Tuesday, September 16, 2014

Quant vs. fundamentals: Should you drop out of college?

I was talking to a young analyst the other day trying to explain the difference between quantitative and fundamental analysis. Consider the following thought experiment: Would you drop out of college if a really good opportunity presents itself? What would be part of the thought process in making that decision?

Here is the quantitative approach. Liberty Street Economics, the blog of the New York Fed, wrote a series of posts about the value of a college education. In Part 1, they outlined the value of an undergrad degree in various ways. The most important is how the NPV of a Bachelor's Degree in constant dollars have evolved over the years:


In Part 2, Liberty Street Economics discussed the ROI of a Bachelor`s degree if you completed it in more than four years. Needless to say, ROI is negative if you drop out, especially if you are saddled with student debt.


In Part 3, which I won`t show, they suggested that if you are an underperformer, the value of a Bachelor`s degree may be no different than a high school education. In Part 4, they discuss the evolution of the job market for college graduates over the years.

Based on these quantitative (statistical, think "Big Data" style) studies, the typical student would be much better off staying in college than dropping out. That would be the "safe" bet to make - and no doubt the decision that most parents would encourage.


The limitations of models
On the other hand, consider the exceptions to the rule - that's when statistical models fail. Business Insiders recently featured a story of dropouts who became Tech billionaires. Names like Gates, Dell, Zuckerberg and Jobs topped the list. Shouldn`t that be part of the decision process on whether to drop out?

That`s where quantitative and fundamental analysis part company. Quants tend to bet on a model which give them a statistical edge. If you make hundreds or thousands of diversified bets, you will win - on average. As an example, my call on February 24, 2009, shortly before the ultimate March stock market bottom, to buy low-priced stocks with insider buying (see Phoenix rising?) was a quantitative and statistical call. There were both winners and losers in the suggested portfolio. Investors who heeded my advice would have seen somewhere between a double or triple on their money a year later.

On the other hand, a fundamentally driven investor will say, "In this case of whether to drop out, I have a single decision that's an undiversified bet. While I understand the statistics of the NPV of college degrees, etc., I need to drill down and understand the key drivers of success of the Gates, Dells, Zuckerbergs and Jobs of the world."

One fairly consistent element is that these "superstar winners" generally had an identifiable plan or path while they were undergraduates. As an example, Michael Dell was selling computers out of his dorm room. It helps that he had an entrepreneurial streak. Wikipedia recounts the story:
Dell attended Memorial High School in Houston, selling subscriptions to the Houston Post in the summer. While making cold calls, he noted that the persons most likely to purchase subscriptions were those in the process of establishing permanent geographic and social presence; he then targeted this demographic group by collecting names from marriage and mortgage applications. Dell earned $18,000 that year, exceeding the annual income of his history and economics teacher.
In this case, Dell quit to pursue his business plan.

It also helps that the successful dropouts went to a top school (think Harvard, Stanford, M.I.T., etc.). The field of concentration doesn't necessarily have to be in technology. Conceivably, the potential dropout could be a performing arts prodigy attending a prestigious institution like Juilliard and could go on to be the next Joshua Bell, Yo-Yo Ma (both of whom graduated, BTW) or Dustin Hoffman (who was a college dropout).

Quite simply, fundamental analysts focus much more on understanding the specific risks of a situation, but they don't have the same bandwidth as the quantitative analyst who looks for a statistical edge and accepts that he will be wrong in any one situation. A good fundamental investor understands his bandwidth limitations and a good quant understands his model's limitations. As it turns out, this analysis of freestyle chess indicates that a combination of the two appears to be the best approach:

  • Fundamental analysts can leverage the computer’s ability to gather data and crunch numbers.
  • Quantitative analysts can leverage the analyst’s ability to sort causality and detect patterns.

So should you drop out? That depends. In what way are you similar to a Bell, Ma, Hoffman*, Gates, Dell, Zuckerberg or Jobs**?

Bill Gates

* Check out this video of the story of Jonathan Goldsmith, who competed with Dustin Hoffman for roles, but wound up driving a garbage truck to make ends meet.
** Also see this advice from Todd McKinnon, CEO of a $600 million start-up.

Monday, September 15, 2014

Time for European small caps to shine?

In addition to waiting for the FOMC and the results of the Scottish Referendum, we will see the first results of the ECB's TLTRO this week. As a reminder, the purpose of the TLTRO program is intended to stimulate lending to eurozone households and non-financials:
In pursuing its price stability mandate, the Governing Council of the ECB has today announced measures to enhance the functioning of the monetary policy transmission mechanism by supporting lending to the real economy. In particular, the Governing Council has decided:

1. To conduct a series of targeted longer-term refinancing operations (TLTROs) aimed at improving bank lending to the euro area non-financial private sector, excluding loans to households for house purchase, over a window of two years.

2. To intensify preparatory work related to outright purchases of asset-backed securities (ABS).
This program should be beneficial to eurozone SME. In that case, why are European small caps underperforming? As the chart below shows, European small caps topped out against large caps (black line) in March and they have been rolling over ever since. This pattern of small cap underperformance is not unique to Europe, as US small caps have exhibited a similar pattern, albeit with a greater magnitude.


As the ECB implements TLTRO, is this an opportunity for European small caps to revive?


Sunday, September 14, 2014

A tactical sell signal, but no signs of a major top

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Negative (downgrade)

The actual historical (not back-tested) buy and sell signals of the Trend Model are shown in the chart below:


Good news, bad news
This is a good news and bad news kind of market. The bad news is that US equities appear poised for a pullback of some fashion. I had indicated last week that momentum was faltering and it may be prudent to pare back some positions around month-end (see Sell Rosh Hashanah?). The weakness became more evident as last week wore on, which prompted me to tweet that my long positions were stopped out on Tuesday. The SPX then proceeded to bob up and down for the rest of the week, which frustrated both bulls and bears alike, and ended Friday on a negative note.

The good news is that, barring some surprise, there appears to be no signs of an intermediate term top in sight.


Short-term deterioration
Shorter term, however, I am seeing signs of technical deterioration. The SPX violated support and appears to be starting to roll over.


I had suggested last week that macro-economic releases were approaching the "too much good news" zone and vulnerable to a rollover. Almost on schedule, the Citigroup Economic Surprise Index started to turn south.


Declining growth expectations may prove to be an impetus to a loss of momentum in forward EPS estimates - a crucial ingredient that has been supportive of this bull run. Indeed, the Atlanta Fed`s GDPNow, a "nowcast" of Q3 GDP growth, fell from 3.6% on September 4 to 3.4% on September 12. Brian Gilmartin reports that the forward EPS growth rate has fallen for seven consecutive weeks, which is a worrisome sign for the bull case (emphasis added):
Per ThomsonReuter’s “This Week in Earnings”, the forward 4-quarter estimate fell to $125.80 from last week’s $126.34, or a decline of $0.48 on the week.

The p.e ratio on the forward estimate as of Friday’s close is 15.78(x) and the PEG ratio is now 1.73(x), still relatively attractive.

The earnings yield (some think this is a proxy for the equity risk premium) rose to 6.34% last week, from 6.29%.

The year-over-year growth rate on the forward estimate fell to 9.13% from last week’s 9.15%. This is the 7th straight weekly drop for the forward estimate growth rate.
Another potentially bearish signal comes from insider trading, the so-called "smart money". Barron's weekly report of insider activity shows that the ratio of sales to purchases have ticked up into bearish territory.


Across the Atlantic, equity markets are losing their bullish momentum as well. In particular, the UK market is getting nervous at the prospect of the Scottish Referendum.



On the Continent, the Euro STOXX 50 is showing a similar pattern of the violation of a short-term uptrend. European stocks may be reacting to several key risks. First, the French-German divide is getting wider, as embattled French President Hollande tries to win a vote of confidence and persuade Berlin to ease off on penalties as France will miss its deficit targets. These tensions are occurring in the wake of apparent growing rift between Mario Draghi and Angela Merkel on the wisdom of continued austerity. As well, the combination of current weak growth environment and further sanctions on Russia could push Europe into a recession, as evidenced by the sentiments voiced by Bob Shiller in a Project Syndicate essay is creating further uncertainty.



As well, the interest rate environment is becoming a little less friendly. Ambrose Evans-Prichard wrote that both the US and China are edging towards tighter monetary policy:
The world financial system is at an inflection point as the US and China both switch off monetary stimulus, a form of synchronized tightening by "G2" superpowers.

Bank of America has warned clients that the glory days of "maximum liquidity" we have enjoyed in the post-Lehman era are coming to an end, with sweeping implications for asset markets across the world.
He also pointed out that the San Francisco Fed released a research note indicating that the market has become more dovish than the Fed`s own projections. Is this an implicit warning for the markets ahead of the FOMC meeting?


As for China, Thomson-Reuters shows that Chinese credit growth, as measured by social financing is dropping off. As credit has been a key driven to China`s economic growth, you can be sure that the pace of GDP growth will surely follow.


Optimists might suggest that the slowdown could be a positive sign as the economy is re-balancing from infrastructure to consumer driven growth. Unfortunately, the latest statistics show few signs of re-balancing:


Evans-Pritchard also pointed out that China is signaling that the markets cannot expect further wholesale or fiscal monetary stimulus in response to slowing growth:
In aggregate, the great central banks are turning hawkish. China's premier, Li Keqiang, sent a chill through the World Economic Forum in Tianjin this week, warning that markets can no longer count on easy money. "We are restructuring instead of expanding the monetary supply," he said.

The Communist Party is willing to endure the economic slowdown, no longer responding to each hiccup with more credit, so long as urban unemployment remains near 5pc. For now the economy is still generating 1.2m jobs a month.

China's budget reform will soon halt rampant borrowing by local governments, adding fiscal tightening to the mix. Regulators are shutting down chunks of the shadowing banking industry.
The lack of credit growth is having a real effect on the Chinese property market, which has been a linchpin of growth (also see my discussion last week of the rising risk levels at Michael Pettis on the risks of the long landing scenario):



Other Chinese growth indicators are also turning south. As the chart below shows, the Li Keqiang Index is weakening, led by falling electricity usage. Indeed, the latest economic releases, namely industrial output and retail sales, came in well below expectations - confirming the hypothesis of a slowdown.


We are seeing the real-time reaction to the China slowdown in the commodity markets. Since China has been a large swing consumer of commodities, commodity prices have therefore been a sensitive barometer of Chinese growth. As the chart below shows, the CRB Index has been tanking since April. The equal-weighted CCI is faring even worse.


Oil markets aren`t behaving any better.


Industrial commodities, which had been holding up reasonably well, are losing momentum.



When I add it all up, it points to the start of a global growth scare which will rein in risk appetite. Already, junk bond spreads are starting to widen.




No sign of a major top
When I use the framework of market cycle analysis, the good news is I don`t see the signs of a market top. As a reminder, here is how I explained the market cycle analytical framework (see The bearish verdict from market cycle analysis):
Here is an idealized version of a market cycle and how market leadership evolves over the course of that cycle:

Early cycle: The economy is in recession or on the edge of a recession. In response, the central bank stimulates the economy with low interest rates (or unconventional policy). As a result, stock begin to rise, led by interest sensitive sectors, such as Financial and housing related stocks.

Mid cycle: Some analysts split this part of the cycle into several pieces, but here is roughly how market expectations change. The economy gets better, or is perceived to get better. More jobs are created and consumers have more money to spend. Corporations find that they start to get capacity constrained. They respond by hiring more people, which leads to a virtuous cycle of more consumer spending, and buy more capital equipment. During this part of the market cycle, Consumer Discretionary, capital equipment sensitive sectors like Technology and Industrial stocks lead the market higher.

Late cycle: The economy starts to overheat and inflation starts to tick up. At this point, inflation sensitive commodity related sectors like Energy and Materials start to outperform. The central bank responds to rising inflationary pressures by raising interest rates, which leads to...

Bear phase: The stock market falls because of the expectations of higher interest rates and falling growth. Defensive sectors such as Consumer Staples, Utilities and Healthcare outperform during this phase.

There are a number of important caveats to this analytical framework. First, this is an idealized cycle which ends with either an inventory recession or the expectations of slowdown caused by an inventory recession. What we went through was not a typical inventory recession but a balance sheet recession, which recovered very slowly.

More importantly, I am describing a market cycle and not an economic cycle. Realize that this framework is based on technical analysis and not economic analysis. A market cycle behaves like an economic cycle, but it only describes the market response to expectations, not the actual economic result. As an example, the economic cycle started at the trough of the Lehman Crisis in 2008-09, but I believe that the market cycle actually began in late 2011, when the markets got over the trauma of the debt ceiling impasse in Washington and the ECB acted to relieve the pressures of the eurozone crisis with its LTRO program.
Let`s go to the charts. Here are the early cycle sectors, which have rolled over on a relative basis. Bull can point to the hopeful sign that perhaps the financials are starting to turn up, but the trend seems to be down, for now. (Note that these series of charts show the relative performance of individual sectors compared to the SP 500, unless otherwise indicated).


The mid-cycle sectors (Consumer Discretionary and Industrials) have also rolled over on a relative basis, though they may be trying to consolidate and perhaps re-take the leadership position here.


So far, the market cycle analysis picture does not look especially bullish. However, the late cycle inflation sensitive sectors are not the market leaders either, which is not surprising given the weakness shown by commodity prices. This is a key indication that that a major top is probably not in sight.


If a bear cycle was truly starting, then the defensive sectors would be turning up on a relative basis. Does the relative performance chart of these sectors show that? Nope.


What are the market leaders? It seems that the market leadership in this cycle has been somewhat unusual. One notable market leadership sector has been health care. I have shown the relative performance of health care and its key components, pharmaceuticals and biotechnology. All of them have shown a steady relative uptrend against the market.


Given the steady leadership shown by health care stocks, one of the key questions is whether the sector is in a bubble. While I do not have any firm opinion as to whether we are seeing a health care bubble, Morningstar has analyzed the evolution of sector weightings over time and excessively high weights indicate an unsustainable advance. For now, their conclusion is that no sector has raced ahead of the others - indicating that even if health care is in a bubble, it is in no danger of being pricked.

The other emerging market leaders has been technology. The sector has been bottoming out on a relative basis and started to turn up. The upward march of this sector is not all an AAPL story. The black line shows the relative performance of the tech sector compared to the SPX, while the blue line is the equal-weighted NASDAQ 100 relative to the equal-weighted SPX, which greatly reduces the AAPL effect.



Technical analysis is the art of listening to the markets. What I am hearing from Mr. Market is that we are seeing a mid-cycle pause in growth. Analysis from Alejandra Grindal of Ned Davis Research is pointing in that direction.



A correction on the horizon?
When I put it all together, the weight of the evidence suggests that the major US equity indices are due for a pullback of some sort, but the longer term trend is still up. At this point, the depth and duration of any potential market weakness is unknown. We will have to wait to see how the fundamentals develop.

My inner investor remains relatively unfazed, as the Trend Model remains in at a risk-on signal and market fundamentals remain sound.

On the other hand, my inner trader has noted that the direction of the Trend Model change is negative, which represents a tactical sell signal. He got stopped out of his long positions last week and he has taken on a small short position. He is highly nervous as event risk next week (FOMC meeting, Scottish Referendum) is likely to produce volatility and a high risk of whipsaw, which is anathema to trend following models that he is using.


Disclosure: Long TZA

Friday, September 12, 2014

How an independent Scotland could become prosperous

For your consideration as we approach the weekend: As we approach the Scottish Referendum on September 18, there have been lots of stories of the negative repercussions of a Yes vote. I had written from a Canadian's perspective about How a Scottish-UK currency union is an idiotic idea. I believe that Credit Suisse summed up the risks best with this paragraph (via Business Insider):
Risk of an economic crisis: In our opinion Scotland would fall into a deep recession. We believe deposit flight is both highly likely and highly problematic (with banks assets of 12x GDP) and should the BoE move to guarantee Scottish deposits, we expect it to extract a high fiscal and regulatory price (probably insisting on a primary budget surplus). The re-domiciling of the financial sector and UK public service jobs, as well as a legal dispute over North Sea oil, would further accelerate any downturn. In our opinion, as North Sea oil production slows, we estimate that the non-oil economy would need a 10% to 20% devaluation to restore competitiveness. This would wages, driven by a steep rise in unemployment.
The FT outlined an equally dire scenario:
A Yes vote will launch Scotland, and to a lesser extent the UK, into years of uncertainty. Among the biggest doubts are those hanging over the currency. Financial businesses that must be regulated and supported by the UK will flee. Scottish deposit insurance would be as worthless as the Reykjavik-run scheme that failed to cover Icelandic banks in 2008. Cautious Scots must already recognise that the pounds in their bank accounts may end up as something else. Far safer to move the money south.

Confronted with currency uncertainty, banks will need to balance their books within Scotland. This will surely force them to shrink the supply of credit to the Scottish economy. The UK government could try to prevent money from leaving Scotland, but this would require draconian controls, which it will not impose. Either Westminster or the Scottish government could offer to indemnify lenders against currency risks. The UK government will not do that. It will let the credit squeeze happen, blaming it on the Scottish decision. It will be Scotland’s choice, if it can meet the cost.
There will be a bad taste on everyone's mouths:
These negotiations will be complex, bitter and prolonged. However amicably a divorce begins, that is rarely how it ends. It is the safest possible bet that when this process is over, the English will resent the people who repudiated them and the Scots will resent the people who did not give them independence on the terms to which they believed they were entitled. A United Kingdom will give way to a deeply divided island.

The Scots will discover the taste of austerity. Scotland cannot sustain higher taxes than the residual UK; that would drive economic activity away. It will pay a higher interest rate on public debt because its government will be unfamiliar and dependent on unstable oil revenues (almost certainly smaller than Mr Salmond imagines). Fiscal fibs will be exposed.

By then it will be too late. If the vote is a Yes, it will be forever. But what about a narrow No? That too will be a nightmare. We could then look forward to more referendums. I would prefer a clean break than that. If Scotland cannot decide firmly in favour of union, let it choose “independence”. And then, enjoy!
While it is true that an independent Scotland, as a small country with an open economy, is subject to many risks that it would not face as part of the UK. But this analysis relies on overly conventional banker thinking. What if the Scots were to think outside the box?


A neutral Scotland?
Instead of thinking like a banker about resolving Scotland`s finances, Alex Salmond could think about the geopolitical dimensions of a potential divorce. Consider, for example, that the SNP's White Paper for independence has called for a nuclear free Scotland within the first term of parliament:
Scotland has been home to one of the largest concentrations of nuclear weapons anywhere in the world, despite consistent and clear opposition from across civic Scotland, our churches, trade unions and a clear majority of our elected politicians. Billions of pounds have been wasted to date on weapons that must never be used and, unless we act now, we risk wasting a further £100bn, over its lifetime, on a new nuclear weapons system. Trident is an affront to basic decency with its indiscriminate and inhumane destructive power.
That brings up the question of whether the armed forces of an independent Scotland needs to be part of the UK`s armed forces structure. Ireland has been neutral for many years - even during the Second World War. Why not Scotland?

Does Scotland even need to be part of NATO?


Military assets: From cost center to profit center
Let`s go down that road a little further. Supposing that the Scottish budget was under pressure, instead of worrying about the fiscal burden of funding Tornado and Typhoon squadrons at Lossiemouth, etc., why not negotiate leases for basing rights with rUK? Such a move would instantly transform those military assets from cost centers to profit centers.

In fact, a neutral Scotland could put the leases at its major bases such as Lossiemouth (air base) and Faslane (Trident) up for bids. What would the Russian navy pay for basing rights at Faslane? It would a Russian military planner`s dream. Russian SSBNs in the North Sea would give Moscow the option of launching a decapitation strike to take out the leadership in European capitals and NATO headquarters with little or no warning.

Notwithstanding the uproar in Westminster, how would Washington react (and pay) to avoid Su-27 squadrons at Lossiemouth and Russian ballistic missile subs roaming freely in the Atlantic and the North Sea?




I had suggested that there was a geopolitical risk element to the Greek crisis in 2011 (see Europe dodges another bullet (not the Catalan election)). Russia could have seized a historic opportunity to rescue Greece and achieve the long Russian dream of achieving a warm water port by funding a Grexit. The test case would have been Cyprus - but the Kremlin chose to pass on that opportunity.

Now Putin might have a second chance. Instead of infiltrating Spetnaz units into neighboring territories, Moscow could just buy the country instead. Already, the Russian press is planting stories like Economic Benefits of Faslane Nuclear Base in Scotland “Overplayed” - Official. What comes next? After all, are we not all good capitalists now?

While what I have outlined is tongue in cheek and fantasy (worthy of ZH), it nevertheless does illustrate the point that if an independent Scotland gets pushed too far economically, the gloves could come off and anything can happen.

Thursday, September 11, 2014

Big trouble in little Hong Kong?

I came across a couple of news items that appeared to be disturbing on the surface to which the markets haven't really reacted. First, there was this Reuters report of the meeting between China's representative with pro-democracy advocates in Hong Kong (emphasis added):
The setting at the Aug. 19 meeting was calm: A room with plush cream carpets, Chinese ink brush landscape paintings and a vase of purple orchids. The political mood outside, however, was fraught. Democratic protesters were threatening to shut down the global financial hub with an "Occupy Central" sit-in if Beijing refused to allow the city to freely elect its next leader.

After the formal smiles and handshakes with Zhang Xiaoming, the head of China's Liaison Office in Hong Kong, the mood soured. Pro-democracy lawmaker Leung Yiu-chung asked Zhang whether Beijing would allow any democrat to run for the city’s highest office.

Zhang, 51, dressed in a black suit and a navy blue striped tie, delivered a blunt response. “The fact that you are allowed to stay alive, already shows the country's inclusiveness," he answered, according to two people in the room who declined to be named.
The truth of the matter is that Hong Kong's share of Chinese GDP has been falling for years and it isn't as important to China as it was in the past.


Under the circumstances, China's leadership is probably in no mood on treating Hong Kong residents with kid gloves.
At the Aug. 19 meeting, Zhang said Beijing had been generous even allowing democrats such as Leung to run for legislative seats. He insisted that the next leader had to be a "patriot".

"We were shocked," said one person who attended the meeting. "But Zhang Xiaoming is only an agent who delivered the stance of the central government without trying to polish it."

Few were surprised, though, when China's highest lawmaking body, the Standing Committee of the National People's Congress (NPCSC), announced an electoral package on Aug. 31 that said any candidate for Hong Kong's chief executive in the 2017 election had to first get majority support from a 1,200-person nominating panel – likely to be stacked with pro-Beijing loyalists.
For now, the markets have shrugged off this development. The Hang Seng Index is currently testing an uptrend and other regional indices, such as the Shanghai Composite, South Korea and Taiwan indices remain in uptrends.



A march to war?
In addition, the FT reported that a majority of the Chinese population believed that war with Japan is inevitable:
The Genron/China Daily survey found that 53 per cent of Chinese respondents – and 29 per cent of the Japanese polled – expect their nations to go to war. The poll was released ahead of the second anniversary of Japan’s move to nationalise some of the contested Senkaku Islands in the East China Sea.
I have written about how the Chinese and Japanese hate each other, but this latest poll indicating a belief of the inevitability of war is a serious matter. The combination of such attitudes in China and a scenario of rising tensions in the South China Sea would seriously freak out the markets worldwide.


At this point, these kinds of worries are highly speculative, but they have a way of not mattering to the market until they matter. Should Chinese growth weaken in the near future, there will be a temptation to play the nationalism card to distract the populace. In that case, the risk of rising geopolitical tensions will present tail-risk that is probably not in too many analysts' spreadsheet models.

Wednesday, September 10, 2014

Recall model assumptions before jumping to conclusions

I have written numerous times in this space about the importance of examining your assumptions before taking any action on quantitative research.

Here is another example. I came upon a study by Alpha Architect on the tradeoff between stock selection and diversification called Diworsification: Trade-off between portfolio size and expected alpha (h/t Tadas Viskanta). The article first laid out a number of assumptions and caveats:
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.
It went on to perform a number of simulations using Monte Carlo techniques (note key assumption in bold):


The spreadsheet conducts 1000 simulations. In each simulation run, a system can either take 1 bet, 10 bets, or 100 bets--all uncorrelated. As the chart above suggests, one can manage risk by pooling truly uncorrelated bets together. As the number of bets increases, the volatility goes to zero and the expected value becomes the observation.

In the real world stocks don't have zero correlation--correlations are much higher across equities. 
Here are the conclusions based on this Monte Carlo study:
What's the bottom line?

30-50 stocks seems to be a sweet-spot where an investor eliminates portfolio idiosyncratic volatility, as additional diversification beyond this point does not help reduce volatility in any dramatic way. However, by diversifying beyond 30-50 stocks, we also prevent our portfolio from concentrating on stocks we feel are "undervalued." In other words, we probably want Warren Buffett to hold 30 or so stocks to ensure he doesn't completely blow up, but we don't want to force him to hold more than that, because it is unlikely he has more than 30 good ideas. In effect, he would be "diworsifying."
How useful is the 30-50 stock answer?

I believe that while this was a useful first step and study illustrating the tradeoffs between the effects of stock selection and diversification, I would take the conclusion of 30-50 stocks as the "sweet spot" with a grain of salt. Consider the kinds of assumptions that are made in this study:
  • Individual stock returns are un-correlated
  • The study does not identify the source of alpha
The second point is particularly important as it ignores Richard Grinold`s Fundamental Law of Active Management.


The Fundamental Law of Active Management
Grinold's seminal paper on this issue outlined how a manager should size the bets a he should make in a portfolio.
where IR = Information Ratio
           IC = Information Coefficient
           N = Number of independent opportunities

What Grinold means by the above formula is that a manager’s value-added (Information Ratio) is a function of his selection skill (Information Coefficient) and the number of opportunities (N) he has. In plain English, the portfolio manager should make bets in accordance with the size of his edge, or alpha.

Even then, the formula, as outlined, presents a number of implementation problems (see my previous discussion Examining your assumptions: The fundamental law of active management). They relate to time periods and optimal re-balancing; and the definition of independent opportunities (which the Alpha Architect study assumes that each stock is independent of each other).

For example, if you buy a portfolio of 100 low PE stocks, does N=1 (all low PE), 100, or somewhere in between? How different N be if it was a portfolio of 20 low PE stock?

Under these circumstances, how applicable is the Monte Carlo simulation study that 30-50 represent the "sweet spot" of diversification?

The moral of this story: Know your assumptions before coming to conclusions.


Tuesday, September 9, 2014

Michael Pettis on the risks of the "long landing" scenario

I received an email from Michael Pettis on my recent post (see The Pettis China "long landing" scenario hits an air pocket). To recap my previous post, I outlined Pettis' views of China's growth path outlined in his most recent blog post:
The first stage of China’s growth story, which occurred mainly during the 1980s, consisted of liberalizing reforms that undermined the Communist elite and which were strongly opposed by them. Because power was highly centralized under Deng Xiaoping, however, including a loyal PLA, he and the reform faction were nonetheless able to force through the reforms.

The next two stages of growth, I argued, required policies that had a very different relationship to the interests of the Chinese elite. Because they involved the accumulation and distribution of resources to favored groups whose role was to achieve specific economic targets, they helped to reinforce the wealth and power of a new elite, many of whose members were, or were related to, the old elite. Not surprisingly this new elite strongly supported the growth model imposed by Beijing during these stages.

The fourth stage, I argued, is the stage upon which we are currently trying to embark. In an important sense it involves liberalizing reforms similar politically to those that Deng imposed during the 1980s, making it vitally important to their success that the current administration is able to centralize power and create support to overcome the inevitable opposition, which it seems to be doing.
He continued with an optimistic "long landing" scenario (emphasis added):
This is why, even though Beijing doesn’t seem to have yet gotten its arms around the problem of excess credit creation, I nonetheless think it is moving in the right direction. For now I would give two chances out of three that Beijing will manage an orderly “long landing”, in which growth rates continue to drop sharply but without major social disruption or a collapse in the economy. 
To achieve the Third Plenum objectives of re-balancing the source of economic growth to the consumer, or household, sector, financial repression needs to be eliminated, or at least drastically reduced.
Under these conditions it should be no surprise that borrowers with access to bank credit overuse capital, and use it very inefficiently. They would be irrational if they didn’t, especially if their objective was not profit but rather to maximize employment, revenues, market share, or opportunities for rent capture (as economists politely call it).

The second point to remember is that in a severely financially repressed system the benefits of growth are distributed in ways that are not only unfair but must create imbalances. Because low-risk investments return roughly 20% on average in a country with 20% nominal GDP growth, financial repression means that the benefits of growth are unfairly distributed between savers (who get just the deposit rate, say 3%), banks, who get the spread between the lending and the deposit rate (say 3.5%) and the borrower, who gets everything else (13.5% in this case, assuming he takes little risk – even more if he takes risk).

This “unfair” distribution of returns is the main reason why the household share of income has collapsed from the 1990s until recently. I calculate that for most of this century as much as 5-8% of GDP was transferred from households to borrowers. The IMF calculated a transfer amount equal to 4% of GDP, but said it might be double that number, so we are in the same ballpark. This is a very large number, and explains most of why the growth in household income so sharply lagged the growth in GDP.
By re-balancing growth from credit-led infrastructure growth, which has mainly benefited SOEs, to the household and consumer sector, Beijing addresses the problem of mis-allocation of capital. It all made sense...then I came upon this analysis from Anne Stevenson of YCapital (via FT Alphaville):
Consumer spending is second only to unemployment as the most atrociously tracked statistic in the economy, and the NBS numbers offer little insight. We have, however, been choosing two smaller cities per month as focuses of research, conducting interviews with vendors across commercial categories and triangulating the interview data with what we can see from the statistics. In each case, cities that have seen a decline in property sales almost immediately see a decline in spending in the industries we survey, with the sharpest downturns generally in property-related categories such as furniture and building materials. Next-weakest are usually consumer electronics and white goods, then food, while there is often growth left in clothing and personal care. The near identity between property and the consumer economy indicates that a slump in property must lead to a spike in investment in order to buoy the preferred areas.

The consumer segment, to the extent that it can be independently tracked, provides a clear trace for how capital moves through the economy at large and spills out in the form of commissions and kickbacks on contracts, higher compensation locally, and better liquidity for the housing market, leading individuals to spend.
In other words, property prices are intricately linked to consumer spending. If real estate prices tank, as they seem to be doing in the non-Tier 1 cities, so will consumer spending. In that case, how can re-balancing occur?


Pettis' comments
After I published my blog post, I received the following email comment from Pettis, which I reproduce in its entirety with permission:
Cam, thanks for your excellent analysis and kind words. I think you have hit precisely upon the main vulnerability in my "best-case scenario" argument, and because I am a big fan of Anne Stevenson's work (JCapital), I read her reports with the same trepidation you do.

My "best-case" rebalancing scenario, as I think you know, consists of an upper limit to average GDP growth of 3-4% over the presumed decade of President Xi's administration (2013-23), driven by growth in household income of 5-7% and commensurate growth in household consumption. Although when it comes to China I have been the big, bad bear for so long that perhaps I tend to want to understate my pessimism, I nonetheless always try to remind my clients, sometimes not very loudly if I am in a public forum, that this is not my expected "most likely outcome".

In fact I don't really yet have a "most likely outcome" because I think the final result is likely to be highly path dependent, and it is too early in the reform process and, more importantly, in the process of political centralization, to make anything but a rough guess. My "best-case" scenario is just one of the plausible ways in which rebalancing can take place, and, obviously enough, it is the one with the highest average growth rate I am able to work out arithmetically, given the logic of rebalancing and the constraints China faces.

I stress "plausible" because I can also propose "better" outcomes, but these would require policies that although not impossible are, I think, pretty unlikely. For example if Beijing were able to implement policies that transferred every year the equivalent of roughly 2% of GDP directly or indirectly from the state sector to median households, my simple arithmetic allows me to show GDP growth rates of perhaps 6% or even higher.
At any rate whether or not my claim that the upper limit of average growth during 2013-23 is 3-4% is credible depends on at least four factors:

1. China must not run up against debt capacity limits. My guess (and it is only a guess), is that China can continue the current pace of credit growth for another 3-4 years at most, after which it cannot grow credit fast enough both to roll over what Hyman Minsky suggested was likely to be exponential growth in unrecognized bad debt (and WMP and other shadow banking assets will almost certainly be absorbed into the formal banks), and to provide enough new lending to fund further economic activity. If there is less time, as I think Anne Stevenson might argue, or if Beijing cannot get credit and rebalancing under control before then, I think we can probably assume my "orderly long landing" scenario is less likely.

2. Beijing has largely squeezed out the main mechanisms for both rapid growth and the "unbalancing" process (financial repression, currency undervaluation and low wage growth), but tight rebalancing timetables still require direct or indirect state transfers to the household sector, as proposed during the Third Plenum (hukou reform, financial sector governance reform, interest rate and currency liberalization, land reform, privatization, environmental protection, etc.). These will be politically tough to implement, as you know.

3. Even if the above happen, the uncertainty, especially political uncertainty, can cause nervous households to restrain spending, so that even 5-7% growth in household income might not translate into similar consumption growth, which would reduce potential GDP growth.

4. Finally, and this the point you make about Anne's work, if declining home prices cause a negative wealth effect, (and indeed if consumption growth is positively correlated with investment growth, as Murtaza Syed at the IMF found, especially in the poorer western provinces), it will be hard to maintain current levels of consumption growth as investment growth and housing prices decline.

The wealth effect argument may seem obvious by the way, but it might not be complete. Remember that declining home prices have a negative wealth effect on those who are long real estate, especially speculatively long, and the impact is likely to be immediate, but as these people are likely to be relatively wealthy, the impact on consumption might be limited. For Chinese who are effectively "short" real estate (young people, poor people, renters, migrant workers), declining home prices will have a positive wealth effect which, because they are poor, may affect consumption more, but may take longer because declining prices might not be immediately as credible to non-owners as to owners. I wouldn't suggest that the wealth effect impact of a real estate slump could be positive, but it might not be as negative as it was in Japan or the US.

This is a long way of saying that while Anne's research is first rate, mainly, I think, because she identifies and untangles chains of risk rather than build the data-intensive and largely misapplied math models that much of the sell-side prefers, I think the jury is still out. On the whole I still think the long-landing scenario is more likely than a collapse because Beijing does have levers and a stable, if inefficient, banking system, but my 3-4% number is for me a likely upper limit, not the expected growth rate. At any rate we shouldn't doubt that rebalancing is always the hard part, and because it was too long postponed, any distribution of predictions should come with very fat left-side tails.

Sorry for such a long comment, but because you seem to explain even my own arguments better than I can, I thought I would exploit your blog and get your reaction.

Regards,
Michael Pettis

A lot of moving parts
I have had the greatest of respect for Pettis and I have been following him for many years. Because of his work, I have adopted his "long landing" scenario as my base case outlook for China. However, I did find a number of his comments to be interesting.

First, while he remains optimistic, the projected "best-case" rebalancing scenario of "average GDP growth of 3-4% over the presumed decade of President Xi's administration (2013-23), driven by growth in household income of 5-7% and commensurate growth in household consumption" is not his "most likely outcome".

As well, but he stated that he really does not "have a most likely outcome because (he) thinks the final result is likely to be highly path dependent". (Maybe he has been listening to Janet Yellen too much)

Notwithstanding the issues raised by Anne Stevenson, Pettis outlined a number of positive effects from a falling real estate prices, namely that the consumers who were priced out of the market will benefit, even though the effect will be longer term.

There are a lot of moving parts here. On one hand, Beijing appears to know what steps to take in order to rebalance growth. They appear to be taking the right steps in order to achieve their longer term objectives. On the other hand, near-term speed bumps, such as the buildup of credit, falling real estate prices, etc., serve to heighten the risk that the growth path slips over the precipice.

Under these circumstances, I believe that the most appropriate viewpoint comes from the most recent Howard Marks memo on risk:
The future should be viewed not as fixed outcome that's destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.
The "long landing" scenario remains in play, but its probability has retreated a bit in view of the most recent developments.

Monday, September 8, 2014

Finally, academics discover technical analysis!

It is good to see academics catch up with how traders think. I recently came across this summary of a research paper called "A New Anomaly: The Cross-Sectional Profitability of Technical Analysis" by Han, Yan and Zhou in CFA Digest published in the Journal of Financial and Quantitative Analysis:
The authors use a common trend-following strategy to measure the predictive ability of technical analysis. They apply their method to portfolios arranged by idiosyncratic volatility and variables related to information uncertainty. They document high abnormal returns relative to standard pricing models that are unexplained by investor sentiment, market timing, or liquidity risk. Such findings, according to the authors, establish a new anomaly.
Han et al tested whether using moving averages to time trades added value:
The authors use a set of 10 volatility decile portfolios as the underlying assets for their technical analysis. For each of the portfolios, the authors focus on the cross-sectional profitability of the MA timing strategy relative to that of the buy-and-hold strategy of the volatility decile portfolios. In the main study, the lag length is 10 days. The authors also test the alternative strategy with lag lengths of 20, 50, 100, and 200 days for the MA portfolios (MAPs).
Moving average strategies added value on a risk-adjusted basis:
The authors find that the 10 MAP returns are positive and increase with the volatility deciles (excluding the highest decile); returns range from 8.42% a year to 18.70% a year. In addition, the capital asset pricing model (CAPM) risk-adjusted returns, or abnormal returns, increase with the volatility deciles (also excluding the highest decile), ranging from 9.31% a year to 21.76% a year. When the authors apply the Fama–French three-factor model, they find the familiar pattern of monotonically increasing returns across 9 of 10 volatility deciles.

How trend following models works
These results are not a surprise to me. I explained the economic basis for trend following models back in 2008 (see Sheeps can make money too!):
A few years ago, I managed equity market neutral portfolios at a firm that was mainly known for commodity trading using trend following techniques, which are well described by Michael Covel in his book. During my tenure there I noticed that while the commodity positions were spread out among various futures contracts they often amounted to a few macro bets (i.e. on interest rates, on the US$, etc.) I came to the conclusion that these models were identifying macroeconomic trends that are persistent and exhibit serial correlation, which creates investment opportunities for patient long-term investors. For example, if the Fed is raising rates the odds are they will continue to raise rates until they signal a neutral or easing bias, i.e. there is a trend to interest rates, which is information that investors can use. The key risk in this class of models is knowing when to exit the trend, as short and long term reversals can be devastating to the bottom line.

The whipsaw problem
What was a surprise, however, is that Han paper did not find that these models do not work well in trend-less markets as these kinds of models are suspectible to whipsaw. (That`s a feature, not a bug.)

For instance, the latest report card on my own Trend Model account (see Trend Model report card: August 2014) shows solid results. However, as the chart below of account and SPY returns shows, up-and-down stock markets in Q1 resulted in negative returns for the account - a classic whipsaw pattern.


As a reminder, the Trend Model account is based on the application of trend following principles to global equity and commodity prices. The chart below shows the actual real-time (not back-tested) buy and sell signals of the model. I further highlighted the instances when the model suffered from whipsaw. To address that problem, I supplement the trend following model signals with some short-term sentiment models in order to address the whipsaw problem of this class of modeling technique.

Trend Model signal history

Regardless, this research is a form of affirmation that moving average based technical analysis can produce superior risk-adjusted returns. Further, if academics were to further decompose capital market returns in an economic, instead of Fama-French, risk factor mapping, I bet that they will find that these kinds of models are picking up on the serial correlation in economic factor returns.

Sunday, September 7, 2014

Sell Rosh Hashanah?

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Positive

The real-time (not back-tested) buy and sell signals of the Trend Model are shown in the chart below:


A bullish uptrend
Despite the sideways pattern shown by the SPX last week, the index ended the week at another new high, affirming the uptrend identified on August 10 (see A tradable bottom?). In the past week, technical price momentum has been broadly improving. US equities have edged to a new high; European markets surged on news of the ECB stimulus that dare not speak its name; and commodities have been mixed, with positive performance from industrial metals offset by weakness in energy.

Another bullish sign come from the positive momentum shown by Street earnings expectations, which is a key fundamental driver of equity returns. I have long written about analysis from Ed Yardeni, who has shown a steady improvement in forward 12 month EPS estimates.

For a different perspective, this chart from Gavekal of the evolution of North American FY2014 EPS estimates shows that the US earnings outlook has been better than previous years. There is a seasonality effect to Street earnings estimates, as they usually start the year too high and then decline into year-end. I have drawn black horizontal lines showing where market expectations were at this time in the past three years. As the chart shows, current readings are at the top of the range relative to recent experience.


In other good news, the latest Beige Book survey shows that all regions are showing signs of expansion, indicating a steadily improving economy:
The U.S. economy strengthened in all regions of the country in July and August, in areas including consumer spending, auto sales and tourism, the Federal Reserve reported in a survey released yesterday.

All 12 of the Fed’s regions reported growth. Six — New York, Cleveland, Chicago, Minneapolis, Dallas and San Francisco — characterized growth as “moderate.” The other regions reported somewhat slower expansion. Four described growth as “modest,” and two noted signs of improvement.
What`s more, the economy seems to be in a “not too hot, not too cold“ expansion phase that would prompt the Fed to start worrying about inflationary pressures:
The survey found no clear evidence that the economy is expanding so fast that the Fed might soon begin raising interest rates to prevent inflation.
The disappointing August employment report prompted the WSJ's Jon "Fedwire" Hilsenrath to write that Jobs Report Leaves Fed in No Hurry To Alter Views on Slack or Rates (emphasis added):
When Fed officials said in their July policy statement that they saw “significant underutilization of labor resources” – a signal of continued low interest rates – they were looking at an unemployment rate in June of 6.1%. The rate rose a notch to 6.2% in July and returned in August to 6.1%, the Labor Department said Friday.

The fact that unemployment hasn’t fallen since the July meeting —and that job growth slowed in August— suggests Fed officials won’t make big changes to their policy statement and the signal they’re sending about rates when they meet Sept. 16 and 17.
In addition, risk appetite appears to be healthy after a brief scare in late July. As the chart below shows, junk bond spreads are falling again, which indicating a rising appetite for risk.

The combination of bullish trend in global equities, positive fundamental momentum from EPS estimates and a healthy risk appetite all suggest that equities are likely to continue to slowly grind upwards.


Faltering technical momentum
While the intermediate term picture remains positive, what bothers me is that the tailwind provided by the positive price momentum of the oversold rally from August 10 is starting to lose steam. In addition, the intermediate term trend indicator's market views parallels the "steady as she goes" bullish views of the 10 strategists interviewed by Barron`s. That makes me somewhat uneasy as that outlook is the consensus view.


None of the group, whom we survey each September and December, is bearish these days, although some strategists have toned down their optimism because of the market's gains. Still, the most bullish see the benchmark barreling toward 2500 in the next 18 to 24 months. That would be an increase of nearly 25% from last week's close.

Earnings drive stock performance, and the outlook is relatively rosy here, too. Our 10 savants expect SP 500 earnings to rise 7% in 2014, to a mean $117.83, after advancing 5.7% in 2013. They look for earnings growth to accelerate to 8.1% in 2015, for a total of $127.34. Industry analysts' forecasts, as usual, are even more upbeat than those of the big-picture crowd, at $119.31 for this year and $133.49 for next, according to Yardeni Research.
To explain my concerns about the possible loss of momentum, let's review some of the short-term technical and sentiment indicators in my August 10 post that identified the bottom (see A tradable bottom?).

For instance, I wrote about the combination of VIX term structure inversion and TRIN moving above 2 as a powerful tool for spotting previous bottoms (shown by the dotted vertical lines) in the chart below. As the rally from August 10 progressed, note how the VIX-VXV ratio (middle panel) is getting very close to the shaded target zone indicating excessive complacency. We are not quite there yet, but we are getting close.


As well, I wrote about my favorite overbought-oversold indicator (in green), which also flashed a buy signal August 10. Like the VIX-VXV ratio, that OBOS indicator is also nearing its target zone.


Option sentiment may also be getting a tad overly bullish. The 10 day moving average of the ISE Equity-only call-put ratio of opening transactions show that readings are getting elevated, which suggests that a crowded long condition.

I don't want to give the impression that all short-term models are indicating an overbought or crowded long condition. Rydex funds flows, which I referred to last week, are in neutral (see last week's post A sweet spot for equities). As well, the CNN Money Fear and Greed Index also moved from an extreme fear to an neutral reading. Both of these indicators suggest that the current rally may have more legs in the short run.



Nevertheless, I am starting to wonder when all this positive technical and fundamental momentum might start to falter. The chart below of the Citigroup US Economic Surprise Index shows that, notwithstanding the surprising miss by the August Employment figures (and August is notoriously flakey), economic releases have moved from an extreme of misses to an extreme of beats. Readings are nearing my "too much good news" zone - indicating that the momentum in positive economic news may near nearing a peak.


Right now, the Atlanta Fed's Q3 GDPNow estimate is 3.6%. .What if, as the Fat Pitch suggests, trend growth reverts to 2% real after a snap-back from a disappointing winter in Q1?
In May we started a recurring monthly review of all the main economic data (prior posts are here).

Our key message has so far been that (a) growth is positive but modest, in the range of ~4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely. This is germane to equity markets in that macro growth drives corporate revenue and profit expansion and valuation levels.

This post updates the story with the latest data from the past month.

The overall message remains largely the same. Employment is growing at less than 2%, inflation and wages are growing around 2% and most measures of demand are growing at roughly 2% (real). None of these has seen a meaningful and sustained acceleration in the past 2 years. The economy is continuing to repair, slowly, after a major-financial crisis. This was the expected pattern.
A 2% growth rate would be an enormous miss:
With valuations at high levels, the current pace of sales growth is likely to be the limiting factor for equity appreciation. This is important, as the consensus expects earnings to grow at 8% in 2014 and 12% in 2015.


Sell Rosh Hashanah, buy Yom Kippur?
All of these concerns are not fatal to the current bullish undertone of the US equity market - yet. Given the positive momentum shown by the US, international equities and industrial metals commodity markets, I expect that the SPX can continue to grind upwards for a few more weeks.

However, the positive momentum tailwind from the oversold condition in August are likely to start to peter out in the near future. In that case, the strategy of adopting the Wall Street adage of sell Rosh Hashanah, buy Yom Kippur may not be a bad idea. Bespoke showed the profitability of such a strategy in 2011 below. Though the sample size is relatively small, the strategy did show a negative bias in equity returns during such a period.


Even though I am not a big fan of seasonal trading strategies, my wild-eyed guess is that at least the "sell Rosh Hashanah" part (on Sep 24) of the strategy may be a decent bet this year. For the moment, I remain cautiously long the market.


Disclosure: Long SPXL, TQQQ

Friday, September 5, 2014

The Pettis China "long landing" hits an air pocket

Noted China watcher Michael Pettis recently wrote a new blog post entitled "What does a good Chinese adjustment look like?". In it, he details his growth scenarios for China:
The choice...is not between a hard landing and a soft landing. China will either choose a "long landing", in which growth rates drop sharply but in a controlled way such that unemployment remains reasonable even as GDP growth drops to 3% or less, or it will choose what analysts will at first hail as a soft landing - a few years of continued growth of 6%-7% - followed by a collapse in growth and soaring unemployment.

A "soft landing" would, in this case, simply be a prelude to a very serious and destabilizing contraction in growth. Rather than hail the soft landing as a signal that Beijing is succeeding in managing the economic adjustment, it should be seen as an indication that Beijing has not been able to implement the reforms that it knows it must implement. A "soft landing" should increase our fear of a subsequent "hard landing". It is not an alternative.
Pettis believes that the "soft landing" is the "this will not end well" scenario for China. The so-called "long landing" is the optimistic scenario in China's four stages of growth:
The first stage of China’s growth story, which occurred mainly during the 1980s, consisted of liberalizing reforms that undermined the Communist elite and which were strongly opposed by them. Because power was highly centralized under Deng Xiaoping, however, including a loyal PLA, he and the reform faction were nonetheless able to force through the reforms.

The next two stages of growth, I argued, required policies that had a very different relationship to the interests of the Chinese elite. Because they involved the accumulation and distribution of resources to favored groups whose role was to achieve specific economic targets, they helped to reinforce the wealth and power of a new elite, many of whose members were, or were related to, the old elite. Not surprisingly this new elite strongly supported the growth model imposed by Beijing during these stages.

The fourth stage, I argued, is the stage upon which we are currently trying to embark. In an important sense it involves liberalizing reforms similar politically to those that Deng imposed during the 1980s, making it vitally important to their success that the current administration is able to centralize power and create support to overcome the inevitable opposition, which it seems to be doing.
Pettis remains optimistic that Beijing can pull it off:
This is why, even though Beijing doesn’t seem to have yet gotten its arms around the problem of excess credit creation, I nonetheless think it is moving in the right direction. For now I would give two chances out of three that Beijing will manage an orderly “long landing”, in which growth rates continue to drop sharply but without major social disruption or a collapse in the economy. In this issue of the newsletter I want to write out a little more explicitly what such an orderly adjustment might look like.
The one key ingredient of the "long landing" scenario is achieving the Third Plenum objective of rebalancing from credit-driven infrastructure driven growth to the consumer driven growth. This involves the ending, or at least, the reduction of financial repression, which lowered the cost of capital for SOEs at the expense of the household sector as regulated banking interest rates were driven to below zero in real terms by the central government.
Under these conditions it should be no surprise that borrowers with access to bank credit overuse capital, and use it very inefficiently. They would be irrational if they didn’t, especially if their objective was not profit but rather to maximize employment, revenues, market share, or opportunities for rent capture (as economists politely call it).

The second point to remember is that in a severely financially repressed system the benefits of growth are distributed in ways that are not only unfair but must create imbalances. Because low-risk investments return roughly 20% on average in a country with 20% nominal GDP growth, financial repression means that the benefits of growth are unfairly distributed between savers (who get just the deposit rate, say 3%), banks, who get the spread between the lending and the deposit rate (say 3.5%) and the borrower, who gets everything else (13.5% in this case, assuming he takes little risk – even more if he takes risk).

This “unfair” distribution of returns is the main reason why the household share of income has collapsed from the 1990s until recently. I calculate that for most of this century as much as 5-8% of GDP was transferred from households to borrowers. The IMF calculated a transfer amount equal to 4% of GDP, but said it might be double that number, so we are in the same ballpark. This is a very large number, and explains most of why the growth in household income so sharply lagged the growth in GDP.
As financial repression gets reduced, China enters a virtuous growth cycle:
Over time this means that households will retain a growing share of China’s total production of goods and services (at the expense of the elite, of course, who benefitted from subsidized borrowing costs) and so not only will they not be hurt by a sharp fall in GDP growth, but their consumption will increasingly drive growth and innovation in China.
Pettis ended his post with a hopeful prescription and outcome for the Chinese growth path and social stability (emphasis added):
If China can reform land ownership, reform the hukou system, enforce a fairer and more predictable legal system on businesses, reduce rent-capturing by oligopolistic elites, reform the financial system (both liberalizing interest rates and improving the allocation of capital), and even privatize assets, 3-4% GDP growth can be accompanied by growth in household income of 5-7%. Remember that by definition rebalancing means that household income must grow faster than GDP (as happened in Japan during the 1990-2010 period).

This has important implications. First, the idea that slower GDP growth will cause social disturbance or even chaos because of angry, unemployed mobs is not true. If Chinese households can continue to see their income growth maintained at 5% or higher, they will be pretty indifferent to the seeming collapse in GDP growth (as indeed Japanese households were during the 1990-2010 period). Second, because consumption creates a more labor-intensive demand than investment, much lower GDP growth does not necessarily equate to much higher unemployment.
In other words, the economy does not necessarily have to grow at a breakneck pace in order to maintain social cohesion for Chinese society. As long as the average household sees a decent increase in its standard of living, Beijing can keep a lid on social tension and maintain the Mandate of Heaven.


Watch out for the reverse wealth effect
I had long been a disciple of Michael Pettis and I was optimistic that "long landing" scenario could be achieved. That was until I saw David Keohane of FT Alphaville highlight a note from JCapital indicating how consumer spending was intricately tied into the health of the property market:
Consumer spending is second only to unemployment as the most atrociously tracked statistic in the economy, and the NBS numbers offer little insight. We have, however, been choosing two smaller cities per month as focuses of research, conducting interviews with vendors across commercial categories and triangulating the interview data with what we can see from the statistics. In each case, cities that have seen a decline in property sales almost immediately see a decline in spending in the industries we survey, with the sharpest downturns generally in property-related categories such as furniture and building materials. Next-weakest are usually consumer electronics and white goods, then food, while there is often growth left in clothing and personal care. The near identity between property and the consumer economy indicates that a slump in property must lead to a spike in investment in order to buoy the preferred areas.

The consumer segment, to the extent that it can be independently tracked, provides a clear trace for how capital moves through the economy at large and spills out in the form of commissions and kickbacks on contracts, higher compensation locally, and better liquidity for the housing market, leading individuals to spend.
Here is the problem:
Now, the decline in spending we are seeing in each of the cities we survey is going hand in hand with the reduction in investment in new property. Absent a miraculous new source of fast wealth, there is no reason why consumption should not return to the pre-boom level, where it was in about 2006. The land-driven bonanza is over.
Keohane added:
That’s the tricky thing. Consumption is really rather tightly and obviously linked to property investment (and inequality) so forcing a new middle class into existence isn’t going to be easy if/when this round of investment-led money dies off and the property market corrects.
What we have seen is a wealth effect in action as property prices in China have boomed. Analysis from George Magnus shows that while investments in a number of Tier 1 cities look fine, Tier 2 and 3 cities are showing signs of oversupply.

China: Investment and growth by city

Already, the cracks are showing. The latest figures from JP Morgan show that house price declines are spreading to 91% of the cities. In particular, prices in Tier 3 cities are cratering.

What we are seeing, in effect, is the reversal of the wealth effect in China. Because regulated bank interest rates were negative in real terms, savings went either into wealth management products or real estate - and there was leverage in much of those real estate holdings.

When consumer spending is "tightly and obviously linked to property investment", how does rebalancing occur? How can China, as David Keohane puts it, "force a new middle class into existence"?

These conditions call for a serious re-evaluation of China`s growth path. The Pettis "long landing" scenario just hit a major air pocket and its likelihood is quickly diminishing.