"Disciplined Systematic Global Macro Views" focuses on current economic and finance issues, changes in market structure and the hedge fund industry as well as how to be a better decision-maker in the global macro investment space.
Friday, May 17, 2024
Regime-based tactical asset allocation - it can add value
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
Thursday, May 16, 2024
What are you playing - the pricing or the valuation game
Some things don't change with respect to central banking
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
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
Momentum and moments
When is good enough - good enough
Sunday, May 12, 2024
Can AI replace stock analysts? Yes, it can
The recent study "Can AI Replace Stock Analysts? evidence from Deep Learning Financial Statements" shows that an atheoretical neural network approach using financial statement information, stock prices, and interest rates can do as well or better that the predictions of stock analysts. Given a lot of information and without making any assumptions on how to use the information, the NN approach can beat the analysts.
However, the story is a little more complex than just letting the computer do its work. When the analysts compete against the NN model which only uses fundamental company information, the results are in favor of the analysts. When the NN is able to use both interest rate and stock price information, it does much better.
The AI model is able to capture the combination of stock fundamentals with some macro information and price behavior. The value-added comes when the computer is able to blend all these features together.
Momentum crashes - always a fear
Thursday, May 9, 2024
So you think you know the repo market?
Wednesday, May 8, 2024
Dynamic rebalancing works when dealing with alternative risk premium
What do central banks think about inflation - look at gold
Global inflation debases currencies. Higher inflation in the US debases the reserve currency. If the inflation is transitory, central banks should not change their exposures to different currencies; however, if you believe that inflation will last for a longer time, it is time to buy hard assets. Even though we are off the gold standard, and it was described by Keynes as a "barbarous relic", central banks are buying a lot of gold - tonnes of it.
2022 and 2023 were banner years for gold buying. We believe that this is also sanction related. There is less reason to hold dollars if there is chance of sanctions reducing your ability to use those dollars. Look at the world official reserve assets in gold. It has moved from about 950m oz to above 1150m which is close to the levels seen when the world went off the gold standard. Despite high real rates and falling inflation, central banks want gold. Central banks are voting with their gold and they do not want to hold currencies that may lose their purchasing power.
VUCA and the investment world
Tuesday, May 7, 2024
Frank Knight and uncertainty
Multiple models versus an ensemble
"A man with two watches is never sure (what time it is)."
- Segal's Law
There is the view that having competing models is a bad thing. Investors should form one model that incorporates all their thinking. If you have more than one model you will never know or believe what is the true reality. Yet, we also know that models will fail. We will make mistakes. Most models will explain only a small portion of the variation in asset returns.
Yes, having a single model is theoretically pure, but I will usually choose to form an ensemble. An average prediction from an ensemble will usually do better than a single model. The reality is that prediction is about getting it right and if there is a means that is not perfect but gets us closer to a better answer should always be preferred.
Sunday, May 5, 2024
The problem with SEU subjective expected utility
How do investors deal with uncertainty? This is a critical question, perhaps the key question for investing, yet it is often overlooked. Of course, there are many answers to this question, but the fundamental problem is how do investors form expectations about uncertain events. The answer to dealing with uncertainty is to form better expectations of the future.
The investor must first isolate what is the event, and second, the investor must form some probability associated with the likelihood of that event. In return space, the problem can be simplified through just giving different returns some probabilities and have the probabilities sum to one. Once an investor tries to describe specific events, the issues get much harder.
The response from a technical perspective is to use some form of subjective expected utility (SEU) as a framework. The problem is just multiplying probabilities times events with a set of rules for behavior to generate the probability formation. We have all used this type of framework, yet there is something missing when trying to apply it in real life settings.
Where do those probabilities come from? This is again easy if you have countable events, that is, if we use some probability distribution that comes from the sampling of past return. The problem is less tractable if we are trying to incorporate events that have not occurred in the past within our sample of return.
The problem also becomes more difficult if we try and map events or shocks into the return space. If we have an event, say an earthquake or hurricane, we must both think about the likelihood of the event, the type of event, and the mapping of the event to specific asset returns. It may sound easy; however, the work involved is difficult. This is the process that is often not discussed in the classroom.
So how are probabilities formed for non-countable or rare events? They are subjective and rely on the decision-maker. We assume that he will be rational and have a process that is consistent, but beyond consistency, there is little work on how these subjective likelihoods are formed.
There is uncertainty over the process of forming likelihoods of uncertain events. Perhaps that is why rules of thumb are developed and we try our best to in the words of Herb Simon satisfice.
The illusion of financial skill - most don't have any
Saturday, May 4, 2024
The development of core factor investing
First there was the CAPM factor which failed as researchers found that low beta stocks had higher returns and high beta stocks had lower returns than what would be expected with the CAPM model. It is a good theoretical model but its ability to explain cross-sectional returns is limited.
This led to the development of the Fama-French three factor model which included market risk, size (SMB) and value (HML) factors. This was a significant improvement and changed the way investors thought about risk.
From this framework Carhart added the momentum factor (UMD) or (MOM) which created the four-factor model. This now caused a significant amount of finance confusion. How can past performance predict or tell is something about relative returns" There is acceptance hat momentum is present in all assets classes and that is a fundamental risk factor albeit there is a still a view that this is a behavioral problem that should not exist.
However, there was a desire to find more factors based on economic theories which were developed through the papers of Zhang et al. who found what were called q-factors which included operating profitability, ROE, and investment or a real investment factor or asset growth.
Fama and French extended their 3-factor model to include operating profitability robust mins weak (RMW) which is measured by revenues COGS - interest expense SGA scaled by book value, and investment, conservative minus aggressive or CMA which is just asset growth scaled by total assets. This led to the quality factor as a key addition or for some a better interpretation of value.
Since these core factor developments, there has been a zoo of factors to describe many risk premia. Many of these factors have not stood the test of time, but it shows that the search for return drivers is a dynamic and ongoing process. However, the core work of market risk, size, value, momentum, and quality are now the key factors for any discussion of equity returns.
Tuesday, April 30, 2024
Inflation - yes there was a transitory shock but ...
The discussion on inflation can be heated on whether the blame is with the Fed or is this just a tempest in a teapot about the transitory problem. There is no doubt that the pandemic with supply chain dislocations was a strong contributor to inflation.
Claudia Sahm is one of the leaders of the transitory story and her case is strong, yet it seems like the last mile problem of getting to 2% is hard, and the slowing of inflation is not the same as reversing the inflation of the past. Prices are still high and that means if wages have not kept up with inflation, buying power has been diminished.
The question is not whether the Fed must hold rates higher for longer to slow demand and get inflation down to 2% but for how long. Since the transitory problem lasted longer than expected, we can also say that the rate rise will have to last longer than expected. Fiscal policy with deficits at 7% at full employment is a contributor that has yet to be offset. The conclusion is that the movement to normalcy is just going to be longer, yet the fear is that another shock will take us higher and not push us to target. The value judgment is that the Fed under-estimated the inflation lag structure.