>Le Grand Fromage (FIRST GLOBAL)

After the fling…the Pregnancy Test

All of us have been really naughty last few weeks. We have done unspeakable things with the unmentionables. And have done these with highly unsafe practices.

So I though it a good idea to do the right thing and administer a pregnancy test to ascertain whether there is indeed a bull embryo somewhere inside this rally.

So how does one perform a pregnancy test on a rally, to figure out whether it is a bear market rally or an incipient bull market?

Well, the medical approach is to pee on the rally, and see if the color or some such thing changes. I have pee-ed on the rally last 20 days and its color hasn’t changed (well, it has changed a bit in the developed world, but not so much in Emerging Markets.)

So the medical approach has to be discarded in favor of a more financial approach.

And here’s what I decided to do:

The Pregnancy Test for the Rally

Let’s first pay our devoirs to the rally. It has killed both the bulls and the bears, in a salute to the resurgence of Communism. It has leveled the playing field, making everybody poor. The bears have been cleaned out, and surprisingly, even the bulls (like the Long-only funds) haven’t fared too well at all, because they were all overweight “quality”, and “quality” has been an absolute dog.

Quality has been an absolute dog…

Now, there is something in this statement that’s making me think: how can “quality” be a dog in what is supposed to be a bull market?

Let’s start with this central theme and commence our Pregnancy Test (medically-inclined folks can still take a pee).

I asked my quantitative guys to run the following back-tests for the period April 2002 to October 2003. This is the period in which we saw the last bear market wend its way slowly to a global equity market trough in March-April 2003, and then the famous bull market began…yes, the same one that led us to this sorry mess.

The objective of the investigation was simple: does the trade change when a bear market metamorphoses into a bull market? That is, do the countries or sectors, that you are long/overweight, short/underweight, need to be changed in your portfolio composition, when a bear market ends and a bull market begins? In other words, do you have to undergo a wholesale reshuffle of your portfolio, in fact, turn it upside down, when a bear market truly ends, and a bull market truly begins?

The thought for this investigation came from listening to the pain of clients: even the smart guys on hedge fund side who went net long on March 9, still hurt badly…they either remained flat for this period, or made a bit of money, or worse still, even dropped a bit of money.

Even the long-only guys hurt badly, for they were weighted in favor of “quality” or defensives…the consumer plays, the utilities, the healthcare/pharmaceuticals, etc. all of these hurt performance big as the performance disparity between them and the “junk” was nearly two times, in most cases.

So we decided to do a bit of snooping around. Nothing very arduous, mind you, for at my age, the mere act of stirring from my analyst armchair is quite enough exercise. But just enough to get a clue as to whether this is indeed an incipient bull market, or merely a tarted-up bear market rally, painted knees and all.

We did this at multiple levels: Emerging Markets country bets, ie, if you were long the best performing emerging markets in the 12 months preceding April 2003, and short the worst ones, in the same period (essentially the last one year of the previous bear market), how would your performance have been in the 3 months, 6 months, 9 months and 12 months after the start of the last bull market, assuming you made no change to your portfolio in that period?

The same question was asked for Europe: if you were long the best performing countries in the bear market and short the worst ones, made no change to your portfolio when the bear market transitioned into the bull market, in April 2003, how did you do?

For the US, we asked the same question, except that we did it on a sectoral basis: what if you were long the best performing sectors of the bear market, made no change to your portfolio in April 2003, then how did you do in the early stages of the bull market.

We asked the same question, as we did for the US, of an Emerging Market called India. The rationale being that India has a vast number of sectors, like the US, and unlike most other EMs, which are dominated a handful of sectors.(The long only funds can simply replace the terms “Long” and “Short” with “Overweight” and “Underweight”. Separately, the base of the analysis was either sectors or countries, and not stocks.The reasoning behind this was that stocks can undergo very fundamental changes in a cycle, through mergers, divestitures, change of strategy, etc, which can make comparisons across periods difficult, and prone to wrong conclusions.)

To see full report: LE GRAND FROMAGE