Gold prices are now all about political uncertainty

"Buying gold is just purchasing a put against the idiocy of the political cycle. It's that simple." - Kyle Bass. 

Inflation is lower. Real rates for bonds are higher. Yet, gold is near all-time highs. It may not be the political cycle but the uncertainty cycle. The combination of trade wars and policy uncertainty, with talk of a new world order, drives gold buying. If you don't want to buy the dollar and you are wary of other currencies, gold is a good place to be as a safe asset. Can we place a valuation number on the price of gold? No, this is the difficult part of the process, yet uncertainty seems to be the key causal driver.

Words of trading advice from Larry McCarthy

"Higher prices bring out buyers. Lower prices bring out sellers. Size opens eyes. Time kills trades. When they're cryin', you should be buyin'. When they're yellin', you should be sellin'. Takes years for people to learn those basics, if they ever learn them at all."  - Junk bond trader Larry McCarthy.

This is a combination of trend-following and value investing. Higher prices will bring out buyers, which will lead to trends. At the extreme, when there seems to be extremes in sentiment, do the opposite. These are good thoughts to have in mind, yet execution is much harder than you may think.    

Adrian Day's six investing signs to watch

Adrian Day's six investing signs to watch for natural resource mining and extraction companies (from How to Listen When Markets Speak):

1. Underinvestment bias - Look for periods of underinvestment that could lead to shortages and higher prices 

2. Asset location - Diversify away from problem locations  

3. Production capacity - What is the capacity of reserves left

4. Price to free cash flow - Do not overpay for free cash flow 

5. Price to NAV - Do not overpay for ground reserves and the total value of assets 

6. Management - Look for stable long-term management that delivers on promises. 

Good, simple advice for making investments that can all be, to some degree, systematized. 

The explosion in housing wealth - what does it mean?

 

Forget about the stock market as a wealth creator. The housing market is generating a huge increase in household wealth, which should make everyone happy. However, this gain may come from the huge housing bubble, which has exceeded the bubble from before the GFC. So there is a bubble, and households may feel wealthier, but there is a catch. You cannot convert that wealth easily into cash unless you sell the home. The result is that households may have more wealth, but they cannot consume that wealth, and there is a likelihood that the value of that wealth will fall when you want to monetize it.

Dollar and bonds going in different directions

 

There are usually strong relations between the US bond market and the dollar. The dollar goes up when yields go up. The higher yields attract more foreign investors and are usually a commentary on tighter monetary policy. However, we now have bond yields and the dollar moving in opposite directions. This was an immediate response, but it is telling that there is a desire to no longer hold US bonds and/or the US dollar. Think of this as an abandonment of the safe haven, which is no longer safe, and a movement to a home bias by foreign investors. 

The current credit crunch

 

Risky bond issuance has fallen off a cliff. This is the result of uncertainty. When faced with high uncertainty, delay investment decisions. Issuance will decline, and the price necessary to hold risky debt will fall to clear the market. Hence, we are seeing wider spreads. The result is that we are facing a credit recession crunch. 

GDP forecast and expectations all point in the same direction - down

 

Financial markets are in upheaval, albeit stocks are off their lows. Bonds reflect a substantial risk premium to hold both US Treasuries and corporates. Most importantly, expectations for future growth are falling fast. Even the adjusted GDP now is signaling zero growth. This is an analytic nowcast measure for growth that is below the Blue Chip forecasts. Private investment growth has fallen about one point since the election, and the consensus is that we will have a hard landing in the next 12 months.

Forecasts have been wrong in the past, yet the strong consensus should impact spending and investment patterns. Hence, we are facing a self-fulfilling prophecy.   

Factor investing - The 3 P's framework

 

How many factors should you have in an equity?  The factor zoo is constantly expanding, so you must be continually on the lookout for the next new factor, yet there should be a limit on the number. So, how do you determine the correct number of factors? Felix Goltz suggested that the number should be based on the three Ps - Pervasive, Plausible, and Practical. This is simple, easy to remember, and can be implemented by any investor. Of course, there is much room for interpretation concerning these three P's, but that is a deeper discussion.

Pervasive - A factor should stand the test of time, apply across different asset classes, and be verified through independent research.

Plausible - A factor should have a strong theoretical foundation and a straightforward narrative that can explain its presence. 

Practical - A factor should still be present despite transaction costs and should not deteriorate as more investors use it. 

If you have only 3 factors, you will likely be too stringent with your three P's. If you are getting to a number greater than a dozen, it is likely you should review your criteria. Perhaps these numbers are not wide enough, but this is a good start for forming a process for testing and inclusion. 

The Fed - there is no dissent and that is not good

Jim Bianco generated this interesting chart about the Fed and Chairman Powell. He discussed the power vested in the Fed chairman and whether firing him would be good or bad. His argument is that if Chairman Powell were fired, it would be good for the Fed because there would likely be more dissent from the other FOMC voting members. This argument is a little weird. Creating a crisis with the Fed Chairman would create more chaos, and that would be good for markets and policy. 

I don't buy it, but the core issue is the amount of dissent at the Fed. I think of the old phrase, "If everyone is thinking the same, then someone is not thinking".  Why have an FOMC committee if the goal is to have unanimous voting? Granted, this often happens with boards, yet as a public institution with different district banks, it is hard to believe that everyone is or should be in agreement. More dissent will create uncertainty, but if the goal is uniformity, then let's cut the regional bank model and have a small board. 

The types of hedge fund edges

If you investigate and conduct due diligence on hedge funds, you will be asking the question, "What is your edge?". In markets that are relatively efficient and certainly competitive, you want to know what makes a manager special. However, when asked the question, most managers cannot help but go into a long monologue about all they do that they think is special. Generally, this is not a concise answer. It is helpful if both parties are able to place their edge within a category. 

There are likely five different edges that a manager can have. They are not limited to one, and it is better if there are multiple edges. Think of the edge like the moat surrounding a company. If there is a strong edge, other firms will have a hard time replicating the behavior of the hedge fund manager. Here are the five edges with quick descriptions: 

Informational Edge - Access to better or faster information. This is the space of alternative data, or data that is expensive and cannot be obtained or processed by many firms. Of course, this edge is dynamic and can change with the usefulness of the data.

Analytical Edge - Superior ability to analyze the same data everyone has —better models. I call this the conversion of public information into private information. A data transformation can be an analytic edge. This is the realm of the quant firm and its army of researchers. Again, this edge is dynamic.

Behavioral Edge - Ability to stay rational when others panic or overreact — exploiting behavioral biases. This could be considered their ability to manage risk through a systematic process.

Structural Edge - Benefits from the setup, like lower transaction costs, access to certain markets, or priority in order execution. If you are a short-term trader, this is critical, but all firms can improve through working on their structural edge.

Technical Edge—Superior tech infrastructure, low-latency systems, or highly optimized software for faster execution than competitors. Most think this is the realm of quants. The technical ability to process data and information is critical for good decision-making and risk management; however, all firms can work on their technical edge.

Note that all firms may have some skill in each of these areas. The problem is having an edge that will translate into a process that will translate into consistent return. 

Supply chain globalization - a complex system

 

Trade and globalization today are not the same as 50 years ago.  In the old world or stylized world of trade, final goods are shipped between locations. Raw materials are traded for a finished good. It was easy to see where the value-added was generated. Of course, there still are finished goods traded for finished goods, but a growing portion of trade is in unfinished goods as part of a supply chain. In the supply chain trade, a single corporation may outsource the manufacturing of some parts in another country, which is then sent to another country, and then finally sent to the US for finished production.

Production is determined by labor costs and specialization, as well as the transfer price for parts. Welcome to multi-national supply chain trade.  Hence, the tariff on a part may only be a small part of the total cost of production, but the impact of tariffs becomes hard to measure because many goods made in the US may have components from a foreign country. If tariffs impact deliveries, while parts are assessed for tariffs, there will be a disruption of the supply chain, which will impact the finished production. There will be a congestion "tax" associated with the processing of imports, which will create bottlenecks across the US. We are not making a value judgment but rather assessing the impact of tariffs and what they may do to the US economy. 

There needs to be a realization that any economy is a complex system, which means that disruptions to the processes that make the connections across production will have an impact on the system and will require adjustments that will cost both time and money.

Trend-following smiles and frowns basedon time horizons

 

-from Carl Zarattini

Show me the smile. During these times of stress, many investors in trend-following strategies have been looking or banking on the smile associated with this strategy. It has not happened because there is usually a frown in trend-following based on time horizons. A smile using quarterly data will not appear at shorter time horizons. In fact, during short time horizons, there will be underperformance at the extreme. One, extremes may be associated with changes in trends. Two, extremes may cause trend-followers to be stopped out of their positions. Hence, the trend program, which often uses leverage, may have more considerable losses. 

Changing behavior across time horizons is a reality that must be accepted by trend-following investors. 

The changing global trade mix - World trade is different

We produced a variation of this table just last month with slightly older data, yet it is a critical visual that needs to be digested. The US is not the leading trading partner for most countries. That ship has sailed. This has all happened in the last 25 years since China entered the WTO. There are many reasons for this change, but a combination of cheap labor and mercantilist policies was able to change world trade in favor of the Chinese. This is the headwind impacting a change in US trade relations. A strong dollar, higher relative wages, and less focus on trade have pushed the US to a lower trade status. Diving deeper into these numbers with EM countries suggests that China is a leading trade partner because it is importing raw materials; nevertheless, if China is your main trading partner and also provides financing, global markets will adapt and offset the dollar-focused inertia.   

How world trade has changed - the real issue

Tariffs as discriminatory taxes

 

Tariffs are taxes. Just because it is not levied on income or profits does not change the fact that it is a tax. The tax is levied on entry and is paid by the importer, not the exporter. It may have an impact on exporter profits, but someone will pay for the tax - the immediate is the importers, the less immediate the exporter and consumer. A tariff is discriminatory. It impacts specific goods and leaves other goods alone. The impact is that there is a change in relative prices, which changes consumption patterns. The importers need more financing because they have to pay for the tax before goods are sold. Businesses have to change investment plans based not on demand but on the tariff policies of the government. 

Tariffs are an inefficient tax system regardless of policy goals. The best tax systems are broad-based and relatively flat and will have the minimum disruptive effect on private consumer and investment decisions. The most effective tax systems have a minimum of uncertainty, which negatively impacts long-term investment decisions. 

The current environment is not positive for aggregate investment decisions, nor is it good for businesses or consumers who have to adjust to a changing world based on international goods taxes.  

Vibe or math driven markets

 

We are in a vibe-driven market. A vibe market is driven by perceptions, not expectations, tweets, policy, sound bites, and analysis. We don't have to make a judgment on the quality or type of vibe. There are both good and bad vibes. The type of vibes can change within days. It changes reactions and valuation by driving short-term moves that increase volatility. The large intra-day ranges are the result of the vibes. Traders have to "feel" the vibe and show an immediate reaction.

A vibe market is not a math-driven market. Valuation models based on quant relationships will not be effective. In a past life, we would call this market noise. Noise may not have a cause. In this case, we know the cause of the noise: short-term news that has uncertain longer-term meaning or limited context. We are seeing the impact of vibes on the poor performance of systematic traders. We expect this underperformance to continue as long as we have the vibes driving markets.

Rodrik and the contradiction between globalization and sovereignty

Those countries that choose more globalization lose their domestic sovereignty, while those that limit globalization can have greater control over their domestic economies. This is the thesis of Dani Rodrik, a unique thinker on trade and globalization issues.  The issue is not either black or white, but accepting hyper-globalization will impact an economy driven by the behavior of other countries. Independence in sound production and capital movement is lost. There is a substantial benefit, but in the extreme, cheaper imported goods may hollow out internal production, which generates less domestic control over the economy. Globalization may be at odds with national security. Again, there is a loss of control. The globalization shock worldwide was swift, often with limited consideration of the long-term impact, yet reversing the effects of hyper-globalization is not simply a reversal of the trade. The process of deglobalization, even on the margin, takes time and will have costs. 

Solving a contradiction is not without costs. There will be winners and losers, and it takes time. A process of reversal will be painful and needs careful consideration.  

Treasury trades and liquidty

 

Most of the Treasury RV trades all have something to say about liquidity. In the past, traders often looked at the TED spread as an indicator of liquidity concerns and stress. Now, we have a wider set of liquidity indicators based on hedge fund-levered Treasury trades. A shock in these spreads is based on a change in Treasury yield expectations and will lead to a decline in liquidity that will force deleveraging or arbitrageurs to leave the market.

Treasury Basis trade—The difference between Treasury futures and the cheapest-to-deliver bond. Treasury futures trade at a premium to cash bonds, yet that premium will change with market conditions, albeit converge at delivery. Hedge funds can sell futures and buy the cheapest-to-deliver bonds to capture this premium.

Off-the-run vs. on-the-run trade - The difference between the current Treasury bond most recently issued and bonds that are slightly older since issuance. There is a liquidity premium with holding the on-the-run bond that offers investors an opportunity to profit from the differences in the price of these similar bonds.

Swap-treasury trade—The difference between fixed-pay swaps and Treasury yields, especially for longer maturities, given that the swap will often require less capital than holding the Treasury bond based on the supplemental leverage ratio. Hence, the swap spread will be negative.

SOFR RV trade - Differences in short-term yields based on the technical issues of SOFR versus other short-rate alternatives. 

The four eras of trade? Douglas Irwin's view

Douglas Irwin—there were three alliterative eras: “revenue, restriction, and reciprocity.” Yet we may be in a new fourth era of retribution.

The first era was the period pre-Civil War when tariffs were used as a revenue generator. The second post-Civil War period was one of tariffs that restricted foreign competition and allowed US manufacturing to grow. The post-WWII period was one of reciprocity, where the objective was a mutual decline in tariff levels. This led to a great explosion in global trade through GATT and the WTO arrangements. 

The Trump era may be a combination of the first three with a fourth objective of retribution for those who cross the Trump objectives. Irwin's assessment seems to be a good framework for thinking about trade issues beyond the tactical issues of new policies.

Forget the bond market - look at bonds

 

The weekly change in 10-year Treasury yields is unprecedented. We have to go back almost to the beginning of the 21st century. Of course, this was coupled with the huge decline in stocks and then a large positive increase. The intraday moves in Treasuries are even more extreme, which suggests a liquidity problem.

The size of the Treasury markets has outstripped the ability of dealers to maintain an orderly market. What has been the driver for liquidity has been quasi-arbitrage traders who keep markets inline through their active trading activity in the Treasury basis at high leverage. If the market volatility increases to extreme levels, these RV traders will have to exit the market or deliver, which creates a liquidity vacuum. If RV traders are pushed out of the market, they will not be easily replaced, which means there will be a more permanent impact on liquidity. This will impact all Treasury trading. 

Markets are "yippy" ... the word of the week

We have a new term from President Trump to describe the markets—"yippy," not "yippee." The reality is that markets react to uncertainty. We can use the VIX as the perfect example. Volatility has declined since the extreme earlier last week, but levels are still elevated. If markets are yippy, there is a reason and it is not just unwarranted anxiety.

The Kindleberger trap and today

 

A provocative article in the FT, "Avoiding the Kindleberger's Trap," is starting to represent the current thinking about financial and trade statecraft. Traditional diplomacy can be considered, but currently, more of the action is associated with implementing economic policy—financial and trade variations. The Kindleberger trap is the problem between the hegemon of the past falling from power or showing a lack of will without a new hegemon to take its place because of an unwillingness to fill the void. Who will be the world leader who will guide our global institutions and rules? 

The US is now an unwilling leader, and no one can enter the void. Hence, if there is a worldwide decline and a need for liquidity or a safe asset, it is unclear who will fill the breach. The big void was in the 1930s after the stock market crash 1929.  

During both the 2008 crisis and the 2020 pandemic, the US, or more specifically, the Fed, provided liquidity and was the lender of last resort. We are currently seeing cracks in market liquidity, which begs the question of whether the Fed will be the willing provider of liquidity. This is a scary environment for a global system conditioned on leverage and short-term financing.  

The stock market - It is not your normal distribution

The stock market is not your normal distribution, yet we often focus on normal return stats. For risk management, assume normality at your own peril. Market extremes usually come in clusters when there is a regime switch in volatility, which does not change the fact that outliers exist. You can windsorize to take out extremes; however, that does not change the risk. Yes, April has been an unusual month. 

Weak and strong hedge asset; weak and strong safe assets - A definition

 

It is important to get our definitions right, and there seems to be consensus on some simple ideas about what makes an asset a hedge or a safe asset. We can apply these definitions to an asset or to a strategy. 

A weak hedge asset - negative conditional correlation with another asset or portfolio.

A strong hedge asset - negative conditional correlation and positive coskewness with another asset or portfolio.

A weak safe asset - uncorrelation with another asset or portfolio during times of stress.

A strong safe asset - negative conditional correlation with another asset or portfolio during times of stress.

If you apply this definition to trend-following, it can be both a hedge and a safe asset. Gold is currently a safe asset. We can make some strong general statements on the characteristics of an asset or strategy.

Kindleberger would not be happy with Trump

 

DeLong and Eichengreen argued that Kindleberger had seen how the “ability and willingness to bear the responsibility and sacrifice required for benevolent hegemony [was] likely to falter” in the United States way back in 1973. Kindleberger anticipated, they argue, what went wrong in 2012 — “extraordinary political dysfunction in the United States preventing the country from acting as a benevolent hegemon, and the ruling Mandarins in Europe, Germany in particular, unwilling to step up or convince their voters that they must assume the task” - Angus Bylsma

There is a US responsibility to guide the global economy. Some may say this is a myth in the current world before Trump, but clearly, President Trump has a different vision that does not include benevolent hegemony. Instead, it is a new form of isolationism based on a perception of trade fairness. Should the foundations and costs of the benevolent hegemony be discussed and adapted to the changing multi-polar world of the 21st century? Of course, rapid change creates uncertainty, and with uncertainty, there is an increased chance of mistakes as countries act and respond. 

Kindleberger's great work on the Great Depression focuses on a combination of economic mistakes and not a single monetarist story. The uncertainty of the 1930s created a set of conflicting policy goals and actions that exacerbated a fragile system after a crash. There was a lack of leadership and vision to coordinate global action to serve the common good. Perhaps this view is Pollyannish or only available through hindsight, but coordinated action across countries is needed, not a singular focus on interests followed by bilateralism.

Holy Grail and trend-following

 

If a trend-following system is too slow, you risk a Type II error by missing a turning point.

If a trend-following system is too fast, you risk a Type I error by reacting to noise.

The Holy Grail of trend following is a dynamic system to adjust speed depending on market/economic conditions.

- from Campbell Harvey Regimes Notes 

I think this is the best way to think about the trend-following problem - a choice between making a type II or type I error. You cannot escape this problem. Reduce type II and you take on more type I risk. Statisticians will often try and to set the type I to 5% and then have a suitable type II at 10-20%. Traders must ask what the cost differences are between type I and type II errors. If you are too fast, you will increase trading costs; if you are too slow, you will miss opportunities. In his regime work, Harvey looks at four states of the world based on observable market regimes, which fits nicely into the idea that trend-following only focuses on price information. The bull market has short-term and long-term returns, both moving higher. A bear market has short and long-term returns moving lower. The rebound has short-term positive returns while long-term returns are negative, and corrections have short-term negative returns versus long-term rates.

His work on regimes shows that return performance can be sorted by these four states, yet further work can be developed to account for other state variables.  

See 

It is all about the market regime or similarity

Momentum and turning points - Working through corrections and rebounds

Currency factors as cluster approach

 

There has been extensive work on currency factors such as carry, value, momentum, and volatility, yet currencies may be unique from equities. The movement of returns in currency may be based on factors that are based on how they may cluster. In "Currency Factors", the authors focus on clustering of currencies into baskets and not traditional factors. They find that G10 currency co-movements can be explained by a limited number of clusters, a dollar currency and a European currency cluster. These clusters can be further extended to a commodity factor cluster and a world factor cluster based on trading volume. This suggests that a mental model of viewing currencies within their cluster and then within traditional factors may be a method to form quick judgments on the co-movement across currencies.

There are limits to the value from a crowd of economists

Is there a wisdom of crowds effect for macro forecasts? The answer is yes, per the new paper "On the wisdom of crowds (of economists)", but the impact of looking at more economists diminishes quickly. Whether the MSE, the change in the MSE from adding another economist, or looking at the relative improvement, the answer is all the same.  Check or average a few economists but the marginal impact of looking at a large group is minimal. Most economists seem to come up with similar forecasts which is not surprising. No economist wants to be an outlier relative to their peers, and most economists use the same models or frameworks which means they are likely to derive the same result. There is no value from looking at a big crowd of economists on the big macro questions. 

Robo-advisors - keep the rules simple

 

More investors are using robo-advisors to get investment advice. Relative to doing it yourself, the robo-advisor may be an improvement. Is this better than a financial advisor is a different question and remains to be answered. We know that the robo-advisor is cheaper, so the investor is receiving net savings versus the standard fees that are usually charged. 

Do you get more sophisticated advice? A recent study shows that the advice given is rather simple and focuses on only a few factors - what is your horizon, goal, and loss reaction are the top three. These simple rules are driven a lot of client money and will tie the movement of savings to a limited set of variables. See "What drives robo-advice?"