Follow the equity risk premium

 

There should be an equity risk premium over bonds. Equity is riskier than bonds, yet the current market does not suggest this. The bond market has disconnected from equities. One can always say that bondholders are pessimists relative to equity optimists, yet there is more going on than just behavior. 

Bonds are pricing stagflation, while equities, through cap-weighted indices, are pricing an AI productivity revolution. Perhaps both can be right, but that does not bode well for holding equity in traditional companies. 

The politics of the Fed run through Congress

 

This is an interesting chart on the politics of the Fed. Clearly, Powell is a political animal. There is nothing wrong with being political. It is important to maintain good communication with politicians to ensure they understand the Fed's role and mission. One of the key Fed battles has always been the level of oversight from Congress. (I was involved in that fight in the 1980's when consulting for the GAO on primary dealer oversight. Getting data from the Fed was an ordeal.)

Powell needs to limit interference from the executive branch and ensure there is limited oversight from Congress. Independence takes work. 

So bonds are not the solution?

The chart from Nicolas Rabener of Finominal compares the drawdown from bonds versus managed futures. If you ask most investors, they would say that a managed futures fund is riskier, yet when you look at the long history of bonds, it does not look attractive. There can be drawdowns for decades. It is unlikely the 10-year will get out of this drawdown in time in the near future. Of course, it is critical to think about upside and what a bond drawdown means. 

Edmund Phelps - more than a macroeconomist

Edmund Phelps died this week. Unfortunately, many may not remember his path-breaking work in macroeconomics, which opened the door to neo-Keynesian models. His most important macro work examined the inflation-growth trade-off through the lens of inflation expectations and addressed the natural rate of employment. First, if inflation expectations rose, there would be a corresponding impact on wages, leading to a wage-price spiral. Second, if central banks attempt to maintian emeplyent above the natural rate (the equilibrium rate) there will be a surge in inflaiton. 

While he was viewed early on as an important macroeconomist, he provided significant insights into innovation and creativity as drivers of economic dynamism. Few economists have had many important pieces of research across fields. 

He could not be placed in any school of thinking and should be viewed as one of the few truly independent thinkers on a range of topics. 

Large moves in the FX markets

 

In the paper “Large Moves in the Foreign Exchange Market", the researchers show that large currency moves are not random but related to the term structure of option-implied volatility. The difference between short-term and long-term implied volatility is a good predictor of the absolute value of current moves. Given this information, investors should buy straddles when the volatility curve is inverted. Being long the straddle allows for gains in either direction.

The implied volatility inversion provides useful information that can be exploited through straddles. It makes sense that high short-term volatility will likely see greater-than-average moves. 

Unsustained sales growth and AI

 

We are seeing very strong expectations for AI sales growth. There is no question that new technology will see stronger sales growth than the average firm and that, during the initial growth period, sales may be well above average. The question is, how do you temper these sales expectations to form more realistic estimates? The power of compounding will work against you. You can, of course, rely on some form of mean reversion, yet this can be guesswork.  

This problem was addressed in two papers by Counterpoint Global - Bayes and Base Rates: How History Can Guide Our Assessment of the Future and Bayes and Base Rates 2.0  I like this work because it takes the emotion out of the sales forecasts associated with AI and focuses on what we know across decades of data, within different industries, and with major changes in technology. We can form base rates using priors and then derive normal forecasts. The conclusion is that the sales forecasts are just too large, even if we isolate new technology, focus on specific industries, and account for the very best historical events. 

This does not mean investors should short these companies. It is unclear when reality will be realized, but arriving late is problematic, shorting can be a fool's game, but buying on these aggressive growth forecasts will be disappointing.  

The time series of risk shocks

In an earlier post, we discussed the differences in risk regime through decomposing the VIx index. 

The time series of risk regimes

We can also do the same for risk shocks, which are measured by changes in the VIX. We use bin analysis based on quantiles to form three groups of risk shocks. 

Again, a simple null hypothesis is that risk shocks occur during periods of market extremes, such as recessions and market turning points, yet we find that the time series of changes in the VIX, or risk shocks, appears more random. 

There is a different market response to risk shocks than to the risk regime; more simply, positive changes in the VIX index are associated with large market downturns, but their clustering differs from what we see in the risk regime.

The time series of risk regimes

The VIX index has been used as a fear index, but we believe the best way to view it is to define risk regimes. There are periods of normal, high, and low risk and the behavior of markets during periods of high risk will differ from periods of low risk. Before we start examining the market response to different risk regimes, we should examine the time series of risk regimes and determine when high- and low-risk regimes occur. 

A good null hypothesis is that market returns are independent of the regime. We assume there is no relationship. However, we do expect there is a trade-off between risk and return. The market will react to risk, and the reaction should be stronger for high-risk regimes.  

We take a long time series of monthly VIX returns and divide the series into quantiles, with the low risk being the lowest quantile, the middle range being the next three quantiles, and the high risk representing the highest VIX value quantile 

We find that high equity risk will coincide with turning points in the stock market. Specifically, a high-risk regime will be associated with recession and drawdowns in equities. There will also be low-risk clusters, and these are associated with higher return periods.

Returns respond differently to high-risk periods than to low-risk periods. This is a piece of ongoing research we are focusing on. 

EU Geopolitical risks - different from Anglo geopolitical risk

There has been a boom in indices that measure risk by analyzing news story words, yet not all news is created equal. There can be big regional differences, and recent research shows that geopolitical risk measures in one region may not align with or accurately reflect those in another. The recent research paper, Geopolitical Risk in the Euro Area: Measurement and Transmission, shows that there are differences between EU and Anglo geopolitical risk. Clearly, some events are more important to Europeans. We can see this in the residuals from a simple regression. The more recent history shows a strong divergence in risk. There are also clear spikes in the daily data that indicate European risks differ.

The risk differences have clear macroeconomic effects. European geopolitical risks show a stronger influence on industrial production and inflation.

Causal inference and critical statistical thinking

Causal inference is one of the most important topics in finance today. There is a difference between what correlates with or is associated with X and Y and saying that X causes Y. We can thank the work of Judea Pearl for truly focusing our attention on causality rather than correlation. 

You should not ask what tends to happen to Y when X is high. Of course, you can ask, but that only refers to the association. The real question for causality is, "What will happen to Y if we set X to a specific vlaue and all other factros are held constant?". To answer that question, we have to consider the relationship between X and Y, and also ask what other factors may influence Y, such as variable Z. Does Z cause X, which then affects Y? Does Z affect Y directly? This type of thinking is not about fitting a set of past data into a relational model, but about asking the primary question of whether there is a reasonable link between these variables. 

Before you run a statistical test, think about causal relationships and how they may be linked together. What type of relationship are you trying to find? 

Hedge fund strategy rebound

 

There has been a strong rebound in hedge fund strategy performance in April after poor March returns. All the HedgeIndex Main strategy returns were positive for the month, with especially strong performance in emerging markets, global macro, and long/short equity. Of course, the overall equity market showed strong April gains, so the market exposure for these strategies provided a tailwind, and positions placed at the end of the market were able to take advantage of the stock market improvement despite the continued uncertainty associated with the Iran War.

Commodites versus stocks - Go with the real economy?

 

The power of supply shocks and the real economy can be seen when we compare the BCOM with the NASDAQ and SPX. Since the beginning of the year, there has been a strong acceleration of commodity prices. This momentum was even before the Iran conflict. A combination of strong demand and a supply shock has been driving the commodity market, even amid all the buzz about AI. Of course, AI is driven by electricity (energy) and infrastructure (metals). 

So ends the view that inflation is tamed

 

So ends the view that inflation is tamed and rates should fall. The PPI is accelerating and moving back to the type of supply shocks that we saw post-pandemic. The CPI is also heading higher and moving further away from the target with a 3-handle. There is no room for a Fed rate cut, and with real rates now near zero, there is a strong case for a rate increase. 

We do know what the Fed hates - supply shocks. Monetary policy is a tool that is not built for supply shocks, yet here we are.

Why nothing works - We cannot decide whether we are Hamiltonians or Jeffersonians

 

Why Nothing Works: Who Killed Progress and How to Get It Back by Marc Dunkelman is one of the more interesting books on politics that I have read this year. It is thought-provoking and can help explain the problem in getting things done in the US. It may not solve the problem, but it offers a plausible framework. 

The progressive movement, now well over 100 years old, is driven by conflicting philosophies about the role of government. These two approaches, Hamiltonian and Jeffersonian, represent very different views on how government should be used to solve problems. The Hamiltonian approach is a top-down, big-government approach that seeks to offset large private-power and control projects through experts. The Jeffersonian approach to government looks at large institutions and power as corrupting. The power should be dispersed and controlled by the people, not by experts or large institutions. 

How can you get something done if top-down control by Hamiltonians is viewed with suspicion by the Jeffersonians? You may not be able to have ot both ways, and vacillating between the two will lead to inaction and program failure. The train to nowhere in California is all about the Big project, Hamiltonian government micromanaged by Jeffersonian rules and regulations to get local input. 

No one seems to want either extreme, but the middle ground leads to an environment where Nothing works.

The Doom Loop - Explaining the dollar

 

The Doom Loop: Why the World Economic Order Is Spiraling Into Disorder by Eswar Prasad is a good book for explaining the current trouble with a dollar for anyone who wants a non-technical read on the subject. It focuses on the intersection of economics, finance, and geopolitics rather than on the theory of international finance. 

The book’s main focus is that we are caught in a destructive feedback loop driven by a changing geopolitical environment. The movement away from US hegemony in globalization is now being replaced by a fragmented system with more dispersed economic and financial power. It is not that we should go back to the old system, but globalization caused fissures that cannot be replaced. The backlash to a global hegemony of rules and governing institutions means that a single currency cannot dominate the world and create a stable world order. 

Can the dollar be replaced? The answer is no: the dollar cannot dominate, which means there will be more financial instability in a world order that cannot be controlled. 

What are equity markets discounting? it is not risk

 

The Iran conflict is not over, yet the markets are optimistic. Perhaps it is because we don’t know what to call this oil crisis. Is it a war? A dispute? A current pause? The SPX was up over 10% for the month. The high beta names were up over 15%. For the sector extremes, the communication services sector was up over 18%, while the energy sector was down 3.45%. Surprisingly, emerging markets were also up over 11% for the month and strongly higher over the last 12 months at 32%.  Even bonds were slightly higher for the aggregate index.Yet the market is facing a significant commodity shock, with the DJCI up 31% so far this year.

Is there anything to worry about? Central banks? Growth? Inflation? The markets are either looking through any negativity or do not believe it even exists. This is a path that should concern any investor. 

Periods of Stagflation - there have always been with us

Despite strong performance in equity markets, there is still considerable talk of stagflation. The stagflation story is not just a 70's problem. It can happen in other countries and almost any time. It is more likely that we have a supply shock that can affect both prices and growth. The longer the oil crisis in the Middle East lasts, the greater the likelihood that we will see stagflation. Stagflation has generally been short-lived because the underlying cause changes. An energy crisis is averted through a new supply or a solution to the initial problem. 

Right now, we are not close to the 2% inflation target, and the cost of higher energy is just starting to bite. The likelihood of a stagflationary period in the second half of the year is increasing.

Risk aversion index worth a look

 

There is a growing number of risk measurement indices, although the definitions of these risk or uncertainty indices are not always clear. We can start with the VIX index, which is not really an uncertainty or risk index but a proxy for option volatility and is often called a fear index. There is a set of policies and economic indices, derived from news scraping, associated with countries and topic areas.  

Another entrant to this field is the risk aversion index.

The general estimation philosophy is as follows:  

​

(1) The risk aversion coefficient is utility-based, reflecting the time-varying relative risk aversion coefficient of the representative agent in a generalized habit-like model with preference shocks.                                                          
(2) Given the no-arbitrage framework, asset prices, risk premiums, and physical/ risk-neutral variances are exact functions of the state variables, including risk aversion, in the dynamic (exponential) affine model.

(3) Financial variables are observable. Thus, the market-wide risk aversion should be spanned by a judiciously-chosen instrument set of asset prices and risk variables. We use the Generalized Method of Moments to estimate their optimal linear combination given asset moment restrictions that are consistent with the dynamic no-arbitrage asset pricing model. The instrument set includes a detrended earnings yield, corporate return spread (Baa-Aaa), term spread (10yr-3mth), equity return realized variance, corporate bond return realized variance, and equity risk-neutral variance. 

I find this risk aversion index fits the story expected when there is higher uncertainty, and could be worth following as another indicator of changing behavior in financial markets.