Intrinsic Alpha June 2013

7/28/2019 Intrinsic Alpha June 2013

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Intrinsic Alpha Note – June 2013

“First rule of business, protect your investment.” -

Etiquette of the Banker 1775

“Who would have thought it?!” – Common phrase

“A cynic is one who knows the price of everything, but

the value of nothing” – Oscar Wilde

“Theory disconnects from price via reality, Price =

Theory + Reality” – The Macro Man

A Reflexive Admission

This is the first Insights Note I have authored hence I

apologies profusely for any lack of clear direction and its

obtuseness in advance. I shall begin with an admission, I

am new at this. For the last 5 years I have been a keen

market observant, attempting to cultivate my ownthoughts by trying to get my hands on anything and

everything I could read. The volume of material available,

across books, blogs, cable TV news shows, the Bloomberg,

internet news, analyst notes, fund manager notes and

newsletters is impossible to digest. The vast array of

opinions and views has the effect of drowning the reader.

I am guilty of attempting to swim in this ocean of

information, and yes, I’ve drowned. This informational

barrage is too complex to navigate. I find my own ideas

are difficult to cultivate amidst the storm. For this reason,I have taken some time to think deeply about what I

would like Intrinsic Alpha to become and how I wish to

develop myself.

Any navigator requires a map and a set of principles with

a philosophical structure to hold it all together. Intrinsic

Alpha will be my first honest attempt at attaining

legitimacy in my opinions and the way I place my chips.

To be clear, I am managing my own money, no outsiders.

Hence all the risk borne is mine and mine alone. This

structure gives me flexibility – think of me as a smallpirate ship, where I am the crew and captain. The

philosophical underpinnings of this operation are as

follows:

1. Existentialism is what drives us. We are all free to

define who and what we are, but most importantly what

we want.

2. Due to existentialism, we are in control of our own

destinies and can take full ownership. We are able to

identify inhibitors of our true aspirations and eliminatethese to realise ourselves.

3. The only truth in our universe is in uncertainty, which

implies that strange things happen. We shall seek to use

this to our advantage.

The preservation of capital is paramount to generating

sustainable and meaningful returns. I am a true believerof compounding returns over time and avoiding large

drawdowns. Any trades I execute will adhere to strict

risk/reward criteria – in short, I seek to identify convexity

and take full advantage i.e. trades which require little risk

with asymmetric payoffs should events unfold as

envisioned.

It is no coincidence I have chosen the Alchemic symbol of

Uroborus to represent the philosophies of the operation.

The self-consuming perpetual serpent embodies the

principle of Soros’ reflexivity, that markets look atthemselves for direction, that markets exhibit repeating

behaviours and cycles and that ultimately the cause can

be the effect and the effect the cause. Reflexivity is what

creates convexity.

The Status Quo

People have tried to establish strategies for investing to

help participants navigate volatility and the strangeness

of markets. The Value investors try to pick up 50 cent

dollars, the technical analysts try to drive by looking through a rear-view mirror. Risk Parity relies on investor

flight to liquidity when risk premia increase. Whatever

works. Numerous philosophies and theories have also

been developed, for instance the Elliott Wave Theory

popularised by Robert Prechter in the late 70’s is used to

support his Socionomics theory. I do not believe it is

necessary to subscribe to any single way of doing things –

I believe all of these tools and philosophies can be useful

to some degree, although ultimately investment decisions

are made through the aggregation of thoughts, ideas,signals and hence judgement. This judgement comes

from within, and it is something that cannot be learned

from a book, it is developed over time through

experience.

I have come to the conclusion that the way to generate

returns is to trade market expectations. You don’t need

an event to unfold completely, only for market

participants to change their thinking.




Another way to think about this is in terms of probability

distributions. The price of any security is the

instantaneous aggregation of supply and demand. At any

given point in time, there is a chance the price will rise orfall. Options on securities seek to capture this via the

volatilities that are used to price them. The resulting

volatility skew is what informs the shape of the

distribution participants are pricing in. Value investors

believe the market has got the distribution wrong and

that price will eventually reflect intrinsic value. Macro

traders believe they can foresee turning points or jump

on trends to ride price action. All of these strategies rely

on price movements. My take on this is that it is most

effective to trade market expectations. For example, in

May 2013, it was consensus that Greece would default on

its debt and leave the Euro. Financial media even coined

the term “Grexit”. Market participants exhibited text-book

behavioural biases:

Anchoring and Availability – everyone was

talking about a Grexit, many credible pundits

claimed it was a matter of time. People took this

to mean it would happen.

Estimating Probabilities and Valence – a Grexit

was easy to imagine, hence people believed itwould happen. Individuals tend to accept

outcomes that are easy to imagine. Humans are

also notoriously poor at evaluating probabilities.

It was no stretch of the imagination to believe Grexit

would happen, yet it did not. Why not?

Google Trends analyses a portion of Google web searches

to compute how many searches have been done for the

terms you enter, relative to the total number of searches

done on Google over time. I decided to try "Grexit", andgot this:

Clear capitulation in May 2012 – just coming up to the

Greek election that would decide the fate of the small

nation and most likely the Euro project. There was a clear

high convexity trade at that point in time. If the election

result means Greece stays in the Euro, the stock market

would ramp up. If not, the market would make even

lower lows. A leveraged long position could have been

executed with a tight stop to create high reward potential

for a small margin outlay. What came to pass was the

Athens Stock Exchange General Index bottomed out at

477.42 on 6 June 2012 and has since risen to 1035. If I told

anyone at the time I was going to risk £80 to go long a

single CFD contract on the index, they would have said I

was crazy. Lesson learnt. Separate the signal from the

noise and be crazy.

Another example of this was Japan’s recent monetary

revolution. On 5 April 2013, the front page of the

Financial Times (UK edition) displayed the headline“Japan starts monetary revolution”. Haruhiko Kuroda,

Japan’s new central bank governor was going to create

2% inflation by doubling Japan’s monetary base. Simple.

Anyone would expect gold in Yen terms to explode

upwards on the news – he’s practically going to destroy

the Yen. But no. What happened instead was a collapse.

Why? Because before we can get inflation in Japan, we

must admit something – there is deflation. Kuroda was

admitting that doubling their monetary base is required

to stave off deflation. The question I want to ask is, what

happens if it fails and Japanese CPI registers nowherenear 2%? Could it be that before the phoenix rises it must

burn?

Today being a gold bug is all the rage. To be long gold

means you are a genius, so much money is being

“printed” and it has gone up for 10 straight years in a

row. This year, is not looking so good. The trend has

changed, but the bugs will never change their views and

be squashed under the weight of their biases. They view

the metal as revenge against the “banksters”. They are

probably right for the long-run, but it’s the path of

returns that matters, remember, above all preserve capital

by avoiding large draw downs.




My Greek experience led me to investigate the notion of

market expectations. Greece did not default, yet there

was money to be made by going short all the way down

to capitulation, and then going long to ride the wave up –

trading market expectations. It is unnatural to switch

from long to short in an instant. The emotional andintellectual investment required in deciding whether to

go short or long a security makes “the flip” difficult. The

internal conflict is almost too great. Perhaps that is what

is meant by “having balls” or “courage in your own

convictions”. Problems arise when one tries to fight the

market. You increase your chances of being stopped out.

I am not a fighter. For this reason, any trade idea I

cultivate will be based on the legitimacy of trend. Recall,

there are three types of trend, up, down and sideways

and money can be made from all of them.

When I grow up I want to be like

Hugh Hendry. The brazen

Scottish hedge fund

manager at Eclectica AM

serves as a perfect role

model. He is a true

contrarian, but admits it

pays to be contrarian only

20% of the time. I have read(and I’m still digesting)

everything I can get my

hands on regarding Hugh

Hendry. His words are full

of wisdom and he is truly

inspirational to me. I was

once fortunate enough to see him walking in the streets

of a posh London suburb one afternoon, while I was on

my way to write an Actuarial exam – how ironic, the

exam was on the subject of Investments, and I failed. I

took that as a sign. Sure, Hugh would say “God is dead”and “you’re on your own”. He would say screw the

exams and follow your dreams. I am trying. The universe

conspired to allow for a chance encounter that would

change the rest of my life. Who would have thought! I

will try to embody the following aspects of Hugh’s

wisdom:

You are fearful of the consequences of your

decisions.

Not to be a hostage to your errors – learn from

these.

Don’t you dare take it easy for a single day in

your life.

You have no chance of seeing the future.

Procrastination kills you in a business that is

concerned with managing risk.

Strange things happen…very bright people tend

to be logical in the way they construct

arguments…the joy of our life is strange things

happen.

How I (will try to) run my ship

I’m going to structure the operation into two components

which are not mutually exclusive:

Using between 5 and 10 liquid positions for each

component of the book, I will achieve suitable levels of

diversification across risk factors. Each position will be

considered in the wider context of portfolio exposures. Iwill not use misleading risk measures to disguise risk.

Rather, I will monitor exposures on a daily basis and

adjust these should the portfolio swing out of kilter.

The Macro Strategies will set the tone for the overall

portfolio. I seek to cultivate a view based on trends that

take time to develop, not daily fluctuations. History will

provide the map that will help navigate forward. Time

should be on the portfolio’s side although the trades I set

up will have defined horizons.

The Equity Strategies will focus on individual stocks and

sectors. I shall seek out opportunities trading below

intrinsic value and ride momentum trends where these

are set to continue. I intend to be long only using cash as

a buffer when I am bearish.

I intend to use basic technical analysis tools to ascertain

trends and gauge momentum across any potential

positions, ensuring risk is managed accordingly (keep it

simple). Over the coming months I will elaborate on my

ideas and trades and I hope you will enjoy following meon my journey.

Regards,

The Actuary

Macro Strategies

Growth

Inflation

Equity Strategies

Value

Momentum

Intrinsic Alpha June 2013

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