The warnings from October - The end of the easy money bounce

The take-aways from October performance should generate concern for any investor.

• Stock (SPX -2.66) and bond (Agg -.17) benchmarks were both negative for the month. The normal bond hedge was not effective. The returns for bonds are worse when using Treasuries index over Aggregate.
• The 3-month return for a 60/40 stock/bond  (.37/-.97) portfolio return was negative by -.17. The base asset allocation position did not lead to positive returns.
• The strategies that have worked this year are showing signs of investors exiting. Information technology was down 5.10 percent and growth, quality and momentum were all negative respectively -3.08, -3.75, -4.17 percent for the month. These were the strategies that investors profited from after the March crisis.
• There is still no return protection from holding low volatility (-2.87 for S&P low volatility index) but there were October gains for those investing in utilities.
• The yield curve has steepened with long Treasuries, corporates and high yield all generating negative returns for the last three months. This has occurred even though there has been no change in Fed policy.
• There is no protection through international investing in developed equity markets with Europe equity benchmarks all lower than the US. Some protection existed for investors in emerging market equities or Asian stocks over the last three months. 
• Commodities were down for the month based on downward revised expectations for energy markets. 

While there has been talk about US election uncertainty increasing on a perceived decrease in the gap from polls between Biden and Trump, the real driver is the COVID19 bump. The daily increase in positive tests versus total new tests taken is at level near the end of June. Broad brushed, countries with increasing daily case counts are seeing asset price declines. Countries with limited increased counts in Asia or EM have held value. A COVID increase will delay any further recovery and will  likely lead to a reversal of economic growth.

Intuition as an alternative mode of thought - Experience can help with some decision tasks

Should investors use intuition? As an alternative mode of thought, the answer is yes. As defined by Robin Hogarth, the expert in decision sciences, "Intuition or intuitive responses are reached with little apparent effort, and typically without conscious awareness. They involve little or no conscious deliberations."

Investors should always prefer conscious deliberations and awareness, but there are periods when decisions are time sensitive, require quick action, or are repetitive enough to be done without deep deliberation. There is a place for using intuition as long as it is based on focused skill and experience.  

There are different modes of thought for information processing that can be learned to help investors. Facing a significant flow of constant information, investor require different levels of attention and processing. All decisions do not require deep analysis. Modes of thought can range between intuition, a tacit process, and analysis which is focused and deliberate. The investor needs to choose a mode of thought based on its speed, accuracy and the amount of effort required. 

Learning through experience works to support intuition. An experienced trader may use intuition while a novice trader will require more work because he does not have the experience of facing the same task repeatedly. However, the intuitive trader with experience may only be good at these decisions and not others where he has less experience. 

Learning is based on context, knowledge of the specific world that requires a decision, and rules, the process of how to do things. Intuition uses tacit or implicit knowledge which is the ability to understand after repeated exposure how certain phenomena work even if the action cannot be explicitly verbalized. The great pool player has implicit knowledge about how to shoot even if he cannot verbalize the physics. The trend-follower who is just looking to find market direction is using a systematic intuition. 

The problem faced by the intuitive trader is that the learning environment is not always friendly. There is not always a strong link between action and response. This poor learning link environment is called a "wicked" environment as opposed to a "kind" environment. See "Kind" versus "wicked" learning environment - Financial markets are not kind.

Intuition can be rules-based and does not mean action without thought. Some will argue intuition will be filled with biases, but that argument does not account for the learning and experience that is required for good intuition. 

The intuitive trader develops habits that resemble the scientific method. There is observation, speculation, testing, and generalization, but it is done through repetition from experience and not as a conscious effort planned in advance. See The OODA loop - A simple approach for how traders should behave. The good intuition we are discussing is not associated with feelings or emotions. In fact, the good intuitive trader will be unemotional about what needs to be done. The intuition we are focusing on is a form of expertise which can be developed through direct feedback for specific tasks in a controlled environment which has circuit breakers to minimize the cost of mistakes.  

 

Margin calls and the danger of feedback loops and pro-cyclicality

The March pandemic liquidity crisis was real and a test of what could be seen in the future. The low interest rate world has led to increased leverage and risk-taking. Higher volatility and large market moves will see an increase in margin requirements which will spill-over levered markets. There will be a positive feedback loop. Market sell-off will lead to higher volatility which will lead to higher margins. The higher margins will cause positions to be closed as traders delevered their risk. The financial flows through clearinghouse will be significant. This is well documented in the just published FIA working paper: "Revisiting Procyclicality: The Impact of the COVID Crisis on CCP Margin Requirements". This is a scary but important read for all investors who need to appreciate the structural issues faced during a financial shock.

The initial margin increases in the first quarter were significant across all major asset classes. Equity index margins increased by 100% and interest rate margins were up by 2/3rds. Commodity margins also increased but varied case by case.  

 

For example,  the e-mini SPX futures increased from just over $6000 pr contract to $12, 000 in less than a month. Even if an investor is hedging an equity position, the cost increase is substantial. The same problem existed for bonds. If a trader was holding a basis trade or speculative bond position, the cash flow requirements were sizable. Raise money for margin or get out of the position as a forced seller.

The money flows were staggering. The initial margin held at the CME at the end of the quarter was more than $230 billion, an increase of close to $100 billion. This is real cash that had to be moved to the CCP. 

This was all necessary because the number of margin breeches from the fourth quarter to the first quarter more than doubled from 3000 to over 6000 and the average size of the margin breech was more than 4 times greater than seen in the fourth quarter.

These changes in margin add an accelerator of pro-cyclicality to financial markets. This is especially true if there are extended periods of low volatility that are punctuated by a financial shock. This is an endogenous risk that markets have to be better prepared. Obviously, markets survived the March shock but only through massive Fed intervention. Investors have to think through the implication of no Fed or a late intervention and what that may mean for financial market integrity.

Food for thought on political cycles and stock returns

There is a well know stock effect in the US based on the political party in power. Periods of Democratic presidencies see higher stock returns than Republican administrations. The excess return difference is significant and greater than 10 percent as measure between 1927 and 2015. The last four years, while different, does not change the long-term relationship. A recent working paper has tried to answer this political cycle effect through an endogenous model of economic behavior. See "Political Cycles and Stock Returns" by Pastor and Veronesi.

Their simple model is based on the market response to time varying risk aversion. It is not what president do but when they are elected. When risk aversion is high such during a crisis, voters will more likely elect a Democratic president who will more likely provide greater social insurance. When risk aversion is low during periods of economic boom, voters will more likely elect a Republican because they are willing to take more business risk. 

Higher (lower) risk aversion under Democratic (Republican) administrations will result in a higher (lower) equity risk premium and thus higher (lower) stock returns. The authors show that there is direct link between risk aversion and voter preference. 

Is this year going to be different from the endogenous political cycle story? Economic growth has rebounded, uncertainty is still high, the pandemic crisis has not ended, and the need for social insurance still exist. This environment fits the story for a Democratic administration which is consistent with even late poll numbers, yet the uniqueness of the current crisis and strong voter turnout may make this election closer than forecast.