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. 

Sunday, January 13, 2019

That marginal piece of information - What do you need to change you views?

“What would I need to see to change my view?”  
- Adam Robinson

Most data are confirming. New economic data are always occurring, but these announcements just reinforce what we already know. First, a lot of economic data moves together, so there is limited added or marginal information. Second, there is a bias with investors that they look for or see confirming information to their existing view. 

If data are not confirming, it is often viewed as just noise or discarded because of our biases.  Non-confirming data does not often cause us to change our view. In a few special cases, there is new data that will cause change. This exceptional data is what we need to focus on and look for, yet we are unlikely to be prepared for it. Some information is special because it is inherently timely and important, or it is of such size that investors have to take note.  

If you ask investors what announcements do they need to see this week that will change their minds about the construction of their current portfolio, most will not have any idea what you are asking. They will understand the question, but will not think about focusing on any one piece or set of information, yet in reality, it is a limited set of information that often causes portfolio changes. A good investor should know what marginal piece of information is necessary to change his portfolio and focus on that information.

Think about events earlier this month, the market perception was that the US was headed to recession. Then the 300,000 jobs print occurred and the world changed. The same could be said about monetary policy. The investment world was up in arms about a Fed that would be too restriction, but then Chairman Powell said everything was on the table and the world changed. The investment world is not that cut and dry, but let's also be realistic about how new facts may be the catalysts to a new narrative or a change in the narrative. The two events could not have been forecasted, but n investor should know that jobs report or a Powell comment can change market expectations.

To be more specific and systematic, an investor should rank or prioritize information announcements. Some information is useful but not meaningful. Other data are critical for making a decision. An investor should know what is critical and make sure the focus of his time are on those data and events most important. 

Saturday, January 12, 2019

Recession probabilities - There is no consensus

What is the chance of a recession this year? Many have tried to build systematic models to give a probability number. This has been a good advancement in thinking about macro forecasting, but the variability of forecast is unusually wide. Different inputs will give different probabilities and there is no consensus on what should be the right inputs.  

Currently, there are systematic models that estimate the probability as being less than 1 percent as well as models that say the likelihood is 90 percent. There is also survey work that measures the median view of a recession. There is no doubt the chance of a recession is higher today than a year ago but a median of all the forecasts is around 25 percent. This is not high enough to cause a fully defensive cash rich portfolio to be implemented. However, the upward trend in expectations is signal enough for investors to reduce risk. 

Continued increases in probability should, in general, lead to further reduction in risk exposure, but the high dispersion means there is a greater opportunity for higher returns based on swings in market judgment. 

Wednesday, January 9, 2019

Risk Parity - A tough year for this diversification strategy

Risk parity was thought of as a portfolio strategy that would protect investors buffeted with uncertainty. Don't think about dollar allocations, but risk allocations; it is a better way to manage a portfolio. Unfortunately, theory does not always work in practice. Using a simple benchmark of the average return for mutual funds with 50-70% equity allocation would have had slightly better returns than the 10% risk parity index and would have done much better than the higher vol indices in 2018.

When no asset class does well and volatility is targeted at higher levels, risk parity cannot save an investor from loses. A combination of two volatility shocks, February and the fourth quarter, was enough to cause under performance. Levered into a volatility spike and then delevered on the reversal after the spike will create a whipsaw effect. There is no safe harbor with risk parity. Does this mean investors are done with the strategy? It will still have advocates, but there will be a search for new portfolio solutions. 

Set it and leave it alone portfolio management has significant costs when there are regime changes. While active discretionary management may not be a solution, systematic rules that address regime change will help with allowing for some flexibility when there is a market change. 

Tuesday, January 8, 2019

Where are institutional investors going to put their money? Not where you may think

It was a tough year for money managers. All asset classes underperformed cash and most were negative for the year. Equities were a return disaster for December. Hedge funds did not do well for the year. So what will investors do? 

The BlackRock Institutional survey for 2019 has come out and provides some interesting choices by managers. The survey represents over $7 trillion in assets under management and and 230 institutional managers. The actually timing of the survey is not clear so I cannot say whether all of the return information for 2018 was available when the survey was conducted.

The  number show a decrease in equity and increase in fixed income for 2019 with hedge funds and cash allocations staying about the same. However, private equity, real estate, and real assets all show an increase in allocations. Does it seem at all odd that after a poor performance quarter, greater talk of recession, higher volatility, and the likelihood that we are late in the financial and credit cycle, investors want to increase their exposure to less liquid investments?

There was the stretch for yield when rates were low but now it seems like there is a stretch for investments that don't have to face the ugly effects of volatile pricing. How can anything go wrong with holding less liquid assets when if there is an economic slowdown, there will be increased redemptions on the part of end investors?

What are shadow interest rates telling us?

We cannot forget that the zero bound on interest rates caused distortions in market price signals. Now in the US rates are above the zero bound so it seems like the concept of a shadow rate is not important; however, it is still relevant for many other central banks and it provides a good measure of where we have come over the last few years. Using the shadow rate as a historic measure of relative tightening, we can say that the Fed has actually been on a tightening policy since the end of quantitative easing. The size of this tightening is not much different than what we have seen in other Fed tightening cycles. While we cannot measure the true bite of rising rates, we can say that the Fed has been at tightening for much longer than most investors think.

The concept of the shadow interest rate was developed to determine what should be the short-term interest rate when constrained by the zero bound. The shadow rate can be an important tool to look at monetary policy even when rates go above the zero bound because it can give investors insight on where we have been versus where we are with rates. 

We use the Central Bank of New Zealand website as a place to check on the shadow short rates around the  world. 

For example, you cannot think about US rates rising from zero as the amount of tightening seen by the market. Rather investor should think about the rate rise from the minimum of the shadow rate. In this case, the Fed has been tightening for longer and the amount of tightening is significantly more than 200 plus bps. Similarly, there has been a significant rise in the shadow rate associated with the ECB. 

Looking at some of the research by the original author on shadow rates, Jing Wu from the University of Chicago, "A Shadow Rate New Keynesian Model", it is clear that tightening really began when QE ended. The connection with rates is a link that has been missing with many market watchers.

There is a fair amount of estimation error with these shadow rates. It is not  precise tool, but we can go back to the Taylor Rule and see that it does a good job of predicting the fed funds rate as well as the shadow rate. The shadow rate is similar to the Taylor Rule implied rate. Track the shadow rate and follow the Taylor Rule and you have a pretty good combination of indicators of what central banks may be up to without relying on reading central bank tea leaves through policy speak.

Sunday, January 6, 2019

Hedge fund performance - Not great for those looking for absolute returns

The only hedge fund sectors that made significant returns in December were global macro and systematic CTAs.  These are the divergence strategies that are supposed to generate returns when there are market dislocations. Macro and systematic managers, through casting a wide net across asset classes and going both long and short, should find opportunities when there are significant dislocations. The remaining hedge fund strategies lost money, but significantly less than the exposure to market beta. It was not a successful month for most hedge funds, but it was not as bad as exposure to equity beta. However, long duration Treasuries proved to be a better hedge.

For the year, many hedge fund strategies actually underperformed equity and fixed income beta benchmarks. The only areas that performed well on a relative basis were fixed income relative value and CTA (global macro and systematic) strategies. Of course, these are index averages, but it provides some insight on hedge fund behavior during a difficult year.

Saturday, January 5, 2019

Facts and Stats - Some facts are interesting but not useful

The end of the year is usually filled with reviews and facts about what happened and speculation on what may happen in the future, yet investors can be cluttered with too many facts. Some facts can be very interesting and great for conversations, but that does not mean they are useful for plotting a course for 2019.

One of the more interesting facts about 2018 is that just about all assets underperformed cash or were just outright negative. It was a bad year and the numbers prove it. It was an unusual in its badness because there was no protection, but these facts may not suggest what will happen to 2019.  These facts are interesting but not useful. 

Now, another interesting fact is the number of global stock indices that are in correction or a bear market. This is interesting, but actually useful in context.  We see that the numbers for 2018 are high and have exploded from a low base.  But, we have seen the same thing in 2016 as well as 2012. The number of markets in correction or worse is high but this state of the world is bad but not unusual. 

What makes this more useful is that a US perspective may have warped our view of what should be normal for equity markets. The high returns for the US and the long period without a bear market or a correction suggest that current conditions are not unusual, but that much of the behavior for US equity markets post the Financial Crisis was the extraordinary fact. If you are a US only investor, get used to what the rest of the world has been facing. 

Just as important as Powell Put - China monetary action; PBOC on the move

One of our major themes for 2019 is that investors should more closely track monetary policy developments in China. The reasons are simple: the economy is big, its trade impact is global, and the PBOC at times has followed a monetary policy at odds with the Fed and ECB.

Before the employment number and Fed Chairman Powell's comments at the AEA, the PBOC lowered the reserve requirement ratio (RRR) by a full 1 percent which could have a stimulus effect of $100 billion on the Chinese economy.  The RRR will move to 13.5 percent for large banks and 12.5 percent. This is the fourth change since the beginning of 2018. 

This RRR change was after an announcement earlier in the week that changed the definition of a small business to allow the RRR to impact smaller loans. The PBOC has also tightened the payment of reserve requirements to make policy more uniform.  The RRR will offset an announced of a cut in a lending facility in the first quarter. In December, the PBOC announced their policy stance has moved from "neutral to "an appropriate balance". Some of these actions will provide needed liquidity during the Chinese New Year period, but this is still part of a larger policy of gradual easing.

This announcement is part of an ongoing China policy process to provide needed monetary and fiscal stimulus without leading to or creating credit extremes. The gradualism wants to thread the needle between needed stimulus to keep the economy running well when the rest of the world may be slowing while not providing so much stimulus as to cause a dreaded bubble. This easing is concurrent with the enhanced trade tariff shock from the US.

Are these policies working? If you look at the contemporaneous data on growth, there is an argument that this gradualism is not having a strong impact. The economy may need a bigger boost, but there is the ongoing problem with an excessively credit fueled economy. The addicted economy needs continual fixes to just stay the course. Nevertheless, these internal issues do not change the need for investors to watch China monetary policy closely.

Powell Put in place after AEA comments

Every Fed Chairman has their own variation on the market put strategy; Greenspan, Bernanke, Yellen and now Powell.  We can call this new one the "everything on the table" put strategy where the guidance of yesterday tells us nothing of what might happen tomorrow. This may be a reluctant put. Powell may have tried to stay the course for tightening, but a bear market can change the mind of many a well-intentioned central banker.

The Powell comments at the American Economic Association meeting were fourfold:

  • “We’re always prepared to shift the stance of policy and to shift it significantly if necessary.”
  • "Listening sensitively to the message that markets are sending" (like in 2016).
  • "We will be patient" 
  • "Wouldn't hesitate to adjust normalization" (from the comments in December, "I don't see us changing that..")
However, the Powell put was already being structured in comments by a number of Fed officials since the Jackson Hole Conference when they have stated that the Fed will be sensitive to current economic and market data.  It is now more explicit. 

It is clear that the market has been expecting a change in Fed behavior from the policy of staying the course, just look at the probability of a rate hike since November. The market has believed that the Fed Chairman Put is still alive and well.

There should be no question that the Fed uses more than a Taylor Rule to determine rates; include financial stability. The Fed does not want to be known as a destroyer of wealth. 

Friday, January 4, 2019

Managed futures - Provided return and diversification during difficult December

With strong trends in both bonds and equities, managed futures generated good positive returns for December. The index average does not do justice to the positive performance for some managers. For example, the CS Managed Futures Liquid Index was up around 6% for the month or four times greater than the SocGen CTA index. All of the CTA indices from BarclayHedge reported gains except for Agricultural traders. Managed futures also did well versus other hedge fund strategies and proved to be uncorrelated during the December market disruption. Versus other hedge fund strategies within the Credit Suisse liquid beta universe, managed futures outperformed other strategies by 600 to 900 bps. 

Managed futures funds were able to take advantage of the dislocations in markets from both the long and short-side and were able to effectively position portfolios with the current longer-term trends. Short-term traders showed more mixed performance given the strong intraday ranges seen in markets, but again there was a wide range of winners and losers. The only reason why returns were not larger was because many managers volatility target positions and portfolios. Risk exposures were down in December.

While one month does not make a year, the good performance during a volatile market period may give investor pause about allocating away from managed futures in 2019.  

Strong trends across most market sectors

December was a great trend environment for those focused on intermediate to long-term timeframes. There were profitable opportunities in both equity indices and global bonds. Equity index trends flipped early in December and have accelerated albeit with greater intraday volatility. Bond trends continue on slower macroeconomic growth numbers and the perception of a more dovish Fed. Strong signals exist for short, intermediate and long-term timeframes. There are also strong rate trends as Fed expectations radically changed. Currencies generally show downward trends except for Japanese yen. Nevertheless, these trends are more mixed relative to bonds. Precious metals show upward trends while base metals are generally down. The energy complex shows short signals even with declines in OPEC production. Commodities also show downtrends.

The value of these trends may not have shown-up in performance numbers for trend-following firms because of the higher volatility and the Christmas holiday season. Managers who size positions on volatility have cut exposure in many markets from what was seen a few months ago. Similarly, many managers will cut positions based on liquidity concerns over the holidays. Those firms that trade without liquidity constraints or volatility positioning and targeting likely performed better this month.

Tuesday, January 1, 2019

If it keeps on rainin' levee's goin' to break When the levee breaks I'll have no place to stay.

If it keeps on rainin' levee's goin' to break
If it keeps on rainin' levee's goin' to break
When the levee breaks I'll have no place to stay.
-Led Zeppelin

The levee broke in December with heavy selling of equities. Long duration Treasury bonds offered protection through its negative correlation with stock but there was little to make investors happy for the year. In some cases, the entire year’s return was swiped out in one month. Some analysts have suggested that this is the first time where almost all asset sectors and categories generated negative returns. Bad technicals, a change in sentiment, policy uncertainty, weaker growth data, increased expectations of recession, an inverted yield curve, the continued increase in rates by the Fed, lower liquidity across central banks, a US government shutdown, and tariffs wars can all be used as reasons for the fall. Any one reason seems excessive, but the combination has proved to be too much for further market increases. 

There are good reasons to argue that markets have overreacted, but a simple asset allocation decision is perhaps best - don’t fight the trends. A trend is the aggregate weight of changing market opinions and there has been a sea change. You may disagree, but the cost of being wrong or fighting the headwind is high. Being defensive and waiting for new information will not provide a first mover advantage, but it also allows for better principal protection. However, making significant changes to exploit the December drop may be late especially if there is no reinforcing information.