Never expect a sure thing - thoughts by Howard Marks and Damon Runyon

 

“I tell my father’s story of the gambler who one day hears about a race with only one horse in it, so he bet the rent money. Halfway around the track the horse jumped over the fence and ran away” 

-Howard Marks

One of these days in your travels, a guy is going to come up to you and show you a nice brand-new deck of cards on which the seal is not yet broken, and this guy is going to offer to bet you that he can make the Jack of Spades jump out of the deck and squirt cider in your ear. But, son, do not bet this man, for as sure as you are standing there, you are going to end up with an earful of cider.

-Damon Runyon 

There is no such thing as a sure bet. Plan accordingly. 

Will a Barron's cover be right this time?

 

When an investment theme makes a cover on a business magazine, watch out. It usually means that the opposite will happen. Right now, the drawdown in bonds is worse than the drawdown of stocks during the GFC. Times are different, but it is worth internalizing how bad the bond market is. Investors may not fully realize this because their bond duration is likely less than the long bond, nevertheless, it has been a bad bond environment.

Rates are back up to pre 2008 levels and in the mid-2000's range. The rate increases from less than 1 percent to current levels just below 5% is unprecedented. Should we expect a reversal? To really get a reversal we will need a recession, further declines in recession and monetary easing. If that happens, we will have problems with risky assets.

How bad is the bond market? Take a look at the drawdown

 

It is hard to think about the losses in the bond market given the inverse relationship between price and yield. Rates go up which is good for new money entering the bond market, but you also must think about the losses on existing holdings. The drawdown in nominal is the worst we have ever seen. The 70's and 80's look like calm times by comparison.

The real max drawdown was worst in the 70's but we are approaching similar levels. Someone is taking a big hit in the bond market.

Does hedge fund manager skill persist across asset classes?

 

If you are a good hedge fund manager in one asset class, does that skill transfer to other asset classes? This is an interesting question on skill persistence. A recent paper finds that good FX manager who transfer some of their time to start other funds outside of the FX market carry with them their trading skill. See "Moving to greener pastures: Does hedge fund manager skill persist across asset classes?"

If you are a good trader and can manage risk, you should have the generalized skill to do well in a different asset class. There is domain knowledge that is needed, and all asset classes are not alike, but there seems to be enough commonality between asset classes to suggest that trading management is transferable. Should you follow the man and not the market? The data says yes so if you want to know whether the new fund in a different asset class will do well look at the original FX fund. It is noted that the switch to other asset classes is timed well with a decline in FX returns associated with the move to other markets. Nevertheless, there is always the question of bandwidth and the ability to scale across a wider set of assets. 

Speediness with trend-followers - choose medium term

 

All trend following is not the same, specifically with the look-back for finding the trend. You can be a fast (short-term) trend-follower or a slow (long-term) trend-follower and get very different return patterns; consequently, the speed of the trend-following will serve different roles within the portfolio. 

The long-term trend-follower will be able to capture the longer-term grinds lower or higher in prices and serve as an effect diversifier against long-term equity declines. The short-term trend-follower will capture any quick spikes in price and will have more positive skew. Hence, during the March 2020 market debacle from the pandemic, there was wide dispersion in performance. 

These issues are clearly described in "The Need of Speed in Trend-Following Investing". What has been found in this paper and has been often discussed before is that the medium to slow trends which have look-backs between 12 and 20 weeks are still the best trend length and will produce a Sharpe before costs of around 1. You may not do as well during the worst quantiles of equity performance with a longer trend model but overall, the return benefits will be stronger. A significant advantage of using longer-term models is that the transaction cost slippage is less. 

These return priors should help any trader or investor find the best trend strategy.  

Economic models as metaphors - Limiting our ability to explain

Models are metaphors which follow specific rules and with rigorous standards. We may not notice them as metaphors because of the formalism that surrounds the model. The model with math is often used as the narrative of economics. The actual story, as told in words, is downgraded versus the approach of providing assumptions and a set of equations that are maximized and then tested with econometric techniques. The p-values and sizes of coefficients serve to tell the story. The values are the story. Economic models, through the use of math, serve as a science, yet we are limited by our model metaphor stories. The model narrative is limited by the valuables employed and the tests conceived. 

The value with the model is that narrative can be told in shorthand and in a language that can be understood around the globe. This is a tremendous benefit and allows for everyone to potential understand the meaning of the story in the same way. There is no confusion once we stay within the bounds of there model, yet are imagination is limited by the constraints of the model and we may allow the model to be the end and not serve as a tool for explaining the phenomena we are trying to describe.

"It is wrong to think that the task of physics is to find out how nature is. Physics concerns what we can say about nature." - Ruth Moore Niels Bohr

Hayek's "fatal conceit" and trading

Hayek's "fatal conceit" focused on the impossibility for a socialist planner to be effective at controlling an economy. Man is not "able to shape the world around according to his wishes." The world and an economy are too complex.

For Hayek, “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design. To the naive mind that can conceive of order only as the product of deliberate arrangement, it may seem absurd that in complex conditions order, and adaptation to the unknown, can be achieved more effectively by decentralizing decisions.”

There is knowledge "which is not given to anyone in its totality" which cannot be controlled and managed. Regardless of the size of the model and the number of inputs, a planer cannot replicate the millions of interactions between economic agents in a diverse economy. 

Traders and investors will never know all the factors that may drive return during a period in time. Perhaps there will be periods when a single feature dominates returns and can be exploited, but these periods or features may not last indefinitely.

The same conceit should be avoided when trying to understand markets. Think of this as another way of saying that markets are so complex that any system or use of information cannot consistently generate profits. Markets are so difficult to understand or explain that they are beyond our control to make profits. 

Is it possible to generate profits from trading? Yes. Can those profits be sustained in the face of significant change in market structure and investor behavior? No, not without continual review and adjustment, or the accepting that any strategy can go through periods of drawdown before there is a period profitability. 

The credit and asset price cycle - The potential for bubbles

 

From Between Debt and the Devil: Money, Credit and Fixing Global Finance by Adrian Turner 

This credit and asset price cycle map provides an effective description of the feedback loop which creates a cycle. Start at any point in the cycle and you can walk through how credit gets extended and leads to higher prices. you will get the opposite if there is a fall in prices. Of course, one of the key components of the credit cycle is the link between rising prices and higher expectations for future asset prices. Once you have momentum as a driver of expectations you are ready to have a positive feedback loop and potential for a bubble. You need a negative catalyst to shock asset prices and force expectations lower.

Momentum, which leads to higher prices, allows for more lending against the higher collateral values. The lending will lead to more borrowing which of course forces prices even higher. This is why change point detection is so critical. An investor needs to develop tools to measure or assess when the reversal will begin. The reversal of the credit cycle is not likely to be immediate once there is a fall in prices, but investors need to realize that once credit is pulled from asset markets the price declines will increase.

Trends in all assets can be closely aligned with the credit cycle. Unfortunately, it is often hard to match credit extension with specific markets, so it is hard to see the flow-through in the cycle.

Policy magic - The need to pullback the curtain on policy action

 

There is the magic of sleight of hand, but there is also the magic of forming a new reality to say that the impossible is possible, that the world is without constraints, and the we have clairvoyance. The use of magic was an attempt to show someone had power over the normal to impress and can control. The scientific revolution and Enlightenment stomped out the old magic and replaced the world with rules and order in the natural world. There are limitations of what can achieved. There are bounds on what is possible.   

The foundation of economics is about setting boundaries on what is possible in markets. There are budget constraints. There is sensitivity to price. There are constraints on growth. Most importantly, there are constraints on what is knowable, what can be forecast, and what can be linked across markets.

Now we come to the world of government policy. In this policy world, magic is still possible or at least believed by the magician. There are no constraints. There rules of supply and demand do not always hold. What is wished for can become a reality. There are no consequences for budget deficits. There are consequences from increasing the money supply. Forecasts are achievable if we wish hard enough. We have the ability to see into the future and the effect of our policies will always prove to be effective.  We use language and models to offer confusion on what is really going on. 

Unfortunately, the magician too often believes their magic, but they will be found to be false. Eventually the trick of magic is revealed, and the laws of economics and science will be shown to prevail. Science or in this case the laws of economics were always right. It was just masked through confusion and distraction. Of course, this magical world can also apply to business, but there are more constraints that will reduce the time before the sleight of hand is revealed. Do not believe in magic.

Run away from experts who have all the answers

 

"An expert is someone who doesn't want to learn anything new, because then he would not be an expert."  - Harry Truman 

Truman is right. Show me an expert and I will show you someone who does not want to be wrong and cannot utter the words, "I don't know".  The true expert in inquisitive and will admit what he does not know and spends time searching for the deeper answers. 

Form a simple test. Ask an expert what he does not know about his field of expertise. If he does not have a long list of what he does not know or what he needs to learn more about, then you should walk away. For everything he does know, the expert should also admit to what he still must work on. 

Inflation debasement more than economic - political

"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency." - Keynes 1919 

We must think about inflation beyond the numbers and the impact on Fed policy and asset prices. There is a political component.

You can frame this debasement comment in two directions, a decline in the value of the currency or a decline in the value of domestic purchasing power. Inflation debases your purchasing power - for the same bundle of cash will get less goods. The debasement of the currency is a relative price issue. The dollar can still gain in value versus another currency, a relative gain. Currently, we are not seeing a decline in the value of the dollar but a significant decline in domestic purchasing power. 

Society is destroyed through the growing gap between low- and high-income households. The wealthy have a greater ability to protect against inflation while lower income households are not able to grow wealth and are likely to have more constraints on wage increases. Their marginal propensity to consume is higher. There is not slack in their budgets for higher real prices. If there is no chance for economic growth, thinking is focused in how to get more from others, a redistribution. Politics allow for redistribution especially with the economic majority attempting to take from the minority, those who have wealth. We must accept that politics will be driven by inflation shocks.

The American Question: "If you're so smart, why ain't you rich?"

 

You heard it before, "If you are so smart, why ain't you rich?" I never took those comments too seriously until a read some of the older work of D. McCloskey, If You're So Smart: The Narrative of Economic Expertise. McCloskey calls this the American question, the simple logic of the streets. The basis for how an American life is made - if you have your wits about you, you can get rich. If you are not rich, then you don't have what it takes. You are just talk. This is the taint given to those who are thinkers from the doers. You may have some great ideas, but do they work in the marketplace? The question of acquiring wealth is the quintessential American retort to anyone who is posturing with their intellectual ideas. 

Economists are smart, but not that smart based on the American question. Some analysts are very smart but that does not mean they can make money. They are good at explaining events, telling narratives, and forming stories, but that is not the same as predictions that are correct, and it is not the same as putting risk into the market. 

The markets are fairly efficient, so it is not easy to make money. There are no dollar bills laying on the street. Just because you can make a model it does not mean that it will be able to generate good forecasts. Just because you can tell a good story does not mean that you can make money. And, if you sell your ideas but don't trade them, it is a reflection on their quality.

The American question is brutal, but it focuses on what is relevant. It is what investors want and it is what traders and asset managers must deliver. If you are good, you will generate PnL and not be just a talker.

Charlie Ellis, the loser's game, and hedge fund management

 

Charlie Ellis, the great money management observer, often talked about the investment business as a loser's game. It is not what you do right, it is what you do wrong that matters. The core goal is to avoid mistakes that will separate you from the crowd of managers. The better professionals don't make forced mistakes. 

Ellis uses tennis as the metaphor of a loser's game. The amateurs make mistakes, and the better player just gets the ball over the net. Just get it over and the other player will knock the ball into the net or out of bounds. At the profession level there are no easily forced errors. You must show skill and use better strategy to win the game at the higher level. The easy mistakes are avoided.

The lesson to be learned simple. First do the simple things that will avoid simple investment errors. Manage risk. Do not trade outsized positions. Control the costs of execution. Find cheap hedges. Look for cheap alternatives to gain the desired exposure. If you want beta exposure, buy it cheaply. 

If you get the simple concepts of money management right, you will not make stupid mistakes which will cost you money. With the fundamentals covered and avoiding the loser's game, you can play at a higher level. Albeit simple, these foundational decisions make all the difference as you compound returns over time.

Nature does not make a jump and trend-following

 

Natura non facit saltum - "Nature does not make a jump" was inscribed on the first page of Alfred Marshall's Principles of Economics. He was referring to the core idea that economics is focused on marginal analysis. Economics studies the continuity of changes, the slow adjustment and response to changing prices and tastes. We don't see jumps from one state of the world to the next. We don't see immediate change as consumers and producers move up and down the supply and demand curves. We can use calculus and look at marginal utility and marginal cost to determine how agents reaction to change.

Market behavior generally does to not make jumps. Jumps do occur, but the norm is a world of transitions from one equilibrium point to another with a smooth behavioral response to prices. The speed of adjustment can be fast and at other times slow but there is a movement between prices which can be exploited because there is not. discrete shift between states of behavior.

For trend-followers, the investment strategy is all about trying to find the shift in behavior between one state of the economy and the next. It is not trying to find the cause of shifts in behavior and price. It about finding a method to extract a signal shift. The length of the look-back is the most likely time necessary to find these shifts. Trend is all about exploiting the shifts and not about finding the infrequent jumps. 

Inflation harm - the relativist and absolutist

 

Inflation is coming down. The Fed tightening is working. The consumers are saved. We are returning to normal. You have heard the arguments but that is based view that does not account for the true ravages of inflation. 

Yes, the rate of inflation is coming down but that does not mean that the basket of goods bought at the grocery store will fall. The cost of goods is not getting cheaper. It just means the rise in prices have slowed. If you have not seen your wages go up with the rate of inflation, your purchasing power has fallen. Your savings will not be able to buy the same basket of goods that you were able to purchase a year ago. 

How can we say that the world is better just because the rate has slowed. Wealth especially for those who have less to begin with has been destroyed. Your house may have increased in value but that is not a liquid asset which can be used to purchase goods today. 

The inflation relativist who may be look at the rate inflation may be happy, but the consumer purchaser who is an absolutist may not feel so good. If the price increases of used cars have fallen, that is great, but if the price of those cars have increased over the last few years, there is no bargain for consumers. Used cars have increased 50% over the last three years and new cars have increased by almost 30% while income has only increased 13%. Tell me why this would feel good for consumers. Assume use car prices fell 20%; the consumer will still be behind. 

Hard to say we have whipped inflation if real purchasing power has still declined. 

Ioannidis on research prejudices - You will find the problem in finance

Stanford epidemiologist John Ioannidis contended that scientists “may be prejudiced purely because of their belief in a scientific theory or commitment to their own findings...Or prejudice may prevail in a hot scientific field, further undermining the predictive value of its research findings. Highly prejudiced stakeholders may even create a barrier that aborts efforts at obtaining and disseminating opposing results.”

 “Why Most Published Research Findings Are False.”

While written ion 2005, the study by Ioannidis on why most published research finding are false is a tour de force on what to consider when conducting or reviewing research. We are driven to false conclusions based on our dependence on p-value and not on good clear thinking about what may be possible from research. "Bad" results may tell us something about what is really gapping in data. Too often research is driven by the prejudices of the scientist, the editors of journals and the general science community. If we see this problem with professional scientists, we should also expect it with finance professional. 

Of course, finance should have a higher standard. For research to be effective in finance it must make money. False research will drive you into bankruptcy, yet that does not mean that this not a lot of pseudo-science based on stylized facts. Charts are presented. Numbers are given in figures and tables often without robust testing. 

The true quant investor is skeptical of all tests, of all models, and all data. Use the data, form the models, run the tests but beware that mistakes will be made based on your biases, and it will cost you money.