Wednesday, August 31, 2022
Tuesday, August 30, 2022
How do global equity and bond returns comovements? This is an interesting question and critical for investors who are global macro traders or just global investors. Nancy Xu tackles this problem in her paper, "Global Risk Aversion and International Return Comovement". The comovement in equity markets are different from bond markets because the reaction to macro risk shocks is different.
Equity return correlations are higher than bond markets, are asymmetric, and show counter-cyclicality. When there is a negative shock, equity markets will show higher correlation. In bad times, all stock markets will move together because they all react the same to a shock that impacts risk aversion. Bond return correlations are lower than equities, symmetric, and show weak pro-cyclicality. Bonds as a safe asset will be less sensitive to macro shocks and given the differences in safety bonds will not have the same downside characteristics.
Sunday, August 28, 2022
Trend-following is a price-based system, but that does not mean that trends only occur with prices or can only be exploited through prices. The underlying economic factors that drive prices can also have trends. These macro trends are what often drive price trends. Any price trend will usually be associated with trends in the underlying drivers of markets.
If the Fed is following a policy of monetary tightening, bonds prices will usually fall. When the Fed is following a dovish policy of lowering the rates the trend in bond prices will move higher. If there is a supply shock to the oil markets, oil prices will rise. If there is stronger economic growth, the price of risky assets will increase. Similarly, an increase in risk sentiment will increase demand for risky assets.
The macro link may not be perfect and prices trends can often be driven by short-term market dynamics, but a macro momentum model can be an effective way of trading the markets. This is the foundation for a paper from the folks at AQR, "A Half Century of Macro Momentum". Macro momentum can be another way to play market trends.
The macro momentum approached outlined in this paper is fairly simple although the actual implementation may be more difficult than a classic price-based system. Macro momentum can be broken into four different categories: the business cycle (increasing growth or increasing inflation), international trade, monetary policy, and risk sentiment. The trend in each of these macro factors have well-defined impact on markets which can be exploited.
Increasing growth will serve equity and currency markets while it will be negative for long and short-term bonds. The impact of rising inflation will be positive for currencies although it the change in inflation forecast is at odds with classic PPP theory. Rising inflation will be negative for equities and rates. An increase in trade competitiveness will increase demand for equity indices but have a negative impact on bonds. Monetary policy tightening will be negative for all major asset classes except currencies. An improvement in risk sentiment is positive for currencies and equity indices and negative for bonds, the safe asset.
Macro momentum can be structured as either long/short through cross-sectional analysis or long directional portfolios and can be compared with trend-following portfolios. The response during drawdowns (tail events) will be different. These macro factors can proxy for what many macro managers do.
Thursday, August 25, 2022
Managed futures have had a great performance run this year, but there has been significant dispersion in manager returns. A core problem is that managed futures is often confused with trend-following and all trend-following is not the same. All trend-followers are categorized as managed futures or CTAs as a regulatory matter, but all managed futures managers are not trend-followers. Managers may call themselves trend-followers but may have other strategies embedded in their funds which pollute their trend-following returns.
Cliff Asness of AQR has posted a recent research piece on trend-following to explain what it can and cannot do for investors. See "The Raison d'être of Managed Futures." Managers will often describe themselves as having a dual mandate of high average returns and strong returns during a market downturn, yet a pure trend-follower may have a hard time reaching this dual goal given the characteristics of trend-following.
While not described as a divergent trading by Asness, trend-following is trading strategy that will make money when there are market dislocations or movements away from the status quo environment. If there is market stability, trend-following will not make money. Hence, returns may be high during concentrated periods that are often short-lived. There is less likely to be consistent returns because, by definition, diverges do not dominate markets. The strategy will do well over the long-run, but that does not mean that trend-following will make money all the time. There will be periods of underperformed offset by strong performance periods. The overall returns may be strong, but not during all sub-periods.
The AQR strategy is described as a pure trend strategy; consequently, it will do well when trends exist and have performance shortfalls during periods of stability. When compared to a supposed trend-following benchmark, the SG trend index, which is a bundle of many large managed futures managers described as trend-followers, the AQR strategy will have a different return pattern.
The AQR research suggests that many trend-followers and the created index of managers, have mixed strategies that include more than just trend-following. To meet investor requests for both positive average return and downside protection, convexity, managers who often call themselves trend-followers but also include sometime like carry.
We view carry as a convergent strategy that will do well when returns are stable, so managers may give-up some of the convexity in exchange for more stale returns through adding carry. The data suggests the SG trend has this mixed strategy. Additionally, there are portfolio structuring techniques that will impact trend-following. For example, volatility targeting, or volatility position sizing will have the impact of reducing risk exposure when there may be strong market dislocations. The trend exposure is cut at what may be the most opportune time for making money. The results are lower returns at market extremes.
Investors need to know what they are buying, and in the case of trend-following, you may not be getting a pure trend strategy because of mixed strategies and structuring. Is this false advertising? Perhaps, but a dampened trend may be what an investor wants. However, you should not be disappointed if in exchange for more stable returns you don't do as well during dislocations.
Tuesday, August 23, 2022
Why do investors get forecasts wrong? Why are there failures with predictions? The forecast skeptic will say predictions cannot be made because of the properties of the world and the properties of the observers. We can classify reasons for failures into ontological or psychological arguments.
Ontological: Properties of the world
- Path dependencies
- Game theory
- Asymmetries between past and future
- Complexity theory
Psychological: Properties of observers
- Preference for simplicity
- Belief in a controllable world
- Misunderstanding of probabilistic processes
- Aversion to ambiguity
Thursday, August 18, 2022
We're not overbuilt, we're under-demanded" is one of the great understatements on the current housing market. With interest rates increasing and current 30-year mortgages at 5.5%, demand has evaporated from the marginal buyer. Simply put, many buyers think in terms of their monthly payment. If the mortgage rate goes up, then prices must come down to set a fixed monthly payment.
The spike in rates has caused a housing demand shock.
The supply of housing has moved to the highest level in a decade. What was a housing shortage less than a year ago is now a glut. New home sales have fallen by double digits when last year supply was a problem. Existing homes were in short supply as buyers eagerly paid over the asking price. Sellers are now discounting, and buyers are walking away from signed contracts. All from a change in the interest rate environment and it will not get better anytime soon.
- There is the supply of food - the measurement of what is produced for a given crop.
- There is the command of food - the control of the distribution of commodities.
- There is the end ownership of food - The relationship between the food and the person who consumes it.
- The supply issue is a production problem.
- The command issue is a logistics problem.
- The end ownership issue is a distribution/pricing problem.
This framework is a variation on the economic development work of Amartya Sen on famine which can be adapted to today. There is a supply problem given current weather and production. There is also a command problem because grain from the Ukraine cannot easily come to market. There is less an end ownership problem, but it can arise if there is a shortfall of income and ability to pay from higher inflation.
When an investor wants to discuss food commodities, the conversation should walk through these three issues. You may be surprised by market action because you focused on only one price component. More simply put, looking at supply without understanding demand or logistics is a loser's game. While our discussion is about food, the same framework can be applied to energy markets. The supply exists, but the command over oil and natural gas is restrictive and the end ownership is not affordable.
Wednesday, August 17, 2022
What is making 2022 special for trend-followers? Many have suggested that the higher inflation environment is the answer. Others have suggested that market uncertainty which has slowed decision-making is the key, and finally there are those that say we are in a crisis from geopolitical risks. I have suggested that these are good reasons, but the answer often can be even simpler as we have discussed in our post, Turning points kill trend-following performance.
If there are fewer turning points in each asset, there will be higher Sharpe ratios for a trend-following strategy. If trends last longer than expected with fewer reversals, the strategy will be a winner. The trends can be shallow, or they can be steep, but if they continue, profits will be made. Count the turning points and you will have a good idea of whether there it will be a good for trends.
From the referenced paper, "Breaking Bad Trends", there is a clear linear relationship between turning points and return. A good trend environment has four or less major turning points in a given market for a 12-month period.
Look at some of the major markets for 2022 guidance on why this is a good year especially for long-term trend-followers. For this year, equities have had 4 major switches between 20-day and 80-day moving averages. The 10-year bond, dollar index, and corn have had one switch and oil has had three switches. This does not account for the size of the move but gives an indication of switching costs. The low switch markets have been major winners.
The one thing that is certain for trend-following, the less trading you must do the better will be your performance. If I am working hard at trading, I am not making money. If I am bored with my activity, it is the best of times.
Tuesday, August 16, 2022
While the difference between trend-following and momentum trading is clear to most active style managers, it is important to understand the distinctions and realize that these two strategies will not follow the same return behavior. Don't use these strategies terms interchangeably in conversations. Both look at past price behavior; nevertheless, one should not expect similar performance or a high correlation.
Trend-following is an absolute return, directional strategy while momentum is relative return, market neutral strategy. The trend-following is looking to take advantage of beta direction across asset classes while the momentum trader is looking for cross-sectional opportunities within an asset class.
Can you hold both? Yes, but do not say they are similar.
Wednesday, August 10, 2022
Tuesday, August 9, 2022
Monday, August 8, 2022
The credit cycle will often follow the equity cycle. Both are in bear markets. There can be a classic analysis of determining the positioning within the cycle. Robeco, in its credit outlook shows the current credit path with a weighting on fundamentals, valuation, and technicals. They argue that bear markets and market bottoms are dominated by factors other than fundamentals and valuation. We do not agree.
The widening of spreads is driven by forward-looking fundamentals and valuation not current numbers. Fundamentals are declining based on the expected slowdown of cash flows associated with a growth slowdown and inflation. Valuations are deteriorating based on rising rates and the potential impact of QT which will create a crowding-out effects. Inflation is pushing core fixed income investors to sell duration.
Sentiment and technicals reinforce the core problems with fundamentals and valuation. Liquidity is a growing problem because there are fewer buyers for corporate paper and dealers do not want to hold these risks.
Sunday, August 7, 2022