Saturday, January 19, 2019

Stupidity - Not acting on what is right in front of you

I defined stupidity as overlooking or dismissing conspicuously crucial information. - Adam Robinson

That definition seems obvious, but there has been deeper research studying how to define stupidity. Of course, this research was published in an academic journal called, Intelligence. 

Nonetheless, it seems that one of the key ways to generate success in investment management is to just not do stupid things. Cut the stupidity and you will be more likely be a success. Unfortunately that is easier said than done. Stupidity is all around us. We are not just talking about behavior biases but rather the issue associated with a lack of good sense or judgment. Of course, behavioral biases and stupidity do intersect. The attempt to employ mental shortcuts will lead to stupidity.

Three behavior linked with stupidity from research work include:

  • Confidence ignorance - taking high risks without the skills to be successful;
  • Absent mindedness - the lack of practicality. Not being able to properly execute simple tasks;
  • Lack of control - allowing compulsive behavior to interfere or override important tasks.
Stupidity is not a problem for individuals. There is a spillover effect to others. The economist Carlo M. Cipolla defined some laws of stupidity:

  • Law 1: Always and inevitably everyone underestimates the number of stupid individuals in circulation. We may underestimate the number of stupid investors in financial markets.
  • Law 2: The probability that a certain person be stupid is independent of any other characteristic of that person. Any one group has not cornered the markets for stupidity 
  • Law 3. A stupid person is a person who causes losses to another person or to a group of persons while himself deriving no gain and even possibly incurring losses. There is no intent to be stupid. It happens and hurts others.
  • Law 4: Non-stupid people always underestimate the damaging power of stupid individuals. In particular non-stupid people constantly forget that at all times and places and under any circumstances to deal and/or associate with stupid people always turns out to be a costly mistake.
  • Law 5: A stupid person is the most dangerous type of person. A corollary: a stupid person is more dangerous than a bandit. You cannot form laws against stupidity.

The importance of rules with asset management is very simple. Systematic action helps enforce good behavior on your actions. The use of discipline will help ensure President Obama's rule, "Don't do stupid stuff".

The Efficient Frontier - Not a Line but A Cloudy Dream

This is a very interesting chart of the efficient frontier from Fidelity for a number of reasons. On one level the return to risk locations for different asset classes are relatively stable, but there has been a mean reversion of returns during the fourth quarter that is pulling return to risk ratios back to long-term averages. Excess returns by definition cannot last forever. The fourth quarter was a correction to the long run and by the evidence in January perhaps an over-reaction.

As important as mean reversion is the fact that the efficient frontiers cannot be thought of as fixed lines. They are dynamic and changing through time with the sample of data used. Think of the efficient frontier not as a line but as a cloud. The efficient frontier for any three-year period is just a sample of the true return to risk. Another period will give a different sample. Each sample of returns will have errors and these error are what cause headaches for investors forming asset allocations. 

Consequently, there is no single most efficient point on the frontier. 
--> The sample time period used, and the asset classes included affect the frontier. These are some of the important points made by Richard Michaud years ago that need to reinforced on a regular basis. 
The efficient frontier is constantly changing based on the simple idea that it is only generated from a sample of data on return, volatility and covariance. The actual or expected returns will not match the sample. Hence, there can be multiple solutions to what is the most efficient portfolio for given level of risk. 

Given the actual performance for asset classes will differ from the expected sample values, there can be wide variation in the results generated from an optimizer. This does not mean that there is a failure with optimization but that sampling matters. The optimal allocation will change with samples.

Investors need to think over multiple time periods. Investors should not overreact to short-run return information. Similarly, investors should understand medium returns like the last three years do not represent the long run. Perhaps this is one reason why looking at momentum and trends are important. Trends provides context for where we are and where we have been with price. Finally, the issue of sampling error reinforces the idea that diversification can offset the mistake of investment exuberance.

Thursday, January 17, 2019

Dollar down - A big trade for 2019?

What was keeping the dollar moving higher? A simple difference in monetary policy has been a key driver. With the Fed tightening through raising rates and engaging in QT, the reserve currency provider was out of step with the rest of the world. However, recent comments by Fed Chairman Powell and other Fed bank presidents have changed policy expectations. If there is a pause, patience, and caution, it is less likely that rates in the US will move higher. Expectations in forward rates have already declined significantly. A key underpinning for the dollar has been taken away. If the interest rate gap between the US and the rest of the world does not widen, other determinants will drive currency moves. 

One of the next currency drivers is valuation. In this case, the dollar, as measured by a number of models, is overvalued and the divergence is not trivial. The Big Mac index is just one example. US growth that is more consistent with the rest of the world will support a move to fair value. Now history has shown that the half-life for closing valuation differences can be measured in years, but with monetary policy not as supportive of a strong dollar other factors will serve as drivers. Investors may look to selected equity and fixed income markets to take advantage of these opportunities.

Monday, January 14, 2019

What will be the cause of the next recession?

There has been increased market talk about the next recession. Many are predicting it will occur this year albeit the dispersion of views is wide. To do a proper assessment for the cause of the next recession investors should go back to the causes of past recessions. This one will be different, but we should assume there will be common features with the past. 

Brad DeLong provides an historical view in a recent Project-Syndicate commentary. While his work is not definitive, it focuses on a key point that the last three recessions were all related to a financial crisis or dislocation. There may be a multitude of causes for these financial crises, but there still is the commonality that financial excesses have been the driver.

Working from this premise, it is likely that the next recession will also be crisis driven. Consequently, we need to focus on what will be the financial crisis catalyst that will potentially drive the US economy into recession. It is likely that any crisis will be linked to an inadequate policy response caused by the uncertainty associated with the crisis events and the cautious nature of policy-makers. Policy missteps will exacerbate any crisis, and the potential for mistakes is higher under current policy management.

Given the first cause will still be a financial dislocation, our sleuthing will have to focus on where this financial crisis will occur. The global financial system is highly levered based on the extended period of low interest rates. Many governments continue to run high deficits with little room for counter-cyclical policy. Corporates are highly levered with a high degree of risk in the triple BBB corporate bond market. Consumers leverage is a mixed bag, but student loans have exploded in the last decade. Both European and US banks have been negatively affected by the recent market downturn and there is heightened stress in Chinese financial markets. An especially sensitive area is the dollar denominated debt with emerging markets. 

While many credit sectors are at heightened risk exposure, there is no one single market sector that is extremely stretched. There is no tech bubble. There is no mortgage bubble even with housing prices at highs in some markets. There is not special stress in key financial sectors. The heightened risk from high leverage will make any economic shock more meaningful. The potential for a financial crisis is everywhere and nowhere and that overall leverage risk may be the potential flash point but it may not be immediate.