Inflation - Not what was expected, not what is wanted

 

The US inflation story has been a mash-up of different ideas. Go back two years and we were seeing Fed rate increases because of inflation concerns and a desire for normalization; four in 2018 and 9 since December 2015. 2019 saw rate cuts in an effort to support the economy and inflation. March 2020 caused the Fed to pull out all of the stops with monetary policy to push inflation above target given fears of recession and deflation.

The deflation threat has not materialized. The PCE has stayed above 2015 levels and never moved negative. CPI fell dramatically but has bounced back. The lockdown price behavior has not acted like a normal recession. 

Inflation numbers will be affected by many relative price shocks and will have a fair amount of noise, so a number of Fed banks have developed smoothed inflation series. 

• Dallas Fed - Trimmed mean PCE
• Cleveland Fed -  Median and trimmed-mean CPI
• Atlanta Fed - Sticky-price CPI
• New York Fed - Underlying Inflation Gauge 

The average of the smooth series shows inflation above 2%. The smooth trends are slightly downward but not suggestive of a deflation problem.

• Dallas Fed - trimmed PCE               1.7%
• Cleveland Fed - median CPI            2.5%
• Atlanta Fed Sticky-price                 2.0% 
• New York Fed prices-only UIG        2.1%

Did the Fed save the US from a deflation debacle through strong money growth or was the deflation threat never a real problem? We may need more information to provide an answer, but a vaccine that opens the economy will also prime inflation to move higher from a 2% base.

Public pension funds -There are no quick fixes

The National Conference on Public Employee Retirement Systems (NCPERS) produced a paper, "Ten Ways to Close Public Pension Funding Gaps" which tries to provide some solutions to the problem with public pension shortfalls. All have some merit, but all fall short of the real problem. More money, lots of it, has to be raised or benefits, lots of them, will have to be sacrificed. Without clear specifics for each proposal, it is hard to see how much of the funding gaps will be closed. For those public pensions that are close to full funding any of these choices may be enough to solve any small gap. For those that have significant gaps, the policy proposals will not solve the problem.

The choices:

Leverage and liquify - Borrow money to support pensions or liquify existing assets  

• Pension obligation bonds 
• Action of the Fed - For example, buying municipal bonds to allow leverage and liquidity 
• Bridge loans 
• Securitizing public assets - liquify public assets to pay for benefits

Structural changes - target payments to pensions, obtain scale, target contribution adjustments, increase taxes 

• Dedicated revenue streams 
• Stabilization funds 
• Monthly employer contributions 
• Plan consolidations
• Auto triggers to adjust contributions 
• Reforming revenue and increased taxes 

Why is this a global macro problem? The dynamics of pension will lead to long-term macro drags that cannot be easily solved by monetary policy or federal fiscal policy. If inflation increases or valuations decline, the impact on pay-outs will be real. Any inflation adjustment will not close the funding gap. Lower expected returns will only increase the gap. This is a problem that will have to be addressed by the new US president.

Momentum is everywhere - can even be found intraday

 

Momentum is everywhere, in every market sector, and for all timeframes. It can even be found across weeks, months, and intraday. The behavioral reasons for momentum transcend all markets. There are also structural reasons based on the hedging behavior of traders that will also drive momentum. This does not mean that momentum will work at all time and in all markets, but the odds are in your favor.

A new paper "Hedging demand and market intraday momentum" focuses on intraday momentum that is based on the hedging demand of traders that have to rebalance their risk exposures. There has been a strong view that momentum is a behavioral issue. Investors have a slow reaction to news. However, there also is momentum created from hedging demand associated with specific strategies. For example, option replication like portfolio insurance will create price momentum. Similarly, the rebalancing of option hedges will create momentum as traders offset gamma risk. A short option position that needs to be hedged requires buying when prices are rising and selling when prices are falling. If the demand for hedging is large enough, market prices will show intraday momentum.

The authors of this paper focus on intra-day adjustments across a set of over 60 markets and four asset classes with a sample of close to 45 years of daily data and finds strong intra-day momentum that is consistent with the strong demand for hedging short option exposures. The rest of day (ROD) has an important and statistically significant impact on the last half hour of trading (LH). This effect is especially significant for equity markets that have strong option demand and levered ETFs. The hedging demand is focused on the last half hour to avoid carrying overnight risk on short option positions. 

The research shows that the intraday effect is especially strong for equities and commodities. The impact is less for currencies where the last half hour of trading is less clearly defined.

The intraday effect declines significantly as we add time intervals. The effect is focused on hedging action before the end of the day.

The rest of the day impact is strong across all asset classes and significant relative to other configurations.

Momentum has structural as well as behavioral drivers. An intraday effect suggests that trend-followers and momentum traders can mix and match different timeframes to improve the overall performance of a momentum portfolio. 

The November momentum factor crash - Regime and crowd changes will shock

For the second time this year, the momentum factor experienced a performance crash. Quick reversals in market expectations will lead to these negative factor events. This is especially the case for momentum which buy in-favor price moves and sells out-of-favor securities. You are trading with the herd and when it changes, it can get ugly. 

Performance is worse because there is a loss on both the long and short positions. The long in-favor stocks lose and the short out-of-favor gain so there is little protection for investors. This event can happen even if there seems to be only modest changes in the overall market.

The folks at PremiaLabs in their weekly report show the impact of the post-election crash. The same impact was found by Venn in their weekly factor performance report. Investors should be aware that momentum factors usually do not have any risk management to stop these shocks. Additionally, the construction of the factor matters. If there are no restrictions in sector, industries, or correlation as well as infrequent rebalancing, there will be greater impact  on the created momentum factor. There is no one universal definition of the momentum factor.

At the same time as the momentum shock occurred, there were gains in size and value factors. The small and out-of-favor firms gained on news of a COVID vaccine and macro expectations for improved growth. The old story driven by continued lockdown was reversing, albeit this may change again as positive COVID cases explode to the upside. We may see more of these reversals in the coming weeks. 

Like other shocks, factors correlations moved to extremes. Focusing on one factor isolates risks, but also accentuate return extremes when a regime or crowd switches.

Difference in 2020 factor returns can be seen with the return difference between momentum and value. The gain in cumulative momentum versus value returns was over 60% only to see short-term declines of 15+% and 10% respectively in June and November. Investors have to be cognizant of the rationale for why one factor may outperform another and what will be the scenario for reversal. 

Slowbalization, de-globalization, or a return to strong globalization - An important theme for 2021

 

The Economist coined the term "slowbalization" in 2019 to describe the slow growth in world trade after a period of hyper-globalization. Others have used the word de-globalization. Some of those negative on globalization have focused on the increased populism and China-US trade tensions over the last four years, but the trade slowdown problem started earlier. A good paper describing the history of the globalization and its slowdown over the last few decades has been written this month by Pol Antràs of Harvard University, “De-Globalization? Global Value Chains in the Post-COVID-19 Age”. It is worth a close read. 

One of the important macro themes for 2021 will be whether the slowbalization will be arrested with the new US president. A longer-term trade growth slowdown is not the same as a cyclical trade slowdown associated with a global recession. A longer-term decline is associated with slowdowns in the structural reasons for strong trade growth like information and communication technology, trade costs, trade policy changes, and geopolitical developments.

Right now the latest global trade numbers from the CPB Netherlands Bureau of Economic Policy showed a 12.5% increase in the third quarter, the largest increase since the index was started in 2000. This is consistent with the rebound in GDP for many countries. The issue is whether this increase is just an immediate business cycle reversal. The US trade deficit has exploded from consumer buying, a marked difference from the last recession. Container shipments from China have surged well ahead of numbers from the beginning of the year.

The impact of a continued slow world trade growth or a return to strong globalization will have big effect on all equity and bond markets arounds the world. Trade sensitive equities in both developed and EM markets will improve with a return to the trend of hyper-globalization. A return to higher trade will hurt more localized firms. 

We will not see a change in trade trend numbers until the COVID shock passes, but 2021 changes in the trade environment will determine whether there be a slight uptick or a return to the 1990-2007 trend.  

Trend-followers and managers futures need a better definition of their value-added than "crisis alpha"

Trend-followers have focused on their strategy's ability to provide "crisis alpha", yet there are fundamental issues with the definition of this concept that generates a mixed message for potential investors. 

Crisis alpha has been defined as the excess return of managed futures relative to the market during periods of extreme negative stock returns, a market sell-off. Right away, there is an issue between the traditional or common definition of alpha, the return unrelated to market risk, and the definition of crisis alpha. Crisis alpha is the relative return versus the market conditional on a level of negative market risk. This alpha can vary based on an arbitrary condition used to measure a downturn. It is often set at -20 percent for the equity benchmark, but there is no reason for any special conditional number. 

The definition used in much of the trend-following research and with many marketing presentations focuses on what happens to managed futures trend-following if there is an equity sell-off. In fact, this equity sell-off story has become the standard for funds who discuss the diversification benefit of managed futures. Find periods when there has been a sharp equity declines and then show the returns for a managed futures fund for that defined period. The manager can change the scale or time to form the best conditional relative returns. This crisis definition is related to stock performance and not any exogenous factors that may be associated with a crisis. 

The meaning of crisis alpha becomes more perplexing when you look at the beta of a managed futures fund. The beta for many managed futures funds is often close to zero when measured against the equity market portfolio. By definition and measurement, if there is a significant decline in equities and managed futures have a zero beta, the trend-following strategy will do better in a down market. There is no "crisis alpha". There is just low beta. There may be skill creating a zero beta portfolio and there may be skill with finding trends, but there is no skill in the traditional definition of alpha. 

By forming this relative return concept versus the market condition on a large market decline, any asset that has a stable beta less than one will have some crisis alpha. If there is a lower beta, there will likely be more crisis alpha. At the extreme, an asset that does not move with the market and has no traditional alpha will have positive crisis alpha in a down market equal to the market decline. Trend-followers may produce significant value-added; however, it may not be effectively described through the wording of crisis alpha. 

The definition of crisis alpha as just relative performance during a defined sell-off can apply to many strategies. All of these forms of "crisis alpha" may not employ special skill during a downturn. Any fund well-diversified across a number of asset classes and with the ability to sell short a declining asset should have crisis alpha diversification benefit. The question becomes how well trend-following performs versus other strategies, or what is the overall return versus periods of conditional market stress. The value of the crisis risk strategy should only be judged by accounting for the opportunity cost of holding the offset over time.

• Any asset uncorrelated to equity markets may have "crisis alpha".
• Any diversified portfolio may have "crisis alpha".
• Any strategy that can short an asset class can have "crisis  alpha".
• Any equity put option can have "crisis alpha"

There is nothing wrong with the analysis provided by managers. In fact, even if the research work stops with the traditional crisis alpha charts, the benefit from managed futures is still clear; however, the naming and simple analysis may not provide a deeper understanding of when trend-following will work or why managed futures may be a better strategy than just holding safe assets at critical times. In a perfect world, investors should know the ex-ante conditions that will be good for trend-following. This is a much harder question.

As market trends get stronger, there is increased likelihood of mean reversion

"Trends last longer than expected"

"The success of any trend sows the seeds for its own destruction" 

Two very different views of the world, yet both can be true. Trends will often last longer than expected and most trend-followers will make most of their annual profits on a few major dislocations. All trends will also end and as markets move to an extreme, there is will be some reversal. It is one of the reasons why stop-loss and risk management is so critical for trend-following success.

A recent paper, "Trends, Reversion, and Critical Phenomena in Financial Markets" by Christof Schmidhuber, looks at the behavior of prices across a broad set of 24 markets in four major asset classes. He forecasts the next day's price based on the trend strength across different look-back periods. The next day's price will increase with the measured strength of a trend until there is a maximum at which point there is greater likelihood of a price reversal.

He finds that a cubic polynomial may describe trends at different lengths. There is a linear trend component and a second component that represents the non-linear mean reversion in prices. This trend structure exists across all markets and asset classes; however, the trend/reversal structure will differ based on the length of the look-back period. The best time scales are between 3 months and a year which are consistent with the look-back periods for most trend-followers.

As trends get stronger, there is an increased likelihood of mean reversion. This is not an easy paper to understand on a first reading, but the results are compelling. If the trend is statistically significant and thus likely obvious to most, it is time to get out. The approach driving this analysis is novel and provides some good insight for all those following trends. 

The success of trend traders may have more to do with learning how to exit and beat the mean reversion. At a simple level exits can be driven by trailing stops. If markets pullback by a set amount, exit. At a more complex level, the exit could be driven by a specific model of mean reversion or market extremes. The exit process is a value-add for the active trend-follower. 

Some may find the results in this paper surprising, others obvious, but the most important point is that looking for trends alone may not be good enough to be successful. You can follow trends but realize there will always be a time for reversal.

LDI in a low interest rate world - Overlay different sets of risks on a bond portfolio

Liability driven investing (LDI) strategies have been effective at reducing pension risk by matching long duration assets against measured long-term liabilities, but there is little room for error when interest rates are low and expected to stay low for a long period. Low interest rates raise the value of liabilities and when tied with tight corporate spreads make management all the more difficult if there is a matching error. Low rates by themselves are not the problem if there is also low volatility; however, a constrained opportunity set of investment choices means that there is little room for diversification if something goes wrong. For example, an increase in spreads which reduces asset values with no change in liabilities. 

A solution is to hold the long duration Treasury portfolio to match the long duration liabilities but use alternative risk premia in the form of an overlay to provide diversification beyond credit carry. There is risk with the overlay, but the risks can be spread beyond credit carry. We have discussed this issue in the past, but the issue is all the more important given the poor corporate debt environment.

A simple thought experiment of two scenario illustrates the problem. Assume we have a vaccine that works in first half 2021, how much tighter will corporate spreads be in six months? Assume that the vaccine roll-out is slow and we are in a continued lockdown, where will spreads be in six months? The spread expectations will not be symmetric. The probability that growth will be jumpstarted through effective vaccine logistics is unlikely to be equal.  

The focus is not on the corporate spread forecasts but on the fact that LDI bets in a restricted investment environment are limited. Securitized assets or infrastructure debts may be an alternative to corporate debt, but there is still the issue of cash flow generation in a slow growth COVID world and credit carry risk. Regular investments in other assets may not be available, but there are opportunities to use swaps as an overlay choice.

The advantage of using overlay with alternative risk premia (ARP) through swaps is that the choice of risks will be different. (See Liability Driven Investing (LDI) could gain a boost through ARPs for a comparison of benchmarks.) The focus can move from credit carry to asset classes such as commodities and currency. The strategy factors can focus on carry, volatility, or value and the risk level can be calibrated to mimic the spread duration risk from corporates. Risk can be calibrated to something similar to spreads. As we come the close of 2020, it is time to consider the 2021 world. 

How much value should you place in macroeconomic forecasts? - The under and overreaction of forecasters

How much stock should you place in the consensus macro forecasts generated by the experts? How much value should you place on the forecasts of an individual macro forecast from an expert? These are the core questions address in the paper, Overreaction in Macroeconomic Expectations by Pedro Bordalo, Nicola Gennaioli, Yueran Ma, and Andrei Shleifer. 

Their extensive work is focused on the Survey of Professional Forecasters (SPF) and the Blue Chip Survey and provides analysis on 20 time series expectations in total. They find that there is consistent under-reaction in the expectations of the consensus forecasts. The aggregated expectations and the slow revisions of economist means their forecasts are playing catch-up to reality. This conclusion is not new albeit still inconsistent with a rational expectations view of the world. Given this under-reaction to news, the consensus forecast revisions are positively correlated to forecast errors. The conclusion is that investors should discount these forecasts. 

While the consensus may seem slow to react to news and information when forming a collective expectation, the authors find that there is an over-reaction in the behavior of the individual economic forecasters. This conclusion seems odd when compared with the consensus result.

The authors study closely this individual and consensus behavior of over and under-reaction within the broad set of macro variables and conclude that these results are based on the process of aggregation for the consensus forecast and on diagnostic expectations for the individual forecasts. 

The diagnostic expectations view states that there is a specific Bayesian updating process that is often used by forecasters where there seems to be more weight placed on the posterior expectation or new information. This can occur when it is difficult to assess new information as permanent or transitory. The diagnostic expectations can lead to a representative or recency bias which will produce an over-reaction in forecasting based on new information. Following the forecasts of individual economists can lead to errors from over-reaction.

While individuals may over-reaction, the use of different models, different information, and slow updating will lead to an under-reaction in aggregate. So, the investor should fade the forecast of the individual but assume that the group is slow to respond to the market realty. 

This research reinforces common themes which we have been presenting for years - follow trends in prices  as a core base for any market judgment because following the forecasts of economists may not give you an unbiased forecast, but the potential for both under and over-reactions.  

Risk-on/Risk-off – Actually start with uncertainty high / uncertainty low

Markets have been talking about moving to risk-on from risk-off positions now that the election is supposedly over, yet that view may change again given the spike in COVID cases and the lack of clarity on macro policies. These risk sentiment switches can come fast, yet the sentiment or desire to hold risky assets should be only one focal point for investors. Risk-on/risk-off sentiment is driven by whether the environment is uncertainty low or uncertainty high. Uncertainty generally drives sentiment. Sentiment usually does not drive uncertainty.

There is no special magic with the risk-on/risk-off or RORO indices often used in the market. These indices are a weighted average or aggregation of market information that reflects risk-taking such as corporate spreads, volatility indices, or the price of safe assets. These indices reflect price sentiment through a single number and are not direct measures of outside factors concerning risk or uncertainty.

The driver of risk sentiment has to come from what is not known, what has been changing, and what is surprising in the market. At this point, uncertainty is still high and current volatility levels do not reflect the wide set of changing alternatives the market may face. Look at some of the key  issues:

• Fiscal policy - Not clear what will be the size or consistency of any aid package.
• Tax policy - Not clear whether there will be a rollback, maintenance of existing policy, or something new.
• Regulation - There will be more regulation, but the impact on different industries is unclear.
• COVID policy - A further lockdown is a possibility that could be offset by vaccines.
• Monetary policy - While guidance states rates will stay low, macro-prudential policies are less clear.

Market prices will reflect changing expectations for this policy of policies.

Claude Shannon states, "Information is the resolution of uncertainty." (See Shannon - information is the resolution of uncertainty to understand trader types and how they deal with uncertainty.) New information will remove the policy uncertainty that we are currently facing and that will convert to changes in market prices. Switches in this policy choice resolution will lead to increases in volatility. Investors should focus on uncertainty resolution and not risk sentiment.

Andre Kostolany - The European speculator of wit and charm

Andre Kostolany, Hungarian born speculator active during post-WWII Germany has a strong financial reputation in Europe, but is not well know in the US. I am not clear on his overall financial success, but he was a prolific writer on markets and has a great way of providing useful wisdom through some great turns of phrases:

The whole stock market depends only on whether there are more shares than idiots or more idiots than shares.

Anything is possible on the stock market. Even the opposite.

Stock market profits are compensation for pain and suffering. First comes pain, then comes money.

Who does not own shares when the price drop will not own shares when prices soar. 

Never run after a bus or a stock. Just be patient – the next one will come along for sure.

A personal favorite: 

At the stock market 2+2 is never four, but 5 minus 1. Better be prepared for the -1.

On speculation:

Speculation on the stock market has always been and always will be a difficult way to make an easy living.

You need four things to be a successful speculator: an idea, conviction, money and patience.

I cannot tell you how to get rich quickly; I can tell you how to get poor quickly: by trying to get rich quickly 

Always be fearful, never panic!

There are old pilots and there are bold pilots, but there are not old, bold pilots. 

The secret of his success:

49% losses, 51% wins, and lived well from the difference.

He even was featured in an Audi commercial.

Hat tip to the undervalued japan blog for focusing my interest on Andre and for providing a number of the quotes and  a link to the Audi commercial from 1999. 

Who says good journalism is dead? - Nothing like a good headline - Take your shot

We always need a way to relive the pressure of following the markets. You have to love a good headline that provides a lot of information in a few words. Of course,  when every journalist has the same idea, it can go to an extreme like yesterday. Here is an example of an infectious narrative meme that can drive opinions. From my friend Marty Fridson, the high yield bond analyst guru:

Nikkei Asian Review

Pfizer vaccine hopes give Asia markets a shot in the arm

al.com

COVID vaccine news gives stock market a shot in the arm

 

Nikkei Asian Review

Pfizer vaccine hopes give Dow 800-point shot in the arm

 

The Guardian

BioNTech's Covid vaccine: a shot in the arm for Germany's Turkish community

 

Barron's

Pfizer Covid-19 Vaccine Might Work.

And that should give a shot in the arm to a health care niche that had ...

 

World First Foreign Currency Exchange

Pfizer gives sterling a shot in the arm

 

TechCrunch

5 VCs discuss the future of SaaS and software after Pfizer's vaccine ... news that one was coming was more than a shot in the arm — it was ...

 

NewsCenterMaine.com WCSH-WLBZ

The news, announced Monday morning, is a shot in the arm for public health ...

 

cbs.com

Watch CBS This Morning: Markets soar on Pfizer vaccine ...

Stock markets got a shot in the arm after promising news of a vaccine and election results were announced.

 

Office, apartment REITs get shot in the arm from vaccine news

TRD NATIONAL /

 

Financial Times

Opinion Lombard

Vaccine breakthrough is shot in the arm for Landsec

 

The Australian Financial Review

Vaccine news a shot in the arm for malls, offices

 

Telegraph.co.uk

UK growth to get shot in the arm from 'game-changing' vaccine

 

If everything is historic, then nothing is historic, just historical - Out of the ordinary events are not all historic events

We have historic elections; historic price movements; and historic political battles. The list can go on. The term historic is overused and thus loses meaning. Events can be out of ordinary but not historic. All market surprises are not historic. If everything is historic, then nothing is historic just historical. 

We cannot know what is historic in real time although the definition of historic includes what is "potentially famous or important in history."  We really need the passage of time to determine whether an event is historic.

Any commentary that says some event is historic is a good reason to fade. The historic will be a memory tomorrow and should be viewed as potential drivers of over-reaction. Quantitative analysis is a rational response to the emotions of using words like historic. A frequentist would compare similar events that can be counted to form a measure of extraordinary. The Bayesian would build a prior and then judge the relevance of new information. All "historic" events should be placed in context with other past events to determine whether it is meaningful. If there is not context, there is no meaning. For example, being the first at anything is special and emotional for the winner and his followers. It may create fame and it may be worth noting but it may not change the environment or structure of the world we live in. At least we cannot provide an immediate answer.  

Historic is often tied to emotions. A dispassionate commentator is less likely to use the term historic. The deep study of memory and emotions tells us that what we may view today as important in the future will not be once arrive in the future. Emotional state swill change over time. According to Elizabeth Kensinger, memories are both "resolute and fragile".

Daniel Kahneman focused much of his later study on "predictive utility" or as others refer to as "affective forecasting". What people predict will give them happiness or pain will change through time. Similarly, what we predict today will be historic will change. In general, historic events today will be just history tomorrow. 

The failure of ungrounded investment narratives

The polls got the US election wrong. Financial analysts also got their narratives wrong based on those polls. Remember the “blue wave” story of investment success this fall based on increased fiscal spending coming in 2021? That story has now turned to the “gridlock is good” narrative to explain current equity performance. It will likely switch  again as narratives try to explain that which is not understood about current market behavior. Narratives are used to fill the void of what is unknown in order to provide a sense of safety and control. A good story can provide comfort. However, it can lead to predictive failure if it is not grounded in a theory or in empirical evidence.

Is there a basis for the “blue wave” or the “gridlock is good” narrative? At best, there are just some past events that can be used as an initial point for extrapolation. The presidential polls providing a basis for equity prediction was a story without theory. There is a political cycle but that theory was not linked to the blue wave story.

There will be no blue wave. There may be gridlock, but this just means that it is less clear what will be the policies of any administration. It is not a theory linked to investment performance except as repudiation of a blue wave. Two stories completely at odds with each other but leading to the same outcome. 

Narrative is a powerful tool but used inappropriately it can harm an investor audience.

• Narratives can be used to explain but are not always stories that can predict.
• Narratives do not always add to our understanding but can subtract from reality.

The alternative is not to fit price behavior to a story, but just follow the prices without any explanation. Prices trend up which means buyers are clearing the market at a higher price. There is no story forced on the market. The accumulated behavior from market participants changes prices and that may be the only signal necessary in an uncertain world. Some investors may add more to the trend story, but without clear information, the unadulterated trend is still a good base position for any forecast.

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.