Tuesday, September 26, 2023

Chronological snobbery in economics and finance


C. S. Lewis defines chronological snobbery as “the uncritical acceptance of the intellectual climate of our own age and the assumption that whatever has gone out of date is on that count discredited.”

This can be applied to current economic and finance research. Without a doubt our knowledge of the economy and finance has advanced over the last decade, but it is less clear that we know how to properly discount our current knowledge relative to what is known from the past. Current thinking about monetary policy and our wisdom about how to make policy choices may be worse today than twenty years ago. Current modeling techniques such as ML may seem to have an advantage versus older techniques; however, the benefit after empirical testing may be limited.

A conservative approach to economics or investing does not mean clinging to old ideas as always being better. It does mean that new theories and approaches should be viewed with healthy skepticism - "please tell me your new ideas and then let's determine whether they are truly better." The conceit of today may lead to ruin tomorrow, so always be careful with following the research fashion of the day.

The clouds over the economy - disruptors

What causes a recession? One darn thing after another. Any one of the following shocks may not be enough to cause a recession, but when combined there is enough disequilibrium to create business mistakes that lead to production slowdowns, inventory builds, slower hiring, and less consumer confidence.  
  •  UAW strike - This strike can last given the wide disparity between parties. If it spills over to other suppliers, it will start to be an economic drag.
  • A government shutdown - We have seen this before, but that does not mean there aren't risks. There was just an averted shutdown in June after which the Treasury issued well over one trillion dollars of new debt, so we are back in the same situation.
  • The oil price shock - Production has been cut by Russia and Saudi Arabia and prices are unlikely to reverse in the near-term. With prices now solidly in the $90's, gasoline prices are higher, heating oil is higher, and there is new fuel for higher inflation.
  • Student loan debt - The day is coming that payments will be due, and the cost will hit marginal households. Many households increased consumer debt during the student loan moratorium so new payments will reduce spending power for households that have a higher marginal propensity to consume.
Disruptions lead to new trends which offer opportunities, but the transitions are usually costly for investors. 

The "impossible" triangle for managed futures (or any hedge fund)

The 'impossible" triangle is the combination of diversification (low correlation with an equity benchmark), stable positive return, and "crisis alpha" or positive excess gains in the face of sustained equity decline. Can it be achieved? You can usually only achieve two of the three. It may not be impossible, but it is hard to get all three. It. can just be what is your tolerance to give-up on one of the three.

Diversification can be achieved through trading different assets long and short from the main target or benchmark asset. If you want diversification from equities, trade commodities, currencies, and fixed income. Trade both long and short as well and you will achieve a low correlation with equities. The diversification will pull down returns during a strong equity bull market yet serve an investor well in a bear market. The diversification will cancel some of the more extreme returns, but there is a likely gain in Sharpe ratio.  

If you want to have stable returns in all environments, you will have to trade a combination of styles to ensure that no one style will drive returns negative. Diversification of styles will smooth returns and help with diversification; however, there will be less convexity or excess returns at extremes.

If you want crisis alpha or positive convexity, you must have a high concentration of risk in trend-following; however, by doing this you will likely have lower returns during periods of stable markets. Hence, the convexity is only achieved through giving up the more stable returns. 

So, an investor is going to have to focus on two at the expense of the third. The question is what you can live with or what is more important for your overall portfolio. This is the personal choice that must be made by investors.

What are "stylized facts" but just a narrative with numbers


Economists will often talk about "stylized facts"; some tables, figures, and charts that provide general information about a topic without detailed econometrics. Many authors view that stylized facts are dispassionate and do not have embedded value judgements. Stylized facts are just part of a broader narrative. 

These facts just extend or support a story and are a rhetorical device to convince an audience of an opinion. There are no opinion-less stylized facts. There are no such things as just facts. These facts are only arguments for a story. Nonetheless, all econometric analysis supports a story and is a narrative device to further the argument of the author. 

Jan Tinbergen is believed to be the originator of the use of stylized facts - "To get a clear view, stylization is indispensable. The many phenomena must be grouped in such a way that the picture becomes clear, yet without losing its characteristic traits. Of course, every stylization is a hazardous venture. The art of the social economist's work lies in this stylization. Some stylizations have been unwieldy, others have been unrealistic. But stylization is essential. The alternative is barrenness."

Nicolas Kaldor furthered the view of stylized facts, "Facts as recorded by statisticians, are always subject to numerous snags and qualifications, and for that reason are incapable of being summarized", but theorists "should be free to start off with a stylized view of the facts – i.e., concentrate on broad tendencies, ignoring individual detail."

Robert Solow takes the counter view and is more suspect of stylized facts, "There is no doubt that they are stylized, though it is possible to question whether they are facts". Always think of Solow sitting on your shoulder when looking at facts in an argument.

There is nothing wrong with the use of facts to support a narrative except when the author pretends to view the facts as being neutral and not a critical part of his story. Facts can be just facts, but they are not neutral when used in a narrative.