Fama-French factors and economic drivers - Watch macro

 

The Fama-French factors have been used extensively to describe any set of returns; however, further work is needed to explain the economic drivers behind these factors. The paper "Understanding Asset Pricing Factors" takes a novel approach to analyzing the connection between economic events and factor moves. The authors analyze days with significant factor returns and then classify them by linking them to new articles the following day. Macroeconomic news, monetary policy, and corporate earnings reports are the main drivers of returns for factors, as should be expected. 

The Fama-French factors include four major factors beyond market risk: SMB (small minus big size effect), HML (high minus low value effect), RMW (robust minus weak profitability effect), and CMA (conservative minus aggressive investment effect). It is found that HML value premium is related to the macro factor. CMA is related to the commodity factor. SMB is correlated with the exchange rate factor and the unknown factor. RMW is related to shocks in individual companies. The authors use AI and human coders to classify news events that were tied to the FF risk factors.  

The categorization shows that humans and AI do a similar job and there is a clear distinction between the events that drive factor returns. Unsurprisingly, macro is the dominant driver of large moves. This resurrects the issue that even equity investors who may focus on factors RV should follow what is happening in the macroeconomy.

Trend-following returns during S&P 500 drawdowns are not all the same

We are learning more about the qualities of trend-following as a hedge or safe asset. A hedge asset is one with low correlation to a risky asset. A safe asset has low correlation overall, but will have a negative correlation during a drawdown for a traditional risky asset. Trend-following will have the characteristics of a safe asset, but only if an extended drawdown exists. If there is a short-term drawdown, it is less likely that trend-following will generate the desired return pattern. This is a key risk of holding a trend-following manager.

There may be some diversification gains, but a safety effect may not exist. We have seen Treasury yields during the current crisis, so it is hard to say whether there is a true safe asset. Therefore, it may make sense to return to first principles. A safe strategy is one that can hold either long or short positions and adjust those positions based on the direction of trends. It is not a structural safe asset but a behavioral safe asset based on the dynamic actions of market participants. 

 

Trend-follower dispersion in return performance

SG Prime Serves has provided their assessment of trend-following managers over the past 25 years since the inception of their index. There is dispersion in performance, which should be expected since there are many variations in trend-following. The trend indicator, a simple trend model for comparison, shows that the correlation between managers and a generic fund will deviate when there is a strong macro event.

The data suggests that holding just one manager may not be optimal and that a portfolio will reduce the potential for regret. Now, is there a correct number of managers to hold? That is a more difficult question. One is too low, yet 6 may be too many if the trend allocation for an overall portfolio is 2%. That said, a large pension may want to include a trend index and then add some satellite managers who have specialized skills. 

 

Get your financial stylized facts right - The Bayesian foundation for empricial finance

Economists and financial professionals often use the term "stylized facts" as an alternative to a set of descriptive statistics or just data. Formally,  a stylized fact can be a simplified representation or an empirical regularity that serves as the foundation for building theory. It may not be a simple piece of information, but a formal empirical regularity. In a recent paper, "International Financial Markets Through 150 Years: Evaluating Stylized Facts", the authors test a set of well-known stylized facts across a broad set of markets and a long time. This is the most exhaustive analysis of well-known stylized facts ever undertaken. We will not present all of the findings, but will show the summary table of what was tested.

Why is this so important? The stylized facts should be thought of as the Bayesian prior for any future analysis. Start with the stylized facts of what should appear in the data. You should not find something different, but you should argue that this is the basis for any future work. Before you pass judgment on a theory or set of data, look for the stylzied facts that already exist.

 

Co-occurrence versus correlation- Still learning about diversification

 

There is a need to deepen our understanding of diversification, but is there a limit to how much we can extract given the basic principles of covariance and correlation? Some in finance are starting to discuss the concept of co-occurrence, which, in the case of asset management, measures the cumulative co-movement of asset pairs during a specific horizon. If, over a particular horizon, the cumulative returns converge to the other returns in the portfolio, you may not have the diversification expected. If we have two assets that, over a one-year horizon, generate similar returns, then you are not diversified. The paths are different, but the two assets end in the same place. 

You can measure the co-occurrence by multiplying the z-scores of two assets and dividing by the average of their squared z-scores. The co-occurrence will fall between -1 and 1, much like the correlation. If the z-score of an asset is zero, then the co-occurrence will be zero. If the z-scores are highly aligned for the tested time period, the co-occurrence will tend toward 1. The determinant of the co-occurrence is the joint informativeness of the two variables, which is essential because the correlation of any two assets is the weighted average of the informativeness with the co-occurrence. So, the co-occurrence tells us something about correlation when we align the return horizon, which we do not do with traditional correlation measures. 

Correlation is useful, but we also want to see how assets move over longer horizons to determine whether there is a pattern of behavior that tells us whether performance diverges or is similar. 

Evaluating trading strategies - Harder than you think

Most investors often rely on a simple search and ranking across managers to find the best trading strategies. For example, sort by the highest Sharpe ratio and choose the manager with the highest number; then you have a winner. Alternatively, search for a manager with a minimum Sharpe ratio and then conduct due diligence as a two-step process. 

Unfortunately, life is more complicated. There is a distribution of Sharpe ratios across managers and over time, based on the strategy type and analysis used. If there is an average Sharpe for a strategy, then outliers on the high side may not be following the strategy named, or they may be subject to mean-reversion. The Sharpe ratio for any period may differ, so the last three years may not be representative of the manager's performance over the long run.  There is a reversion to the mean when you sample the Sharpe ratio for a set of managers over a specific timeframe. Time and context matter.

If you look at enough managers, you will find some that are perceived to have an edge based on the sample data collected, yet this analysis may generate a false signal. For managers, you need to examine the sample set that has been analyzed. For quantitative strategies, you need to consider the backtesting performance and the length of time reviewed for the strategy. Again, sample size matters.

Additionally, evaluation is usually not concluded with the numbers but through extensive discussion with the manager to find their edge, yet the edge narrative or the manager's story-telling is inherently subjective. Is the choice of the manager a function of their skill at describing what they do or what they actually do? 

Perhaps a critical selection skill is reviewing why you chose a manager who failed as well as looking at the managers that you rejected who then went on to perform better than your existing portfolio. What your selection impacted by bad luck, and where the managers you rejected subject to good luck, or in either case did you miss something that is not in your due diligence analysis.

Sharpe on thinking about risk

 

"If you're not thinking about risk, then you're not thinking." William Sharpe

"Portfolio management is risk management" is a mantra that I follow. Risk cannot be separated from return. If I can lower my risk, I can increase the Sharpe ratio without focusing on finding a better-returning asset. Of course, lowering risk will impact return. There is a cost to risk management. The secret is trying to manage the risk at a low cost. The critical component is portfolio construction because diversification is the only free lunch in finance.

A pet peeve of mine is that managers often discuss the return generation process before jumping to the risk management discussion. I understand that it is easier to separate the two, yet the link between return and risk is critical.  

Hofstadter's Law - applies to macro events

 

Hofstadter's Law: It always takes longer than you expect, even when you take into account Hofstadter's Law. — Douglas Hofstadter

We have written about this, yet it keeps coming up in project management. It can also come up with crises. We may identify the key issues that may cause a crisis, yet it often takes longer to reach the actual event. What has been found with Hofstadter's Law is that while the median time to get a project done is usually within expectations, there are often very long tails beyond what is typically expected.

We know that uncertainty is high and impacts investment and consumer behavior. Still, the manifestation of this uncertainty may take months to show up in asset prices and actual data. Hence, identifying an event and seeing the impact of these expectations may not coincide. Being first when making a forecast is not the same as profiting from a forecast. 

See The planning fallacy and Hofstadter's Law

What is on risk radar for family offices?

What is most interesting about future risks is that they are often not countable events. They are events with little past precedent and are hard to handicap. They are subjective probabilities, not objective measures. A major geopolitical event will be adverse for risky assets, but what is the severity of this event? When we use the term 62% probability, does that mean that 62% of the respondents think there will be a geopolitical event, or does it mean there is a 60% chance of it happening? Sometimes, when we present numbers, we do not ask what they really mean. When we use small phrases we are not clear what that phrase could mean. For example, what is a food crisis?

We may love survey work. It provides a foundation for further discussion, but that does not always mean the survey generates clarity of the risks faced. 

Machine learinng and currency trading - still driven by momentum and carry

Traders are still dealing with the puzzle of currency prediction. For decades there has been a simple challenge and research conclusion. Most models cannot beat the random walk at predicting currency movements. The machine learning explosion allows traders to explore different methods for looking at the same data. In a new paper, "Machine Learning in Foreign Exchange", the author looks a number of prediction techniques including neural networks and tree-based models. It finds that a neural network approach outperforms linear and tree-based models and can do a good job of predicting cross-sectional excess returns. It can beat the random walk but the predictive power declines at longer-term horizons. 

A non-linear approach does much better than simple linear models; however, many avoid using ML techniques given their more difficult explainability. The author uses local interpretability techniques like DeepLIFT and Layer-wise Relevance Propagation (LRP) as well as Shapley values for global interpretability. What should not be surprising is that the key factors we always know as important for explaining currency returns still hold. Momentum and carry are still the most important factors for making currency predictions, yet  it is how and when they interact with currencies that matter. The non-linear influences dominate currency production. Use the same features but link them together in new ways.

Now, when looking at the set of models. It is not always clear why one approach does better than another. There clearly may be overfitting with some models. The feature importance also are complex. There are many carry features that can provide forecast value which seems odd. Nevertheless, there is a lot of good work her which needs further testing to further support currency predictions.

Business and financial cycles are different but an important indicator

The idea of a countercyclical risk premium tied to consumption asset pricing models is the standard view in macrofinance, but there is also a growing view that there is a financial or credit cycle with booms peaking before macroeconomic real behavior. Equity and factor premium are tied to credit availability and balance sheet constraints. Hence, investors should not just look at business cycles, which are intermittent, but also at the financial environment to capture poor financial environments. See the paper "Financial and Business Cycle Risk Premia". 

Using a Markov switching model, the author identifies financial and business cycle regimes. Recession states suggest that there will be higher equity excess returns the following quarter, but this equity premium will be even greater if it is consistent with a financial crisis. This impact is even greater if the poor regimes are matched with deteriorating macro conditions. There will be higher unconditional equity returns if there are favorable financial conditions. 

Regardless of the model being used, knowing where you are positioned relative to the business and financial cycles is critical. While the extremes in the business and financial cycle are not frequent, tracking these regime changes will have an appreciable impact on asset allocation.

A pivot to Europe requires an understanding of history

 

The uncertainty concerning US policy, as well as the hegemony of China, at odds with Western thinking, means there is a new interest and pivot to Europe. We are seeing the pivot to Europe in the stock returns for the year. This move is at the beginning of a change, but worth following closely.

One of the best books on the topic is Rethinking Europe's Future by David Calleo. It is not a book of Europe's future but a history of its past, as it tells how Europe got to its current state of a partial European state. While many consider Europe a third alternative to the current bipolar hegemony, it is still far from a finished political product. Europe is a state of mind, an ideal, but still not a reality. There is monetary policy integration and movement to some form of political and economic union. However, the idea of nation-states still burns in the heart of most Europeans. Citizens still identify as their country of origin and not as "European". The transition will still take time, and as of yet, has not ensured success. Europe is a work in progress, which means that economies of scale, common regulation, universal financing, and speaking with one voice for international affairs are still in the distant future. 

We can be excited by a Europe of strong investment opportunities, but the chance to outshine the US equity markets will still take time. Investing in Europe is a good tactical trade, yet it may not yet be a strategic re-weight. 

The future of the dollar today - there is a framework for this discussion

 

The discussion on the dollar's decline is at a fever pitch. While the dollar's demise has been an ongoing topic, it has never been as front and center with investors this century. The talk has been one-sided, with all commentators focused on the dollar's decline. It is a question focused on when, as opposed to if. Yet, little work has framed the question appropriately through criteria for why the dollar will lose its premier status. 

Nevertheless, a good book on the subject has provided a valuable framework for thinking about the dollar's value. See The Future of the Dollar. The editors, Helleimer and Kirshner, engaged with some of the leaders in international political economics to generate different views on the dollar's future. The framework of looking through market-based, instrumental, and geopolitical lenses is a helpful way of focusing on the key issues concerning dollar dominance. The dollar dominance can either be sustained, albeit with stress, or in decline. The three-level approach provides the stories for each of these choices. The book also presents the best way to classify different parts of the world based on their relationship with the dollar. Although this book is over a dozen years old, the characterization still fits the current time. The exception is the rise of China and how the current tariff wars fit within this framework. 

Will the dollar lose its dominance? The decline in dollar hegemony is not likely to be reversed, yet it will remain dominant. The dollar is overvalued. There will be a standard adjustment. The move to US neo-isolationism with trade will cause the dollar to lose importance, and the use of sanctions to isolate other countries will place more downward pressure on the dollar. This seems to be conventional thinking, but unlikely to be wrong. 

Gold price increases tied to higher uncertainty

Gold is considered a safe asset because it has the safe asset statistical qualities of being negatively correlated with risk assets during a market downturn. While this is generally true, it is not always the case. We know that gold has some of the characteristics of a safe asset because it will do better when there is high uncertainty. A simple examination tested more formally in academic research finds a positive link between gold, volatility, and uncertainty. From volatility, there is a change in asset demand. More risk with risky assets will lead to higher demand for safe assets.

Relative uncertainty impacts safe asset demand

 

What is a safe asset? There is growing discussion on this issue, yet we think that, at its core, a safe asset does not face significant uncertainty. If there is more policy uncertainty, safety fundamentals are in jeopardy. A safe asset, whether short-term Treasury bills or a safe haven currency, will have low volatility, so we must devise other means of measuring safety. 

A safe currency will have low volatility, but most safe-haven currencies will also have low volatility. A better measure may be relative uncertainty. If the US has high uncertainty compared to other safe-asset countries, then on margin, the US will see fewer safe-asset flows. The dollar outflow will mean that capital must move to another safe haven. It could flow into the Euro or Japan, or if there is a general increase in policy uncertainty, it will be gold. Note that the dollar increased during the pandemic, even though US uncertainty spiked versus Europe, so more work has to be done on this topic. 

A good second-order effect is to examine policy uncertainty not just in the US but globally. It is the relative uncertainty that matters. 

Living in an uncertain world - All policy uncertainty indices point in the same direction

 

Several policy uncertainty indices can be found in the FRED database. All tell investors the same thing: We live in an uncertain world. There is a difference between risk and uncertainty. Risk is measurable, has a specific measure, and is based on counting. Uncertainty cannot be counted. It is subjective and based on our ignorance of what we do not know.  The policy uncertainty indices try to turn this ignorance measure into something that can be measured.  

While the trade policy uncertainty is off the charts, all the other measures are close to extremes. This will have an effect on markets, investment decisions, and consumption. Regardless of current data, the future does not look bright.  

Cropland decline - A future concern

 

US cropland has declined over the last ten years. It was steady from 1998 to 2014, but the farmland acreage is decreasing. See the farmdoc daily blog for the details. What is especially scary is that the economists who have looked at the data do not have a good explanation for this fall. We should be especially concerned because if there are no increases in productivity, we will be in a food deficit. Of course, Latin America has been a large marginal producer, and there is no current problem, but the risk of a food shortfall will increase if there is less land for farming. This is an issue worth keeping on the radar screen.

Dollar during a crisis - The tariff issue is different

 

The current dollar performance is different from other crises. In general, the dollar has been a safe haven compared to other currencies. The Asian crisis, which started outside the US, saw dollar improvement. During COVID, a global crisis, money also flowed into the dollar. The same effect occurred with the GFC or the Lehman crisis, yet this trade crisis is different. We are seeing the dollar decline from an overvalued level. This is a concern that foreign investors, in this case, do not want increase dollar exposure. 

Trump - The long gamma presidency

 

Michael Kao  - "Trump environment is a long gamma trade environment."

Many would like to avoid describing the market environment in only a few words, but this is one phrase that may stick for the next four years. It seems as though it was the case for the Trump1.0 and is also the trade for Trump 2.0. I cannot tell you what will be the direction of the market although it seems like is is pointing lower, yet I can say without a doubt that this will be a long gamma presidential period. Certainly, the last month seems to be proof for the argument.

VIX history and market crashes - the connection

A long history of the VIX, as presented by BNP, shows that spikes are related to specific market events. These events are often related to recessions, but they often occur with market-related events that do not translate to recessions. 

It is also clear that events associated with VIX spikes and lead to market declines are associated with high equity valuations. If the market is overextended, then it will see a greater decline. 

We have seen a large market event with the current Trump trade wars, but right now, the market has offset the Liberation Day declines. That does not mean the market is ready to retrace all its losses, but there seems to be optimism that did not exist a month ago.