CME Outage, Quant Models, and Prices

 

Prices are the lifeblood of any quant model. If you have the wrong input, you will get incorrect predictions. In the case of an outlier, a single incorrect price may generate misleading signals about future opportunities, so any model should be thoroughly reviewed to assess its sensitivity to wayward signals. 

If there are incorrect inputs, the model output should be adjusted to reflect the change in data when a replacement is made. Users have to be alerted to any changes. These are easy cases to deal with. There are also more difficult issues, such as data oddities or anomalies. 

For example, the CME outage during the Thanksgiving period is a market anomaly that has to be addressed, especially given that it occurred at month-end. To provide context, there was an 11-hour system outage ending at 1335 GMT. It was during the Thanksgiving break, which is associated with low trading volume in the US, but it impacted all global markets on a Friday, a month-end. An outage will lead to a change in trading and a surge upon reopening. Hence, the inputs for open, high, low, and close will be distorted from what they would be in the absence of an outage. This will lead to slightly different signals generated from any model. 

So what should a modeler do about this? One response is that the price is the price and to do nothing. It is reasonable and defensible, yet it may seem odd not to account for some distortion; however, there is no way to determine the impact of any outage. What would be the right price? Another option is to drop the price to the last close. This can be defended, but replacing data seems somewhat arbitrary. 

The best response is to focus on the output and look at the marginal trade signals generated. Does it matter? An output sensitivity analysis can be conducted to see what happens with the new prices, rather than looking at what would have happened if no change had been made. If there are small marginal changes, then keep the latest prices. If there is a large set of new signals, investigate further on why and flag the changes. The prices can be kept, but the flagged trades can be ignored. However, this creates another set of problems if the trade is closing an existing position. When do you exit the old position?

These real-life problems tell the user that there is no such thing as a fully automated system.

The 60/40 stock/bond mix can result in periods of no return

 

Still spending time on the 6/40 stock bond mix. The reason is simple - it is the benchmark for asset allocation. Yes, it works; however, investors should be aware that there are extended periods of flat returns. You can have lost decades of no performance. The challenge is finding alternatives during these flat periods, especially when real yields are negative. Can alternative investments do the trick? The core solution is to find positive real returns with low correlation to equities. Trend-following can do it, but the core returns do not match the periods of lost decades. The challenge is finding the right mix at the right time, with clear rules for triggering a switch in asset allocation.

The changing value of diversiification

 

Hail the 60/40 stock/bond portfolio. It has worked, yet a recent AQR research piece, Diversifying and the Rearview Mirror,  suggests that the value of the 60/40 portfolio will change based on the variable Sharpe ratio of the stock-bond combination. There are times when diversification beyond the 60/40 mix is a drag and other times when it is needed. The average Sharpe ratio for the stock/bond mix is 0.4, so if the Sharpe ratio reaches 1 or falls below -0.5, it is likely to mean-revert. Hence, a selective diversification strategy is valuable. If you feel too good about your 60/40 mix and it feels like diversification is a drag, start diversifying, and if you think the 60/40 mix is proving to be wrong, it is likely to work in your favor. In practice, this is not easy to implement, but it is worth thinking through when to diversify.

Narrative sentiment and attention matters - Read the news!

 

In the paper "The Power of Narrative Attention: Linking Geopolitical and Economic Storylines to Currency Risk and Return Predictability", the authors find that narrative shocks are not fully priced into FX markets and will impact returns over a period of weeks. Even after accounting for major factors, fluctuations in currency markets show time-varying exposure to economic narratives such as recessions, trade wars, and inflation. Narrative sentiment can vary depending on the tone and volume of coverage.

Even if you are a quant, you should read the news and stay aware of current market narratives. However, these narratives can be systematically measured and incorporated into a model to increase explanatory power. We always knew this was the case, but the key finding is that narrative sentiment persists and is independent of other factors.

Be situationally aware of what is being reported in the news, which can often be systematized. 

Global equity correlations falling - flows following cheapness

The overall tendency for correlation across global equity indices is high, given strong economic integration across countries and the multinational business of large-cap stocks. Nevertheless, we note the current decline in equity correlations. The US is obviously moving higher on tech (Mag 7) and strong valuations. We note that the Mag 7 is showing increased dispersion, and valuations outside of tech are more reasonable; however, perceptions and flows suggest a decoupling as investors look for cheaper investment opportunities. The theme of seeking international cheap valuations will drive investor focus in 2026.

Equity markets overvalued, but what should you do?

 

The talk of overvaluation always has to be placed in context. It has to be given a number. High P/E levels are associated with lower future returns. This is a strong headwind. Does this mean that stocks will fall soon? That is less clear. The equity risk premium is falling, but it is still wider than it was during the tech bubble. There is also evidence that forward returns will be higher than what is predicted by valuations. 

Our concern is the catalyst that will cause a decline. High valuations coupled with macro shocks are the combination that will send stocks lower. The real macro economy is not as healthy as many think. Consumer sentiment is lower. Survey diffusion data is at best neutral but tends to suggest a slower economy. Shipping is down. While the Fed may not lower rates because of inflation worries, there should be growing concern about economic growth.

Commodities diversification more than just gold

The talk of the commodities markets has been gold and silver, yet this asset class is much larger and still offers investors diversification opportunities. Diversification is more than just correlation - it requires respect for returns. However, investors should not forget that many commodities and sub-commodity groups can provide diversification for the same reasons as gold. Real assets are effective hedges when inflation is still above central bank targets. There will be cycles, but at high gold price levels, other real assets become more attractive.

The need for diversifiers - Not coming from bonds

 

HSBC generated a helpful chart on the correlaiton when inflation is higher than 2.5%. The Fed will not, or cannot, get inflation back to 2%, so we expect the stock-bond correlation to remain positive. This means that there should be an active search for diversifiers. It is unlikely that any hedge fund strategy beyond managed futures will generate negative correlation. Still, there is an opportunity to find strategies with low correlation and higher risk-adjusted returns than a bond portfolio. 

Where are the expected shocks for next year?

A Fed survey shows that the most significant potential shocks or risks in the market are not bubble risk and overvaluation but policy uncertainty and geopolitical risks. These macro risks are more complex to hedge for the long-only crowd and harder to handicap, as they are based on events that most investors will have a hard time researching. The expansion of the war in Ukraine or tensions with China cannot be assessed in a balance sheet or an income statement. 

Watch the macro risks that are hard to handicap. 

Hedge fund leverage high

 

The recent Financial Stability Report shows that hedge funds have high leverage. Now, this is gross leverage, so there can be a significant amount of long positions offset by shorts, yet this high level can be an essential risk if market dispersion and correlation change. A mismatch between long and short risk can create significant exposure for hedge funds. 

What is interesting is the large increase in balance-sheet leverage among the most significant hedge funds. These would be the multi-strat pods. Their leverage has exploded over the last two years, while the leverage of smaller hedge funds has remained relatively stable.

Watch the market liquidity - hidden risk

 

A key statistic to watch is the market liquidity in equities and Treasuries. If there is a market shock that increases risk, there will be a move out of equity and into bonds. If there is a rate shock affecting the safe asset, there will be a shift out of long-dated Treasuries into cash. In both cases, a key cost will be the bid-ask spread and the cost of exiting the market. 

Equity liquidity is still below average, though higher than during the spring period associated with tariff shocks. Treasury liquidity has increased substantially since the second quarter, but liquidity in the 2-year Treasury remains low. 

Liquidity is not a concern until you need it, so risk management should consider the exit costs before a crisis.

TPA - Total Portfolio Approach - Is this a fad?

 

I am trying to understand the relatively new concept of the Total Portfolio Approach (TPA), which is being embraced by many large pension funds and endowments. Now, we know the foundations of SAA (Strategic Asset Allocation) and TAA (Tactical Asset Allocation), but there does not seem to be a clear definition of TPA.

SAA is structured around an investment committee allocating capital to major asset classes based on expected returns for each class. This is a long-term perspective, and in the short run, it will be applied for the year. TAA is a short-term. Both of these involve a top-down process in which the focus is on identifying asset classes and then making assumptions about future returns, volatility, and correlations to determine a set of portfolio weights. The allocations are then given to specific investment groups that aim to beat the benchmarks for each asset class. The investment committee monitors the performance and the weight for each asset class. The foundations of this approach are modern portfolio theory, with a focus on diversification. 

The reality is that many endowments have not been able to beat their SAA portfolio benchmarks, and the benchmarks themselves have not been effective because the underlying return and risk assumptions have proved ineffective. The process does not seem to work, so there is room for an alternative approach.

The new approach is the total portfolio approach, which still embraces diversification and modern portfolio theory. It also embraces the idea that allocations should be more flexible, drawing on the principles of tactical asset allocation. Still, there is no new theory behind the concept.

There is a belief that allocations should be more flexible and that endowment portfolios should not be siloed into fixed asset-class weights. There is a shift in investment staff to compete for capital across all asset classes. It argues that siloed thinking will not be effective for generating alpha or for adjusting to a dynamic market environment. TPA is more of an approach to managing the portfolio and not setting goals. The objective is to maximize surplus (assets - liabilities), subject to a downside or volatility constraint on surplus risk. 

This all sounds good, but it is not clear that there is a single acceptable definition of the concept. Hence, TPA may be in the eyes of the beholder.

Hedge fund performance mixed for October

 

Hedge fund return performance was mixed in October, with the overall HedgeIndex Main, a combination of all Hedge Fund managers asset-weighted, declining for the month. The stand-outs were with convertible arbitrage and Global Macro, while multi-strategy and emerging markets were a drag on performance.

The overall performance of hedge funds has been positive this year, with managed futures the only strategy not generating positive returns. 

Creditworthy - An interesting history

 

We take for granted the process of receiving a credit score and the distribution of our credit history across banks and retailers, yet both are recent phenomena. We also assume that retailers' credit extensions are relatively simple. Pre-Civil War, most retail purchases were made in cash or with simple extended terms from a local grocer or retailer. Credit amounts or ratings were held by an single institutions and only extended to those that were know. 

As cities grew and consumers, this was not a workable solution. Even in a city, there began sharing arrangements regarding customers' credit histories. Runners would move from store to store to gain information on a new customer. The transaction costs were high, but not knowing the consumer was costly. 

Suppliers placed pressure on retailers to pay their bills so retailers had to better know who they were extrending credit to. Lists were made, and the process started to be centralized through local credit bureaus. As more credit was extended, there was a need for more credit professionals and further automation to track and rate consumers. This was furthered through the use of comutuers and the ascent of credit cards.

There is not much to apply to trading with this history of credit information. Still, Creditworthy: A History of Consumer Surveillance and Financial Identity in America by Josh Lauer is a fascinating history that makes you think about the fundamentals of credit information and ratings. 

The current credit bezzle

 

With the bankruptcies of First Brands and Tricolor, there are clear signs that we are facing mounting credit issues. More importantly, we are seeing the classic Bezzle described by John Kenneth Galbraith in his book on the 1929 crash. We are not faced with a downturn in the business cycle. There is no recession; however, there is an exuberance that has been described by Minsky in his financial instability hypothesis. When overly optimistic views of the economy are coupled with extreme asset values, there is a higher likelihood that some will take advantage of the situation and cut corners, potentially committing fraud.

A review of the bankruptcies and new reports suggests that, in both cases, there was potential fraud or financial complexity that did not provide debtors with accurate information about the economic health of the firms. If we are seeing this under current healthy conditions, we can imagine more bankruptcies if asset prices fall. This is called the "febezzle" by Charlie Munger, referring to the false wealth created by high asset prices. If prices fall, the excessive wealth will quickly fall.

The key takeaway is that credit risk premiums should increase and investors should be paid more to hold risky debt.

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

The bezzle and markets - Risks could be rising

Industrial policy thinking is back - Not clear that this is good

 

Marketcrafters by Chris Hughes is a quick read featuring stories of individuals who used government to shape market direction. In general, the stories are positive, yet some individuals used their power to bend policy in ways that had adverse market effects. The overall theme of this book is that effective industrial policies can influence markets for positive economic outcomes, whether in housing, monetary policy, international finance, energy, or crisis response. Hughes makes the case that good policy leads to good outcomes, but he also shows that bad policy can have severe negative consequences. Hence, a new industrial policy view will not be effective in creating a better economy. My takeaway is that industrial policy should apply the precautionary principle and be careful not to bend markets to your will, because the law of unintended consequences may lead you down a path worse than a market solution.

All bond hedges ae not the same

Most movements in the yield curve are parallel, so the correlations between different Treasury maturities and the S&P 500 will show strong co-movement. When the yield curve changes shape, likely due to a revision in monetary policy, there will be a dislocation in correlation co-movement. We are seeing this in the 2025 correlations. There is a positive correlation between 30-year Treasuries and the SPX, while there is a negative correlation for 2, 5, and 10-year Treasuries. We expect that these will converge in 2026 as the Fed stabilizes its monetary policy.