The arrival of a new year affords us the opportunity to review the year which has passed and muse about the prospects of the year which has just begun. In doing so, we hope to draw some substantive conclusions about where we have been, how and why we were there and what that teaches us about where we are headed. And 2010, like its predecessor, looks to be a year of uncertainty. Before we look down that road, let us review how ROE Capital Management fared in 2009.
2009 was a tough a year for money managers, regardless of their methodology or market of choice. Just about every conceivable trading paradigm was challenged by an equity market which collapsed and bounced, inflated with unprecedented central bank and government intervention. Managed futures investments, which outperformed all other asset classes in 2008, struggled most of the year, with the Barclay CTA Index returning (0.09%) in 2009.
The extra liquidity pumped into equity markets buoyed prices to such an extent that any net seller was crushed after the first quarter; quite simply, with the exception of short lived news sell-offs, the market was inundated with buyers. Once the market was assured that the assistance of the central bank and government knew no end, a rally was sustainable and the rush to cash of Q1 reversed. As long as bad news meant more government or central bank stimulus, bad news was good for equity prices; as long as good news meant the recovery was in force, good news was good for equity prices. The result was so skewed to the buy side it wreaked havoc on anyone not in the ‘buy and hold’ camp.
Despite this, 2009 was a successful year for both of ROE Capital Management’s managed futures programs: the Monticello Equity Spreads Portfolio and the Jefferson Index Program. Each program was ranked in the top 20 stock index trading CTA programs by its 2009 return (on BarclayHedge.com). In trading it has been said that where you end up is less important than how you got there, so I dove into those rankings a little deeper, adjusting the top 20 stock index trading CTA’s compounded average rate of return for the risk they endured. (I simply used the Calmar ratio, dividing the Compounded Average Annual ROR by the Maximum Drawdown for all programs in the top 20 list). This moved my programs up to a rank of 5th and 7th.
Since many stock index traders have high account minimums (0K+), I isolated our peers in the minimum capital requirement metric for an ‘apples to apples’ performance comparison. When you compare risk adjusted returns for 2009 for stock index CTAs with minimum capital requirements of 0K or less, the Jefferson Index Program is the number 2 trading program for 2009 and Monticello Equity Spreads Portfolio is number 3.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
PEER PERFORMANCE COMPARISON
Jefferson Index Program
Rank by 2009 ROR
Rank by Compounded Average ROR
Rank by Risk using Calmar Ratio
Rank by Risk Among Programs at 0K or less
Monticello Equity Spreads Portfolio
Rank by 2009 ROR
Rank by Compounded Average ROR
Rank by Risk using Calmar Ratio
Rank by Risk Among Programs at 0K or less
I am quite proud of the performance of both ROE Capital programs for 2009. Relative to the broad market, though they were outperformed in returns, both programs trumped the major averages in risk, with the S&P 500 drawing down over 3 times their worst levels. Relative to their managed futures peers, both programs substantially outperformed all major CTA indexes in returns. In total, both programs successfully navigated 2009′s morass of fishy economic data, low trading volume, shrinking volatility and flood of zero interest dollars that pumped up the equity markets all year.
Part of the success of each program was achieved through the augmentation of my trading algorithms with a series of volatility filters. These models were designed to keep my programs out of the many head-fake signals that abounded last year. In mid-August I deployed these filters, which nearly halved trading volume. Current clients probably noticed a substantial reduction in trading, as we should see round turns per million shrink to 7,000 and 5,500 in the large and small portfolios respectively. These filters will remain active in 2010, as we await the return of ‘real orders on the street’.
Even though the trading models of ROE Capital are systematic and not concerned with the fundamentals of the stock market, a look at the macro situation instructs our position sizing, risk management and performance expectations. 2010 looks to be a year abundant with risks which will pressure equity market pricing. At the time of this writing, the markets are characterized by contracting volatility and anemic volume as they await the first headwinds of 2010. Most of the equity market rally post August 2009 occurred in the overnight trading sessions, with sideways trading during US market hours. Volume and volatility will remain weak during the US session until those headwinds pick up speed.
The key factors affecting equity pricing in 2010 will be a normalization of monetary policy, the looming sovereign debt crisis (ushered in by debt burdened US states), bursting emerging market asset bubbles, anti-business policy coming out of Washington, DC and the lack of new job creation in the US economy. Most of these externalities will induce a sell-off of the inflated value of stocks. Stocks are cheap to cash when the fed funds rate is near zero, so stocks will continue to rise until one of the aforementioned externalities weighs in on equity prices. Corporate profits will continue to look good, bolstered by low cost structures, not by growth. In order for stocks to move higher or maintain their 2009 gains throughout 2010, an engine of job growth must emerge. Otherwise, equity markets-which are presently exhausted-will struggle throughout the year.
I believe that 2010 could be the year that public debt among US states is finally internalized by equity markets, forcing equity valuations lower as public sector debt swamps more states than just California. A crisis of public debt could expose the central structural problems in the US economy: financing the difference between income and living standards, masking productivity loss with inflation and over-reliance on a credit fueled consumer.
My home state of Illinois is a perfect example of the risks posed to the economy by public sector debt. At the end of 2009, Illinois is effectively insolvent. It has .1 billion in unpaid bills 90 days or older, .4 billion in unpaid Medicaid and group health bills and .4 billion in short term debt which must be repaid in 2010. Its 2009 budget gap was filled with federal stimulus money which is unlikely to return in 2010. With falling tax receipts, a mere 2% cut in state spending, three credit downgrades in 18 months (and more on the way) and little additional federal assistance on the horizon, the cash shortfall will be even greater in 2010.
Complicating the current unpaid liabilities of the states are their unfunded long-term obligations in the public pension and health systems. These obligations will start to extort a major toll on state budgets in the coming years. Depending on how you calculate it, Illinois has between and 0 billion in unfunded pension liabilities. Since Illinois’ politicians have grown spending at the expense of funding pensions, they are now forced to add billion to the pension funds next year and billion each succeeding year to meet pension obligations.
This crisis, fostered by hiding the true cost of retirement from public employees, is not limited to Illinois. The largest 116 state and local pension funds in the US are underfunded by .12 trillion dollars using conservative estimates. This is over 3 times the states’ combined municipal debt (0 billion). Some of these benefits-as is the case in Illinois-are guaranteed by law, making default more than just politically treacherous-default is actually against the law.
Even if a debt crisis is postponed beyond 2010, there are still tremendous risks for growth. The expiry of Bush tax cuts will reign in private investment. Congress is examining a host of policy initiatives, any one of which could stall growth and add to long term obligations. As private investment gets crowded out and the public sector falters and contracts, the overall effect will be negative for jobs and consumption. Without a new asset bubble to inflate the market, defensive moves by companies to reign in cost structures will no longer be sufficient to manufacture profits. Valuations should begin to move in line with earnings. All of this argues for lower equity markets in 2010 and an expansion of volatility.
On the other hand, there is an argument for a contraction of volatility and another year of 20% gains in US equity indices. Historically, 20%+ returns in the major averages in years following contractions have more often than not extended through the next year. Midterm elections in the US could change the tone of policy coming out of Washington. States drowning in debt may be able to summon the political will to correct their fiscal course at the state level and use federal funds to get back on track. Since the US has successfully papered over the decline in personal income for many years, there is no reason to assume this year is the year the market takes its medicine.
But the growth scenario is less likely; if the midterm elections do change the course of policy in Washington, it is likely to come at the expense of stimulus for 2010 and signal the markets that a faster retreat from quantitative easing is politically expedient. This would cause the equity market to decline in 2010, though it will be good for the market in the long run. The biggest indicator of a tough year ahead would be if the indexes post a January close below their December lows; if that is the case, equity prices are likely to move lower throughout the year.
Fortunately for algorithmic traders like ROE Capital, we can turn off the macro side of the brain and focus on executing our methodology. I am committed to the systematic, dispassionate execution of my trading models, which are technical in nature. The takeaway from the above macro conditions is that volatility is likely to continue to contract until events unfold which move the market lower. In the event equity markets extend their gains through 2010, volume and volatility remain weak throughout the entire year. Though I favor the case for more pressure on equities and higher volatility, in either eventuality we will be focused on position sizing as we face contracting ranges. When the volatility expands, we will need to be ready to size down, shift our focus to risk and settle in for more price fluctuation and trading opportunities.
As an asset class, I believe managed futures will outperform equities in 2010. While most managed futures programs struggled last year and equity markets showed impressive gains, these gains came at the expense of risk. Who would knowingly risk over half of their investment to earn 25%? In the past 10 years, equity markets have essentially provided no gains (if you adjust for inflation, they have provided a negative return); managed futures have returned anywhere from 75% to 90% over the same period. As many US investors are heavily overexposed to US equities (in IRA investments, mutual funds, individual stocks), alternative investment vehicles like ROE Capital Management add an essential component of diversification to a portfolio, reducing dependence on the performance of the US stock market.
What separates ROE Capital Management’s programs from the pack is that they offer diversification not only from the US stock market, but also from our macro trading colleagues in managed futures. We maintained a slightly positive correlation with the major averages in 2009 (0.45 to 0.50), almost zero correlation to my managed futures peers (0.05 to 0.15) and negative correlation with US and world bonds (-0.10 to -0.22). As my algorithms are structured to perform in either macro environment described above, I am hopeful that we can maintain low correlation with traditional investments as we continue our success in 2010.
It is my hope we extend the gains of both of ROE Capital Management’s managed futures programs in 2010, with less risk and more return. As always, I will be focused on continuing to achieve the mission of ROE Capital Management: to obtain the best possible risk adjusted returns for my clients.
John L. Roe | President | ROE Capital Management, Inc. | http://www.roecapital.com
Ranked as one of the top stock index CTAs in 2009. | For performance – http://www.roecapital.com/perform.asp | For market commentary – http://www.roecapital.com/newsleters.htm
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. An investment with ROE Capital Management is speculative, involves a high degree of risk and is designed only for sophisticated investors who are able to bear the loss of more than their entire investment. Read and examine the disclosure document before seeking ROE Capital Management’s services.