Great investors and hedge fund managers: their methods and evaluation
Prof William T Ziemba
Alumni Professor of Financial Modeling and Stochastic Optimization
(Emeritus)
Mathematical Institute, Oxford University
ICMA Centre, University of Reading
William T Ziemba Investment Management Inc, Vancouver, BC
Dr Z Investments Inc, San Luis Obispo, CA and
Private International Wealth Management, BC Capital Group, Nassau
CARISMA Seminar, June 25, 2007
Session 2: Forward looking prediction measures and crash models
WTZIMI
7. The bond-stock measure for medium term large crash prediction.
Application to the 1987 US, the 1990 Japan, the 2000-2001 US and the 2002 US crashes
• The idea is when long bond interest rates get too high relative to stock returns as measured by
the earnings over price yield method then there almost always is a crash.
• I used a difference method in Ziemba-Schwartz (1991) and results of that are in Ziemba (2003)
and Berge, Consiglio and Ziemba (2007). See also Ziemba and Ziemba (2007)
• The graph (slide 2:16) uses a ratio or log approach and is equivalent to what is now called the
Fed model, see Koivu, Pennanen and Ziemba (2005)
• I started using these measures in 1988 in my study group in Japan at Yamaichi Research. It
predicted the 1987 crash; see that on this graph. It also predicted the 1990 Japan crash and I
told Yamaichi executives about this in 1989. but they would not listen. Yamaichi went bankrupt
in 1995; they would have survived if they had listened to me and my study group.
• They could have paid me a million dollars for an hours consulting and still made more than
1000 time profit from the advice. It was more important for them to be nice to my family and
me as they were than to listen to the results of a gaijin professor. How could he possibly
understand the Japanese stock market? In fact all the economics ideas were there; see
Ziemba and Schwartz (1991). I did enjoy these lectures, dinners and golf but being listened to
dominates.
WTZIMI
2:2
7. Cont’d
• The great economist Paul Samuelson wrote me: the Japanese stock market is held together
with chewing gum. He was right, sort of. But I did find that all the US research on anomalies,
prediction models, etc worked in Japan on 1978-88 data
• We found for 1948 to 1988 that every time the measure was in the danger zone there was a
fall of 10% or more with no misses. In late 1989 the model had the highest reading ever in the
danger zone and predicted the January 1990 start of the crash then.
• George Soros shorted Japan in 1988 before the bond-stock model went into the danger zone
and lost millions.
• Had he waited till the model said to short, late fall 1989, he would have won millions with
his deep pockets.
• The market peaked at the end of December 1989 with one more interest rate hike.
• Then in January 90 the market started to fall on the first trading day and the entire decline
was -56%.
WTZIMI
2:3
Bond stock danger model (medium term): US October 1987 Crash
.
S&P500 index, PE ratios,
government bond yields and the
yield premium over stocks, January
1984 to August 1998.
Source: Ziemba and Schwartz,
Invest Japan, 1991
WTZIMI
2:4
Bond stock danger model cont’d
• Bonds and stocks compete for the money: strategic asset allocation.
• Model was in the danger zone as early as April 1987 (S&P=289.32, then in
August/September it moved further into the danger zone then there was a large fall in
October 1987; S&P peak = 329.36 end August down to 245.01 at end of November
1987 (actual fall more)
• Stocks continue to rally in danger zone but once they get in the zone, it is quite certain
they will eventually fall, that is have a decline of 10% or more within one year.
I also use a short term behavioral measure based on put and call prices on the S&P500
futures for trading that also works extremely well with a 2-3 month horizon; see §8.
It correctly predicted losses in 3Q2002 (big loss) and 3Q2002.
Otherwise there were no danger signals from 1990-2007.
WTZIMI
2:5
Bond and stock yield differential model for the S&P500, 1980-1990
Source: Ziemba and Schwartz, 1991
.
All 3 danger
zone violations
led to 10%+
declines
WTZIMI
2:6
Bond and stock yield differential model for the NSA, 1980-1990
Source: Ziemba and Schwartz, 1991
.
• We checked all all of >10%,
1949 to 1988.
• Whenever the measure was in
the danger zone, there was a
fall of 10% from the time it
entered the zone. No misses.
WTZIMI
2:7
Japan, NSA
Value of NSA for various spread values
Date/level
Spread, %
May 29, 1990
4.88
Mean
3.79
Upper limit
4.23
Lower limit
3.35
NSA
32,818
20,222
23.754
17,303
• The 4.88 in May 1990 means that even after the drop from 39,816 to 32,818
the stock market was still way in the danger zone
• The lower limit then was 17,303
• The upper limit then was 23,754
So 32,818 was still way too high and the market later fell way below this
WTZIMI
2:8
Short term interest rates in Japan, June 1984 to June 1995
The crushing blow: interest rates increased 8 full months till august 1990. It took years and
. recover from this despite dropping interest rates after August 1990 to 1995.
years to
Bernake and the
Chinese will not
make this mistake in
2007-2009.
WTZIMI
2:9
The 2000-2003 crash in the S&P500: April 1999 enters danger zone
Bond and stock yield differential model for the S&P500, 1995-1999. Source: Berge and Ziemba, 2001
• In the danger zone
in 1999, getting
more into the zone
as the year
progressed.
• The fall was not
until the April 2000
peak and the
August 2000
second peak with
both peaks in the
1500 area
• The S&P500 in
April 1999 was at
1335.
• In 2007 the S&P
has gone to the
level of April and
August 2000
WTZIMI
2:10
Bond and stock yield differential model for the S&P500, 1995-1999
March 24, 2000 1527.46
April 4
1356.56
Sept 1
1420.00
Dec 1998
1229.23
Dec
1999
1460.25
PE flat, 32.34  33.29
Long bond 5.47  6.69
Spread >3, in danger zone
3.69 Dec 1999
WTZIMI
2:11
Price earnings ratio, 1881-2000, Shiller, Irrational Exuberance,
April 2000 updated in 2005
WTZIMI
2:12
S&P 1990-2002: observe mean reversion
Mean
reversion
WTZIMI
2:13
NASDAQ 1990-2002: observe mean reversion
Mean
reversion
WTZIMI
2:14
US Stocks, 1802 to 2001
WTZIMI
2:15
Fed model, 1980-2002, logs of bond-stock yields: my favorite
Called the -22% fall in the S&P in 2002; so did my short term measure in
§8
It called July 2002’s fall (-12% in 3Q2002)
WTZIMI
2:16
Koivu, Pennamen and Ziemba, Co-integration of the Fed model, Finance
Research Letters; 2005
WTZIMI
2:17
Fed model, 1980-2002, logs of bond-stock yields: my favorite
Called the -22% fall in the S&P in 2002; so did my short term measure
It called July 2002’s big fall
WTZIMI
Koivu, Pennamen and Ziemba, Co-integration of the Fed model, Finance
Research Letters; in press
2:18
WTZIMI
2:19
8. A sentiment short term T-measure based on relative option prices:
application to the S&P500 and FTSE100, 1985-2007
The T measure for medium (1 to 3 months) stock market danger measure
• T is the proprietary index of relative put and call prices and the measure of the
expected return of the bias trade that WTZIMI and DR Z use in trading.
• It is a behavorial finance concept based on overconfidence that has been very
accurate since 1985.
• WTZIMI and DR Z also use the medium term bond-stock crash measure based on
long term interest rates and stock earnings yields comparisons.
See Session 5 for details.
WTZIMI
2:20
9. The dangers of inverted yield curves: is this time different?
P.F. Cwik (2004) An investigation of inverted yield curves and economic downturns,
PhD thesis, University of Auburn, Alabama, May 14.
•
The yield curve tends to invert one year before a recession
•
Except for the Q3 1990-Q1 1991 recession, the yield curve has inverted in
every recession since the mid 1962
•
Exceptions: Sept 1966- Jan 1967 the yield curve inverted but no
recession occurred
•
But Q2 1967 had -0.06% real GDP
•
A true exception was Q2 1953 = Q2 1954 recession when the yield curve
flattened but did not invert.
WTZIMI
2:21
Yield curve spreads between 1953 and 2002, Cwik (2004)
WTZIMI
2:22
US business cycle is predictable
Source: Harvey (2003)
WTZIMI
2:23
Is this time different?
Always dangerous to hear this word
Previous recessions had
•
Sharp increases in short rates, plus
•
High long rates
This time slow rise in short rates and well signaled by Fed plus low long rates so many
(like Prof Alan Blinder, formerly vice-chair of the Fed) feel that the danger is not there
•
especially if the inversion is small like it has been so far
But we must be prepared for a bit of a slowdown later in 2007.
But the probability of a serious crash, given the other models, seems low.
We always have to guard against Sept 11, 2001 unexpected crashes though.
Commodity prices are important
Chinese actions are important
•
Purchase of $3 billion stake in Blackstone is the tip of the iceberg of investments of
equities worldwide from the $1.3 trillion and growing foreign exchange reserves
WTZIMI
2:24
10. What was it like in February 2006?
WTZIMI
2:25
What is it now in June 2007?
Bond-Stock Measure
The 10-year bond was about 5.15% on June 18, 2007. The PE is about 17 and earnings
gains continue but at a slower rate so
D = long bond –(1/PE) = 5.51 - (100/17) = 5.15 - 5.89 = -0.74.
So there seems to be no danger here from high long term interest rates relative to
earnings as it has been all 2006.
You need to be about +3 to be in the danger zone.
That would take a huge increase in the 10-year bond rate plus a big PE expansion (higher
stock prices and/or greatly lower earnings).
Neither seems likely. So this is bullish and a buy signal in the sense that large downside
risk is small.
WTZIMI
2:26
T measure December 2005
December 16, 2005 S&P Dec =1274.84
T(March)= 168.6
T(June) = 282.05
So according to T there was little chance of a large fall in the S&P500 in the
following 3-6 months
WTZIMI
2:27
T measure February and June 2007
February 3, 2007 S&P Mar = 1453.10
S&P Jun = 1466.40
T(March)= 81.30
T(June) = 298.40
June 18, 2007 values for September and December give T>100
So according to T there was little chance of a large fall in the S&P500 in the
following 3-6 months
WTZIMI
2:28
Global Interest Rates, January 20, 2006
QuickTime™ and a
TIFF (U ncompressed) decompressor
are needed to see this picture.
WTZIMI
QuickTime™ and a
TIFF (U ncompressed) decompressor
are needed to see this picture.
2:29
The US yield curve keeps flattening with long term 10 and 30 year rates actually
dropping
QuickTime™ and a
TIFF (U ncompressed) decompressor
are needed to see this picture.
WTZIMI
2:30
Global interest rates 17 June 2007
WTZIMI
2:31