Uncertainty is always a macroeconomic problem

 

" economic forecast are better than nothing, but their origin lies in extrapolation from a partially known past through an unknown present to an unknown future.."

- Denis Healey UK Chancellor of the Exchequer  1974-9 

I recently gave a talk on uncertainty or more specifically - VUCA - Volatility, Uncertainty, Complexity, and Ambiguity, and the above quote would have been a great way to describe the problem. We face more than just volatility. We really don't know the past of the where the economic has been. We don't always know where we are currently at in the business cycle, and our job is the describe an unknown future. 

The first challenge of macro investing is knowing where you are at before you make a judgment about where you are going. We have internal uncertainty based on our ignorance of the present which then must be blended with the external uncertainty of the future that may not be known because the underlying driver and relationships may change.

The direction of causality may change through time - the challenge for investors

This is still one of the key issues within macro-finance. What is the line of causality between the movement of two assets and what are the unknown drivers that may impact both assets? Tests of causality can be conducted, but that provides just a glimpse of what could be the driver of returns. 

The problem becomes even more difficult when looking at policy responses. Does inflation drive central bank action or does central bank action drive inflation? We know there is a relationship between the two; however, the direction of causality may change through time. Policy drives inflation until there is a point when the target variable drives policy. To be successful, an investor needs to anticipate the change in causality.

What is probability? It can be defined many ways

Probability pertains to a relative frequency of occurrence.

Probability is a logical relationship between evidence and belief.

Probability measures a subjective degree of belief.

Probability is a measure of the propensity to occur.

- From Willful Ignorance 

When we talk about probability, there is no simple definition. The above are four simple descriptions which provide insights on how to think about probability. It is work just sitting back and focusing on each one of the these. 

The Missing Billionaires - Worth the read regardless of your finance knowledge

 

Missing Billionaires: A Guide to Better Financial Decisions - This is a good book. It has been on several best books for the year in 2023. It is also an oddity. It is a book of investment advice for everyone, but it does not pull any punches with being simple and just wordy. It is grounded in modern finance with all the math that is necessary, yet it is still accessible and easy to read. Never has a set of authors done a better job of explaining the usefulness of expected utility and the use of core finance embodied by the work of Robert Merton. 

There are two core theses with this book. One, make sure you get your bet sizes right. Two, understand your expected utility through knowing your level of risk aversion. 

For the first point, understand the Merton share which like the Kelly Criterion states that the optimal bet size is related to your level of risk aversion time the expected return relative to volatility. There dictum is very clear. Do not take too much risk in any part of your portfolio. Temper your bets to ensure that you can maximize wealth through staying in the game.

The second point is critical for setting bet sizes, know and understand your risk aversion. You are not indifferent to risk and this aversion can be measured. When risk aversion is measured, it can help set bet sizes and portfolio risk. 

The amazing part of this book is that seasoned investment professionals will get a lot from this work just the same as a novice. Even someone who has studied formal finance will find their framework thought provoking and useful.

You need Mindware to make better decisions

 

Richard Nisbett, a leading psychologist, wrote a great book on the current research on how to think smarter in his book MIndware: Tools for Smart Thinking. This book provides more than an easy to read review of modern psychology research and thinking but an approach to viewing decision problems many will face. For an investor this is a great book for improving your thinking skills. While many of the chapters describe behavioral biases, the book provides a fresh take on how to implement this work to sharpen your decision skills.  The take-aways from each chapter are helpful.

The schema and framing of problems matters.  We often use the representative heuristic to find similarity, yet that framing creates the wrong assumptions. All perceptions and beliefs are just inferences which can be biases by incidences and irrelevant perceptions that affect our judgment.  

Context matters and situational factors influence or behavior and as the environment changes so will we.  Hence, it is critical to be formal in our thinking and generate a cost/benefit analysis to move beyond on unconscious thinking. Sunk costs are sunk and opportunity costs are real. 

We are lazy, so we want to maintain the status quo and are susceptible to the endowment effect. Realize that observations are only samples, so you need to think about getting more data for any problem to reduce sample error. Of course, correlation is not causality and must always be placed in the front of the mind. When we think about correlation relationships, we must also consider reliability and validity. What we see and count is not immediately the true reality. We are susceptible to illusory correlations. 

Even reasoning can be flawed; syllogisms from Western logic is a different perception of thinking from Eastern dialecticism. Others see the world differently which impacts decision-making. 

Follow Nisbett's thiking and be a better decision-makers

Willful Ignorance - Finding probabilities in an uncertain world

 

Willful Ignorance: The Mismeasurement of Uncertainty by Herbert Weisberg is a great book on the history of probability and the measure of uncertainty. It is not so much a history but rather a discussion of how great thinkers have tried to develop probability to address problems of uncertainty. 

Many of the great early thinkers about probability focused on gambling with set rules of the game. In real life, there are qualitative issues with uncertainty for which we must employ ignorance to make problems tractable. There is the need to think beyond the simple probability problem set-up and create a broader vision on problem context which addresses issues of uncertainty. Is this necessary? No, but thinking about uncertainty will lead to better problem descriptions and solutions.

The big inflation mistake - the problem of a generation

The screen shot is from the always insightful substacks of Rudy Havenstein who always seem to have unique pulse on key investment and economic issues. I don't intend to get political but highlight issues that impact investing. The inflation shift was a regime change that has been impactful on all models and macro thinking. 

The quotes tell the story that policymakers completely missed the potential inflation problem both from a short-term and long-term perspective.  From a short-term perspective, they got it wrong with the transitory story. From a long-term perspective, they did not consider inflation a problem that impacts labor and consumer markets. 

Even with lower inflation, the price level is still high for many consumers. Prices are not going back to normal. "Beating" inflation from a policy perspective just slows it down. The purchasing power is gone, and the only hope is that wages will increase to make up for the purchasing power shortfall. At best, the hope is to stay even with the future and not make up for past shortfalls in purchasing power. 

Equity premium events are associated with macro announcements

 

The equity premium is time-varying. More importantly, the equity premium changes are often associated with events days and these event days are associated with macro event days. In the paper "Equity Premium Events", the authors look at short dated option expirations to measure the equity premium and find that it is often associated macro releases like the FOMC, CPI and non-farm payroll.

The paper is based on measuring implied equity premium, the premium in implied by option prices across the option term structure.  The implied equity premium, SVIX, will vary significantly across time and across the term premium. The equity premium is interestingly lower than the actual realized volatility; however, these premia have been elevated for FMOC and CPI releases over the last two years. With the growing importance of FOMC and CPI announcements, there has been a corresponding increase in risk. 

Generally, changes in risk are associated with changes in risk and uncertainty around macroeconomic announcement dates.

Always come back to stock-bond correlation as the key diversification issue

 

I always come back to this key chart, the correlation between stock and bonds. We have ended the great period of diversification, the 60/40 era. This correlation switch is the ultimate diversification regime shift. From this relationship comes all other diversification decisions. You don't have as great a need for alternatives when the stock bond correlation is negative. Investor search for diversification should be at a heightened level. This correlation is not going back to negative anytime soon.

Thinking about asset correlation differently

 

Michael Stamos, head of global R&D multi-assets at Allianz Global Investors has provided a different take on showing the correlation across asset through a two-dimensional view.  Investors want diversifying assets that are in the green zone and away from the white area. The true diversifying assets are cash and commodities which protect from both stock and bond risk.  This was not an issue when bond and stocks were negative correlated, but times have changed. Some may view the green region is over diversification. That level of diversification is a choice that investors must make.  

Smart people make big money mistakes - It is behavioral

 

This book, Why smart people make big money mistakes and how to correct them, is now 25 years old, yet it still has great advice and lays out the foundation for our behavioral biases. This list of biases is long and have not been eliminated over since this book was published:

• mental accounting mistakes 
• loss aversion and the sunk cost fallacy 
• the endowment effect
• money illusion
• anchoring and confirmation biases 
• overconfidence 
• following the herd 

Unfortunately, we still don't have a unified theory for biases, but we do have a reasonable solution. Follow rules and have a bias checklist to stop from making these mistakes. While this sounds simple, it has not been easy implement for many investors. 

Money supply and GDP; money is falling at a fast rate

A look at GDP and M2 shows money has been falling from its peak levels. More importantly, we see the M2/GDP ratio falling below trend. If you have any monetarist leaning you will be concerned by this decline. Of course, the lag between money and GDP are not very stable; however, the fall relative trend suggests that money will be a constraint on growth. We just don't know when or how this will manifest. 

The impact of macroeconomic surprises through time is significant

There has been significant focus on macroeconomic surprises, but much of this work has been over very short intervals. Investors are often not able to reach to these short-term moves and are more interested in the reaction of surprises over longer time periods. 

The paper "Caught by Surprise: how markets respond to macroeconomic news" by Baltussen and Seobhag looks at the time series of surprises and finds that economic surprises related to growth with a strong positive relationship with risky assets and a negative relationship with safer assets. If we have positive growth surprises, risky assets will increase in value. Surprises persist and these surprises tell us something about the global business cycle. This economic growth impact also applies to bond over a longer horizon. If you believe in the idea that macro trends lead to price trends, then this is a good road map on how to exploit.  Clearly, knowing something about economic growth will tell us something about future expected cash flows. 

This impact will differ between good and bad news. Positive surprises will be more important when an economy and asset prices are coming out of period of bad performance. During contractions stock markets respond negatively to rising unemployment but will show a positive response during an expansion period.

This relationship is not found with inflation surprise data. 

Macro surprises still drive financial markets

 

Macroeconomic announcements move markets. The surprise from an announcement will move equity, bond, and FX markets, yet the response will not be same and the announcement that will have the greatest impact will differ. The author of the paper  "Economic Surprises: What really moves the markets?", Maria Vieira, looked at 5-minute intervals around the announcements and them measured the different reaction between the positive and negative shocks. She also measured the strength of surprises across a wide set of announcements. The focus of most investor attention is on just a few announcements like non-farm payroll, PMI, retail sales, and inflation. 

The Fed is data driven, but given the strong surprise effect, they are forced to be reactive and cannot focus on forecasts.

For investors, they should think of surprises as either trend reinforcing or trend reversing. Does the trend support the trend or is it a reason to adjust exposure down?

Think about your current subjective distribution for investment allocations

 

The folks at BNP Paribas provide a simple framework for looking at alternative risk premia trades based on the expected macro environment. There are three risk choices: The right tail risk of more inflation risk, the left tail event of deeper recession, and the main case of muddling through with the current environment. If the base case is muddling through, hold carry trades and add risk. The recession scenario requires defensive risk-off strategies, and a higher inflation environment requires rate production and a move to value.

Subjective probabilities concerning the macro environment will drive investment choices. The tough question is determining what those probabilities should be. We have moved from rates lower, slower growth, and lower inflation to a higher likelihood of muddling through over the last three months. 

Big Mistakes - Everyone makes them even great investors

 

You think the best investors are perfect? You are wrong. Everyone makes mistakes. The question is whether you can learn and survive. Michael Batnick wrote a short book called Big Mistakes: The Best Investors and Their Worst Investments. that selects some of big bloopers from well-known investors. It is a quick read and tells us even the great will make mistakes, yet they are able to survive because they learn. Mistakes often occur when they stray from their decision framework and move outside their zone of competency. Know your limitations and control your risk so as not to be knock out of game.

Problems and questions in hedge fund return generation

Questions that are worth considering. Driven by the presentation "Problems that keep me awake at night" by Giuseppe Paleologo at the Fordham Quantvision 2024.

Each of the these are key "big questions" that will impact any model or research. 

1. How do you better incorporate flow into modeling, "Your flow is my alpha"? Flow creates price pressure which should lead to dislocations that will mean revert. How do you measure this flow and how do you find flow that is meaningful? 

2. Still have a problem with crowding. Accept that it occurs but how can it be exploited? If you are first, you want crowding, but when does it become too much?

3. What is the best way to combine signals. Use separate models and then net signals? Combine signals into a single model as different factors in a regression? How do you control costs with multiple signals?

4. How do you more effectively deal with factor or strategy rankings? Most of long/short factors based on buying and selling portfolios based on rankings, yet the distance between ranks can be highly variable. How do you rank multiple factors? 

5. How do you form effective feedback loops from trading, or how do you learn from mistakes. This is critical with decision-making and is only more difficult when you have a "wicked" versus "kind" learning environment.

6. We know that returns are not normal, but how do you effectively deal with fat-tailed world beyond Winsorizing? Fat-tailed distributions are often caused by mixed distributions, so how do you deal with changing distributions? All the real action is in the tails. 

The fallacy of obviousness - it is obvious because we want it to be

 

“What people are looking for – rather than what people are merely looking at – determines what is obvious.” -Teppo Felin

“What the human being is best at doing is interpreting all new information so that their prior conclusions remain intact.” - Warren Buffett  

One of the more interesting ideas I have come across is "the fallacy of obviousness" from Teppo Felin

(@teppofelin) is a professor of strategy at the University of Oxford’s Saïd Business School. 

Many behavioral biases start with the problem of observation. We see what we want to see not what may be in front of us. we are not blind to the obvious because we only see what we want to see as obvious. There is no obvious. There is only finding what we want to find. Our mind works on focusing and excluding, not just observing. Our mind is a qualifier which wants to hold specific ideas and the fact that support our views. Hence, we only see what we want to see and miss the rest. A foundational problem is trying to see or look for more than what we want yet looking for more open us to more noise and perhaps even less clarity. This is not just a human problem. A computer or AI problem is that it looks for what it has been trained to look for.  Even unsupervised learning requires an algorithm to find connections. 

The challenge for investing to look beyond the obvious or change what is obvious so we avoid the problem of just looking for the facts that support our current thinking.

Daniel Kahneman - The man who made economics again a social science

Daniel Kahneman died recently, and he may be the singular most important economist (non-economist) in the last few decades. He won the Nobel Prize in Economics, but he really was a psychologist who happened to work on foundational economic problems associated with choice and decision-making. He was behavioralist. Hence, he focused on the psychology of how individuals made choices. At the primal level, economics is about choice theory not just in theory but in the laboratory of testable behavior.

From the normative of how agents should decide, Kahneman focused on the positive of how individuals really decide. His focus was teasing out the actual behavior of individuals with all their flaws and biases. Humans are only human which became a revelation for many economists who only wanted to deal with modeling in a rational manner. Of course, we need to focus on both how decisions are made in a perfect world and how they are made in the real world.

What made Kahneman a great researcher was his willingness to ask and test simple questions on behavior and then let the data speak for itself. He could be wrong, but he was always willing to engage with others and see if there was better theory. He will be missed as someone who changed minds. 

Long live capitalism - Our history

 

You will not often find as full-throated defense of capitalism in this short book by Thomas DiLorenzo, How Capitalism Saved America: The Untold History Of Our Country, From The Pilgrims To The Present. This story of capitalism starts with the Pilgrims and moves the current through telling stories about our economic history as a response to the narratives often used by those who can be called anticapitalist. This book is needed more today than almost any other period in our history as numerous groups argue for the reimagining of capitalism on the margin or more radically a wholesale upheaval of our system of free enterprise and entrepreneurship. 

At times, this books veers into political advocacy when the facts speak for themselves, yet there is enough good economic history to give the reader a new perspective on how capitalism has been critical in making the US an economic history. Of course, there is a need for regulation and the need for the state to support policies that help those in need and growth; however, as the author clearly states, it is the dynamics of capitalism that makes everyone better off.   

History in five crashes - Finance in the last century

 

A History of the United States in Five Crashes by Scott Nations is a fun quick read on key events in our financial history. Is this a history of the United States? No, but what makes this a good read is the set-up history for all these events. The crashes may not have been predictable, yet they should have been expected. They were not black swans, but neon swans with clear warning signs that something was wrong between economic policy, the business environments, and market behavior.  Bad policy coupled with a weak economy is a recipe for a financial disaster. At some point the markets come to their senses that prices must reflex a new reality.

An unfortunate part of the history is the lack of discussion after the events. The post-crash behavior had as much an impact on our financial history as the events leading up to the crashes.

For any reader, this big tells us that it is critical to have a longer-term macro view that accounts for changes in policy. This will not help with the prediction, but it can tell you that the downside risks are increasing and worth a portfolio revision. 

March rotation from growth to value

 

Most investors focus on the top-line return of the stock market. The SPX was positive at 3.2%, but the real action was the rotation from growth to value. Value stock returns increased by double versus the overall index and beat growth by more than 50%. Nevertheless, value still underperformed growth for the first quarter. Momentum has done very well this quarter with strong relative returns versus the index. This is with a backdrop of low volatility, correlation, and dispersion with stocks in the index. 

What is also interesting is the decline in Mag 7 performance versus classic value for the month. Perhaps this mega-cap hype has reached a peak. 

Long-short market neutral adds value

 

The paper "Key Design Choices in Long/Short Equity" by the folks at AQR provides a strong case for holding long/short equity strategies. Clearly, this strategy should do better than a long-only strategy because it will include the best ideas on the short side of the market. Good managers should know what to buy, what to avoid and what to sell. The strong Sharpe combined with low volatility can create a portfolio that is stronger than holding just long-only exposure.

The alpha decomposition at least equally distributed between long and short trades. In many cases, there are stronger returns from trading factor risks on the short side. The diversification benefits with good alpha generation can make this a good addition to any long-only portfolio.

Economic trend signals and price trends can work together

In the new paper, Economic Trend, the authors focus on the simple question, can economic trends lead to positive returns or trends across a markets? The answer is yes.  Using simple signals for growth, inflation, international trade, monetary policy and risk aversion, the paper provides expected asset class directions. Using these trends, the authors build portfolios that generate positive Sharpe ratios. These positive Sharpe ratios apply to each macro feature and across four major asset classes. When blended, the economic trend composite will have a Sharpe ratio above 1.

The economic trends generate positive returns during periods of both equity and fixed income drawdowns. Follow the macro trends and you will avoid downside risk.

The economic trend model does well against a price trend model, and the blend of price and economic trend will have a Sharpe as good or better than a strategy that just uses price information. A blend of price and macro trends will do better for both equity and fixed income markets. The economic trend will underperform in commodities which should not be surprising given the international nature of most commodity markets. For the case of commodities, the economic trend model will again underperform which should be expected since a currency is a relative price between two countries; consequently, only looking at dollar focused macro data may not capture the relative importance of currencies.

There is good reason to combine price and macro trends to create an improved trend-based model. Certainly, economic and price trends are not perfectly correlated so a combination will provide a smoother return pattern.  

Good chart to show equity dispersion - Magnificent 7 not all alike

 

It was not a good month for all stocks. More interesting, the Magnificent 7 do not all move together. In fact, Apple and Tesla showed negative returns and some of the other mega-caps were just within the broad middle for stock returns. Do not believe the hype when you hear about a group of stocks.

Value and momentum ARPs complement each other

 

The paper, "A Global Macroeconomic Risk Model for Value, Momentum, and Other Asset Classes" looks at why value and momentum is an good combination of alternative risk premiums as a portfolio from the perspective of sensitivity to macro factors.  Past work has shown that value and momentum complement each other given their low correlation, but there has not been a good rationale for this combination. The authors in this paper try to look at different macro factor loading to answer this question. 

For their macro factors, they use the Chen, Roll, and Ross (CRR) macroeconomic risk factors. The CRR factors are a well-defined set which includes the term premium, default premium, industrial production, expected inflation, and unexpected inflation.

The negative correlation between value and momentum is caused by the different sensitivities to macro factors. Value has a strong positive load to the term spread but negative factor loading on all the other macro features. In the case of momentum, there is a negative close to zero loading on the term premium, but there are strong positive loading on the other four macro factors, growth in industrial production, unexpected inflation, change in expected inflation and the default spread. Nevertheless, because the factor loadings are different, it is not the case that forming an equal weighted portfolio between value and momentum will lead to a portfolio that is market neutral to macro factor loadings.  Changing the weights will give an investor a tilt to the loadings desired. 

New Fed Financial Conditions Index points to more liquidity

 

The Fed has developed a new measure for financial conditions. This is not the first measure, and it is not clear this is a better measure. There are several financial condition indices from brokerage firms and Bloomberg. The objective is the same for all these indices. They try and provide some indication on whether financial conditions are loose or tight. If the FC index is showing tight conditions, there may be a reason for the Fed to lower rates. Alternatively, if FC conditions are loose, there may be a reason for the Fed to tighten. See: "A New Index to Measure U.S. Financial Conditions."

The new Fed financial conditions index has a different take on what is measured. It looks at what is defined as the financial conditions impulse response to growth. It looks at the change in seven input variables which the Fed funds rate, the 10-year yield, the 30-year mortgage rate, the BBB corporate bond yield, the DJ stock index, the Zillow house price index and the nominal dollar index which are weighted using an impulse response coefficient that measure the cumulative effect of unanticipated permanent changes in each of the inputs with real GDP over some forward period. which is then called the FCI-G or financial conditions impulse on Growth. The index looks at the contribution to GDP growth for 1 or 3-years using three-month changes. 

Right now, the Fed FC index is showing loose conditions after a 2022 which showed tight conditions. Note that these financial variables will be impact by stability and their contribution to wealth creation. If the Fed follows this index as a guide, it provides a focus on financial well being. 

Macro factor investing can exploit opportunities

 

"A Century of Macro Factor Investing - Diversified Multi-Asset Multi-Factor Strategies through the Cycles" explains how a portfolio of diversified factor strategies can be created to protect or exploit specific macro risk exposures through computing macro factor mimicking portfolios (MFMP). Using a wide a set of factors, the researchers create growth, inflation, defensive, and parity portfolios and then compare against different market environments. They find that these portfolios can effectively generate return during positive environments; however, there is the ongoing problem of predicting when these environments will occur. These MFMP portfolios will do better than portfolios just associated with macro factor exposures. 

The data show that defensive portfolios will do a good job across all environments and are well diversified.  The authors go on to show that creating portfolios that include forecasts on the macro environment and factor momentum will do better than static portfolios. Active management in a Black-Litterman framework can effectively add value to a portfolio of alternative risk premium.

Based on a century of data, ARP portfolios focused on macro exposures can add value over the long-term.