Inertia - An application to investments as simple go to rule

 

“An object at rest will remain at rest unless acted upon by an external and unbalanced force. An object in motion will remain in motion unless acted upon by an external and unbalanced force” 

- The first law of Newtonian physics  

I don't want to get into the battle of whether finance is like physics, but Newton's first law of motion is a good framework for thinking about markets with respect to trends and reversals. 

A market in trend will stay in trend until there is a force to stop it. Similarly, a market at rest and rangebound will stay rangebound until there is a force that exerts the market to move it either up or down. Yes, as a starting framework, this is simple, but it serves as a good foundation. Reversals will occur when there is a reason or shock to the market. Markets will trend when there is a force pushing expectations and there is no change in that driver. 

The hard part is determining what are the forces that will drive prices. These can be macro and associated with central bank announcements or with economic data. For individual stocks, the force may be an earnings announcement. Of course, there are multiple forces that may exist outside of these announcement shocks. There is rebalancing, changing of sentiment based on volatility, reaction to news, and the general flow of funds across strategies and trading groups. Nevertheless, a key role of investing is identifying the forces that will drive markets to trend or reversal.

However, the foundation of trend-following and price-based models is that the forces driving price motion are hard to identify and even harder to properly link to prices. The reaction of economic agents and the impact of expectations make the link between force and price noisy. Hence, the focus for many is on extracting the signal from prices.

Commodity skewness is a risk factor for excess returns

Skewness matters because it tells us something about the tilt in sentiment and crowd behavior in commodity markets. By looking at the skew for a portfolio of commodity markets and sorting by quantiles of low to high skew based on the rolling prior year of information, it is found that there is significant gains from buying the lowest skew and selling the highest skew. This factor has been measured to be stronger than other well-known commodity risk factors, see "The Skewness of Commodity Futures Returns".  The impact is statistically significant and cannot be explained by other pricing models like the overall commodity market portfolio (equal weighted) momentum, term structure, or hedging pressure.

The argument for holding these negative skewed commodities is that investors prefer lottery tickets and are affected by prospect theory; those commodities that have positive skew which will be overpriced in the marketplace. Those commodities that have negative skew need compensation to hold these skewed assets. There is also a selective hedging story that places longer hedges for positive skew (producers hedge less and consumers hedge more) and shorter hedges for negatively skewed assets (producers hedge more and consumers hedge less). It is found that negative or low (high) skew have more backwardated (contango) characteristics, but the skew effect cannot be explained by other factors.

The positive value (premium) from skew works for both time series and cross-sectional analysis and provides another way to measure risk premia within the commodity markets. 

Does bank regulation need to be streamlined? Should the Fed be the key bank regulator?

 

Who is the top regulator of banks? The Fed. Yet, the Fed is not a government agency. It was formed by an act of Congress but is a public/private combination where there are 12 regional banks with board of directors from member banks in a region. The banks must hold stock in the regional Fed bank, but all excess profits from the Fed are sent to the Treasury. The Fed and its regional banks have their own budgets, but the Chairman is required to report to Congress and the Board of Governors of the Federal Reserve System are selected by the president subject to approval by the Senate. Within this structure, the regional banks will regulate member institutions. 

To put it simply, the regional Fed banks will regulate banks that can have executives on their board of directors. That was the case for SVB. The supervisors have a conflict with their member boards. It may not occur, but the appearances or chance for conflicts seems high. 

All the problems with SVB were evident by reading their SEC filings, so what were the bank supervisors doing? What effective oversight were they providing? What should be their role to limit bad behavior before we have a tun on a bank? 

The Fed has supervision of national banks so that it can ensure the safety and soundness of the financial system and the execution of monetary policy. A streamlined regulatory system makes sense, but is that what we currently have? 

Just in case you need a refresher, here is a simple map of current regulatory oversight from Chris Skinner.  So, who is responsible for overseeing bad management? If everyone is in charge, then no one is in charge.

Here are two more graphs which should make the point clearer from everycrsreport.com. So, can you tell me who is the chief regulator and who should be held accountable? There should be clarity and no conflicts. I don't know if we have that.

Cheap money can give very expensive lessons

 

Cheap money can lead to very expensive lessons. Unfortunately, the time between an era of cheap money and the expensive lesson can be long, so we do not often make the important connection. 

There are two problems here: one, investors don't realize that there is a disconnect between cheap money and expensive lessons, and two, the learning of this lesson is confounded by the delay between the event and consequences. We learn quickly when the time difference between cause and effect is short. If there is a delayed response, learning is slow. A quick feedback loop is a "kind" learning environment, while a long lag will often be called a "wicked" learning environment.

Cheap money means that we will accept projects that have a lower return based on the assumption that cheap money will last forever.  When the market moves back to normal, investors will be holding lowering returning projects that can only be sold at a loss. If cheap money exists for a longer period of time, investors get used to it or in some cases get addicted to it. They will not be prepared for more expensive money. The reach for yield at lower absolute levels must be reversed. Remember just a few years ago, there was well over a trillion dollars of global government debt at negative rates. That seems like ancient history.

The key banking problem is that financial institutions were living off cheap deposits that can move anywhere for higher yields. The flow could be to larger banks or to MMF that do reverse repos with the Fed which causes a reduction of reserves. Those cheap deposits funded longer term assets at low yields. Now, the cheap money game is over, so banks must adjust and reprice their low yielding asset portfolios.

See "Kind" versus "Wicked" learning environment - Financial markets are not kind