The bezzle and markets - Risks could be rising

In many ways the effect of the crash on embezzlement was more significant than on suicide. To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country's businesses and banks. This inventory—it should perhaps be called the bezzle—amounts at any moment to many millions of dollars. It also varies in size with the business cycle.

- John Kenneth Galbraith, The Great Crash 1929

Credit spreads are tight. Key equity markets are higher  although it may not be the case for the average firm. Commercial real estate has fallen yet valuations are not fully reflective of market reality. If there is not a sale or refinancing, the old valuations do not have to be adjusted.  A growing concern is the ratings of CMBS. A triple-A rating may not hold. The result of where we are in the business cycle and the pricing in some markets suggests that the environment can have hidden bezzle risks. 

Going back to basics, there are potential principal / agent problems where managers and owners may hide or lack forthcoming of current conditions. There is a cyclicality with embezzlement, and this should be a growing concern. If there is a change in the tide of the business cycle, these actions will be revealed. 

I don't have clear evidence of any wrong-doing other than to say that business cycle changes will reveal management incompetence or worse.  

 See John Kenneth Galbraith and the "bezzle" - It is a global issue

Connectedness and networks in finance

All knowledge is connected to other knowledge. The fun is making the connections. 

-Arthur Aufderheide Paleopathologist "the mummy doctor"

I have been spending a significant amount of time studying the measurement of connectedness across markets and looking at network analysis. Much of finance is focused on the properties of a single market or a pair of markets, yet it may be better to think about markets as a complex network of relationships with each market representing a node and the connections are edges. 

Some may view that network analysis is a just another way of thinking about correlation and they would not be wrong on an initial level, but thinking about markets as networks provides a deeper understanding of the connections between markets. Correlations between (x,y) and (y,x) are the same, but a network analysis can provide some insights on the direction of causality. It is extremely useful to understand whether a market shock has a spillover or contagion effect. Causality tests like those developed by Granger is one way to approach the problem but that analysis does not provide any visual insights of how a set of markets are connected. 

While there has been significant work on networks and financial markets, it has not been mainstreamed and seems to be a backwater area for a small group of technical quants. Network analysis should be used as a fundamental tool for describing market relationships. From market networks, we can move to something deeper concerning the networks of trading agents. This requires a lot of data and computing power, but it would allow us to explore the behavior and actions of some agents on the overall market. This will get at the heart of market power, information advantages, and market flows.

I will be posting more on this very interesting area of finance. 

More trendiness when you look at wider commodity universe

In the paper, "Increasing Diversification of Commodities Trend-Following Strategies", the authors compare a trend model using the constituents of the BCOM against an alternative set of commodities called the off-BCOM to show that in the post-GFC environment broadening the set of commodities will provide a higher return to risk. This is clear evidence for enhancing diversification and adding more markets to a trading strategy; however, looking at a selected short period for comparison does not prove the case. 

The researchers compared the 24 BCOM markets against an alternative set of 16 markets. The new portfolio is equal weighted and includes markets in all the major sectors. The success of the alternative portfolio is closely tied to the transaction cost assumptions.

I like the overall results and it fits with the priors of many trend-followers that adding more markets is better than trading less, but these selected results are not a definitive conclusion. Less liquid markets may have greater behavioral biases, more frictions, and more hedging demand on average which will lead to more trends, yet the costs of trading these markets are significantly higher. The authors look at different transaction cost levels and show that at reasonable costs, the off-BCOM mix works.

If possible, add more markets but do your homework on the cost of trading.

US Bankruptcy - Consider that it has only been a year since two bank failures

 

It has been more than a year since we have had two of the top four bankruptcies in the US. All the top four have been in the financial sector, yet we seem to have shrugged at the big failures from last year. Interest rates are still high. The mark-to-market value of bank portfolios should give any investor pause, yet we move forward with tight credit spreads and high equity prices. 

The bank ETF, KBE, is flat over the last two years, and KRE, the regional bank ETF, is still down 20% over the last two years but the important issue is that from the financial sector there can be contagion into the real economy. It may not happen suddenly, but the potential for financial drag may be higher than what is currently priced in the market. The potential for the repricing of credit if rate continue to stay high and growth slows should be considered.

BULL! - A great financial history book

 

Maggie Mahar wrote a great book on financial history surrounding the bull market which lasted until the tech debacle of 2000, Bull! A History of the Boom 1982-1999. I have read this book before but wanted to take a second crack at it given all the extremes currently seen with the magnificent six and the extended rally this year. 

We are in a different environment, but the drivers of any bull, fear and greed still exist. There will be warning signs, but, of course, many will miss theme because there is a bias towards market optimism. Like past bull markets, there will be cautionary tales, but there will be a rumble of the herd as it continues to push prices higher to ensure they do not engage in the fear of missing out (FOMO). 

I am sure you can find Bull! at the local library.  It is not formal history, but in the hands of a skilled writer, you will not be disappointed. It is a quick read but good food for thought.