Thursday, September 29, 2022
Wednesday, September 28, 2022
Sunday, September 25, 2022
Equity risk factors are tied to the business cycle. Condition on where we are in the business cycle and returns will be markedly different. The researchers at FTSE Russell show this relationship in "Do factors carry information about the economic cycle Part 1: The Investment Clock: Linking factor behavior to the economic cycle" They start their analysis by breaking up the economic environment into four phases that represent the business cycle: expansion, slowdown, contraction, and recovery. These can be identified through using a measure of inflation against a long-term average and growth through the ISM survey.
The gain from making equity risk factor adjustments conditional on the business cycle can be substantial. The market risk will perform the bets across the full business cycle; however, switching will offer upside and protection especially during slowdowns and contractions.
Saturday, September 24, 2022
Friday, September 23, 2022
The hawkish Fed policy is bad for EM financial markets, but there has not been an EM financial crisis for some time. EM markets are in much better shape than in the 1990's, yet that does not mean they will be immune to a significant rate shock especially if the purpose of the rate rise is to cut aggregate demand. There may be opportunities with holding EMB bonds, but we may not be there yet as the market reprices global interest rate risk. See "Emerging Markets and the Hiking Cycle: This Time, Really, May be Different" for this more optimistic perspective.
If Col Jessup from "A Few Good Men" opined on uncertainty, he would say most investors cannot handle uncertainty. Investors may say they can deal with uncertainty and risk, but they often avoid engaging with the messiness associated with uncertain environments and decision-making. We know this from extensive analysis of people's need for closure. Most like finality and not decisions or actions that are open-ended. Trading decisions are open-ended because with each mark-to-market there is another decision. Each new piece of information requires another decision, hold or fold. In an uncertain world, many will avoid action and wait. Waiting can be the appropriate action but taken to access it will be costly.
The desire for closure has a significant impact on decision-making. This desire can be another explanation for behavioral biases. Someone who needs or wants closure will look at decision-making differently from those who are comfortable with uncertainty. A person who wants closure will likely suffer from regret and may hold losers over winners. A person who wants closure will likely make decisions based on recent information and will not look for more data. Those who embrace uncertainty will be willing to be more open-ended in their use of information. Closure sensitivity will also impact whether someone is willing to change their mind and adjust their decision.
Arie Kruglanski, a well-known psychologist, has extensively studied the problem and has created questionnaires to measure the degree of closure that we may desire. See the Need for closure scale (NFCS). If applied to traders, we can determine whether an individual can be overly sensitive to uncertainty. Those who desire a high degree of order will not do well when markets are volatile or less orderly.
The use of rules for investment decisions is an attempt to gain closure. Once a set rule is hit, action is taken, and the decision is closed until the next rule is triggered. Just because someone wants closure does not mean he will be a bad investors and someone who is open-ended will not always be a good trader. The important point is that each of us has a different sensitivity to closure and we should account for this sensitivity with our decision-making. Someone who is very closure sensitive should stop and determine whether he is being too hasty with action. Someone who is open-ended should ask whether he has enough information to act as opposed to waiting for more information.
Determine your sensitivity to closure and adjust your decision-making to account for any bias. You will be a better investor from this process.
Thursday, September 22, 2022
There is a high uncertainty surrounding FOMC announcements. Upon the announcement the uncertainty is resolved. There has been found a risk premium associated with the period prior to announcement. See our post "FOMC Risk and Resolving Uncertainty".
Additional research has further decomposed the risk prior to FOMC announcements and finds that there is a sizable left-tail premium that is unique to FOMC announcements and is not found in other macro announcements. See "Fed Tails: FOMC Announcements and Stock Market Uncertainty" This left-tail uncertainty predicts rate decisions and is a concern with FOMC members. Researchers suggest that this premium is attributed to supply shocks in the crash insurance market.
Investors worry about downside risk from an FOMC announcement and will go to the options market to buy protection. This protection cost is then embedded in prices and is be displayed in premiums. The size of the premium is related to whether there is expected a positive or negative announcement shock.
Investors should be able to see the market premium tilt and determine the expected FOMC action. When faced with downside risk from monetary uncertainty, investors will seek protection which disrupts prices prior to the announcement. Someone must take the other side of crash insurance. Watch option behavior and you can measure investor downside fear.
A recent strategy paper from a large bank quant group focuses on the benefit from holding CTAs in a portfolio and the signal generation from CTAs. Diversification is enhanced and drawdowns are reduced when CTAs are added to an equity portfolio and to a lesser extent fixed income portfolios. CTAs show consistent long-term performance albeit there will be periods of negative return. Of course, this work does not make the key distinction between CTAs and trend-followers. Trend-followers are CTAs, but CTAs are not always trend-followers. Nevertheless, the research further documents the value of trend-following when added to a portfolio.
These conclusions are well-known and reinforce the value-added from CTAs; however, this is not the main purpose of this research. This quant group attempts to engineer CTA signals in order to help investors better manage asset class exposures. Take what CTAs do and convert the strategy into signals on flow and crowdedness so that investors can use these signals without investing directly into a CTA.
The quants suggest that these signals provide a better tool for investors that trying to determine CTA positioning from commitment of traders reports as generated by the CTFC or making the direct investment. Follow CTA signals and you may get the best of both worlds, signals that enhance returns and offer diversification.
This type of signaling research can be useful, but the analysis presented will generate reader confusion. First, the research does not define terms correctly. Trend and momentum are not the same, and this research does not focus on this difference. Second, the presentation of signal development is not clear; consequently, the quality of the signal is suspect. Trend followers may be similar, but there are large differences in the look-back period and processing of data. Without clarity on trend identification, the signal does not tell us clearly what is being modeled. Third, the signals are structured to replicate the thinking of trend-followers and not find the best trend signal for markets. The signals are a combination of exponentially weighted moving averages adjusted by market volatility and converted in signals between 1 and -1 while accounting for liquidity and portfolio volatility. They then assume that these signals represent the trading positions of CTAs.
Nevertheless, we can learn from this work. Trend signals have forecasting power and do not serve as just indications of flow from CTA strategies. Second, trend signals are noisy indicators of crowdedness just like the commitment of traders information. Strong identified trends like large trader commitments do not reverse but show continuity. We cannot make judgments on reversals.
The bank quant group spends significant time linking CTAs (trend-followers) with their CTA trend identification model when what they are just doing is providing trend signals that can allow investors to replicate the behavior of trend-followers. All they had to do was say that they generated a good trend signal model that is similar to a classic trend-following manager.
Wednesday, September 21, 2022
Tuesday, September 20, 2022
Of course, looking at the price of gold in other currencies may paint a different picture. The drawdowns for GBP and EUR are less than the bear market in dollars. The price of gold in Yen is much higher but the price is still off highs. Investor must focus on alternative ways to diversify and stay away from this precious metal.