar investments, it is going to be subject to currency risk.

Traps with CFD Providers: A Cautionary Tale

I was contacted recently by someone who had traded CFDs over foreign stocks for the first time and had an unpleasant surprise regarding the way in which CFD providers calculate the profit or loss on these trades.

Most people would assume that the profit or loss from holding share CFDs denominated in a foreign currency would equate to the result that one would get from holding the underlying physical shares, however, this is definitely not so and can be an expensive lesson to those uninitiated in the ways of CFD providers.

An example will illustrate what I’m talking about.

In Table 1 below, we take the example of someone based in Australia (with an account held in Australian dollars) buying 1,000 shares in a US listed company at $US 50.00 per share. The cost of these shares is $US 50,000 and at the time the trade is entered into, the $A is worth $US 0.78, so the Australian dollar cost is $64,103.

When the trade is closed, the price of the stock has fallen to $US 48.00 per share, but the Australian dollar has also fallen against the US dollar and is now worth $US 0.765. Therefore, the position’s value in Australian dollars is $62,745 and the actual loss in Australian dollars is $1,358 ($62,745 less $64,103). This is the result that would have been achieved if physical shares were being held.

However, the trader holding CFDs, is in for a nasty surprise because their CFD provider simply calculates the trade loss as $US 2,000 ($US 50,000 original cost of the position less $US 48,000 closing value of the position) and then simply converts that loss at the current exchange rate (i.e. 0.765), leaving the trader with a $2,614 loss (or twice what they would have had if they had held the physical shares)!

Back in late 2013, I wrote about a trade I had done in Berkshire Hathaway. Had I been holding that trade as CFDs (which I was not), my profit would have been only 60% or so of the actual profit that I made. So, this is an important concept to understand for those of you who are new to trading CFDs over foreign companies.

Table 2 gives an example of making a $US 2 profit on each share (the opposite of the example in Table 1). Once again, the unfortunate trader has a worse result than he would have experienced had he been holding the physical shares.

 
There are three clear lessons from this:

1.    Holding CFDs over foreign shares WILL NOT give you the same result as holding the underlying physical shares traded on an exchange (if you hold your CFD account in your home currency);

2.    If your home currency is depreciating against the currency in which the foreign share is denominated in, you will ALWAYS achieve a worse result than holding the physical shares (the opposite is true if your home currency is appreciating, your profits will be larger and your losses smaller); and

3.    If you wish to trade CFDs over foreign shares, you may want to hold the funds in your CFD account in that foreign currency to avoid the above issue.

CFD traders would be advised to be very cautious trading foreign CFDs with Australian dollar denominated accounts in the current environment.

The Argo Global Infrastructure IPO

Just a quick post for those of you mulling over the Argo Global Infrastructure IPO. As always, these are my thoughts only and not investment advice.

I don’t have any strong feelings either way about this one. Basically, Argo is lending its name (call it brand) to a fund which will be managed by Cohen and Steers Capital Management. Argo and Cohen and Steers will take management fees and Argo will invest a token $25 million in the fund.

Think of it as Argo under a newish managing director trying to be a bit like Macquarie Bank rather than Argo, and I don’t know if I like it (or if the rather elderly Adelaide shareholder base will like it).

I can’t really see how Argo is adding much value to this process – they are simply acting as middlemen. Argo’s board and the management of the Global Infrastructure Fund have no experience in managing infrastructure assets and that’s why they have outsourced the job to Cohen and Steers.

Global infrastructure is obviously an attractive asset class and there are limited opportunities to get a pure exposure to this class on the ASX. But of course, you only want exposure at the right price!

Looking at the prospectus, Cohen and Steers Capital Management’s record is ok over the last 10 years or so, but you wouldn’t call it fantastic.

The only concerns I would have are that according to the prospectus, 50 percent of the fund’s assets are likely to be invested in US infrastructure securities. With the US markets at record highs and a low Australian dollar against the US dollar, one gets the feeling that this fund would have been a much better idea three or four years ago rather than now (in fact, it would have been a superb idea three or four years ago). However, further declines in the Australian dollar are expected, so perhaps Jason (Beddow) and his argonauts haven’t completely missed the boat, so to speak.

The managers plan to invest all the IPO proceeds in around 30 days. That is slightly off-putting for me. It smacks of investments being made in haste.

There is no mention in the prospectus of proposed dividend levels. This would normally be of paramount importance to Argo Investment’s shareholder base (who presumably would be significant potential buyers). One also presumes that dividends will have limited franking given the offshore source of the majority of the profits, but I’m no expert in this area.

Personally, I won’t be buying in the IPO, there just isn’t enough information there right now to coax me into making an investment. By this I mean, we don’t really know what securities the Fund will be invested in (and I know they can’t spell it out right now, but that simply means potential investors can’t really value the Fund), but more importantly, we don’t know what the distributions will be. These two things are very important, and in particular, the fact that we don’t know what the distributions will be will deter quite a few people.

Positioning for the stock market bubble

Now that the Reserve Bank of Australia (RBA) has successfully created a bubble in the residential housing market, they seem hell bent on creating a bubble in the equities market as well.

With vast amounts of cash still sitting in bank accounts earning returns below the rate of inflation (let’s face it - virtually nothing) and even more pain on this front to come, we are now seeing material amounts of these funds leaving banks and entering the stock market because people cannot maintain their standard of living when a bank will only pay 2.8% on a term deposit.

Cheered on by the RBA, the market is potentially poised to go much higher (before the inevitable pull-back or crash). However, this may not happen until the Australian market is above its peak of 6,800 or so which it achieved way back in late 2007.

When a 10 year Australian Government Bond only yields about 2.7% (equivalent to a price-earnings ratio of 37 times), the stock market should be much higher than it is and if I was a betting man (and I am), I would wager that it’s going higher.

Now, don’t get me wrong, the stock market is not cheap based on fundamentals, it’s cheap as a result of artificially low interest rates which lead to artificial stock market booms (the US has been a textbook example of this over recent years).

At this point of the cycle, I want some fairly meaningful exposure to the Australian stock market, but I also want some level of hedging in place. I can get this exposure through certain ETFs and I have been increasing my exposure on this front.

I sincerely hope that the RBA’s actions don’t ultimately destabilise the entire Australian banking system (and that’s not out of the question, just ask Mr Greenspan about it). The RBA is taking us into dangerous uncharted waters and hoping everything will be ok. As I’ve stated before in these pages, I simply don’t have any confidence in them. I believe their policies are insane and will ultimately reduce the living standards of the average Australian.

But at this point, any possible adverse repercussions from the RBA’s policy settings are some way off. So, I hope to enjoy a bit of a ride in the equities market and then hope I’m prescient enough to exit before the clock strikes midnight and Glenn Stevens turns all those remaining at the party into turds. If I’m not smart enough to exit in time, my short exposures will soften the blow of any crash.

Interest rate cuts anyone?

Christopher Joye wrote a great article very recently in the Australian Financial Review. It perfectly critiques the demented policies of the Reserve Bank of Australia (RBA) and the dire consequences that may eventuate.

Glenn Stevens and his cronies at the RBA are abetted by that bunch of buffoons in Canberra that passes these days as a “Government”. Sadly our Treasurer (Joe Hockey) hasn’t a clue (neither has our completely out-of-touch Prime Minister, Tony Abbott, an individual, who, I for one, will never trust again). And yes, I’ve been a long time Liberal supporter, but what a disappointment this Government has been. It’s sad and pathetic.

As a side note, it’s also very alarming that Newscorp journalist Terry McCrann still appears to be being briefed by someone in the Reserve Bank regarding interest rate decisions before they are announced publicly. This gnome-like man moves markets with his (grammatically poor) writings in the grubby Murdoch tabloids - it beggars belief. What sort of country runs on this basis?

Anyway, I digress. Here is Christopher Joye’s article (main points):

The Reserve Bank of Australia has screwed savers by giving them negative "real" interest rates that do not cover their cost of living (after tax, they're miles behind). It has ruined retirees who cannot earn anything remotely like the 2 to 3 per cent real return above inflation they've become accustomed to since the RBA started targeting consumer prices back in 1993.

With the cash rate set at depressionary levels, main street and conservative retirees are being forced to take complex risks (hybrids anyone?) they cannot fathom in a search for yield that will end in tears.

What is less appreciated is that the RBA, and its myopic political co-conspirators in Canberra, are also emphatically screwing home buyers pouring their life earnings into five-times leveraged assets that are grossly overvalued. My current mark-to-market is Australian housing is trading at least 20 per cent above fair value.

Central bankers are taxing future generations to superficially stimulate the present. It's classic human hedonism or, more technically, hyperbolic discounting. The economy is like a human body. If you fall sick, there's a case for temporary medicine to mitigate the malaise and facilitate recovery. The policy analogy is lower interest rates and budget deficits. But if you dope up the patient on extreme quantities of drugs for long periods, you actually start damaging the body's capacity to heal itself. Rather than relying on its innate ability to repair, the body becomes addicted to external bailouts. And the medicine morphs into the problem.

Imposing excessively stimulatory interest rates for unnecessarily long periods (it is eight years since the GFC first hit) undermines the regenerative qualities of the economy that are the cornerstone of long-term productivity growth. Ridiculously cheap money inflates the value of leveraged assets to unsustainable levels, sucking scarce people and capital away from other businesses. Debt-laden firms are rewarded while the prudent are punished.

These distortions are especially acute in Australia where the price of money for most households and small businesses is based on the variable overnight cash rate rather than the long-term fixed rates that are popular overseas. The unusually high share of variable-rate debt in Australia is why the RBA was able to deliver such powerful relief to consumers by slashing its cash rate from 7.25 per cent in August 2008 to 3 per cent in April 2009.

The worry is policymakers have come to believe that if they keep debasing borrowing costs to zero, they can diversify away the business cycle and massage nominal growth back to their ivory tower conceptions of "trend". They have forgotten that episodic downturns –aka creative destruction –are precisely what the economy requires every so often in order to replace bad businesses with good ones.

The whole point of the GFC is that it was a negative productivity shock. Those stunning 2008 and 2009 price falls reflected in freely functioning markets, while painful for our portfolios, were perversely positive because they signalled that we had tied up too much money in unproductive retail and investment banks, and leveraged assets such as commercial and residential property.

Officialdom was not listening. CBA is worth 111 per cent more than it was in 2007 while our house prices are 29 above their pre-GFC peak. Australia is destined not to learn the lessons of history and it will take our own, very personal shock to set us straight. You can only stretch the market's elastic band so far before it snaps back in your face.

Every half-smart investor I know is worried about deflation. But you don't make money from consensus views. I hunt out heterodox opportunities. Lower asset or consumer prices triggered by excess supply or insufficient demand in one area (e.g. housing, financial services, petrol, or commodities) can be a vital part of capitalism's rehabilitation process that apportions winners (renters and consumers) and losers (bankers and miners). Therefore, I'm not convinced a bit of deflation is an absolute evil in the same way some inflation can be a good thing.

Right now, we have strong asset price inflation across housing, listed equities, private equity and bonds. Core consumer price inflation is expanding at a normal pace despite crisis-level interest rates. My contrarian view is that as the US labour market tightens and wage inflation stirs, the world's largest economy will start exporting inflation. This will be reinforced by dearer Chinese product prices as their once-cheap labour gets repriced and a large middle class emerges. Inflation stoked by the two biggest economies will then likely be amplified by central bankers keeping rates too low for too long, partly because of pressure from politicians to continue monetising public debts.