Buy high volatility for capital efficiency

 

Cliff Asness in his work "In Praise of High-Volatility Alternatives" argues that holding a higher volatility may be better for a portfolio. The normal view is that higher volatility will be a drag on compounded returns. Hence, many managers attempt to keep volatility low in their strategies. However, there can be better capital efficiency if you can lower the dollar exposure and take on the higher risk. This is subtle argument based on a number of assumptions, but it can make sense. If there is a volatility associated with a dollar investment, you can lower your dollar exposure through cutting the dollars committed to the strategy. 

This really work well with a strategy like managed futures. If you think the volatility is too high at a 5% exposure, then cut the exposure. As usual, you must look at the correlation and diversification benefit from a strategy. A low correlated alternative can have a higher volatility and provide strong benefit at a lower allocation. This is not an especially innovative paper, but it goes back to basics and provides some insights on portfolio structure. Volatility is not always bad.

The less-efficient markets hypothesis

 

In a provocative paper, Cliff Asness argues that equity markets may have grown less efficient than 40-50 years ago. The one measure of market inefficiency is the presence of bubbles. They should not occur, yet they do although the term is often overused. HIs arguments are based on the observations that stocks have become more disconnected from reality based on the value spread. The value spread between expensive and cheap stocks has increased and reach extreme not much different from the dot-come bubble. 

His argument for markets being less efficient is based on three hypotheses or was to measure relative efficiency. 

One, indexing has ruined the markets. This is possible because if everyone is just investing in the market portfolio, who will make the markets efficient. Asness argues that more work has to be done on this topic. 

Two, very low interest rates for a long time. Low interest rates distort valuation, yet financial history does not seem to match well with this story. The tech bubble was not associated with low rates; however, financing was cheap. Still, low or negative interest rates will distort investment decisions.

Three, the effect of technology is backwards. The impact of technology which causes crowds not to be independent but provide a mechanism for positive feedback loops makes for situations where markets are less efficient.

Although markets may be less efficient, there are still opportunities for profit from good rational investing. Markets may deviate from some idea of fair value for longer time periods, but that does not mean they will be misplayed forever. Volatile may be higher especially volatility that is associated with forecast errors. The horizons may be longer for good investing, or the type of strategies employed may be different. 

Over-precision and forecast errors - don't follow the professionals

 

In the paper, "Overprecision in the survey of professional forecasters", researchers look at one of the longest macro forecast surveys and find that these forecasters are overly precise. Thye have much more confidence than what would be expected by their accuracy. They may not have an optimistic bias, but they sure have a confidence bias. Follow their forecasts with skepticism especially when they say that their forecast is a no-brainer. 

With this overprecision, there is a good reason to do your own research or just follow the forecast that is embedded in prices. You don't need the professionals.

Belief overreaction and stock market behavior

 

Markets forms beliefs as embedded in the long-term earnings of stocks, yet the markets will often overreact to those beliefs which drives stocks higher only to see them fall or under-perform in the future. Investors love good news, and they believe that this good news will continue. The extrapolation of long-term earnings will lead to stock prices to being pushed higher only to fall when the market finds that their optimism is not rewarded. This seems to be a very reasonable story that can be applied to all markets as presented in the simple paper, "Belief Overreaction and Stock Market Puzzles". 

This paper solves the stock market puzzle that there is excessive return predictability for both time series and with cross-sectional equity prices. Errors in expectations from relaxing the assumption of rational expectations leads a solution the stock market puzzle without generating complex models.

What this tells us is that if investors make mistakes, we can get variations in valuation that can be exploited. These can be exploited by the trends in prices. If expectational mistakes trend, then prices will trend. Instead of trying to focus where those expectations make mistakes it may be easier just to follow prices especially during periods of exuberance. 

The Kahneman legacy - The impressive thinking outside the box

The work of Danny Kahneman is truly impressive. He was not just a prolific writer who put psychology back into economics, but the breadth of his work is astounding. Here is just a list of some of his major accomplishments.

Hat tip to Charles-Henry Monchau of Syz private bank for compiling the list:

1. System 1 and system 2 thinking - (fast versus slow / subconscious conscious, error-prone versus reliable). This is the basis for his most important book. 

2. Investor irrationality - There were many others working in this area but his focus on decision bias change the direction on thinking that we always act rationally.

3. Prospect theory - This was, by far, his most important theoretical achievement.

4. The Halo effect - If we see the good in one part of a company, we will think it applies more broadly.

5. Availability heuristic - We will focus on information that vivid or readily available. 

6. The fallacy of sunk costs - This is well know, but the psychological research tell us we cannot avoid it.

7. The confirmation bias - we always look for information that will justify or actions or decisions.

8. The hindsight bias - Of course, I know that there were behavioral biases, and the efficient markets hypothesis was wrong.

9. The framing bias - This bias leads to the major idea that we can nudge individuals to make better or at least different decisions. 

10. The anchoring effect - We don't want to give up what we already hold.

  

Active or passive investing? Think about strategy investing as another alternative

 

“You either have the passive strategy that wins the majority of the time, or you have this very active strategy that beats the market... For almost all institutions and individuals, the simple approach is best.” 

- David Swenson, former CIO of the Yale Endowment and the architect of the Yale Endowment Model 

Swenson comment is a cautionary statement. If you can find the active manager that has skill then use him and beat the market, but those managers are few, so the better downside protection is to just focus on the passive investment. For most the passive approach is better than chasing the elusive skill-based manager. 

Yet, if we are headed to a market slowdown or downturn, it may be worth looking at a subset of managers that may have timing skill at avoiding the downturn. Unfortunately, the sample size is very small for those managers. We just have not had that many bear markets. A middle ground approach is to add a strategy that does well in down markets. You are not directly investing in skill but playing the odds that the market will have characteristics that can be exploited by strategy action. For example, trend-following that is diversified across asset classes, investing both long and short, and follows trends that may be more likely to occur when there is uncertainty will likely do better in a period of downside transition. If you cannot invest effectively in the man, invest in the strategy.

Forecasting and Shakespeare

 

If you can look into the seeds of time 

And say which grains will grow and which will not,

Speak then to me 

Macbeth (I, iii)

Of course, this is a conversation with witches, but the basic premise holds true. If you can look at a handful of seeds and say which ones will grow, then let's have a conversation otherwise, it is a waste of time. For investors, if someone has the skill to forecast correctly expected returns, then it may be worth conducting active management, but if there is no skill then focus on passive allocations.

China is the key headwind against global growth

The China economy is a global driver for growth for the simple reason it is a big economy and has a large trade footprint, but the current state of the Chinese economy is negative and not getting better, so China is likely it will be a drag on global growth for the rest of the year and well into 2025.

Consumer confidence is low and not improving. The animal spirits of optimism do not exist.

The real estate market continues to grind lower which impacts wealth and consumer spending. You can have strong consumer confidence it the largest investment of consumer is falling in price. 

The PMI numbers are weak and clearly show a recessionary. environment for the real economy. Businesses are not making money.

The stock market pushes lower and is not providing a positive signal for the economy.

Finally monetary policy is pushing rates slower, yet government policies are tilted to stagnation as economic data are suppressed and there is little innovation in policy.

This weakness will show in commodity prices and in global trade. It is a growth headwind.

Zillow versus Case-Shiller housing index - Liking Zillow data

 

I have been studying the housing market for the last few years. We are in another housing bubble that is worse than the last one before the GFC. The great increase in money during the pandemic added fuel to the bubble fire. 

Of course, this time is different. There is less leverage, and many buyers have locked in low rate mortgages, We are currently in a world of limited supply which has not allowed prices to fall, but there is a fundamental problem looking at the housing market. What is thew right price? 

The go-to choice for tracking the housing market has been the Case-Shiller index, yet there is now a good substitute. I am really liking the Zillow index which is more comprehensive and timelier. It tracks well with the Case-Shiller index, but a review of the differences suggests that this may be a better measure. It is worth following and is available through the FRED database. 

Who is going to solve the debt problem - the bond vigilantes?

 

The US government deficits are not going away regardless of who is elected president. If there is an economic slowdown, the deficits will increase at the very least because of automatic stabilizers. If there is normal growth but plans for either higher spending or tax cuts are passed, the deficit will increase. 

There is no plan to solve this imbalance problem, and no one really wants to talk about it. The only solution is that the markets will have to send a signal that it has enough Treasuries, yet that signal is unlikely to be sent, nor will it be heard. 

We would like to believe that bond vigilantes will impose market discipline, yet the activities of central banks make it harder for large private buyers to impose their will on the bond market. The Fed can change its QT sales. The Treasury can continue to fund short-term. If the rest of the world is in slowdown and the dollar is stable, money will move into Treasuries. The wake-up call may be coming, but the process of how it will happen is still unclear.

It is not the inversion - it is the switch back to normal that signals a recession

 

There has been a lot of discussion about inverted yield curves indicating the likelihood of a recession. The curve inverts and the recession will be coming, yet this time has been different. The size of the inversion has been large and the time inverted has been long, yet there has not been a recession. 

The story has now changed. Yes, you need an inversion, but the real indicator is that the inversion moves to positive. We are now at the point of having a positive yield curve, so the recession is now coming. If you look at the data, the inversion and then a switch before a recession is all true; however, it is not clear what is the underlying story for this combination. A recession may be coming, but the inverted yield curve story just does not hold the same water as before.

There is no bear market memory and that is a problem

There is truth in this comic. The memory of many investors is very short-term. There is an over-emphasis on the immediate with less focus on the historical. There was the crisis of March 2020 associated with the pandemic, but it only lasted a month. We really must go back to the GFC to have major bear market. Think about it. It has been 16 years since the market crisis associated with Lehman Brothers. You may have worked on Wall Street for 15 years and never traded or dealt with Lehman or Bear Stearns. 

What will investors do when the bear market comes? It is hard to say but panic seems like a good word. The markets seem to panic at the first signs of a market pullback and immediately look for some relief. 

I cannot forecast the next bear market, but it is critical to have a plan if it does happen.

Gold behavior - Not what you may expect

 

Gold has always been known as an inflation hedge. It has also been known as a good investment when the real rate of interest is negative. Now we are seeing inflation lower with current levels at approximately 2.5% and real rates are positive even if the Fed starts to lower nominal rates. Under this world, we are seeing gold reach new highs of $2500 per ounce. This is not what one would expect. 

A higher gold price only makes sense if the market believes that inflation is not tamed, the dollar will move lower, and there will be significant financial risk. The gold market is an expectational market and the view from gold buyers is that the future will not be as good as what we currently see. 

Sector galaxies based on risk aversion and business cycle sensitivity

This is an interesting way to use cluster analysis in two dimensions. These 2x2 matrices look at the sensitivity of different sectors to risk aversion and the economic cycle. All sectors are not the same. Some are very pro-cyclical. Some are less sensitive to risk. These galaxies allow for thinking about sector rotation. Of course, you must make a judgement on the direction of the business cycle and risk aversion. 

Narratives and momentum - another source of trends

 

We read stories in the newspapers. Most investors are new junkies. They are constantly reading the news and looking for new information to support their thinking or developing new ideas. I am not saying this is a good idea. It is just a fact. Even if someone uses a model, there is still the desire for news validation. An understudied area of research is narrative economics which was developed by Shiller. Markets are often driven by stories or narratives which can lead to excesses. 

An interesting study has focused on narrative momentum or the fact that investors often under-react to news narrative based on the intensity of news reports. Simply put, investors do not respond quickly to rising narrative intensity. You can gain an edge by buying stocks that have an increase in news intensity. See Narrative Momentum. This would be a failure of the efficient market hypothesis, but it makes sense. 

There is an increase in the interest of stock based on narrative intensity. If there is good buzz about a stock will start to rise, but there is a time lag between the increase in the narrative and the reaction in price. It takes time for the narrative to move through the investment community and create enough reaction to drive the price higher. Investors need validation. They take time to react.

If this is the case, there trend-follower who does not follow the news but only prices may have an edge. When the trend-follower see prices increase, he will be a buyer and not look for supporting news. The trend could be driven by a special narrative, but that does not matter. Only the movement in prices matter. These trends exists because the there is a slow reaction to news, but you do not need to follow the news to make the trade.  

End of summer and investors are satisfied

The summer is not officially over, but Labor Day usually marks the end. Schools start and vacations are over. It is looks like we have had a good summer with the Fed likely to lower rates, inflation manageable, and still no recession. The markets seem to have rationalized albeit it is still a large cap world. Small caps have done well this summer even with a give-back in August. The Mega caps in information technology and communications eaves have started to rationalize although they still dominate the markets. Growth stocks have slowed their ascent, but there is a rotation to low volatility and high dividend stocks. Bonds have done well this summer. Overall, the markets are preparing for the Fed cuts, assuming inflation has been tamed, and see continued potential gains but with a focus on getting more defensive. 

It was a good summer, now we must prepare for fall and winter. 

Some basic rules for financial regulation

  

From an old article in the Institutional investors by John Liew of AQR, there is a good list of what government regulation should and should not do with respect to finance. I agree with this list and would be happy to add to it, if there is something missing. 

• The government should recognize that bubbles can happen. It is rare, but the cost of a bubble is high and should be addressed prior to the peak. 

• The government should not subsidize or penalize some activities over others. Picking winners and losers should not be the role of the government even if other country may have a different view.
• The government should not promise to eliminate the downside. Capitalism is about winning and losing.
• The government should encourage disciplining mechanisms like short-selling (and conversely, it shouldn’t ban or penalize them). Markets need short-seller to keep the markets honest.
• The government should encourage, not tax, liquidity provision. Liquidity is critical for the pricing of markets and regulation to reduce it will have strong negative effects. 
• The government should punish true fraud harshly. Fraud creates a lack of trust. Trust is critical for market success.
• The government should have consistent laws consistently applied (for example, when it comes to bankruptcy). Consistency is critical if long-term investment decisions are to be made.

• The government and self-regulatory bodies should encourage consistent and reasonable accounting. Accounting is the lifeblood of market information.
• The government should encourage that financial institutions mark more things to market.  Book value accounting masks mistakes.

 

Market efficiency and two schools of thought

 

Tests of market efficiency are two tests. One, a test of efficiency, and two, a test of the model used. This is leads to the great divide in finance. There is one school, the behavioralist view, which states that a failure of a model is based on irrationality. There are mistakes caused by a deviation from rationality, behavioral biases. The other school states that markets are rational, rather it is the model that is the problem. If we have a model failure it is because we have not modeled risk properly. Any anomaly is based on our inability to correctly measure risk. Hence, there are two camps or schools of thought, the risk pricing camp and the behavioral camp. 

Many of the factors that are studied in finance cane be structured around these two camps. The value factor can be thought of as price for value risk or it can be thought of as a behavioral issue. The same can be said for something like the momentum factor. The challenge for the efficient markets hypothesis is whether there is a good risk story for market anomalies or whether it is necessary to fall back on a behavioral story.

Can markets be irrational or inefficient? Yes, it is possible, but it is rarer than often thought and the first view should be that markets are rational but prices are not modeled correctly. Anomalies exist relative to our core theory and modeling. Markets are reasonably efficient, but this is not the same as perfect efficient. Market usually use all information, but the pricing of this information may not be properly models which offers opportunities for investors. Efficiency is a theory which must be tested constantly. The theory is based on the assumption that markets are competitive, and it is hard to make money in a competitive marketplace.