Steil on Bretton Woods

Benn Steil wrote one of the best book in 2013, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order. He focuses on the relationship of Keynes, the leading economist of the day on matters of international finance and Harry White, the Treasury representative who worked to structure the Bretton Woods agreement.  The most important feature of this book is that political interests and negotiation will drive policy not good economics. 

The end of the WWII required a new financial system and the British centric system from pre-WWII would not be left standing. Bled dry from lend lease and the horrible financial cost of war, Great Britain was in no position to bring back a gold standard or ask for loan relive. It would not even be able to maintain dominance in the commonwealth. The US, through the Treasury, wanted to set up a system that placed the dollar in the center of any world financial order. Yes, there would be a tie to gold, but the real system would be based on payments in dollars with the US serving as the dominant reserve currency. As they often say, the golden rule is that those who have the gold make the rules is clearly applied to the Bretton Woods agreement. The richness of the policy battle and politics is given significant detail and is worthy reading for anyone who wants to learn how policy is actually conducted. 

Unfortunately, reading this type of book makes one careful with asking for a new Bretton Woods agreement or some new policy coordination. It is not clear what the world would end up with if there was a new global agreement. Also, the likelihood of any new international order is based on power politics. If there is no clear dominant power, it is unlikely there will be policy coordination. After learning more how Bretton Woods was developed and looking at the ramifications over the last few years, anyone should be careful when asking for order from what is considered the current chaos. 

Why use models for investing?

Why we use models to help with the investment process:

• Provides structure for discussion; We don't say …  "we feel the market is oversold".
• Provides discipline; creates sameness with decisions.
• Encodes history of markets through numbers.
• Focuses discussion on where there are disagreements. Models serve as a null hypothesis.
• Generates focus on where we are in the market cycle. 
• Allows for "probability speak". We can talk about odds. 

Markets: Efficient or Inefficient?

Market efficiency is like perfect competition - nice in theory not reflected in practice 

In perfectly competitive markets, there are no extraordinary profits.  New entrants and competitors will force trading profits to zero. In reality, frictions, costs, knowledge, uncertainty and risk all make markets less than perfectly competitive. Market efficiency is like frictionless environments in physics. It makes for a good effective starting point but cannot be relied on as the perfect description of markets in reality.

Similarly, there can sometimes be a trading edge by some investors, but it is unlikely to last forever. Any strategy or edge that is successful will eventually be competed away and more players try and employ the strategy. Alpha and efficiency is a dynamic concept that changes through time. A strategy could be successful because of the environment and it could be successful because not enough capital has taken away the extra profits. The alpha can fall only to return when less capital is committed to the strategy or the environment turns more favorable.

Markets that are less complex will be more efficient. It will attract more capital and investors. Hence, a single stock may be more likely to be efficient while the market overall may be more complex and thus less efficient. A stock that is new or more difficult to evaluate will be less efficient; however, the risks will be greater. Greater risk means that capital will be slower to move to eliminate inefficiencies. Market can be efficient with respect to reacting immediately to information but that does not mean that the processing is always done correctly.

Market efficiency is based on the assumption that market participants are rational, but in reality rationality is a difficult assumption to accept. Forecasts have biases and is generally of poor quality. Models have proved to be wrong. Investors have beliefs that they apply in a rational manner, but those beliefs could approve to be wrong.

Which do you think is more likely?

Market efficiency - a simple set of descriptions

• No mistakes - investors get it "right". Markets are close to fair value.  
• No biases - Prices are a weighted average of opinions but these opinions are rational.
• Markets are a fair game. No one can create a sustainable edge. 
• Model of economy or asset valuation is well-known; investors always know the link between information and market reaction.
• Only paid for the cost of gathering information. 
• Market only moves on surprises and the adjustment is immediate.
• No feedback effects.
• Risk premia may be time varying but always reflect risk properly.

Market inefficiency - a set of issues 

• Market can make mistakes especially when facing change or inflection points.
• There are biases in markets because investors have behavior biases.
• On average market may be unbiased but it moves between greed and fear like a pendulum. 
• There is skill from some investors, albeit few have it. 
• Models of the economy are not well-known and change. 
• Information gathering and processing rewarded.
• Surprises do not always lead to immediate new equilibrium. 
• Potential endogenous feedback.
• Markets are cyclical, but prices do not reflect all risks all the time. 

Jeremy Siegel says stocks could go higher

Jeremy Siegel, the Wharton professor who believes in stocks for the long run, stated in an interview this week that equities could go higher by 10-15% if we get higher economic growth above 3%. There is no question that higher growth can lead to top-line revenue increases but the link between economic activity and stock gains is not very strong. This is especially the case when markets have already had a strong run-up and may be pushing above fair value. The economic growth has to be matched by what is already forecast, and analysts have been optimistic about revenue and earnings for US companies. 

Look at the relationship between the SP 500 and industrial production. We normalized and show that the increase in stocks has way outstripped the gain in production. We also present the relationship between GDP and equities. The dips in GDP correspond to declines in stocks but the relationship with gains is a little more suspect. It is time to be careful about pat answers between stock gains and macro growth. 

Surprise index surprising

A close look at the Citibank macroeconomic surprise indices shows some surprising numbers. The US has seen a steep decline and is also falling much faster than what is going on in the EU or emerging markets. The absolute decline has been quite large. Emerging market economic information has not surprised the market as much as the slower growth in US. Given the fall in EM stocks, one would have expected the big decline coming in the Em country data. Could it be that the EM equities are overreacting to the Fed taper program? 

This decline has an impact on markets. When the surprise index moves from positive to negative there will be a stock correction. We have already seen a correction in January but the surprise trend is still pointed downward. It is a clear warning sign to be careful in risky markets.

Japanese trade deficit increase not expected

Just because the yen declines does not mean the trade balance will do what is expected. In fact, sometimes the unexpected is the normal. A decline in the yen should lead to more exports and greater domestic production. Exports are cheaper for foreign consumers. Similarly, imports become more expensive.  There is no J-curve here as Japanese consumers paid more to buy foreign goods.  Part of the whole Abenomics is to have cheap money from the BOJ increase inflationary expectations which will increase domestic demand, drive down the yen, and make exports cheaper. 

Exports grew in January by 9.5% but the import costs were much higher. Imports increased 25%. In this case, the demand for foreign energy given the cut in nuclear power has changed the trade dynamics. Many were expecting that the revival of the Japanese economy would be based on rising exports and that the weak yen policy was an extension of the "currency wars" around the globe. The numbers do not suggest this story is playing out as expected when you have inelastic demand for imports. The growth pattern in Japan for 2014 is not clear and this is going to cause more global uncertainty. 

The specter of deflation returns

With the strong sell-off in economies after the Great Financial Crisis, central banks around the world engaged in massive quantitative easing to halt any deflationary fears and expectations. The battles were not directly expressed as one to stop deflation but rather as still trying to hit inflation targets. In a leveraged world, deflation is an economy's worst enemy. However, central bank actions of increasing credit offset these risks. Financial assets were bid up eliminating financial asset deflation. Money was increased, so credit was available to stop the erosion of general prices and allow for leverage to be adjusted slowly. Central banks were successful with their goal, or so they thought. In a world where output still exist, normalizing monetary policy is not easy.

In 2014, the specter of deflation is again scaring markets even though inflation from currency devaluations is also a potential problem for selected countries. The inflation rate for the EU is well below target. It is also below target in the US. The IMF has sounded the alarm for deflation in the developed world. The attempt to return to normal by the Fed has sent emerging markets into a growth scare. Any global growth slowdown says that economies are still fragile and means prices can be biased downward. Currency devaluations increase import prices but a global slowdown will also have a negative impact on commodity exports and lead to a negative feedback on EM growth. 

The G20 meeting in Sydney will be critical to trying to address the new deflationary pressures around the world. But it is unlikely we will make any progress on deflationary discussions. The Fed has not any desire to include international considerations in monetary policy. Central bank coordination has not been a theme that has interest. There is much more focus on staking of positions within an uncoordinated G20.

Investment decision-making on the micro level

I like to read investment books just to see how others are thinking about the markets. On a recent trip, I read Kenneth Posner's Stalking the Black Swan: Research and Decision Making in a World of Extreme Volatility. I was expecting a practical approach to thinking about the work of Nassim Taleb's path-breaking work on extreme market moves and Black Swans. What I got was a thoughtful piece on how to be a good financial analysts. This was a good surprise as Posner goes through the trials and tribulations of being an analyst who is trying hard to get things right but will get surprised in spite of their hard work. You need to get the framework right to be a great analyst.  

His rules for avoiding Black Swan events requires being quick on your feet to changes and following a couple of good rules.

• Focus on the critical issues; know what are the return drivers.
• Think in probabilities; the world is not certain.
• Study the power of new information; it could be a catalyst.
• Watch and eliminate cognitive dissonance; it is lurking in our thinking when we are not precise.
• Go simple when the environment gets volatile; complexity is your enemy when there is more uncertainty.
• Change when you have to; markets are changing.

Should we still be worried about the Financial Crisis?

Just finished reading The Creation and Destruction of Value: The Globalization Cycle by Harold James. James is a professor of history and international affairs and provides in his book an interesting take on the financial crisis. He views the Financial Crisis through the lens of the history of the Great Depression. Everyone generally believe that the primary cause or problem was when the stock market fall in 1929, but he would argue differently. The real focus should be on the banking crisis in 1931. The stock decline caused a fall in wealth. Real value declined. The banking crisis created a decline in value but of ideals and trust. Contagion creates a more value destruction in institutions. 

The focus of the 1931 global banking and currency crises is not on the destruction of traditional value as seen through the price decline in stocks but on the destruction of institutional structural value through trust. Countries went off the gold standard. Loans were not paid. Inflation moved to destructive levels. Institutional structure as the glue that kept markets functioning broke.

Contagion in banking was the problem that lead to global value destruction at a higher level. The currency system was destroyed. We are now five years away from the Financial Crisis and we have not had a banking contagion like 1931, but we still have institutional and structural problems that have to be addressed. There is less policy coordination on currencies. This has been the "currency wars" discussed in the popular press, but we had not made progress at stabilizing policies. Trade agreements have not been signed and capital controls are more evident. Even with banks regulatory changes like Dodd-Frank and the Volcker Rule, we have not solved the problem of too big to fail. We have moved forward on systemic risk monitoring but the preparations for any future banking crisis in not clear. Basel II and new regulations in the EU still do not solve the problem of large global financial institutional risk and the still existing problem that financial globalization is declining as banks pull back to their core national interests.

Contagion banking liquidity issues require global coordination and communication. Forward guidance on an individual central bank level is not enough. We have not had to deal with another round of crisis post Greece. The ECB has said it will do whatever it takes, but there are limits to what a central bank can do when we are at the zero bound. Clearly, the Fed is finding that quantitative easing does not affect the credit channel if there banks do not feel as though there is a positive lending environment.

There was a vacuum of power politics in the 1930's and there is a similar problem today. The US is unable to impose any new world order. It is viewed by many as the problem, yet Fed policy also affects the world order through the liquidity it provides or doesn't when it cuts back on funds based on domestic goals. The EU and China are both not able to impose a new world order in financial markets because they still do not have the financial power that existed with the US in the post-WWII period. We still need policy coordination to avoid problems like the 1930's. We are not in the same predicament, but there are similar issues that have to be addressed.

Keynes and investment management

The focus on Keynes has always been on The General Theory and macroeconomics; however, there is also another side of the brilliant Keynes, his life as an investor. There have been a number of papers and books on his active investments skill which also show an interesting evolution as an investor. Much of this analysis of his investment skill can be found in the simple book, Keynes's Way to Wealth: Timeless Investment Lessons from the Great Economist by John Wasik.

Keynes was a hedge fund manager, an insurance company portfolio manager, a private speculator/investor, and he ran the endowment for his college. He was an active commodity speculator who tried to create an information edge through his active research of markets. He used his knowledge of international finance to actively trade currencies. He used leverage to increase his risk when he thought he had a edge. He acted no different than an active global macro hedge fund manager.

When the rest of the market believed that endowments should only invest in high quality bonds, he actively increased stock allocations. Through to the mid-1930's he was an active macro manager through trying to play the credit cycle and to find the best asset allocation mix across a broad set of markets. His views to investments included a focus on maintaining purchasing power, looking at commodity supply and demand as well as imbalances between savings and investments. He built portfolios that included what he called "opposing risks" which is an early way of thinking about diversification and hedging.

His portfolios as reviewed by a number of researchers were able to beat the markets but he also took on large risks. He was not afraid of holding assets for which he had strong convictions even if that led to substantial drawdowns.

Keynes was also a complex investor because he changed his style to managing money in the 1930's. He moved over time from a macro trader of credit cycles to one that focused on long-term value. He clearly moved from trading market beta and taking large risks to a strategy that focused on finding intrinsic value with a focus on stock picking through understanding cash flows.

The keys to Keynesian investing are simple:

1. Stocks win in the long-run. Consistent with current thinking on risk premia.
2. Speculation is dangerous because it is based on the premise of superior information.
3. Need to think in terms of probabilities and not certainty.
4. Opposed risks will help balance a portfolio. Diversification is good.
5. Look for value.
6. Dividends do not lie and critical when determining value.
7. Don't follow the crowd.
8. Invest for the long-run.
9. Do not over trade.
10. Enjoy life; drink Champagne.


Whether it be "animal spirits" or the "beauty pageant" analogy, Keynes was a path-breaker on thinking about investing from the macro, fundamental relative value, and market sentiment perspectives. He embraced capitalism and the investment game with a passion that would surprise any trader. 

Gentleman Bankers

What was the world of banking like 100 years ago? You can get one idea through reading the new book Gentleman Bankers: The World of JP Morgan by Susie J. Pak. There was high finance pre-Depression that included large underwriting for countries around the world. Underwriting syndicates were made and capital flowed with major all getting done through strong cooperation across firms. there was competition but a sense that help was needed to raise the amount of capital needed by borrowers. Unfortunately, theses gentleman bankers were not always gentlemen with biases, racism, anti-semetism and a clubbiness which excluded many from the inside workings of Wall Street.

While I have often taken the view that relationship banking would be good for finance over the transactional banking of today, reading Pak's book makes you think that anonymous banking is fairer for the outsider. Without question, Pak's book suggests that trust drove transactions even when there were social biases and exclusionary practices.

For today, the need for trust in finance is even more important. The trust between Main Street and Wall Street is at a low and the trust between broker and investor is no better. The trust across boarders between finance ministers or central bankers is no better. Policy cooperation is low. Globalization cannot occur without trust in institutions. Finance is a business of trust regardless of who is doing the business and trust cannot be regulated or controlled by law. We contract today for cash flows in the  distant future. All contingencies cannot be written into a contract nor can all clauses be enforced without trust. It can only be learned and experienced over time through  repeated interaction. It is hard to gain and easy to lose, but without trust all of the legal documents signed at a law office are worthless.

Cleveland Fed financial stress indicator

I have worked with a number of financial stress indicators. They were very effective tools during the Risk-on/Risk-off (RORO) period before and just after the financial crisis. They have been less valuable recently because the variables have all shown low levels of stress. (Maybe they are doing their job effectively.) However, after the last month, I am feeling more stress. Funny how that always happens when the markets move lower. 

Hat tip to a friend who show due another stress indicator. The Cleveland Fed has put together a nice site on their take on financial stress. I like the completeness of the site with details on all of the index components. The stress index has 16 components which are broken down into equity, funding, credit, foreign exchange, real estate, and securitization markets. This is all price based which give an indication  of cross market stress. There are no volatility indicators which i think are very valuable, but the level of detail and diversity in this stress indicator makes it a winner. 

Relational versus transactional banking

Would the world be different if we had more relational versus transactional banking? Transactional banking would include trading and syndication as well as high volume retail banking based on credit scoring. Relational banking would be more closely aligned with the early 20th century "House of Morgan"-type of business. On a local level, relational banking would be practiced by a smaller bank that knows customers and is less willing to syndicate loans but rather hold the loans in portfolio because it has an information advantage at understanding the quality of the client.  

There is a dark side of relational banking. At the extreme, is relational banking just crony capitalism? It could be if the relationship is based on access to government favoritism. If the relationships of banking is not based on the ability to assess the character of the customer but to have access to regulators, there will be inefficiencies.  Still, if we had a less transactional banking there may be a reduced chance of excessive risk-taking, or at least the risk-taking could be clearer. The packaging of unknown risks may had been one of the biggest problems with the financial crisis. One could argue the other side by stating that bank runs occurred more frequently in the periods when there was more relational banking.

I am conflicted on the right answer but my general view is that more character focused lending based on direct private information on the borrower and less packaging of loans would be helpful for the economy. 

Crowds and power

There has been a lot of focus in finance on herding behavior, so I have tried to get different perspectives on this issue of how crowds may effect financial markets. The herding behavior  can result in bubbles or at least viewed as an irrational response which cause trends in prices. There is herding that may be viewed as irrational but herding may also be a rational response when an investor is at an information disadvantage.

A unique view on crowds is from Elias Canetti, the 1981 Nobel Prize winner in literature. He wrote a wide ranging piece, Crowds and Power which looks at historical, cultural, and religious implications of crowd behavior. This is not an easy read, but presents the view that crowd behavior has driven many of the big movements in culture. This could be the exact opposite of the view that individuals matter. Put differently, the individual leader is successful because he can manipulate the crowd to be the instrument for change or the status quo.

Elias defines different types of crowds and how crowds change with goals and different stimulus. He then discusses tighter groups, the pack, which is a more focused crowd with specific goals and desires. Crowd behavior is tied back to the desire to survive and the elements of power. control,  and command.

The elements of Canetti's thesis can be applied to financial behavior. I found it to be an interesting exercise to try and apply his ideas to market behavior. As  a more quantitative person, I ask the question of how this can be measured or forecast. Here, I am at a loss at this time. Crowds, fear, the desire to survive all figure into markets, but the dynamics are not easy to explain, measure, or forecast.

Buffett valuation of stock market

Hat tip to zero-hedge for reminding me of the old and simple valuation of the stock market used by Warren Buffett. No need for P/E or B/P or other more complex measures. Just take the market valuation and divide by the GDP. It is available on the FRED database. When the market cap to GDP gets too high, the market is in trouble.

Now this is just one tool and there are problems with the measure like the large secular increase post-1995. It is hard to say what should be the true relationship between equities and GDP. All we can say is that the market cap has had a significant rise into territory which should make any asset allocator to stocks nervous. 

I am curious about the big declines. Are these bubble crashes? What happened in the 1970's when we had stagflation? If you extrapolate the trend from the pre-1995 period, we may at a level closer to this trend, but that begs the question of what had happened over the last fifteen years.

Still, if you want one simple measure, this is a good place to start and you are in good company using it.

Hedge fund fees and the fall in innovation

The Economist reported that hedge fund fees continue to decline with management fees down to, on average, 1.4% and incentive fees dropping to 17%. The days of 2/20% are over. Managers may post 2/20% as the stated fees but everyone wants a deal. The result is that less innovation will occur because the money necessary to start a hedge fund will be higher. The large funds that show declining performance because they become more beta-like will be able to reduce fees and still make a healthy profit at the expense of smaller funds. As funds get larger, they can discriminate between management and performance fees. Cut management fees for higher performance fees since the fixed costs are covered or just offer a flat fee on a higher AUM. 

All of the evidence suggests that small and newer funds perform better, but if there is more fee compression the market will not get the entrepreneurial manager starting out with a better idea. 

More on looking

Alexandra Horowitz opened her eyes walking around her block. Just finished her new book, On Looking: Eleven Walks with Expert Eyes. The author had a simple premise. She would walk around her block on the upper westside of New York City with different people and have them tell her what they see from their perspective. 

No pun intended, but it was a real eye opener. She started with her toddler son and just observed what he looked at and what interested him. A very different sense of what is important. She followed her dog. She walked with a geologist. She strolled with a bug specialist. A botanist. Someone who is blind.  An artist.  Each saw the world differently.

So what would you see if you looked at the markets from a different perspective. If you are a discretionary investor, can you see the markets through the eyes of the quant. Can you see what the technical trader sees? What does a central banker see? I am not suggesting that you become something different, but if you can observe markets from a different vantage point would you have richer invest perspective? 

Certainty versus uncertainty - what a choice

Uncertainty is an uncomfortable position. But certainty is an absurd one. - Voltaire

We have to live with uncertainty and not fight it. Living with uncertainty will always force you to make better decisions because the first answer or the obvious answer is not the answer.

Golden rule and macro investing

Golden rule of investing: “no asset (or strategy) is so good that it can it be purchased irrespective of the price paid.” This is the rule that is every value investor employs when picking stocks. But how about macro investing? The same golden rule applies to asset classes as well as individual assets. If fact, since the asset class decision is bigger than a choice of purchasing an individual asset, it is even more important. 

Get the asset allocation right and you will be rewarded handsomely. Decrease exposure to stocks when they are rich. Buy bonds when they are cheap. Stay away from expensive emerging markets. Buy risky assets when the economy is growing. The only problem is that value investing acres asset classes is harder than a comparison across two stocks. Stock picking is "easy", discount the cash flows. Now, how do you compare cash flows across asset classes in aggregate? 

This is not impossible but difficult. Still, the cost of being right or wrong is much higher with respect to asset allocation. In fact, academic research suggests that even if the R-squared of a simple macro factor regression is low the positive impact on portfolio management of using the model is significant. 

You have to generate a lot of alpha from small positions to make up for the fact that you have the wrong stock allocation. There is value with macro investing and good asset allocation. 

Observing, scientific investigation, and investing

The art of observation "is not passively watching but is an active mental process", and it is important to of distinguish it from what we call intuition. - Hat tip from the always interesting Brain Pickings website. 

Is observation a precursor to intuition. You cannot really have intuition if you are not a good observation. Intuition without observation is just random thoughts about connectiveness. 

So we need to observe everything closely? In fact, wisdom is being able to observe freshly but not look at everything. Selection is another skill of observing. This is what makes observing so intense and difficult. Most will throw-out information from not looking closely enough. Observing is about close seeing for differences and connections or patterns through intense training no different than other forms of exercise.

I need more seeing exercise no different than I need general exercise.  

Hanke's Bernanke

Steve Hanke wrote a nice piece in the Globe Asia Magazine (February 2104) on the Bernanke legacy. It is nice piece from Steve perspective, but it is not a nice view of former Chairman Benrnanke. 

The mistakes at the Fed started with loose monetary policy in the post 2000 period. Inflation was not up but financial prices or relative prices for financial assets exploded. This lead to the crisis in 2008. Now when rates are driven down to zero you are not going to get more local investors to put their money in short-term lending. You can see that from the carry trade. Everyone headed for the exits and into, say, emerging markets. This put upward pressure on exchange rates which was offset by foreign central bank buying of Treasuries. Then we came to the post-crisis period where we are now stuck in the zero rate bound environment. The only policy choice is to increase money through quantitative easing except if this money high powered money is not translated into more bank money - short-term lending or near money, there is a contraction of credit. We have less liquidity than before the crisis. Kill the shadow banking system and increase capital requirements and the credit transmission channel is strangled.

Yes, but financial marts are booming. Still the real economy is not very excited. Relative prices are tilted to liquid assets not new long-term investments. This is coupled with the search of yield away from short-term rates. 

We are careening back and forth from one side of the road to the other trying to get control but just over steering. 

Templeton on bull markets

John Templeton, "bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria". 

By this measure, we can go further with this market. Sometimes you have to take these adages with a grain of salt but I still like the thought process here. The question is always what makes this the same or different from past bull markets.

F for Fake and Investments

Thinking about forgery opens up an issue of what is an expert. Forgers are able to be successful because experts are just not very good at seeing the details even when presented to them in their area of expertise. Their conceit and ego will not allow them to admit failure. 

This reminded me of the old Orson Welles movie F for Fake about the hoax biographer Clifford Irving, the master forger Elmyr de Hory, and of course Orson Welles, the man who created the radio hoax "War of the Worlds". If you have time, see Welles' muddled masterpiece. It is on youtube. It will certainly have you think about what is truth and what is fiction. 

There is a lot of fraud in the investment world. This is not about what is legal but what is truth. Professionals passing themselves off as experts, but really just talking heads. Investors believing whatever they are told. A lack of clarity between truth and opinion. 

Still, there is an answer to this problem. Do your own research and follow the numbers. 

Art forgery and observing

Just finished a nice little throw-away mystery novel - The Art Forger by B.A. Shapiro which uses the  Isabella Stewart Gardner art heist as a backdrop for a story about art forgery in Boston. It is always a thrill to read a book set in your home town because you can place yourself in local settings and better visualize the place of characters. However, I am not writing a book review.

What caught my attention was the key theme of observing. We see what we want to see and do not actually observe what we are looking at. A Degas painting is viewed as a Degas because we are told that it is so. Is it really? Can we spot a forgery? If we are told a painting is a forgery, but that information does not fit our priors will we believe it?

Perhaps this discussion on art forgery has nothing to do with investing, but my guess is that the greatest failure in investing is seeing what is before us. If we are told by enough people that the economy is doing better, will we really look closely for signs of the opposite. Can we spot the fraud in analysis and investment advice? Most likely we do not want to look hard enough at the evidence. 

The changing nature of commodity markets

There is a significant change in the relationship between commodities and equities. If you would like to call it the single factor effect - equities and commodities moved together with the swing down in global growth. The markets were also linked by global fears which was displayed through RORO behavior. That is now over. Commodities are responding to local supply and demand events and stocks are linked to valuation sentiment. 

The diversification story for holding commodities is now back. 

Equity and bond flows - a new story

There is a significantly new story in the equity and bond markets if you follow flows closely. Since 2008, we have had significant inflows into bond mutual funds and outflows in equity funds. Forget about performance, money has been moving into bonds for the last few years, and the market has not committed to this stock rally until 2013. Now we are getting the strong equity inflows and money moving out of bonds. The "Great Asset Switch" is now finally taking place. Of course, it could be a little late, but the taper tantrum and the high absolute equity returns have finally caught the attention of mutual fund holders. 

What is next for interest rates?

With a bad month for equities, one of the natural questions is what will be the direction of interest rates. Should bonds be used as a hedge for equity positions or should you view it as a stand alone investment?

The long history of interest rates in the US tells us that you would be hard pressed to believe that rates can stay low. The priors let us to be careful. History is against holding bonds. 

The more recent history tells a divergence story between maturities. The taper tantrum caused a general increase in rates, but then we had a big divergence in rate behavior. The forward guidance talk of continued low rates through the next year brought short-rates down but caused long rates to move higher. 2-year constant maturity rates have moved higher but not to the same degree as the 10-year. Since the 2-year rate is the combination of expected short rates, there is a clear view that rates will be going up quickly after 2014. Under current environment, there is little reason to hold fixed income. Of course, we are subject to the whims of central bankers but the odds are against you right now. 

Impact of QE on equity markets

Hat tip to DoubleLine and their package of charts. A close analysis of quantitative easing on equity markets shows some interesting patterns, or more importantly, there is only one interesting pattern. If there is loose monetary policy, the stock market will rise.  When the Fed takes the foot off of the petal, there is only a limited rise in stocks. How may ways to do you have to say it, "Don't fight the Fed."

Or, for the current period, if the fed is not providing liquidity, be careful!

Deciding how to decide

A recent issue of the Harvard Business Review highlighted an article "Deciding how to Decide" by Hugh Coutney, Dan Lovallo, and Carmina Clark. It plots the choices of tools available for making a good decision. It is a nice piece on the what is available to executives who have to make difficult decisions. Their framework can also be very useful within investments. Finance seems to rely too heavily on quantitative methods which often are not appropriate given the type of uncertainty faced.  In fact, setting up the problem may be the most useful part of decision analysis. You have to know what you know and know what you do not know. If you don't have the right information or data, or you cannot frame the problem within specific bonds, you are limited in your choice of tools. They break the world into five types of situations or contexts based on whether the outcomes can be defined and the amount of knowledge you have about the problem. If you can define it and measure it, then you should move in the direction of quantitative tools and if you cannot, then you should focus on cases or analogies. The context through these two lens will determine the type of tool that should be used. 

If you understand the model which describes the situation and you can predict the outcome from a decision with a high degree of certainty then you can use some simple tools. If there is little uncertainty about what the environment will be like, then focus on just discounting cash flows in a straight-forward manner. Unfortunately, there are view of these situations, but you can think about a repeatable event where we have a lot of past information to help us look at this type of situation. This would be a classic textbook problem.

A second situation is when the causal model or links are well understood and there is some uncertainty and it can be easily bounded. If the information or knowledge required is not disperse than quantitative tools with scenario analysis should be used. This would be the classic type of work that is undertaken by an investment quant. If knowledge is more disperse, there is a need for some sort of further data analysis or information aggregation to provide context for alternative scenarios. 

If decision outcomes are not easily known, the use of quantitative scenario analysis is not enough to provide an answer. There has to be some form a qualitative analysis coupled with cased-based decision analysis to handle this situation. This would be fundamental analysis with expertise from past knowledge or experiences. 

If the model for describing the situation is not known, the decision outcomes become even more unclear. If set of possible outcomes are known and knowledge can be controlled then, forecasting tools can be applied with case-base decision analysis. This is similar to the second situation but we are not sure of the true model. When faced with new central bank policies we may not understand the causal model that can be applied but we are able to bound what are possible outcomes. 

When the causal model is not known and and the outcomes are not well understood, the only choice is to use a case-base decision making. Look through past similar experiences in order to find situations that may fit the current events. The use of analogies is critical when faced with significant uncertainty.

If I strip away the usual management jargon, decision-making can be broken into two major choices. One, problems where we have a well established model and data to analyze that can tell something about market reactions, and two, problems s where there is more uncertainty about the model to be used and limited data to analyze. In the first case, we use quantitative tools that can be used repeatedly and in the second case where our best option is to look for past situations or cases to compare to the current event. 

When you have a model and data, use it in quantitative approach.

When you don't have a model and limited data, use a qualitative approach and look for past cases.

This seems simple but finding the right framework is critical for decision success. 

Herding and financial markets

One of the reasons why trend-following works in markets is because of investor herding. If fact, one reason why markets are not always efficient is that fact that herding behavior exists in markets. It is not unusual and is a response to uncertainty.

Recent research has tried to define and focus on why herding occurs. See "Estimating a structural model of herd behavior in financial markets" in the AER January 2014 by Marco Cipriani and Antonio Guarino. 

A good simple definition for herding is that it occurs when there is decision clustering. Everyone is making the same decision at the same time. However, there is complexity caused in this definition because there are two types of decision clustering. Clustering can occur when there is a common reaction to some new information. For example, the Fed makes an announcement and investors decide to change their bond allocations. This cluster can be considered spurious herding. Actions are being taken simultaneously by many but it is a perfectly rational response to new information. The herding that is less rational would be when an investor  is willing to follow the crowd even though their private information is in disagreement. 

Herding is more likely to occur if there is event uncertainty, that is, there not clarity on whether an information event has occurred. An investor does not know the cause of the decision cluster. When there is less market clarity, price adjustment will be slower so there will be serial dependence in price data.

Herd behavior will always exist in markets and create market inefficiencies because investors cannot untangle information events from liquidity trading or hedging. Hence, information traders may switch between herding and only using their private information. The authors develop a nice theoretical models that can be used to analyze transaction data. Herding is pervasive and dynamic and worthy of careful analysis by any market participant. 

Free trade and the EM crisis

There is more at stake than currency declines in EM countries which have bad current account deficits. The poor EM environment will have spill-over for trade and this will hurt the world. Trade growth has fallen below global growth in the last year. Capital flows have declined significantly since the Financial Crisis. Trade agreements around the globe have stalled and a recent survey of the G20 shows that there has been a 23% increase in protectionist measures since 2009. The growth in protectionism is even higher when you move beyond the G20. It is not clear that the Trans-Pacific Partnership (TPP) will be agreed to by the US and Asia. 

Now we have currency devaluations which will make imports more expensive. Exports for these countries will be cheaper but devaluation usually hurt growth in the short-run as central banks raise rates to protect from further currency slides. Tightening monetary policy, capital controls, currency uncertainty, and growth disruptions all spell the same thing for trade, less good and services moving around the world. 

Who is going to be an advocate for global trade? Where is the policy coordination? The global markets needs leadership and it is not clear who is going to provide it. 

Buy-rent shift will take a bite out of housing market

Any softness in the housing market has been explained away by the cold weather throughout the US. No one is going out in the cold to make major purchases, but a more interesting dynamic is the shift between buying and renting costs. It is now cheaper to rent. It does not seem to an issue that has been the focus of many. The recent Business Week chart is an exception.

"Beijing Consensus" will be put to the test

After the Asian crisis, the "Washington Consensus" policy choice was rejected by many emerging market countries. The free and open markets with floating exchanges and no capital controls was viewed as a recipe for disaster. Sudden stops would be possible and hot money would rule the choices available to central bankers. Emerging markets moved to a new "Beijing Consensus" of "stable" but more authoritarian controlling governments with policies of high export growth. Financial repression internally would keep investment growth high and capital controls would limit hot money flows. 

This new consensus is going to be put to a test in 2014 with slower growth in many emerging markets. The slower growth will lead to more unstable politics which can add a much higher level of market uncertainty. We do not know what will be the longer-term policy choices of Argentina, Ukraine, Turkey, and India to name just a few. The central bank policy of raising short rates will start to cut internal growth which will lead people into the streets. Then what? 

Gloom and doom in 2014 - one graph

Bloomberg - Business Week and Mark Glassman produced a nice graphic on the gloom and doom we may face in 2014. It compares the possible impact with the likelihood of the event happening. Makes you think we are in a scary for world. The first month of the year has not been something that I would like to see repeat this year.

Notice that most of these events are not related to the policy choices we spend so much time dissecting.