We fight against straw men not reality

 "So true is it that, in science as elsewhere, we fight for and against not men and things as they are, but for and against the caricatures we make of them." - Schumpeter

We fight not against the Fed of reality, but the Fed we imagine. 

We fight against the fiscal policy we would like to see not what is present.

We fight against the behavior of the market we believe should occur and not what actually happens.

Let us resolve to to fight for and against what is and not what we think they are based on our notions of value. 

Andy Grove's Principle of Didactic Management

Andy Grove's Principle of Didactic Management - "Ask one more question!" - from High Output Management 

I have to follow this advice for 2025 - ask one more question, be inquisitive and dig deep for added knowledge.

I was recommended this management book from a good friend, and I was very impressed by the quality of advice. There is no shortage of management books, but most keep their discussion at a high level and do not get specific with the advice. Andy Grove's book is as practical as you can get. For example, it does a good job of explaining how to run a meeting. The basic premise is that you should manage like it is a production process. It is a factory that can be broken into specific steps. I got more out of this book on how to be a better manager than almost any other in 2024. 

OECD survey of skills - The new Dark Ages?

The OECD just released its latest literacy survey, and the numbers do not look good for the US or for many other countries. How can economic growth and productivity surge if there is poor literacy, numeracy, and adaptive problem solving for any country. The US does not do well versus the OECD average or selected countries. What is very disconcerting is the high percentage of level 1 or below and this is a trend that is getting worse since the last survey. We have some very strong numbers at the high end of the survey, but they are supporting a growing percentage at the low end. 

The dispersion in education performance has real economic consequences. Level 1 and below have lower job participation, lower income, and higher unemployment. The level 1 individuals have lower health, trust, civic engagement, and life satisfaction. Of course, this leads to more economic inequality, yet it may not be an issue of spending more money on education. The US is spending more than many other developed countries but does not have better results. There are bigger issues that are not being addressed. 

 

The politics of consumer expectations - hard to understand

It may seem very odd that consumer expectations would have such a strong political component. It is even odder that we have seen a complete flip in the expectations since the presidential election. This may have something to do with the type of work that is done by each group and their income levels. It should not be associated with what is being read by voters.

If the Republicans represent blue collar voters who have been harmed by inflation and perceived government policies that may explain the divergence and why there has been a surge in Republican consumer sentiment under the view that the economy will do better under a new administration. It does not explain why there should be such a fall in Democrat consumer sentiment given the survey focuses on spending patterns and not social and political sentiment. The perception of consumers based on politics seems like a rich area for further analysis.

Consumer sentiment, in total is moving higher after a fall earlier in the year.

 

POSIWID (“the purpose of a system is what it does”) - think about this

Stafford Beer, the great thinker of cybernetics, developed the simple idea of POSIWID (“the purpose of a system is what it does”) during his study of organizations. An organization may have a stated purpose but that is not always what it does or what it is successful at. 

The Congress may have the official duty of representing district and pass laws for the good of the country. The POSIWID of Congress is to maintain power for those elected. The official purpose or goal of the Fed is to maintain stable prices and full employment, yet its POSIWID is support Wall Street and maintain the jobs of the economists running the Fed. A university is supposed to educate, yet it may engage in activities to perpetuate its status.

Yes, this sounds and is cynical. It is supposed to be. It is not always easy to get an organization to do what it is supposed to do, the real reason for its existence. 

hat tip to doomberg.com for mentioning Stafford Beer. 

What makes a good economist?

 

“There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must before seen. Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.” 

- Bastiat 

I love this explanation of the difference between a good and bad economist. You have to think about the longer-term or second order effects form some policy action. This is especially true when being a macro economist in finance. The Fed lowers rate which may have an immediate effect on short rates, but you have to think about how this changes expectations and impacts other markets. It is not the immediate effect bur rather the impact on expectations that matters.

Forecasts - we get it wrong - a year-end reminder

At the end of the year, Wall Street makes annual predictions. Wall Street is a prediction machine. Markets are in the prediction business through expectations embedded in prices. Yet, the judgement or value in these predictions is poor. Just look at the predictions of the stock market. Surprisingly, the stock predictions are more conservative than reality.

For the bond markets, the futures prices are a poor forecast of future rates. During the QE period, markets expected rising rates that never occurred, and more recently, the markets were not able to predict the Fed rise in rates. Now, the forward prices are expecting strong declines. if the past is a predictor, don't bet on it.

 

Factor and price momentum across the globe

 

Many have tried to to explain away price momentum as driven by factor effects, but a recent study that looks at a large set of anomalies across a large set of countries fins that price momentum is still a key factor, see "Factor momentum versus price momentum: insights from international markets" The question answered in this paper was simple, does factor momentum drive stock price momentum? 

Now, factor momentum is strong across most international markets, but factor momentum cannot entirely explain stock and industry momentum; however, factor momentum based on principal components does a better job than traditional factor modeling. Nevertheless, price momentum often does a better job of explaining factor momentum. So, we can conclude that price momentum is distinct and cannot just be a combination of factor momentums. The paper provides an interesting display of comparisons between price and factor momentum that makes the story more compelling.

What make a historian important - perspective

The worst historian has a clearer view of the period he studies than the best of us can hope to form of that in which we live. The obscurest epoch is today. 

 - Robert Louis Stevenson 

History majors are becoming rarer at universities. Who wants to study the past? How is history going to help me with my job? I am only looking to the future. 

Yet, historians if they do their job correctly, try to make sense of what is often viewed as nonsense. The historian thinks about context. He thinks about cause and effect and what information can be found to support a set of explanatory arguments. There may be a model, but the model does not focus on the elegance of methodology but centers on the ability of explain and give some sense of order to disparate events. This is a skill which if often lacking when we are in the heat of the moment. 

The passions of the current are only tempered with time, but time is not possible when events are unfolding.

Knowledge would be fatal, it is the uncertainty that charms one. A mist makes things beautiful. - Oscar Wilde 

"If everyone is thinking the same, someone is not thinking" - a variation

Gentlemen, I take it we are all in complete agreement on the decision here. Then, I propose we postpone further discussion of this matter until the next meeting to give ourselves time to develop disagreement, and perhaps gain some understanding of what the decision is all about.

-Alfred P. Sloan 

Everyone talks about diversity of crowds, but the crux of the issue is having diversity of opinions and disagreement. Of course, disagreement for the sake of being disagreeable to worthless. Disagreement requires deep thought. It requires thinking about pros and cons. It requires an attempt to eliminate ignorance whenever possible. Agreement is caused from a lack of thinking and assuming that all the information necessary to make the right decision is available.

Of course, disagreement may lead to paralysis, so someone must decide but the decision has to be made through a blend of choices. 

What is the cause of the valuation between the US and the rest of the world?

Valuation for US stocks are higher than the rest of the world. What is the cause? Vanguard does a good job of visually providing a breakdown for the last ten years. Clearly, a clear driver is valuation from investors, but what is very clear is the strong impact of revenue growth. Revenue has been much stronger in the US than the rest of the world. What is surprising is the relatively small impact of profit margin expansion versus what is seen in the ACWI ex-USA. US companies have grown the top-line and have been rewarded with higher valuations even though margins have not expanded. The big gains in the US equity index are all driven by the huge gains in revenue and valuations within the information technology sector. Overall, the US and global differences could mean that US companies are more sensitive to any changes economic growth or investor sentiment related to valuations. 

 

Yes, we live in a non-linear world - get with it

 

We act as though we are in a linear world because it is easier to calculate behavior in the linear world. It does not matter if the linear model does a poor job, we can make the calculations. Nevertheless, the machine learning explosion has led to better and easy to apply non-linear models which allows researchers to make better forecasts. The latest AQR paper, "Can machines build better stock portfolios? The virtue of complexity in the cross-section of stocks" shows what kind of improvement you can get from using non-linear techniques. While modeling should always strive for simplicity, adding complexity can have significant benefits.

Surprisingly some techniques are easy to implement and just adjust for non-linear relationships at the extremes, yet using these techniques will generate significant improvement in Sharpe ratio. The two exhibits from the paper show the improvement with nonlinear models and provide a simple picture of what it means to have a non-linear relationship.  In this case, the AQR folks use ridge regression as the technique to gain the Sharpe improvement. These improvements can come even when looking at simple value and momentum factors. 

so, the Fed says the inflation problem is not solved?

The data-driven Fed lowered rates by 25 bps and made a major adjust for 2025 by suggesting there will only be two rate cuts in 2025. Of course, we now know that GDP will be steady, but PCE inflation and core PCE inflation will both be higher in 2025 and not reach the 2 percent target until 2026-2027. If that is the case, why cut now and why suggest any cuts in 2025. Why pretend that you have a plan when the actions taken are not consistent with the plan nor are the actions going to get you to the goal.

The stock market tells us that the expected action from the Fed for 2025 is a surprise. Think about the almost panic at the fed before the September meeting only now to see the fed wants to slow-walk further action in 2025. The 50 bps cut and SEP forecasts in September now look like a mistake. 

The VIX is telling us the market is in panic beyond the overall market decline. We are not at August carry trade debacle numbers, but we are heading in that direction. The dollar shot up like a rocket and the bond market and the long bond fell to levels not seen since June. This Fed action changes equity forecasts for 2025.

 

All ML for predicting stocka returns are not alike

 

Choices. Choices. What machine learning tool should I use? A recent paper, "Design choices, machine learning, and the cross-section of stock returns",  looked at over a thousand machine learning models applied to a single problem and found wide variation in results. You may think you are engaged with systematic investing, but there is a significant amount of discretion when making model design choices. Nevertheless, the idea that you should try and account for nonlinearities is critical in the choice. The key advancement with machine learning is accepting the idea that we live in a non-linear world.

The authors of this study compared algorithms, target variable, target transformation, post-publication treatment, feature selection, training window, and training sample which leads to over a thousand combinations that are tested on a common set of features to analyze out of sample results. The range in performance between the top and bottom monthly returns is greater than 15x. The difference in Sharpe ratios is more than 20x. Design choices matter. 

This is a critical piece of research. New techniques have to be benchmarked against the techniques that they are expected to replace. Why choice a new ML model unless you can say something about how it fits within the other choices available. 

Yellen gaslighting the bond market

 

This is an incredible comment from the outgoing US Treasury secretary. We have heard in the past that deficits do not matter. At times, they do not but as the size getting larger there is a choke point where rates have to go higher to clear the market. We have seen longer rates move higher while inflation is coming down, but it is hard to decompose the drivers of the rate change. Growth is expected to be higher in 2025, inflation is not expected to fall as quickly, deficits are expected to stay high, and term premium are expected to rise. 

Nevertheless, the mendacity of telling the markets that you are concerned about fiscal responsibility just reduces the creditability of Secretary Yellen. She actively pushed issuance of Treasury bills higher to reduce the impact on longer rates. It was her job, but there was no push to support lower spending. She will retire but we will be left with the bill. 

Competition across nations starts at home

I was recently discussing the Draghi report on EU competitiveness and stated thinking about the old work of Michael Porter and his work The Competitive Analysis Across Nations which was an extension of his work on competitive analysis of firms. Porter developed the five forces diagram which is followed by most business students when they study strategy analysis.

For his study of nations, Porter developed his four diamond graph which is based on analyzing: factor conditions, the endowment of resources; the firm strategy or domestic conditions; demand conditions for what is needed, and the infrastructure of other industries. Governments can help with the environment, but countries do not have competitive advantage, industries do. Governments cannot make companies be more competitive. It can only create an environment that allow for competition. The private sector is where there is innovation and gains in productivity. If the EU wants to be more productive, then let companies compete gain scale and meet market demand. 

30 years of momentum research and it is only getting stronger

 

It has been over 30 years since the first major work on momentum was presented in a leading finance journal (Jegadeesh and Titman). Prior to that study, the conventional wisdom of efficient markets believed there was no trend or momentum effect. The world has changed and over the last three decades we have extensive research that has improve the initial research and strong explanations for why momentum exists. There are both behavioral and risk-based explanation for momentum and they have stood the test of time. Markets will under and overreact to new and will have different time dimensions. There is also a systematic risk component that can provide a reasonable explanation for momentum.

Momentum does not just exist in equity markets but is present around the global, in commodities, currencies, and fixed income. There is also commonality in stock momentum through industries and factors. Momentum is one of the strongest, most pervasive, and well researched factors in the marketplace. 

Of course, the strong long-term research results do not mean that momentum will always work as has been tested, momentum works strongest when there is a strong overall market sentiment. When more investors expect momentum is a given, it is more likely to have a poor performance year. There is a range of performance. 

All if this work is nicely presented in a review, see "Momentum: what do we know 30 years after Jegadeesh and Titman's seminal paper?" 

The out of control momemtum factor - can it continue?

 

The exceptional factor for 2024 is momentum. There are many ways to calculate this factor, but a simple equity benchmark is from S&P which has a broad suite of equity factors. The momentum factor is up 48% through the first eleven months of the year and is more than 50% higher than any other year and any other factor. Strong momentum factor performance does not mean a reversal in the next year, but the size of this move is extraordinary. Of course, the driver a just a few stocks which means that is not likely that this can continue if these key stocks have any slowdown or reversal. The high momentum winners may see a reversal after the one-year mark, but the follow-through on these names which have lasted for more than a year suggests that it is not a given that there will be a January effect. 

Realize that factor extremes can happen but does not suggest that there will be continuity. The rebalancing of names can support factor returns but looking at distribution properties leads to caution in holding the momentum factor.

Using generative AI for economic forecasting

 

Generative AI can be used to enhance economic forecasts through simple aggregation from corporate conference calls. We know that corporate CEO's provide economic outlooks on their earnings conference calls. It is part of the job, and it is critical that they get their forecasts right. The cost of being wrong high. Firm profits may suffer.

These conference calls provide a unique and special insight on the direction of the economy when all this information is aggregated. It is possible to aggregate all the verbal comments from transcripts using generative AI. All the information in conference call transcripts can be aggregated to form an index through highlighting key words and phrases like many other LLM models. An AI Economy Score can be employed to improve forecasts of GDP. 

Researchers have found that there is positive incremental value from using the score from the conference call transcripts. See "Harnessing Generative AI for Economic Insights". This paper scratches the surface on using AI to help with macro forecasting, but it provides a good foundation of how new tools can support better global macro decisions.

Factor investing across different regimes

Factor risk premiums are time varying and a simple approach of breaking the economy into a four quadrant macro regime world will have significant benefit. The mayor regime is based on rising or falling inflation and the composite leading indicators for the US. Both are easily obtained, and the four quadrants can be easily generated using monthly information.  Based on the factor premium indices from S&P Global Intelligence, we can identify changing factor return profiles. For the full story, see "A Historical Perspective of Factor Index Performance Across Macroeconomic Cycles". 

Specific regimes may last for long time periods only to see significant uncertainty as regime shifts come frequently. These factor returns will vary significantly. Clearly falling growth and rising inflation is worst environment followed by falling growth and falling inflation. The best environment is when growth is rising and falling inflation. 

The quality factor index shows the best returns overall returns followed by the low volatility strategy. While outperformance and hit ratios are clear during different regimes, the gains may seem small relative to transaction costs, yet a simple strategy of regular rebalancing will lead to significant gains over the longer run.    

 

The sobering impact of consequences and facts

 “Wisdom consists of the anticipation of consequences.” 

— Norman Cousins

“Consequences are unpitying.”

 — George Eliot

"Facts don't care about your feelings"

 - Ben Shapiro

“Should facts get in the way of truth?” Or, “Should truth get in the way of facts?”  

- Brad Feld  

The core of decision-making is accepting that there are consequences from actions. It is not a forecast or prediction that is the consequence. It is the action from the prediction that creates gains and losses. It is the action that has consequences.  

Similarly, facts are not feelings. Facts may differ from the truth you may want. Of course, there are interpretation of facts that may differ, but if the consequence of your interpretation is wrong, it is not the fact that is wrong. It is the interpretation. 

This may all seem obvious, yet it often requires reinforcement.