Machine Learning + Regime Switching = Profitability?

My article on a trading strategy based on regime switching and machine learning techniques is now available on Automated Trader magazine (subscription required). The software I used to research this model is Alphacet Discovery, an industrial-strength backtesting, optimization, and execution platform.

Are high oil prices due to hedge fund speculation?

The economist Paul Krugman advances an interesting argument today in the New York Times against the idea that high oil prices are due to hedge fund speculation.

He believes that speculative buying can lead to persistent high prices (which has been the case for the last few years) only if there is physical hoarding. Yet oil inventory level has been normal for this period.

Indeed, I have been trying to find a mean-reverting strategy to trade oil and oil-related assets for some time now. So far, none have outperformed (even on a risk-adjusted basis) just buy-and-hold energy stocks for the long term!

5%: an important number for real estate investors

Equity investors like to check out a company's price/earnings ratio before they invest in its stock. Likewise, real estate investors should do the same before buying a house. The equivalent of price/earnings ratio for real estate is the price/rent ratio, or inversely, the rent/price yield.

What is a reasonable rent/price yield for US residential real estate? According to Morris Davis of the University of Wisconsin-Madison, and Andreas Lehnert and Robert Martin of the Fed, the long-term average is 5% (i.e. the annual rent of a house should be about 5% of its market value). As the Economist magazine has reported, at the height of the US housing boom, this figure dropped to as low as 3.5%.

Currently, this ratio is at about 4.3%, which implies that average US housing price has to drop another 14% in order to return to its historical fair value.

Can quantitative traders profit from this prediction? Well, we can always short the S&P/Case-Shiller Home Price Indices futures at the Chicago Mercantile Exchange.

A combination momentum and mean reversal model based on earnings annoucements

Mark Hulbert of the New York Times just discussed 2 momentum strategies investigated by professors David Aboody, Brett Trueman and Reuven Lehavy.

Strategy A: pick stocks in the top percentile of 12-month returns. Buy them (individually) 5 days before their earnings announcements and sell them just before the announcement.

Strategy B: pick stocks in the top percentile of 12-month returns. Buy them (individually) 5 days immediately after their earnings announcements and hold them for 5 days.

Strategy A is very profitable: the annualized excess return is 47% before costs. (To be taken with a grain of salt due to the large transaction costs associated with trading momentum strategies, especially if small-cap stocks are involved.) Strategy B is very unprofitable: the annualized excess return is -43% before costs.

So what are the ways we can make best use of this research?

Naturally, instead of buying the top percentile after the earnings announcements, we should have shorted the stocks, thus making Strategy B a reversal strategy instead.

Furthermore, what about the bottom percentile of stocks? Should we have shorted them prior to the announcements, and bought them after the announcements? If so, we would have a very nice dollar-strategy for you statistical arbitrageurs out there!

8 Recommended Sites for Economic Research

I am happy to have my guest blogger Heather Johnson write about economics again. (I hope to emerge from my hiatus soon after finishing the final draft of my book on quantitative trading.)

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8 Recommended Sites for Economic Research

By Heather Johnson

Without the proper research, your trading strategies are just a shot in the dark. Don't rely on soundbites and headlines to tell you how the economy is doing. A wise investor will be following trends and analyzing his or her own collected data. Below are eight recommended sites for economic research that traders should find very useful.

1. AEI Research - The American Enterprise Institute (AEI) for Public Policy Research is a non-profit group that is dedicated to educating people on economics, as well as politics, government and social welfare. You can find economic policy reports here that may influence your trading.
2. BEA – The U.S. Bureau of Economic Analysis (BEA) provides economic data in a timely and unbiased manner. This service to the public helps people to gather a more accurate view of the U.S. economy. Reports are categorized by region and industry.
3. CIBC World Markets – This organization is the corporate banking department of CIBC, one of the largest North American financial institutions. The global economic data provided by CIBC World Markets is considered to be amongst the most reliable sources for economic indicators.
4. FedStats – This site offers the full range of economic statistics provided by the U.S. federal government. It also gathers data and trends from over 100 agency Websites.
5. Federal Reserve – A trader should always be interested in what is going on with the Fed. Here, the institution provides regularly updated bulletins and data.
6. The Financial Forecast Center – While this isn't a virtual crystal ball, it does offer third-party, objective economic data and forecasts. Compiled by artificial intelligence and available in a free subscription, everything found on this site is completely quantitative.
7. Free Lunch – Ah, and you thought there was no such thing. This source of economic data and analysis begs the question, "Why pay anything?"
8. Bloomberg.com Economic Calendar – This helpful calendar is brought to you by one of the most well-known names in finance. A day trader will find this calendar most useful when trying to determine how the market will move.

Although the list above is far from exhaustive, it should give you plenty of information to chew on for a while. Whether you are trying to forecast today's market or the market over the next six months, you will need to conduct some serious research beforehand.

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Heather Johnson is a freelance finance and economics writer, as well as a regular contributor for CurrencyTrading.net, a site for currency trading and forex trading information. Heather welcomes comments and freelancing job inquiries at her email address heatherjohnson2323@gmail.com .

5 Steps to Managing Risk as a Microfinancier

It might surprise some of you that lending money to middle-class American home owners to buy houses may be much riskier than lending money to Bangladeshi farmers to buy their first cellphones. (The beauty of diversification at work here?)

I have invited guest blogger Heather Johnson to explain microfinancing, and the quantitative risk management tools available if you want to do it yourself.

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5 Steps to Managing Risk as a Microfinancier

By Heather Johnson

Microfinancing is a growing trend among investors, as it offers low-risk money opportunities and a way to bring social change to poverty-stricken communities. "Low-risk" doesn't equal "no risk," of course, so many potential microlenders are keen to learn the ins and outs of credit risk management in this arena. After all, most microborrowers have poor credit or no credit at all. A villager who needs $200 for starting a third-world chicken farm isn't going to fare well in that department, as you can imagine.

The good news is, even in the event of a loan delinquency, you won't be losing a substantial amount of money. Most microloans range from a few hundred to a few thousand dollars. Any losses are unfortunate, though, so you will want to manage your microlending risks and keep loan delinquencies to a minimum.

Here are five steps to managing your risk as a microfinancier:

1. Research Your Borrower – If you're lending through a site, such as Prosper, then you will have access to your borrower's profile and credit reports. However, don’t be afraid to ask more questions if you have any doubts about this person's ability to repay the loan. If you are lending the money through other channels, definitely start with the credit reports and interview the borrower.
2. Lend With a Group – Though this won't make your borrower any more likely to repay a loan, lending with a group will help to spread out the cost and share responsibility. In other words, you will be risking less money and will have other people with the same interests to consult with.
3. Use Analytical Tools – Third-party applications can help you determine what is working best with your microlending. Both seasoned microlenders and newcomers are highly encouraged to use such tools. Microfinance sites that come with excellent built-in tools include Trickle Up, Opportunity International and Heifer International.
4. Provide Incentives – Consider an incentive program for those who pay on time. A small, inexpensive gift will be very appreciated by those living in third-world countries. Lenders have used food, such as rice or corn meal, as a bonus.
5. Be Proactive in Collecting – This doesn't mean you should harass your borrowers. However, you should research your delinquent accounts as soon as payments are late, rather than letting them go into default. There could be a simple breakdown in communication or an emergency on the borrower's end.

One of the biggest draws of microfinancing is the relatively low risk involved. However, that doesn't mean that you will have a 100% success rate. The best way to get your feet wet is to start with a small loan. Something as low as $100 will let you learn the process and allow you to become more comfortable with the system. Microfinancing isn't for everyone, but you may just find your niche with this kind of investment.

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Heather Johnson is a freelance finance and economics writer, as well as a regular contributor for CurrencyTrading.net, a site for currency trading and forex trading information. Heather welcomes comments and freelancing job inquiries at her email address heatherjohnson2323@gmail.com .

Upcoming seminar on subprime mortgage crisis

For readers who live in the New York area, here is an interesting upcoming seminar at Columbia University:

The subprime mortgage crisis of 2007: Anatomy of a market failure

Date: 03-10-2008
Start Time: 6:00pm
End Time: 7:30pm
Speaker: Kenneth A. Posner, Morgan Stanley
Location: 412 Schapiro CEPSR, Davis Auditorium


ABSTRACT

As home prices soared in 2004-5, consumers, realtors, mortgage lenders,
homebuilders, and investment banks all benefited. But few thought the good
times would last -- after all, everyone had learned to recognize a bubble
when they saw one. If that's the case, how did mortgage losses turn out so
large, and why do we find ourselves today confronting a major financial
crisis? This presentation will survey the damage resulting from the
subprime mortgage crash and provide a possible explanation for the magnitude
of the surprise which may be relevant to investors and risk managers in
other markets.


BIO

Kenneth Posner is a managing director and head of the mortgage finance and
specialty finance equity research team. Prior to joining the Equity Research
department in 1995, Ken worked in Morgan Stanley's investment banking group,
where he focused on commercial real estate transactions. He previously
served as a captain of infantry in the US Army, and was airborne and ranger
qualified. Ken earned a B.A. from Yale University in 1985 and an M.B.A. with
honors from the University of Chicago Graduate School of Business in 1991.
He is a Certified Public Accountant and holds the Chartered Financial
Analyst and Financial Risk Manager designations