What you need to know about "crowdedness" risk and return

A Yogi Berraism: At Ft. Lauderdale Yogi was listening to his teammates talk about a restaurant in the area. Said Yogi, “Aw, nobody ever goes there. It’s too crowded.”

There always has been a significant interest in trade crowdedness, or more specifically, the big trades of hedge funds. However, there is a yin and yang with crowdedness. We want to know what smart money is doing so we can follow it, but we realize that if everyone is following the trades of others there will be a tipping point where the crowd will kill the golden goose trade. This is another way of saying the mix of buyers and sellers has an impact on the future direction of prices especially if there is a crisis. The structure or composition of funds and markets matters.  

Now crowdedness has not been well-defined, but a good measure is the numbers of days to liquidate equity positions held by hedge funds. Research has found that crowdedness as measured by the position-taking of hedge fund managers through the 13F filings will generate positive excess returns of approximately 300 bps versus stocks that are not crowded. (See "Crowded Trades and Tail Risk") 

This new crowdedness factor seems to be independent of other key equity risk factors. The collective wisdom or information edge of hedge fund managers along with their buying power seems to find stocks that will generate good positive relative returns. But there is a catch.

A close review of the crowded portfolios of hedge fund managers shows strong decline in returns or drawdowns when there is a negative market environment or crisis. Crowded trades do well until the market faces stress that may require liquidation. Investors will receive compensation for holding these crowded trades, but they will pay a price when there is a flight to the exits like during the GFC. Trying to piggy-back on the smartness of others can work, but when this collective smartness needs to find the exits, the market decline will be strong. The negative case is very specific, but it does suggest that following the action of others will have downside during a market unwind.

Geopolitical risks - The spillover to markets is real

 

Geopolitical threats create risk and uncertainty. This seems intuitive and can actually be measured through tracking geopolitical risk indices. These threats can be linked to market reactions, so investors can measure and act on these evolving risks. Below is the widely used Geopolitical threat index developed and updated by Matteo Iacoviello. It uses key word searches from leading newspapers around the world to measures geopolitical threats and acts. In many cases, elevated threats will impact financial markets.

A common theme of my investing thesis has been to focus on the nexus between risk, uncertainty and pricing. If uncertainty increases, it will carry over to market risk as measured by volatility. This increase in market risk will add to market dispersion, change correlations, affect risk aversion and sentiment, and change risk premia. Even if market prices don't move significantly, there will be a change in the wings of return distributions. 

Markets that engage in global trade in sensitive geopolitical area or have been perceived as a place of safety should be more sensitive to changes in these threats. Threats go up and there should be a flight to safety and a movement out of risky assets. 

A causal link from geopolitical threats spillover to oil price volatility and gold moves has been found with recent research. Similarly, threats influence the capital investment decisions of companies. This alternative data index can help with global macro decisions.

See recent research:

“Are geopolitical threats powerful enough to predict global oil

price volatility?” 

Environmental Science and Pollution Research https://doi.org/10.1007/s11356-021-12653-y

“Geopolitical Risk and Corporate Investment” Ruchith Dissanayake, Vikas Mehrotra, and Yanhui Wu

“Hedging geopolitical risk with precious metals” Dirk G.Baur and Lee A.Smales Journal of Banking & Finance Volume 117, August 2020,

“Forecasting realized gold volatility: Is there a role of geopolitical risks” Finance Research Letters Volume 35, July 2020

Margin credit - More complex than just saying it is rising

With the prime broker loses on levered positions, market talk has focused on overall stock margin; however, looking at some of the numbers suggests that the story is more complex than saying leverage is higher. 

We are certainly not arguing that the economy is not levered. The low interest environment is all you need to know. Cheap money will lead to greater credit usage. This is especially the case if the financial instruments being purchased are trending higher. Nevertheless, financial leverage is not the same as borrowing for long-term investment in plant and equipment where the measurement of uncertain future cash flows in an illiquid investment makes for a more difficult assessment.

The quick take:

1. Margin debt balances have increased significantly since the March 2020 crisis. Money is cheap and plentiful, and investors are taking advantage of the opportunity. 

2. The debt balances relative to the SPX market capitalization are increasing but the numbers are below the highs seen two years ago. Leverage has grown with the strong market, but the overall levels are not at extremes.

3. Free credit balances have grown from 2019 lows. There is money available to invest and it not as though all investor cash is being used to boost leverage. Margin accounts are getting the benefit of the rise in equities, so free cash levels have not seen excessive declines based on extreme speculative desires.

In the unregulated swaps markets, the world can be quite different, so any generalization on margin usage should be tempered with a fuller picture. In the regulated market, the leverage usage is more controlled.   

Sell-side research - You get what you pay for, no more, no less

 

Remember, all Sell-Side Research contains at least 1 of the following 3 elements

1.Trades that 40-Act Funds are running after serious traders/HFs stopped out.

2.Death Trap Trades where the bank’s desk needs to take the other side.

3. An honest opinion of an analyst.

Never forget, in life, even lies are intriguing and useful, they reveal where someone's interests are

- Matt Kessel

This view is an extreme, but there is truth in the words that sell-side forecasts and analysis can be biased, are driven by incentives, and have potential conflicts of interest albeit the biases are small as measured by numerous studies. There is also an element of dispersion in forecasts because the quality of analysts varies.

Honest opinions of experts can diverge between being poor and very effective. Academic and private researchers have studied analyst forecasts for decades and we do have a pretty good idea of the benefits and costs of research especially for equity markets. Additionally, there is enough analysis of sell-side forecasts to determine how to weigh this information to generate better forecasts. Don't use single forecasts blindly but employ the wisdom of crowds. Use the crowd estimates as a placeholder for market consensus. Agreement with the crowd may generate positive returns but will not create unique alpha.

In general, research finds that earnings and stock price forecasts may be slightly better than time series forecasts, but they may not be efficient and there may be biases over both under- and over-reaction to different market environments. Analysts have a hard time with turning points and change. Macro forecasts are biased and may not be efficient. There is limited edge gained from using sell-side information.

One of the more current issues with analyzing sell-side research is that the focus has been fairly narrow. There is a difference between reporting or producing analysis and forecasting price or earnings. The analysis comes first and may be more valuable. From analysis, there is an inference or a forecast. If the analysis is poor or assumptions are flawed, it is impossible to get the forecast right. The quality of sell-side research should be centered on the ability of the analyst to provide firm and industry information quickly, cheaply, and efficiently. Providing description of the market details in order to support investor analysis may be more valuable than the work of generating an earnings estimate, stock estimate, or point forecast.