Peter Lynch and behavioral finance

 

"Everyone in the world is a long-term investor until the market goes down." 

- Peter Lynch, the Fidelity investment guru

We found this out again during the current bear market. This is another variation on the old, "sell your winners and hang onto your losers" mentality that gets investors into trouble. 

This Peter Lynch phrase is a nice way to describe prospect theory - the fact that perceived gains have less of an emotional impact than perceived loses. Of course, there is more to prospect theory, but the differential impact of gains versus loses on investor psychology makes investors do things that are not expected based on traditional expected utility analysis. 

A key role of quantitative investing is offsetting the natural tendency to be biased with our perception of gains and losses. Quant rules can hardwire good behavior. 

"Don't fight the Fed" should work in both directions

The adage for most traders is that you should never fight the Fed. If the Fed is lowering rates, assume that this is good for risky assets. This has worked for decades. It should also work in the opposite direction. If the Fed is raising rates, stay out of risky assets. Yet, it seems like we have a "fight the Fed mentality". The Fed has stated "we have more work to do" and "ongoing increases in the target range will be appropriate" which is not suggesting that rates have topped or will be coming down soon. The Fed has stated that is data based and six months of data not three months is more likely needed before there is a pause. At least two, more likely three, will be the cards. 

Should the markets bid up risky assets to front-run the Fed? We know that markets are forward-looking, but it may be premature to expect that cash flows should be discounted by a lower rate this summer. A pause in rate increases is not the same as a decline, and inflation stickiness will increase as the rate of inflation falls.

While Fed forecasting has been poor and there may be a revision in SEP forecasts in March, the core view that the Fed wants to constrain the economy should be the market regime foundation. Additionally, central banks around the world may be behind the curve and require more increases regardless of Fed action. 

One darn shock after another - supply and demand shocks since 2020 control the macro economy

 

If we look at the macro environment since 2020, we can see that investors have been facing a series of supply and demand shocks which are overlapping with little rest in between. The pandemic shutdown was a supply shock in the sense that business could not get done. Money was available. It just could not be spent. Fiscal stimulus mitigated the shocks, but it just led to higher or excessive savings. Of course, once the economy opened, the economy faced a demand shock with spending increasing but goods being unavailable from the supply chain shock. Supply chain problems started to reverse as we entered 2022, but there was another supply shock from the Ukraine War which disrupted energy prices especially in Europe. Within 2022, we can say there was a supply shock in China from COVID. Of course, we are now facing another demand shock based on a global slowdown. Don't worry there is likely to be another shocks before the year is out.

The 1990's was called the "The Great Moderation" by Ben Bernanke; however, the 21st century is turning into the century of shocks. Governments are trying to mitigate these shocks, but it is unclear they whether they are able to get the size and timing right. The monetary shock in March 2020 may have lasted too long. The fiscal stimulus may have been too large. Both contributed to increasing demand and leading to inflation. Now the Fed may be too restrictive. We will see.  

Davos and risk gloom - Nothing good out there

 

The World Economic Forum produced their 18th Global Risk Report at the start of the Davos conference. There is little optimism in this report. Of course, one should expect pessimism in a global risk report, but the current dangers may be heightened given that so few are economic in nature. Non-economic risks are harder to price and do not have easy solutions. If we cannot price the risks, then the potential market impact will be all the greater if we have a severe shock with the top ten risk list. This applies for both the short and long-term horizons risks. 

These top ten risks are also interconnected which means that they cannot be separated or looked in isolation. Environmental damage, climate change natural disaster, migration, and cost of living are holistic. One cannot address one risk without also dealing with another.  

Extreme risk events lead to fat tails and fat tailed events or market divergences will lead to significant trends unassociated with market forces. These risk events are not likely to be easily solved, so the dislocations may last for extended times. 

International trade concentration is a problem not discussed

 

While everyone talks about international trade as a complex web of competitive suppliers, the reality is different with a high level of concentration in many key industries. The high concentration with few suppliers means supply disruption like we have seen over the last two years are more likely. See McKinsey Global Institute "The complication of concentration in global trade". 

About 40% of global traded is concentrated with only a few suppliers. Importers around the world are dependent on these key suppliers so a trade disruption cannot just be solved. by moving business to a different firm. Pandemics, sanctions, supply chain disruptions will all be magnified if shocks are focused in these key industries. Manufacturing may be competitive but the raw inputs may be concentrated, so international dependency is significant. This is especially true with agriculture, mining, and electronics. Supply shocks may be more prevalent given this concentration which will translate into higher "inflation". Supply chains matter.

The "Age of Disconnect" and global macro investing

We are not in the pandemic period, and the post-GFC period has ended. We have had a spike in inflation but that may not be the hallmark of this period. We need another name to describe the current global macro and geopolitical environment. I will call this period, the "Age of Disconnect". 

The disconnect starts with the end of the golden age of globalization. It is not that the world will move to isolation, but there will be a slowing in the flow of trade. There will be a new regionalism with friend-shoring, and on-shoring. Inventories will build because just-in-time management will not work if there is another trade disruption threat. Trade sanctions are a continuing reality and capital controls will impact the flow of money across borders. If trade surpluses decline, governments will use other controls to maintain exchange rate stability.

We are already seeing greater divergences in monetary policy as central bankers address different types of growth and inflation trade-offs. The connection of all central banks behaving the same is over.

Domestically, large deficits will have to be addressed with changes in tax policy, and the tilt to active government regulation from ant-trust policies to climate change make for disconnects across industries. Industrial policy will be used to move capital to different industries which again will cause distortions in market prices.  

Geopolitical risks will not go away, whether war in Ukraine, Middle East upheavals, or an assertive China within Asia. There is no US hegemony or international organization to control the excesses of nationalism, extremism, and neo-imperialism within regions. 

The confluence of different problems all occurring at the same time will lead to poly-crises which will not have easy solutions. 

This is does not have to be an Age of Despair. We can navigate disconnects, but it requires different thinking. There will be limits to arbitrage. Correlations will fall and markets disconnect. There will be large dislocations that may not be closed immediately. Capital will be scarce because cash will be a fair alternative, so speeds of adjustment will be slower. Investors will need more compensation for risk. All of these change the investment landscape.

Black swans, pink flamingos, and Treasury liquidity

 

Black swans are large unknown unknown events, but pink flamingos are known knowns. While investor attention is often on black swans, we cannot do much about them other than diversify and hope for the best. However, pink flamingo events are right in front of us, and we should be able to do something about them. 

Treasury liquidity or the decline in liquidity is a current problem that is well documented and will have a strong impact on financial market, yet there is little that has been done about it. It is a pink flamingo, a known known.

We know Treasury liquidity is lower based on the top of the book orders. We know that Treasury dealers are now less important in the process of Treasury auctions. We know that the financing for Treasury dealers has been an ongoing issue and has required extra repo funding, and we know that bank Treasury dealers have committed less capital to dealer operation given the restrictions from the supplemental leverage ratios, yet there is no real action other than to discuss how the structure of the Treasury markets are changing. 

This is a large pink flamingo which we have created and not addressed. It may not be an issue today, but with bond volatility high and the Fed selling more Treasuries through QT it is just a matter of time before we have a problem.  

Recession fears are realized and should not be discounted

A recession is coming. A recession is coming. This has been a drumbeat from the professional economists, (who are often wrong), yet it clouds the actions of investors who have added to fixed income based on inflation falling, the Fed rate increases peaking, and a slowdown as an economic backdrop. 

Geopolitical risks and volatility are still significant issue and surveys suggest that views for the global economy have not changed much over the last six months. The macro view is more downbeat than a year ago but have come off the lows during the period when the Fed was raising rates at 75 bps per meeting. 

Nevertheless, we are looking at the macro data closely for signs that any investor optimism is misplaced. We are concerned that while the Fed may be peaking with their rate increases, the cumulative effects of higher rates have not been fully embedded in the real economy. Central banks tend to overshoot with policy and 2023 may not be the exception. An overshoot will have a big impact on returns especially during the summer when the markets turn on as switch in the real economy.   

 

Is the 60/40 portfolio back after proclamation of its death?

 

See -  AQR Capital MarketAssumptions forMajor Asset Classes

2022 was a difficult year, but the fall in prices and change in valuation means that the expected real returns across all asset classes for a longer-term time horizon are more appealing. 

The overvaluations at the end of 2021 have moved to numbers that are more reasonable. This is especially the case for fixed income and cash which have moved from negative to positive real returns. Fixed income has shown the largest switch from last year. These changes suggest that bonds should not be sold but potentially added to the portfolio and cash can be used as a positive returning asset. This is good news for many who have stuck with a balanced portfolio; however, it creates a challenge for alternative investments that have been positioning themselves as bond alternatives. Their absolute return and diversification benefit should be improved versus bonds. 

The AQR work is very transparent and provides clear descriptions about how they derived their numbers. You may change their assumptions and get different answers but the framework very helpful. 

Asset allocation for the long-run - Diversify with alternatives and factors and dynamically adjust exposures

Different forms of asset allocation show different approaches to generating efficient returns over the long run. See A Century of Asset Allocation Crash Risk. The authors look over a long data set and across sub-periods for a 60/40, global 60/40, risk parity, diversified, endowment, factor-based, and dynamic models. The results suggest two major take-aways: 1. always diversify especially with factor and alternatives as displayed in the endowment and factor models, and 2. be dynamic through the use of momentum and volatility risk adjusting. The three best strategies are the endowment, factor, and dynamic asset allocations. 

The endowment model includes alternatives and private equity while the factor model focuses on a diversified set of factors. while not shown, the diversity with style and factors with dynamic adjustments will prove to be especially effective for efficient allocations that will maximize return. Using these strategies will minimize the maximum loss for investors and will also allow for significant upside. The 60/40 may have been effective in certain environments but focusing on broadening the allocations and making systematic adjustments is superior.

 

DeLong on the reasons for economic growth - They may be trending lower

 

In 1870 the last pieces of the institutional complex that supported what Simon Kuznets labelled “Modern Economic Growth”—average real income and productivity levels doubling every generation, growing at an average rate of 2%/year or more—fell into place. The addition to the institutions that were there before pushed humanity across a watershed boundary with the coming of

• the industrial research lab,

• the modern corporation, and

• the globalized market economy

These revolutionized the discovery, development, deployment, and diffusion of human technologies useful for manipulating nature and cooperatively organizing ourselves. 

- Lecture notes from Brad DeLong Grasping Reality

We are in a different era, beyond the neoliberal period, which will be different in terms of growth and globalization. To understand where we are headed, we need to think about long-term economic growth and why the last 150 years have been so different than prior economic history. Brad DeLong is grappling with this question through his research and presented in his book, Slouching Towards Utopia: The Economic History of the 20th Century. This book is a singular achievement given its breath, deep analysis, and unique views from a truly gifted researcher. Many will not agree with his work, but that does not change the fact that you will learn a lot about economic growth.

Are we in a better era of discovery? it is not clear. Has the value of the modern corporation exceeded its limits? Again, not clear, but it seems to be tilted lower. We do know that the age globalization is changing and may have ended. 

Along with the three key factors of DeLong, the institutional environment is moving away from growth. The celebration of the bourgeoisie and businesses seems to be over as the culture and government has changed, and the desire to have corporations focus on profit is also declining. The economic environment is more fragmented and the goals for economic improvement and growth are less clear. Overall, the environment matters and the current cycle for growth may be ending.

Factor exposures and smart beta sensitive to the market regime

Factor beta or smart ETFs provided a range of protection for investors. This is not the same as principal protection, but holding, for example, value or low volatility exposure was extremely helpful for any investor. Style factors are regime dependent. 

This can also be seen with the long-short factor performance which generally did well. However, in a volatile market factors like quality may not have the opportunity to show its value. Quick adjustments may lead to long underperforming relative to short that are expected to improve. 

Overall, the regime for any factor matters and should be the focus of investor. An inflation environment with slow growth and a bear market bias will be better for some factor exposure like value. Define the regime and then think about the investment exposure.

 

Forecasting is hard; now try and engage with predictions

 -Jason Zweig The Devil's Financial Dictionary 

No one said forecasting is easy. It is not. Yet, we must engage in predictions, extrapolations, scenario analysis, and judgments. We first must admit that it is not easy, and we will likely fail. Second, we need to realize others are not good at it either. Third, providing deep descriptions and details about the past and present are not forecasts, that is just sharing knowledge. Finally, we constantly must make judgments, assessments, or likelihoods about the future. 

Doing nothing involves a prediction, a prediction that the world will stay the same. Good luck with those predictions, but you can help yourself by using trends as a base for judgment.

Professional forecasters worse than a flip of a coin

 

Don't put much stock in the view of professional forecasters, they are worse than a flip of a coin. See St Louis Fed research, "Professional Forecasters’ Outlook for 2023 and Caveats Based on Past Performance". 

The consensus shows that real growth will only be .3% for the year, inflation will come in at 4%, and unemployment will be at 4.4%. There is little deviation in the Blue Chip forecasts. This is the common knowledge, yet it is highly likely that what everyone may agree to will not occur. Therefore, it is important to think about how you create views around the consensus which are actionable. 

We always focus on the road map. One, know where you are in the economic cycle. Two, know where you are going in the cycle. Three, know where everyone else is headed or thinking. This is not often easy work, but it makes for better success with any investment strategy. 

If you cannot determine where you are or if you want a simple guide, follow the traffic which is the trend in prices. 

Be a closet trend-follower and protect your portfolio

 

- Paul Tudor Jones 

Even if you are not a 100% trend-follower, you can still use trend-following principles to support your allocations decisions. Use the 200-day moving average as a core indicator to support portfolio changes. If prices fall below the 200-day average, use discipline, and get out or reverse positions. You can use other trend lengths but place some core logic in the 200-day indicator. The investment world may be uncertain, but this indicator will always offer protection. You can always be a closet trend-follower.

Shortages, disequilibrium, and the current adjustment process that causes inflation and slowdowns

The problem with the economy is a disconnect between demand and supply which has been playing out since the pandemic and the switch from an unconstrained financial system to a constrained system. 

Oh, that seems like an easy thing to say, but the current inflation and potential recession problem is that we are still trying to balance out the disconnect from the pandemic. Restrictions on demand with strong fiscal policy has led to excess demand in some key sectors. Supply side dislocation and logistic problems have led to shortages on the other side. Think of an economy in disequilibrium which cause dislocations in production and pricing. The labor and demand markets need time to adjust, and the process of adjustment has led to inflation and slowdowns in growth. This is not the only issues, but it plays a key part. Additionally, low rates have not served as any discipline on credit. Poor firms have not had to discipline their behavior because the cost of capital has been so low. That is now changing, which creates a different disequilibrium. The current economy must come to grips with this ongoing adjustment process.

Hat tip to Joseph Politano of Apricitas Economics in his post "Monetary Policy in a Shortage Economy" for resurrecting some interesting work from Janos Kornai on the economics of shortages. Shortages can occur in a planned economy when there is no bound from profitability. State owned or firms that are not constrained by profitability will compete for resources which create shortages. The hard bound of profitability causes firms to focus on demand while in an economic environment not bound by profitability there will be shortages as firms all grab for labor and input resources.

With low financing and zombie companies allowed to exist, there is no constraint from profitability and the process of reaching an equilibrium where poor companies no longer exist and good companies thrive does not occur. Higher rates will allow for a better allocation of resources; however, before that occurs there will be economic pain. 

Why discuss this macro theme? With all the focus on inflation, there has been less focus on the core issue of reallocation of resources as rates normalize and this will be where the greatest risks and opportunities will occur.

New Fed recession signal based on state growth

 

Economic dispersion matters or looking at more localized data and can be helpful with indicating the onset of a recession. The Philly Fed generates state coincident indices that look at key variables associated with state-level growth trends. (See how these are formed below.) 

The St Louis Fed took those numbers and then looked at the number of states with negative growth. If the number of negative states gets above 26, there is a likely recession signal. The current numbers are not looking good, but still below the threshold. However, we will note that the inputs are subject to revision so there is noise with the count each month. Nevertheless, this is a simple recession indicator that can easily be tracked and serve as another recession signal.

Briefly, the SCIs are calculated with a dynamic single-factor model using each state’s nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements (deflated by the U.S. city average consumer price index). Each state’s SCI trend is also set to match the long-term trend of its gross domestic product (GDP). In other words, for each state, the long-term growth of its SCI matches the long-term growth of the state’s GDP.

Moneyball - 20 years later

Moneyball was a great book when it was first published, and it still is a good book 20 years later. I want to reflect on the book and what investor should still takeaway from Michael Lewis's ultimate story. 

I first wrote about Moneyball and learning from Michael Lewis in my first blog post in 2007 and another a few weeks later. See "Moneyball and Market Efficiency" and "Learning financial research from Michael Lewis".

I have not significantly changed my views from these two posts; however, I have further developed my thinking by adding structural and behavior aspects to the disruptive thinking of Lewis. Quantitative methods can be disruptive because it can find relationships that others take for granted or assume away. Market relationships are taken for granted because we have behavioral biases. These biases do not easily go away even when they are identified and highlighted. 

Nevertheless, disruptive thinking can learned, so the baseball analysis of 20 years ago may not work today. Opportunities can last for some time because they may be structural in nature, but this is usually the exception not the rule. Opportunities from specific analysis can fall in and out of favor.  Looking for value is not often easy when the objective may be to win today at any costs. If the market is overvaluing certain players, you may have to pay the higher price. 

Success is always about a disciplined approach to following the numbers and not getting caught up with emotions. Excess return is always about seeking disruptive ways of finding value not used by others.

The words of the year - polycrisis and shrinkflation

The word of the year is POLYCRISIS. 

"A global polycrisis occurs when crises in multiple global systems become causally entangled in ways that significantly degrade humanity’s prospects. These interacting crises produce harms greater than the sum of those the crises would produce in isolation, were their host systems not so deeply interconnected."

See Polycrises - multiple crises are a reality. 

In 2023 we will see multiple crises come together to create a bigger market dilemma for the global economy. The Ukraine-Russia War will spill over to the energy and commodity markets again. The slowdown in Europe will continue as it searches for a more effective energy future. The COVID pandemic in China will be a headwind against growth in many EM countries. All this means that global macro will be a dominant strategy for 2023.

The second word of the year is SHRINKFLATION - the process of adjusting to inflation through maintaining prices but offering less quantity for what may seem to be the same package. See Higher labor costs and "shrinkflation" - Inflation beyond the headlines.

Firms are negatively affected by inflation because costs cannot always be passed through to buyers. Earnings will shrink for many firms, and this will have a further impact on valuations. Shrinkflation is a first response but cannot last forever. 2023 will be the year that firms must adjust to the price shocks of 2022. Inflation may fall but the impact on firms is just beginning.  

2022 - A year of extremes

 

2022 was not a good year for holding passive exposures, but a close look at the details shows that the dispersion across asset classes, factors, and sectors was large and could be exploited. The 60/40 allocation decision was problematic, but adding greater exposure to some factors and sectors that are viewed as defensive would have cushioned the overall decline.

Holding stocks with dividends was a winner. Low volatility strategies lost less than 5% and a value focus was down only 5%. A simple strategy of holding an equal weighted portfolio would have outperformed the SPX index by close to 800 bps. Th switch from growth to value and a focus away from overvalued pandemic high-flyers was a good defensive choice. This switch was a derisking strategy based on rates rising.

Holding energy stocks would have outperformed SPX by over 75%. Utilities, a classic defensive sector, gained 150 bps for the year. Commodities were another winner albeit with large swings and volatility. 

The answer for 2023 is to look for factor and sector exposures that will offset the downside potential from holding the market-weighted benchmark. Following a simple trend model can identify some of the sector and factor exposures that can serve as defensive allocations and still offer return opportunities.

We know that history will repeat and 2023 will be very different from 2022; however, the dispersion across sectors and factors will continue. This offers investors the chance to exploit return differences. Even if all of the dispersion is not collected, the large differences offers ways to extract return.

The challenges for 2023 - Can you see better than the consensus

 

The challenge for 2023 is not different than for any year. It is not about predicting the future market direction but preparing for the changes that may occur in the new year. There will be changes in 2023.  Our forecasts today will be wrong. The challenge is adapting quicker than the market to stop downside risk and take advantage of upside opportunities when the forecast errors are realized.

Some of the changes for 2023 are already embedded in the market consensus. Our job is to be prepared for both downside and upside events away from this consensus. The left and right-tail opportunities will be determined by the deviations from consensus. The challenge is to first know the current environment or regime and then handicap the potential for change in the regime. 

For example, the consensus is that Fed will likely top out rates at around 5% before the summer with a decline in rates during the second half of the year. This is based on an inflation forecast which shows continued declines and the potential for a recession in the second half of the year. Much of this consensus is already embedded in prices. The challenge is to look for signals that suggest the consensus will not be realized before the market identifies a change. 

Forget predictions and focus on the how to prepare and react when the current consensus changes.