Forward guidance and the PBOC

The People's Bank of China has been loosening monetary policy but you would not know it without a careful review of all the tools available to the central bank. The PBOC runs monetary policy through a set of strategies that has lowering interest rates as just one of the choice available. While most central banks employ raising and lowering rates as the primary tool for policy, the PBOC seems to choose unconventional tools first. The central bank may not have gotten the global memo on forward guidance as an important tool. Communication is just not that important for the PBOC. This is at odds with the behavior or standards of most other central banks.

In the last six months, we have seen significant increases in indirect lending facilities through the China Development Bank, lowering of the deposit ratios, re-loan rates, deposit, and lending rates. All these changes are attempting to boost growth without having to directly explain that Chinese growth needs boosting.

This lack of transparency will lead to more speculative behavior by investor and also the chance for major mistakes. The large stock market move is in part a direct response to this monetary stimulus. Growth is slowing but monetary stimulus is increasing so we are seeing asset price inflation.  Without guidance, many investors are thinking these increases in lending facilities will continue along with lower rates.

In fairness, even central banks who espouse forward guidance and transparency have not always done a good job; however, the risk of miscommunication is higher when communication is in short supply. 

Pump down the noise - Decision silence

The hardest part of decision-making is being able to separate information from noise. In a textbook investment problem, you are given useful information which you employ to form a probability distribution of possible returns. You take all of the information and find the expected value for an investment and make the decision. 

The real problem is when you have too little or too much information. The issue of too much information is one that has always vexed investors but is usually not handled in an investment class. (Case studies may be the exception, but classic finance classes do not address noisy information.) Nevertheless, there are simple solutions that have always been used to deal with this problem. We just may not speak about it in terms of noise.

A large part of the value associated with trend-following is on noise reduction and price smoothing. Think about the simple case of the moving average. For example, you take twenty days of information and average to compress into one number. This is a noise reduction technique. All of the ups and downs from highs and lows as well as the daily movement is filtered out through averaging. We cut the noise to find the true signal.

Most system research is trying to find the right trade-off between noise reduction and information efficiency. If you take too long of a moving average you are throwing out too much information. Employ a short-term moving average and you still have significant noise. 

Break-out or channel systems are another form of noise reduction. If you are inside the range, you may ignore the prices and throw out this noise. This approach provides a new twist on the concept of noise traders which have often been given a bad name.

Noise reduction changes the decision process and reduces the decision choices. This reduction process may calm decision-making for the better. Silence is good.

You don't have to make an investment decision

There is a major economic announcement, the market starts moving, and trading volume has increased. The talking heads are abuzz with their analysis. Under this situation, many investors believe that they have to make a decision or take some action. If everyone else is doing something, I must do something too. Follow the herd when the twig snaps. However, without a plan, this could be the worst possible action.

Perhaps one of the greatest qualities of employing a system is knowing when not to trade. A good trading system will likely have you sit and do nothing a lot of the time. Shocks to the market will generally not be significant. Success is based on waiting for those that are meaningful. The idea of any rules-based system is to limit trading to those times when there may be an edge or a true reaction is necessary. It will have you do nothing if there are no identified opportunities and it will have you sit and do nothing if you are in trade that is making money regardless of what new information may be coming into the market.

I like to idea that a system can tell me when to act. I may like it even better when it tells me not act even when I have the urge to do something. A system stops my emotions from getting the better of me. Patience is an investment virtue. Keep calm and do nothing until the odds are in your favor.

Marks' "failure of imagination" and the new year

Howard Marks often talks about the "failure of imagination" as one of the key problems with investment management. Investors do not see the full set of possibilities no matter how improbable. Additionally, most investors do not think about second order effects of the some shock to the investment world. For example, investors did not see the decline in oil prices and certainly have not fully realized the secondary impact of the decline across markets. This will lack of imagination will continue to be played out in 2015.

This failure of imagination is being unable to conceive of all of the alternatives or possible outcomes.  What is not thought of cannot be handicapped. It cannot be put into the possible states of the world. The lack of imagination increases the likelihood of surprises. For many, the surprise event is only a surprise because it as not not though possible no matter how unlikely.

The failure to imagine means that we do not see or accept change when it occurs. Market failures are rare events, so we naturally are not going to imagine what the world will do differently in those situations.

The failure of imagination is also being unable to think across assets. If an event occurs in one market, will it spill over to the next market or asset class? You may imagine a decline in oil prices, but do you fully realize what this means for growth or inflation? Can you conceive what the impact will be on interest rates or credit markets? The quantitative analyst will focus on asset correlation, but this is a much simpler idea. You do not need the stats to think about the linkages across markets. In fact, assuming correlations stay the same may be the greatest lack of imagination.

Is it possible to gain investment imagination? It is not easy, but there could be some simple steps to help the process. The first and foremost understanding what the world is like at a given moment. If you do not know the current state, you cannot determine or imagine different states. Second, is engaging in the research of looking for change in relationships and understanding the history surrounding past market events. Your imagination is limited if you do not know the history of markets. The final and hardest part is conceiving what can change in the current environment. Of course, a simple way to increase imagination is to just not follow the consensus or think about what is an alternative to the consensus. The consensus at the beginning of 2014 was for higher oil prices. The simple imagination test is working through scenarios which could cause a lower oil price.  Imagine the opposite as a start. For example, good risk management is just imagining what you will do if something goes wrong.

 For 2015, let's increase our investment imagination.