Wednesday, May 29, 2024

Fed confusion because reality is confusing



Minneapolis Fed President Neel Kashkari says it's all part of the Fed's policy-as-performance art initiative: "Yes, it is confusing, but the economy is confusing right now, and so the confusing communication reflects the confusing reality that we're all trying to sort through," 

from Barchart brief 

President Neel Kashkari does not rule-out a rate increase and suggest that we need more positive news on inflation before a rate cut. 

Nevertheless, the Kashkari seems confused or that is the forward guidance that is being provided to investors. Why is this so difficult? If there is no clear direction in the data, then there is no reason to change policy. This is easy to communicate. 

Tuesday, May 28, 2024

So. much for the inverted yield curve indicator

 



The inverted yield curve has been the go-to indicator for recession in the post-WWII period. It is market based and easy to follow even with disagreement on which inversion to follow. The lag relationship has been variable, but the result has been the same. Inverted the curve and the recession is coming. The story was easy. An inverted curve means the central bank is tightening policy. Allow some time for the tightening to hit the economy and we are good to go.

So, what is the issue this time? For one, current Fed policy is not tight as measured by any number of indicators. It may not be loose, but there is not enough of a bit from nominal or real rates to matter. This could be associated with the QE of the past. There is still a lot of money out there even with QT. The markets are less sensitive to rate moves. For example, many homeowners have fixed rate mortgages at low rates. They are not impacted by the higher rates.

We just wait? The recession is coming? The yield inversion is not a good indicator if there is a poor link between the signal and the response. We will just have to look for a new indicator.

Monday, May 27, 2024

Market direction - time series or cross-sectional


Watching the market is usually an up or down visual. Call this watching the systematic risk. Watching side to side is not tennis but focusing on the cross-sectional risk and opportunities.  Investors should be doing both.

Rotation in corporate behavior - from pricing power to expense management


The chart above that mentions the term pricing power and expense management during earnings calls for the S&P 500 companies shows a significant change in corporate behavior. During the surge in inflation, consumers were not able to distinguish a general price increase versus a local price increase. The inflation noise allowed firms to increase prices as more money was chasing fewer goods. See the surge in pricing power in 2022. Now, we are returning to a more normal environment where expense management is more dominant. In fact, firms are now more expense focused than at any time over the last decade.  This usually occurs when growth is slowing.

Why don't more investors use the equal-weighted index

 


I am surprised that more investors don't use the equal-weighted index. We know that a cap-weighted index is a closet momentum index. We know that a cap weighted will place excessive weight on the top performing names, yet there is a still this core bias. Investors may be stuck in their old ways, yet if we look at the equal-weighted performance it shows good performance versus many of the alternatives. There are rebalancing costs, yet it does diversify risks. Clearly, we know that an equal weighted avoids many of the issues with portfolio optimization, so this simple portfolio may be an effective way to max diversification and avoid any concentration bias.

Saturday, May 25, 2024

Hedge funds and portfolio construction - better in a high inflation environment


In a higher inflation environment, hedge funds will closely match the returns on the market portfolio. Below average inflation is the problem for hedge funds. Additionally, hedge funds seem to be a better diversifier now that the stock/bond correlation has moved higher. You are getting less from the 60/40 portfolio mix and now you are getting more from holding hedge funds.  See the research paper from UBS, "Hedge fund performance in the context of the current market & macroeconomic environment".




 

Hedge funds versus bonds - some key relationships


Exposure to hedge funds conditional on the interest rate environment can make a difference to your portfolio returns. See the UBS paper, "Hedge fund performance in the context of the current market & macroeconomic environment".

Yields are not a drag but can represent a tailwind for hedge fund investing. The upward slope is slight but coming out of the zero-rate environment may increase return opportunities. There is the view that high interest rates will mean that investors should switch to the safe asset, yet the evidence suggests that absolute and relative returns are higher when overall yields are higher. This is not the time to switch to cash.


 

Hedge funds versus equities - some general conclusions




A recent research report from UBS is touting hedge funds, and it does a good job of providing some useful insights that make intuitive sense. See "Hedge fund performance in the context of the current market & macroeconomic environment".

First, hedge funds will do better when equity valuations are stretched. Long equities will underperform when valuations are high, but hedges funds by being able to go both long and short can exploit extreme valuations. There will also be greater alpha contribution during periods of high valuation.

Second, hedge funds will do well when equities are range bound. Again, this makes good intuitive sense. When the overall market is moving higher, the name, hedge funds, gives you a clear reason why you will underperform in a directional market. When equities are in the left tail, hedge funds may also show negative returns, but the decline will be less.

Finally, if we are late in the equity cycle, hedge funds will do better on both an absolute and relative basis. Of course, all hedge funds are not like but for specific market situations, the added gain from alternative hedge fund investments can be large.









Market timing and risk management - can you switch between these?


 Ben Carlson does a good job of making the distinction between those who focus on market timing versus those who focus on risk management. I like the simple distinction; however, the world may not be that simple. You can be a market timer who employs risk management. You manage the risk because even if you feel you have an edge with market timing, yet that edge is uncertain. You timing ability is not a point estimate but is usually a probability. You play the odds not just call a direction.

Fundamental versus Quantitative investor - Different views on how to generate returns


Investment managers can be classified as two types: fundamental or quantitative base don how they pick assets, the size of their positions, the narrative developed surrounding their choices, and the type of risks taken. An investor who picks one over the other has a clear view with how thy think about the operation of markets.

Friday, May 24, 2024

No positive feelings in the farm community

 



I don't use this as a trading signal, but the AG economy barometer index from Purdue University and CME provides some context on what farmers are thinking. It is not good. Current conditions are falling, and future expectations are rangebound. The overall barometer is not at lows but heading in that direction. The index has a month lag and does not reflect the current rebound in price, so it will be interesting to see the response to price; nevertheless, farm income will still be constrained.






Wednesday, May 22, 2024

why do we ignore kurtosis and skew?

 


Why do we continue to ignore skew and kurtosis? See "The Impact of Skewness and Fat Tails on the Asset Allocation Decision". We know that most assets have fat tails and negative skew yet we continue to ignore these two distribution features with our mean variance optimization. Perhaps the impact is not that large to some, yet the effect is strong enough to create asset allocation differences. More importantly, not accounting for kurtosis will lead to under-representing the risk for any asset, and as shown in the graph the risk much more undervalued with credit instruments. 

Follow the skew and kurtosis.

Sovereign risk tracker - limited financial risk


The CFR sovereign risk tracker follows a number of key features associated with sovereign risk. Risk is concentrated in those stayed that have failed politics and have been unable to solve their fiscal problems. There does not seem to be a significant amount of risk associated with higher real rates with the dollar. Slow growth tied with higher rates was supposed to be a mix harming many EM countries. This narrative has no played out as expected.

Tuesday, May 21, 2024

SF Fed daily news sentiment turning down

 






The San Francisco Fed has developed a daily news sentiment index from 24 large daily newspapers from around the US. It is an exponentially-weighted index of using the lexicon of words associated with positive and negative economic news. It is a noisy series, but the smoothed trend tells us something about soft economics which may impact consumer spending decisions. It has come off the peak from the highs post-pandemic and is now hovering near zero. Zero may be a neutral signal but the direction is falling and worth watching this summer. 

Friday, May 17, 2024

Regime-based tactical asset allocation - it can add value




A simple paper that focuses on tactical asset allocation based the business cycle suggest that using macro top-down information will be helpful for forming a dynamic portfolio. See "Regime-Based Strategic Asset Allocation"

The authors break up the macro environment into four regimes: overheating, goldilocks, stagflation, and downturn. Given these environments, different portfolios are formed using just five assets: equities, government bonds, credit, commodities, and REITs. Given these 5 assets, the authors form risk-based and equal-weighted portfolios focused on regime probabilities and compare with an optimized, equal-weighted, and risk budget portfolios. These portfolio constructs suggest that regime-based portfolios can support better risk-adjusted returns.










 

Perhaps macro announcements are not that important

 


Following earlier work on macro announcements effects, there is a paper that states that macroeconomics are associated with approximately half of the equity premium. Now this seems like a large number, but earlier works has argued that 100% of the equity risk premium is associated with selected macroeconomic days and over half the days in the sample may be announcement days. This may be due to sample selection. See "More than 100% of the equity premium: How much is really earned on macroeconomic announcement days?"

When all announcements are included, the Sharpe ratio between announcement and non-announcement days are approximately equal. They conclude that these days are not so special. 

This is a good piece of research, but we do know that some days are more important than others, so a selected sample of special announcement days seems reasonable. If we condition on the size of the announcement, the excess return may be even greater. Nevertheless, this research should temper any investor who thinks he can just buy announcement dates as the road to riches. 



Why focus on macro announcements? That is where all of the return action is




Macro announcements matter and impact returns. If we look at announcement days versus non-announcement days, there is a significant difference in excess returns. This is applicable at all levels of beta.  This work is nicely presented in the paper, "The Macroeconomic Announcement Premium", and shows that this excess return story is applicable for stocks and bonds.

Trade the macro announcements for profit. 




 

Thursday, May 16, 2024

What are you playing - the pricing or the valuation game





Aswath Damodaran, the renowned professor of finance at the Stern School at NYU has done a good job of comparing two approaches to looking at asset returns, the pricing game, and the valuation game.

The pricing game is based on the belief that price is the only number that can be acted upon. You don't know the true value of an asset so follow the trend. If prices seem to be moving to an extreme relative to past behavior use that as basis for spread trading. This is the basis for technical trading. 

The value game is based on the belief that an asset can be given a fair value. Find the fair value and use that as the basis to trade. When value is low relative to current prices, buy and when value is high versus prices, sell.

I like this comparison because it is an easy guide to describe the type of traders in the market. Of course, there are hybrids that have the features of both. Similarly, this framework can be used to describe quants and discretionary traders. 



 

Some things don't change with respect to central banking

 


This cartoon is an old trope against central banking, yet it will not go away. The Fed does not have a dual mandate of growth and stable prices, but a third mandate to maintain financial stability which results in policies that protect large banks and other financial institutions. For the Main Street crowd, financial stability through some form of bailout to ensure that bankers don't face the consequences of their actions seems to point to our old cartoon. Cn this perception be avoided? The answer is not clear, but the Fed has generally erred in the direction of supporting banks which have gotten larger than pre-GFC levels. Of course, there is more regulation but that only helps the financial institutions that are too big to fail. The fixed cost is too high for smaller institutions.

Old tropes do not go away because old behavior does not change.

The "New Economic Order" - No more multilateralism

 


The liberal order is dead according to The Economist. The new economic order is completely different with sanctions, tariffs, and restrictions of trade and capital flows. No more world organization supporting free trade and the rule of law. It is more every nation for itself in this chaotic order. The multilateral thinking is dead as countries form bilateral links. 

Sanction have become the norm not the exception, yet these sanctions are often ineffective and create a chaotic system based on changing alliances and not economic efficiency. 

Tariffs have increased under the Biden administration after their use under Trump. Local politics drive decisions, not consumer welfare.

Capital controls and restrictions which limits potential buyers is also the norm, and regulations are placing barriers upon activity across borders. Costs go up and economic efficiency goes down.

The power of international organization has declined and the use of international courts to solve disputes have fallen. The WTO does not solve trade problem in a timely manner or at all.

Simply put, this world order driven by the United States and international organizations like the IMF and World Bank is a thing of the past. Now, some of this order needed reforming but a new world of bilateralism and regional coalitions will not support greater global trade nor raise global income. Delinking will reduce market price correlations.


Wednesday, May 15, 2024

False consensus effect - we are comforted by being with similar people

 


The false consensus effect is present in finance. You pick your friends, and you pick the people you talk to based on their willingness or their similarity to you. Who wants to be around people that don't agree with you. You have experienced it, "There is no one I know who thinks like that...". Hence, we have the problem of the false consensus effect. We often overestimate how much others share our beliefs. We project our view on others or at the least assume that our circle of beliefs is more widely held than reality. 

Why wouldn't this occur in finance. We hire for the team. We go to the same clubs and events. We are often educated at the same institutions. We remember the negative feelings projected on us when we don't follow our crowd. We will then make decisions based on the belief that there will be comfort being in the crowd with others. We get self-affirmation and validation by being with others that have similar opinions. 

The foundation of non-consensus investing is fighting the false consensus effect. However, it may be easier to just following a model. The validation for model only comes with being correct.

Tuesday, May 14, 2024

Running for the exits and liqudity spirals

 

What should we fear in the coming months? Liquidity spirals are a thing and if we have markets that move to extremes, there is a greater likelihood of seeing one. A spiral is different from a bubble although the two can be related. If there are some initial loses, especially if positions are highly levered, there will be funding problems. The funding problems can be caused by higher margins or the requirement to add to margin for existing positions. See "When Everyone Runs for the Exists".

If there is some funding issue even as simple of movement of margin, positions will be reduced which will add to any existing losses. There is a positive feedback loop. Feedback loops drive trends, and these trends will create further liquidity issues. This will only get worse if there are crowded trades. The simple issue is that the microstructure of markets can create endogenous risks which generate liquidity spirals. 

Monday, May 13, 2024

Co-momentum and arbitrage; another tool for improving momentum strategies


The returns for the momentum strategy can be measured through the activity of arbitrageurs who create co-movement of returns. When the co-momentum is relatively low, the momentum strategy is not crowded. When there is less crowdedness, the returns to momentum should be positive and not likely to revert. When co-movement is high, there is likely to be a higher probability of returns to mean revert and reduce overall returns. If there is no co-momentum, there is more stabilizing behavior from arbitrageurs. If there is too much arbitrage activity, that is higher co-momentum, there will be overshooting and destabilizing behavior. The behavior of momentum will be time varying which will mean that there is under and overreaction from momentum.  See "Co-momentum: Inferring Arbitrage Activity from Return Correlations"

What is notable is that this behavior with respect to the momentum strategy is not seen with the co-value behavior or the abnormal return correlation among value stocks. When there is not more co-value, there will be higher returns because arbitrageurs re pushing returns to fair value and increasing the returns from holding value stocks. Momentum does not have fundamental anchors, so more momentum trading will lead to destabilizing behavior.

So how is co-momentum measured?  The asset universe is sorted by the past returns as traditionally done with any momentum strategy. The partial correlations for the past year are then found for each momentum decile from the ranking period. The average partial correlation or co-momentum can be found for the loser and winner deciles for some rolling past period.  When the co-momentum is high there is likely to be lower momentum strategy returns.




Momentum crashes and market highs

 


The momentum risk factor will see crashes. This is a well-known fact. After a significant market decline, there is a high risk that those names that are held short will outperform, generate higher gains than the long positions. That is, there will be negative returns from holding shorts as they move quickly higher on a market rebound. It is also found that the crash risk is predictable and can be reduced through dynamic risk management. 

Another interesting feature with momentum is that those stocks that are far away from their 52-week highs are more likely to suffer from crash risk. See "Momentum Crashes and the 52-week High".  The distance away from 52-week highs can be a key tool for reducing momentum risk given this inverse relationship. This condition seems to be associated with market sentiment.  There are simple ways to improve the momentum factors return profile.