WTZIMI

Great investors and hedge fund managers: their methods and evaluation

Session 2: Forward looking prediction measures and crash models

Prof William T ZiembaAlumni Professor of Financial Modeling and Stochastic Optimization

(Emeritus)Mathematical Institute, Oxford University

ICMA Centre, University of ReadingWilliam T Ziemba Investment Management Inc, Vancouver, BC

Dr Z Investments Inc, San Luis Obispo, CA andPrivate International Wealth Management, BC Capital Group, Nassau

CARISMA Seminar, June 25, 2007

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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.

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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%.

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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

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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.

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Bond and stock yield differential model for the S&P500, 1980-1990

Source: Ziemba and Schwartz, 1991

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All 3 danger zone violations led to 10%+ declines

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Bond and stock yield differential model for the NSA, 1980-1990

Source: Ziemba and Schwartz, 1991

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• 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.

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• 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

Value of NSA for various spread values

Date/level Spread, % NSAMay 29, 1990 4.88 32,818Mean 3.79 20,222Upper limit 4.23 23.754Lower limit 3.35 17,303

Japan, NSA

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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 years to recover from this despite dropping interest rates after August 1990 to 1995.

Bernake and the Chinese will not make this mistake in 2007-2009.

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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

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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

Bond and stock yield differential model for the S&P500, 1995-1999

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Price earnings ratio, 1881-2000, Shiller, Irrational Exuberance, April 2000 updated in 2005

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S&P 1990-2002: observe mean reversion

Mean reversion

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NASDAQ 1990-2002: observe mean reversion

Mean reversion

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US Stocks, 1802 to 2001

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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)

Koivu, Pennamen and Ziemba, Co-integration of the Fed model, Finance Research Letters; 2005

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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

Koivu, Pennamen and Ziemba, Co-integration of the Fed model, Finance Research Letters; in press

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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.

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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.

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Yield curve spreads between 1953 and 2002, Cwik (2004)

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US business cycle is predictable

Source: Harvey (2003)

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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

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10.What was it like in February 2006?

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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.

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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

T measure December 2005

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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

T measure February and June 2007

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Global Interest Rates, January 20, 2006

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The US yield curve keeps flattening with long term 10 and 30 year rates actually

dropping

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Global interest rates 17 June 2007