Limits to arbitrage - Rules and structure explain pricing anomalies

 

The limit to arbitrage is one of the most important concepts in finance next to arbitrage pricing. Arbitrage works in a world without frictions and constraints. If there are arbitrage opportunities, the first thing to think about is not market inefficiency or behavioral bias but market structures that can create barriers to effective arbitrage. 

Limitations, in general, can be caused by regulation, transaction costs, financing, lack of skill, and the lack of capital committed to arbitrage at any specific time. Many of these limits to arbitrage are focused on investment frictions or risks and not market structure or rules constraints. However, understanding institutions matter if a researcher wants to go down the path of looking for and exploiting price anomalies. 

Capital is constantly searching for the best return to risk and small deviation from equilibrium may not be enough to create a reason for capital to close an arbitrage gap. We are perhaps using the arbitrage term loosely. There are few true arbitrage opportunities. Capital has to be committed, financing has to be lock-in, and there has to be no competing similar opportunities. To understand the limits of arbitrage requires a strong institutional knowledge of market mechanics which often does not exist with academic researchers. 

A key issue faced with testing the limits of arbitrage is forming a comparison between an unconstrained versus constrained environment. This test of the limits of arbitrage based on institutional constraints has been elegantly presented in the paper, "The causal effect of limits to arbitrage on asset pricing anomalies" published in the October 2020 Journal of Finance. 

The authors use a novel approach to explore the limits of arbitrage for 11 pricing anomalies. Regulation SHO from the SEC relaxed the short sale constraint on stocks. The paper explains the details of Regulation SHO.  The key is that the changes in short sale rules allow us the compare before and after behavior and a comparison of those stocks with constraints and those without. Regulation, market rules, can create mispricing that would not exist otherwise. It is not a risk story or a behavioral story, but a story focused on market structure that drives mispricing. Remove the limits and the anomalies may disappear. The tables below summarize the main results of the work. 

It is harder to conduct equity arbitrage if you cannot effectively short a stock. Anomalies can continue for the simple reason that the arbitrageur cannot form a risk-free trade. Hence, those stocks which have short sale restrictions lifted will have the limit to arbitrage lifted. Pricing anomalies that existed before should disappear after the constraints are lifted. Similarly, since the short-side constraint was lifted, the excess returns from the anomaly should decline from the short-side of the trade. The researchers try this on a wide variety of strategies from momentum to return on assets. It does not change results in all cases, but a less constrained world is different. 

Mispricing driven by constraints, such short selling rules, is exactly what was found in this paper. When constraints are lifted, the out of the ordinary pricing that previously existed disappears. To trade in the real world, every researcher has to be an institutionalist.

Equity long/short and market neutral hedge funds - Can they improve in 2021?

The investment foundation for equity long/short or market neutral hedge funds is the manager having the ability to widen the opportunity set of choices. Long-only investing is limiting because, at best, poor companies can only be excluded from the set of opportunities. Long/short managers should have a decided advantage versus the long-only manager because they can both hold long and short positions and selectively decide to cut market exposure while still holding a set of attractive long positions. The market neutral manager can eliminate the market exposure and create a portfolio of firm-specific opportunities, a pure alpha opportunity fund. In theory, this widening of choice should be a great opportunity for both active managers who has skill and the investors who wants the broadest set of directional choices for their managers. 

Allowing managers to flex their skill over this broader opportunity set is the way these funds are marketed, yet in practice the results have been less compelling during this post GFC period. There can be a number of explanations for this failure, yet none have been studied too closely in order to provide definite answers. 

The explanation for low long/short or market neutral returns is wide-ranging. Clearly, if the long/short manager has a lower beta to the market their alpha production may not generate enough return to offset a one-way rising market. Alternatively, there is the view that competition in stock-picking may just be too great, so alpha has been eroded. Lower equity dispersion may have reduced the opportunities for stock picking. The classic value play used by many hedge funds managers has underperformed during this period. Small caps have not generated the expected premium seen in the past.

The current environment calls into question how managers are picking opportunities and whether there is active stock-picking or market timing skill by managers. Nevertheless, there are clear winners in this space, just not with the strategy averages. This discussion on the reason for a drag on performance is not about the great managers but the average manager represented in hedge fund indices. As measured by hedge fund indices of managers, performance has been strained relative to their skill at marketing. This is seen in 2020 and in the last year.

Nevertheless, there may be some hope for 2021. First, volatility has increased even with a decline from the highs in March. Second, stock dispersion has also increased versus earlier periods. Third, the overall market is considered overvalued which may allow short positions to profit. Overall, 2021 may be a better year through greater opportunities for shorting specific names and cutting market exposure. 

One man's investment diary through the Great Depression

 

Reading about the Great Depression can be a dry affair. Most investors only focus on a few highlights without spending much time on the details. That is unfortunate. The thumbnail sketch is simple. There was a stock market crash, bank failures, severe unemployment, and then the New Deal solved the problem. Bad Fed decisions and tight money failed the banking sector and economy. For many, activist government policies worked, and the doors were opened to the Keynesian revolution.

Most investors spend even less time thinking through the social impact on consumers and the fear faced by those trying to make investment decisions during this uncertain period. Banks closed and businesses shuttered without warning.  There are some good books describing the social impact from the Depression, and there have been recent revisionist books on the “forgotten man” impacted by the downturn and policy choices, but little has been written about what investors were thinking during this period. 

I jumped at the chance to read about investor perceptions when I recently heard about the book The Great Depression: A Diary, published in 2009. What makes this a good read is the sense of uncertainty that was felt by the author as he walks through the financial ups and downs during this traumatic time. 

The author, Ben Roth, was not a wealthy man but a middle-class lawyer during depression who has trouble collecting from clients and paying his bills. He had a strong interest in investments during this period and made regular diary entries describing his thoughts on the markets and the economic environment. He sprinkles sage investment advice in his entries that is useful even today. Roth describes the ups and downs of stocks, the economic climate in Youngstown, Ohio, and how crowds moved from optimism to pessimism and back again from 1929 until the beginning of WWII. 

Reading his views in real time is fascinating. He has hopes for Hoover after 1929 and concerns with the Roosevelt policies. He writes about bank failures, the inability to collect on bills from those with nothing to give, fortunes made and lost in a wild stock market, the bottom falling out on what was perceived as safe real estate, and the fear of just not knowing when the depression will end or whether the latest policies will actually work. Unemployment led to protests and unrest and it was not clear whether life savings could be withdrawn from banks. Without the support of hindsight, it becomes an interesting tale of how one man deal with financial unknowns.

This book is important because it creates a fearful tone that is often missing from history books. Economic fear is real, and it should not be missed that many are currently living in similar economic fear from the pandemic. Excessive fear will lead to actions that in another time would be viewed as irrational. Hence, we cannot always predict the actions of consumers or investors.

Animal spirits, declinism, and policy choices that will impact asset allocation

There will be significant work published on what should be the right asset allocation for 2021. I read as many of these pieces as I can get my hands on.  There is a simple question for US investors tied to these forecasts that moves beyond COVID and economic policies. Do you have optimist or pessimist view on US economic and political prospects beyond the COVID recovery?

Given the high level of uncertainty, this question can be phrased differently. Should you have positive animal spirits, as described by Keynes, to invest and spend even in an unknown world, or should you take a defensive posture based on economic weakness and US pessimism? 

Beyond the policy tactics of vaccines and lockdown reversals that will affect market expectations, investment allocations should be based on optimistic or pessimistic animal spirits and what is the process and policy choices that will get the economy to a more positive state. This positive state is tied closely with the broad political view of US declinism and pessimism concerning its preeminent status in the global economy and world affairs. The path for a correction to declinism will drive longer-term US optimism. (See "The China Challenge Can Help America Avert Decline: Why Competition Could Prove Declinists Wrong Again" in Foreign Affairs for a general discussion of declinism.)

  

For Keynes, markets are often driven by animal spirits, the optimism or pessimism that exists when the future is highly uncertainty. When uncertainty is high, the normal tools of valuation and analysis are ineffective. Investors just don't know and have to rely on their feeling of optimism or pessimism. In a depression or recession, pessimistic animal spirits drive decisions. A recovery occurs when sentiment changes to optimism. There is no question there is a current sense of financial optimism; however, this euphoria may not be matched in the real economy. More optimistic animal spirits will drive the US economy beyond catch-up to long-term growth. 

Declinism, the belief that the United States is sliding irreversibly from its preeminent status, has been a major theme of the last four year and will be the key theme for the next four years especially if there is a desire for stronger long-term growth. Declinism talk started much earlier but has swept into the general political discussion in more tangible and extreme forms of political choice.  

The declinism solution is centered between two extremes for policy. One position has been it can be arrested through unilateralism and a reversal of the liberal globalist order. The alternative position also believes declinism is caused by inequality and a lack of global cooperation that needs to be addressed through social and economic restructuring and the rule of international law and cooperation. Both argue for a change in the behavior and structure of the United States; nevertheless,  the choice of direction will impact the longer-term pricing of financial assets and the potential for sustained growth. 

Investor allocations will be making a choice on whether declinism can be reversed and the policy form necessary for the reversal. The success of risk-on asset allocation will be determined by the declinism solution accepted by the public and how that path forward will improve both the US and the global economy. Any end of declinism will be coupled with a sense of optimism that problems can be overcome and that investment will be rewarded and productivity enhanced; however, the policy choices will impact the form and placement of the optimism. Investor should consider alternative declinism solution paths.  

This discussion may be an abstraction, but sustained financial gains needs to be coupled with a robust economy that moves beyond a story of COVID recovery.     

Dollar Decline - Policy Words and Actions Suggest Weakness

The dollar, as measured by the DXY index, is at lowest level in almost three years. The consistent decline has been in place since the March liquidity crisis when the Fed opened swap lines, increased the money supply, and cut rates. The Fed action averted a global liquidity crisis, but the dollar has fallen well beyond beginning of the year values.

The question with a new administration is whether there will be a strong or weak dollar policy. The dollar, of course, is a relative price between monetary and economic fundamentals between two countries, yet policy will drive expectations. The choice set is between a strong or weak policy rhetoric and strong or weak policy actions. These can either be consistent or inconsistent. Consistency of policy and actions will drive trends. 

Consistency of words and deeds suggest that the dollar will be weaker. While recent opinion pieces have called for a strong dollar policy, former Fed chairperson Yellen had a bias for a weak dollar, so we don't expect a change in her bias if she is Treasury secretary. The Trump administration was tilted for a weak dollar to improve exports. A strong dollar policy from a Biden Treasury would be an unlikely change in direction. The fundamentals, with continued loose Fed monetary policy, also suggest a weak dollar. Expect the current dollar trend to continue. 

 

Are you with the stocks up and bond yields higher crowd? Being contrarian

Many investment forecasts for 2021 are being published, and there is a clear consensus that stocks will be higher, yields for the 10-year Treasury will be higher, and the dollar will be lower. Let the good times roll for risky financial assets. Yields are going higher whether from inflation or real yields and the dollar will not be a safe haven. 

The average equity benchmark return from the set of Bloomberg reporting market analysts is 9.2% for 2021 as of this week. The low is 2.9% and the high is 19%. The average 10-year bond forecast for the fourth quarter of 2021 is 1.24% or 30+ bps higher than the current level. There is also consensus that the dollar will decline next year; however, the gains in foreign exchange are only slightly higher than the forward rate differentials. Short rate will be viewed as continuing to stay low with no changes in monetary policy.

Everyone is thinking the same, so the real opportunity is to review the case for the alternative and potentially move against the consensus. The stocks up and yields up is based on the simple premise that the vaccine will work and pandemic restrictions will be lifted so that consumption spending constraints will be gone. There will be no ramp-up constraints on business, limited labor problems, and a costless reopening of all small businesses. Liquidity will be still readily available and central banks or governments will effectively manage  inflation, credit, and business issues. 

The glide path is simple to the main thought experiment is thinking through what happens if the everything happens slower or is more difficult. Most analysts will not touch these issues.

For any forecast, walk through the assumptions and ask the simple question, "What has to go right?" Then ask, "What can possibly go wrong?" Finally, review your forecast against these good and bad paths. The odds are still likely that stocks will go higher in a normal world. There is a positive market risk premium. It is also likely bond yields will go higher if growth returns. However, there will be no normal return to normalcy, so betting against the consensus is fair.  

Corporate risk - Don't follow spreads, follow leverage and cash

Corporate spreads suggest that all is well in credit markets; however, the underlying fundamentals are not providing a rosy picture. This is not new information, but investors need a credit risk exit strategy. 

Leverage has been increasing and is at levels higher than the GFC and the tech bubble recession periods. High leverage exists for both investment and high yield credit sectors. 

The earnings to interest expense have been declining since the GFC even with low interest rates and low spreads. A turnaround to the pre-pandemic levels will not solve this coverage problem. There may be some income and balance sheet improvement, but corporate risk will still be high relative to the return to be received. 

This leverage problem should not be surprising given that over 800 companies in the Russell 2000 have negative earnings. Firms have borrowed to maintain operations or improve their current sector positioning. 

The trends in the graphs may suggest a slow increase in risk; however, there should be awareness that if there is a corporate risk revaluation the market reaction can be swift. There will be a non-linear relationship between risk and pricing. Every investor will not be able to exit the market at the same time. There is a strong liquidity mismatch especially given the size of corporate and high yield ETFs like LQD and HYG with respective market caps of $55 and $25 billion. A simple rebalance strategy may just try and outrun the corporate zombies when the repricing begins. A better approach may slowly reduce credit risk for some alternative carry trades. 

Corporate zombies walking the globe - Is this a problem?

Corporate spreads are tight. High yield spreads are tight. Non-financial firms are doing well as measured by the perceived corporate bond risk, but that does not change the fact that we have increased the number of zombie firms around the globe and many firms are not making money. A recent study from the BIS "Corporate Zombies: Anatomy and Life Cycle" provides both good and bad news. Well, mostly bad news on the life cycle of corporate zombies. 

Covering 14 advanced economies for a period of close to 40 years, the authors find that the number of zombie firms has risen by a factor of 4 from around 4% to 15% in 2017. This was even before the current pandemic. 

A corporate zombie is as unprofitable firm with low stock valuations that does not have an interest rate coverage as measured by EBIT above 1. Market value to replacement cost, Tobin's q, is below the median for its industry sector. The firms are smaller, less productive, more levered and have less investment in physical or intangible assets. 

There is a 1/4 chance of zombies disappearing from the market and about a 60% chance of leaving zombie status. The good news is that you can reverse the curse of being a zombie, but these firms will still underperform peers and face a strong chance of relapse. 

The problem of corporate zombies is global. Some countries show large variation in the percentage of zombies while other feature a strong upward trend.

The zombies as a percentage of firms by sector shows there is a high concentration in the commodity sectors especially precious and industrial metals with well over 40% of firms meeting the criteria of corporate zombies. Precious metal firms have improved with the rise in gold prices, but this can change quickly if there is a price fall. This sector concentration also explain why countries like Canada have a high percentage of zombies. Overall, the problem firms are not as widespread across economies. 

Throwing more money at these corporate zombies, either public or private, is problematic. Many will fail and those that survive will still be inefficient. These firms employ workers but there is a drain on productivity which stands in the way for new more efficient companies. Zombies may be value plays but in a low interest rate world there is no way to create value from lowering debt costs and history suggests that even if these firms survive, they limb along with below median sector behavior.  

Trend-following and market inefficiency - It is in the mean reversion

 

A lot can be learned about trend-following by using some simple time series processes to describe the behavior of markets. Some key insights on trend-following can be derived using the simple Ornstein-Uhlenbeck (O-U) process. This stationary Gaussian Markov process can help explain trends through variations in a mean reversion parameters, speed of adjustments. Mean reversion will create trends as price return to equilibrium, mean values, after shocks. A short paper, "To Be Or Not To Be a Trend Follower" by Andreas Junge of Methodica Ventures attracted my interest in this topic.

The O-U process states that tomorrow's price is just today's price minus an adjustment of today's price to a mean value plus an error term. The random walk, market efficiency, is just a special case where the mean reversion parameter is zero. This process is not new and has been a workhorse with many derivative pricing models, but it provides a framework on how markets may work. 

If there is a positive or negative shock to the market, the mean reversion term means there will be a slow trend adjustment back to a long-term mean. Market efficiency as defined by a random walk says there is no adjustment to a mean or a very low adjustment factor. The O-U process also tells us that volatility will be dampened relative to an efficient market environment (no mean reversion). Differences in mean reversion will reflect the potential for trend profits. Unfortunately, while a mean reversion parameter will help generate a trend, future shocks, especially in the opposite direction will create noise that will mask the first or primary trend. It is notable that trend changes will likely be centered on information dates when there is a greater chance of a shock.

A framework for how markets operate when they are efficient and a framework for when behavior will differ from efficiency is useful when looking for market opportunities. A framework describing the evolution of price behavior helps to form a prior for trend expectations.    

What decade will we be living in for 2021?

Some will say that the next ten years will be like the last decade. Others may view the next ten years will be like the 2000's. What decade you think will repeat or whether this will be a new period is essential for forming any asset allocation. Defining the decade is a cute way of asking what environment will we see in the next year. 

It is natural that investors will look for analogies. What separates those who are above ordinary is the ability to define uniqueness for the next year. For example, if we look at 2010's, the economy was coming out of the GFC and was being driven by monetary liquidity through QE. It was a fragile low growth economy for most of the decade coupled with inflated financial assets. This is the decade that may likely repeat. 

The 2000's saw the tech bubble burst and monetary policy used to arrest a recession and generate a new bubble in housing. The 1990's were the period of Great Moderation, albeit punctuated by EM crises and the development of the tech bubble. Within each decade there was an underlying economic issue with a monetary policy solution of liquidity. 

The current decade is starting out with a recession and excessive monetary liquidity, but also excessive pricing in both equity and bond markets, so we may look more like the beginning of the 2000's and not the 2010's. However, in 2000, there was the problem of a shortage of long-term Treasuries and a budget surplus, forgotten themes versus today. 

The next few years are not going to be easy to classify. Yes, there have been periods of strong monetary growth and fiscal deficits, but the size combined with a change in thinking about inflation and fiscal austerity means extremes will continue. The current environment is closer to war-time finances with no limits on financial prices. 

While we may like to associate the future with some period in the past, in reality, the mix is never right. Looking to history for a glimpse of the future is not wrong, but real money is made through forming contrasts and finding the uniqueness that defines the new world.

The value of dissent with investment committees - You want troublemakers; not devil's advocates

 

I recently wrote a post, "Does your investment committee have a Devil's Advocate?". A thoughtful comment came from Matt Dearth who informed me that there is some very interesting research on the impact of dissent in decision-making. 

This research finds that the worst thing to say is "Let me play devil's advocate here..." Phony dissent is no dissent. Others understand the devil's advocate is acting and thus does not take the dissent serious. It actually helps the majority who develop more arguments for their case but do not think about true alternatives. Better decision-making only comes when there are true divergent opinions. Diversity in the form of alternative ways of thinking leads to better decisions overall.

This topic has been extensively reviewed by Charlan Nemeth, a leading researcher in this area, in her book "In Defense of Troublemakers". This is not a new book, but it provides clearly written arguments with all of the supporting research on why you want to have that troublemaker who has an alternative view sitting at the table.

Nemeth uses the movie "Twelve Angry Men" as a backdrop for her discussion of dissent. The one hold-out to the consensus drives the group to think harder about their views and make a better decision. The resulting answer does not have to be different than before and the dissenter does not have to be right. The act of dissenting helps develop better alternatives and thinking. 

Quick convergence to majority thinking may lead to failure. The idea that you want to have a culture where everyone is on the same page is can be troubling. Dissent in a highly uncertain environment is critical. This applies to any asset management committee work, but it also applies to the development of models. Systematic models will be better if there is dissent among the researchers.  Forget the devil's advocate and get people to voice alternative opinions. 

Postscript -

This is the reason why I write this blog; I get new ideas or find out about research I did not know about.

Forecasters give good commentary; they just don't predict well. Follow the trend

Forecasters may give good commentary, they just don't predict well. Did the survey of professional forecaster ever get the interest rate forecasts right? It should be noted that the forecasts seem to do better during periods when the Fed was not actively engaged in QE. For example, the 2002-2007 and the period 2016-2019. 

Generally, it does not seem like the professionals have any handle on the direction of rates even when the Fed provides forward guidance. They may tell good stories, but their forecasts are not worth much. See How much value should you place in macroeconomic forecasts? - The under and overreaction of forecasters.

On the other hand, trend-followers do not give good commentary, but they will tell you simply the direction of rates. There is no fancy words or stories, a trend is just a trend until it is not. You can put more words around it, but the elegance of trends is with simplicity. 

Following the trend is a simpler more efficient way of making an interest rate forecast. A trend in rates is the aggregate behavior of buyers and sellers in involved in markets. This diverse crowd may provide a better estimate than a group of professionals because it is aggregation of their dollar votes. 

Can a trend forecast tell you where interest rates will be in a year? Trends do not provide point estimates, but it can give direction and the trend can provide an extrapolation. The forecast contests have consistently found that extrapolative smoothing model models beat fundamental models. If the world changes, so will trends. There is no ego or second guessing.

Inflation - what is your view on labor slack?

Inflation is coming! Inflation is coming! 

Perhaps we should hold off with this view until we can answer some simple questions. All are focused on the same question of slack.

• Can we have sustained inflation if there is slack in the labor market?  
• Can we have sustained inflation if there is slack in factory capacity? 
• Can we have sustained inflation if there is an output gap?

There is agreement that inflation should move higher if we see these gaps start to close; however, it is not clear how much higher we can go beyond 2% if there is not a full closure of these gaps. Additionally, there is a question with defining what is slack. If workers are discouraged and leave the workforce, there can be a tightening of labor markets with lower labor participation. Perceived slack could be high but labor tight. 

Before you say anything about inflation tell me about your view on slack. 

For recent inflation numbers see Inflation - Not what was expected, not what is wanted.

To move to pre-COVID levels, we will need unemployment to fall by over 2.5%. 

To reach old capacity utilization levels, we need an increase of 2.5%.

Prices paid by service providers have almost reached the highest levels since the GFC and prices paid by manufacturers have moved back to 2018 levels.

Low volatility anomalies - Is it all about the skew?

There is no free lunch. The idea that you can form a low volatility portfolio and get added return or alpha is false once you take into account higher moments like skew. The low volatility or low beta portfolio is not so safe once you account for skew or tail risk. This idea is presented in the well-researched paper "Low-Risk Anomalies" in the October 2020 Journal of Finance. 

If an idea seems to be too good to be true, that is, you get return without having to pay for it with risk, then it is likely to be wrong. It is just a matter of trying to find the risk and figure out the pricing.

This paper concludes that the low risk anomalies are just compensation for coskewness risk, the risk associated with the asset and the squared market return. More important, ex-ante option-implied skewness is related to ex-post residual coskewness. There are tools or measures that can be used to find the assets that are most likely to be affected by coskewness. 

The option-implied skewness can be found in measuring OTM call and puts. If there is a skew in the options associated with a firm, there will be a meaningful coskewness that can account for the alpha in a simple regression of market risk beta. The alpha from a 3-factor and 4-factor model can also be described by this coskewness factor.

If an investor controls or accounts for this coskewness, there is no significant alpha for betting against beta or betting against volatility. Investor may think they are getting extra return by holding these low volatility portfolios, but it is a mistake. 

The argument has been that high beta portfolios are mispriced because of such issues as leverage constraints but this coskewness evidence seems more compelling. We have discussed the low volatility effect, see The low volatility style factor - A great history, but can it continue? and Low volatility / Low beta performance - This smart beta edge has been real, but we did not discuss the issue of skew as an explanation.

Skewness is an important risk potentially priced in the markets. This research highlights the problem of using only one dimension of risk, standard deviation. When investors say that they need to focus on tail risk, here is a perfect way to practically approach the problem. Look for how skewness is not priced in the market. This work does not mean that all low volatility investing should be avoided. It does mean that you are getting paid to take risk not associated with volatility. If you are comfortable with this skew risk, then take it. If you have not thought about it, then avoid the low-risk anomaly. 

David Ricardo - Cut those losses. Ride those profits!

I am not the first person who will comment on David Ricardo being a great speculator, but it is good to remember that basic principles of good money management have not just been discovered recently. There are few new secrets to good money management. Our math has gotten better, and we have learned some new tricks, but the basics have been in place for centuries. As long as there has been tradable markets and volatile prices, there has been speculation that has only been successful based on simple ideas like cutting loses and riding profits. 

For David Ricardo, he had two golden rules as noted by James Grant in his book, The Great Metropolis Volume 2. 

Ricardo made his wealth through being a stockjobber or specialist mainly in government consols, bonds. He often focused on arbitrage between the cash and more liquid forward market and some view him as an early quant.

A contemporary wrote of Ricardo: “He is said to have possessed an extraordinary quickness in perceiving in the turns of the market any accidental difference which might arise between the relative price of different stocks [government bonds].” His transactions would tend to be short-term and he would “realise a small percentage upon a large sum,” typically £200 to £300 a day. He wrote a friend, “I play for small stakes, and therefore if I’m a loser I have little to regret”. from "How David Ricardo Became The Richest Economist In History" by Mark Skousen

The civil servant John Lewis Mallet, who knew him well, wrote in 1823 that Ricardo “is said to have possessed an extraordinary quickness in perceiving in the turns of the market any accidental difference which might arise between the relative price of different stocks, and to have availed himself of this advantage, by selling out of one, and buying into another stock, or vice versa.”...Mallet added that Ricardo “is also said never to have carried his stock transactions to any speculative extent; but to have always, or generally, sold out on the turn of the market, so as to realise[sic] a small percentage upon a large sum.” from ECONOMIST DAVID RICARDO — ONE OF THE MOST SUCCESSFUL QUANTS IN HISTORY by Jason Zweig

Time tested risk management and trading rules have preceded most back-testing history used for analysis. Just follow the rules of great speculators. 

Postscript -

Ricardo was not above using information to game the market. A story from Paul Samuelson recounted by the great journalist David Warsh in "Paul Samuelson's Secret" describes Ricardo's skill. (The blog post from Warsh is an interesting history of Samuelson's speculation and the development of Commodities Corp.)

The bond trader had an observer stationed near the battle. Once the outcome was clear, he galloped quickly to where a packet ship was waiting. So Ricardo in London received the early news, and conveyed it to the British government.

Then he went down to his customary chair at the Exchange – and sold! Other traders, suspecting the worst, sold too, the prices of Treasuries tumbling, until at last, Ricardo reversed course and bought and bought and made a killing, his greatest coup ever, one that put even the Rothschild brothers in the shade.

“If not illegal, an ethical purist would have to fault Ricardo for in effect profiting from his own spreading false rumors,” Samuelson wrote. “In this millennium that might be something to criticize or even to litigate.” Even so, the ploy was not unheard of in the present day, he would confide, given that new news, not yet digested, was what sent markets spinning.

Rudi Dornbusch - How to think about the world of economics

 

Rudi Dornbusch -  “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”

There will be a lot research reports and thought pieces about what will happen in 2021. Some will discuss impending doom and others will focus on optimism, but most will not employ the key thinking from Dornbusch. For many of the big macro issues, we can see them coming, but the impact from any problem will take time. 

• Inflation
• Credit blow-ups
• Government dislocations 
• Stock market revaluations

These events are not black swans. These are grey or white swans representing known risks that will have to be faced, but with unknown timing. 

Policy-makers will do everything in their power to slow the inevitable; macro-prudential policies for the longer-run and liquidity injections in the short-run. We have seen a strong taste of this behavior in 2020. Monetary liquidity in many forms, aggressive fiscal policy, financial repression, and price manipulation were all employed. Why should we expect anything different in 2021? 

All policies will attempt to stop any economic pain and forego any destruction, albeit it is still happening though not immediately obvious. The impact from excessive policies will create new distortion that will have to be addressed through a new set of policies to solve the new problems. Think of the driver who overcompensates when starting to skid. There is no value judgment here other than issues will be pushed into the future until there is a catalyst that cannot stop swift repricing and adjustments. 

So, what can investors do? When reviewing forecasts, answer a simple set of questions: 

• What issues or problems are being expected?
• Why do we expect these issues to arise?
• When will they occur?
• What will be the catalysts to create these changes?
• What will be the policy and market response to these shocks?

You will quickly learn that all of these questions cannot be answered, yet much can be learned though working through the questions and possible scenarios. For some this may all seem obvious, but year-end makes for many proclamations with little support. 

Rudi Dornbusch was the great macro international finance MIT professor who influenced generations of economist. It is worth remembering his macro wisdom. 

Fidelity survey - Digital asset interest increasing - What are you going to do with digital assets in 2021?

 

Fidelity Digital Assets generated the Institutional Investor Digital Asset Survey earlier this year that will have implications for investment research and asset allocations next year. More than 25% of US investors now have allocations to digital assets. Over 50% of US investors have direct investments in digital assets and one in five investors have  digital asset exposure via futures. The survey was quite extensive with close to 800 investors participating and was conducted by Greenwich Associates.

There is no question that central banks are taking a close look at digital assets and they will play an important role as a medium of exchange. Investors will have to watch these developments and have a view on how to play it for their portfolios.  

It has helped that digital assets have shown strong performance in 2020, but there are a number of reasons for the strong investor interest this year. There is a growing interest in digital assets as an alternative currency and as a substitute for holding gold. What to do with digital assets is another key question for 2021. 

An equal-weighted index as an alternative to Tesla's addition to the S&P 500

Tesla is joining the S&P 500. This is not new information, but the question is what investors should do about it. There is the primary effect of adding a new stock that will be the sixth largest to the index and will represent 1% of the index. If you use the benchmark, you will have to have Tesla. All passive investors are now betting on Tesla.

The folks at Irrelevant Investor produced a chart that shows the six largest stocks in the SPX index will equal the capitalization of the smallest 369 stocks in the index. The majority of the index seems of little consequence. 

There are ways to take advantage or protect against this high concentration in just a few stocks which have been momentum leaders. The simplest is to reweigh the S&P 500 index through buying an equal-weighted basket or a non-cap-weighted index. This equal-weighted index has outperformed the cap-weighted index significantly over the last three months. This plays on the themes of a broad recovery given vaccines, the renewed focus on smaller cap names and value. 

This is not the only way to play the concentrated index problem, but it is a simple cheap alternative. Another approach is use overlays of focused protection through a collar on the top six names in the index. Investor should not feel hostage to a cap-weighted index.