Buy pro-cyclical stocks and get a higher return

 

A simple study finds a stock relationship that makes intuitive sense. The paper, "Procyclical Stocks Earn Higher Returns" shows that stocks that comove with the business cycle will earn higher average returns than those that are countercyclical. 

Using close to 75 years of data on real growth expectations, the factor loadings associated with growth show a strong pricing premium that is independent of size, value and momentum effects. This business cycle effect is stronger for large value stocks and momentum winners. It is notable that expectations not realizations are what is priced in the market. The concerns of a switch in the business cycle are relevant when pricing assets.  This paper shows again that have some macro focus even when building a long/short equity portfolio is important.

Making sense of chaos - A readable explanation

 

J Doyne Farmer, a leader in complexity and chaos theory, has written a very readable book on complexity theory for the average reader. Making Sense of Chaos: A better economics for a better world takes the reader through the basics for why complexity modeling is necessary and different from classic economic theory. Farmer then walks through how complexity theory can be used to explain different economic phenomena. 

Complexity theory and simulations can be used to explain the financial crashes we have seen. It can help explain the housing bubble, and it has applications for providing deeper understanding of market efficiency. It has also been useful for explaining the issues of credit crises associated with leverage. 

Farmer provides good explanations for how complexity theory can be employed to predict weather and climate change as well as technical progress. He does a great job of taking a difficult topic and make it approachable by others, but the modeling of a complex system is not easy and requires a lot of simulation work where the results are not always expected. Simple changes in assumptions will give very different results. Nevertheless, it is important to think about many economic problems as complex systems that do not have the same features as an equilibrium model.

Narratives help explain stock returns

 

We can only explain a small portion of the variation in stock returns. We can tie returns with several key factors as displayed by the now classic three and four factor models of Fama-French. While these represent useful models for describing stock returns, their focus is on quantifiable measures of factors such as risk, size, value, and momentum. There is no factor that represents unscheduled news or sentiment in the market. However, there is a growing body of work that emphasizes narrative information such as Google search and sentiment. Popular stories, measured by search, can influence economic behavior that then impacts stock returns. Attention to news that is novel can help explain stock returns. 

I have highlighted the work of Nicholas Mangee who has not been given enough attention. This is not directly related to the exploding LLM work. Rather it is a simpler and thus more powerful as a foundational approach to explaining stock returns. News, especially unscheduled information, creates narrative to explain which then impact return. Simple stories attract attention which then translates into price moves. If there are more stories with the same narrative, there will be trends in price as these narratives take hold and embedded in the price. From narratives, there is a reason for price trends. 

Mangee is coming out with a new book on the novelty-narrative-hypothesis that can help advance our thinking about narratives and stock returns. I have seen a copy, and I am impressed. I will be writing more about this in the futures. It should have strong application for macro and commodity managers were there is less clear information to help with valuation.

Narrative drives return - even if stories do not generate measurable risk

 

There has been a changing focus of industrial organization and the theory of the firm over my career that also may tell us something about the hedge fund industry. The hedge fund and money management industries have evolved with changes in the demand for their product and through competitive threats from other firms.

The study of industrial organization has evolved, and that evolution will help provide a framework for explaining hedge funds. I will start with my undergraduate course in industrial organization that used the textbook by Frederic Scherer. This was the dominant thinking on the topic and used the SCP framework for the empirical analysis on industries. Scherer was a discipline of Schumpeter and focused on competition, change, and innovation. 

The SCP framework, which was foundational for most business schools, looked at Structure-Conduct-Performance as the three drivers for understanding a firm and industry. The market structure, the number of firms and barriers to entry will determine the conduct of the firm based such as pricing and products which then lead to performance as measured by profitability. The Harvard Business School advanced Scherer to new generations through the five forces of Porter as the dominant view for thinking about firm, industry, and strategy. 

The SCP framework focused on the external behavior of the firm, but there was a growing interest in the internal structure of the firm that was explored through the work of Oliver Wiliamson, Ronald Coase, and Alan Alchian. There was a focus on how firms are structured based on minimizing transactions costs and information flows. The transaction cost view looked at market versus hierarchical structures to solve transaction costs problem. Along with the contracting of the firm, Jensen and Meckling applied the idea of the corporation as a set of contracts. The contracting view solved problems of asymmetric information and moral hazard. There was an explosion of research on principal-agent problems. While this work on the internal structure of the firm solved problems with how firms and contracts were formed, there was another school or direction of thinking about how firms interacted in a competitive environment. 

The work of Meyer, Milgrom and Roberts (MMR) applied a game-theoretic approach to the competition across firms and strategic behavior. This approach focused on information and incentives issues between firms. The work on information asymmetries helped explain strategic decisions. Like the work in finance to explain incentives for shareholders and managers, MMR applied this asymmetric information thinking for explaining the actions of firms. Firms will make strategic decisions to influence the behavior of their competitors. There also was work focused on competitive threats and whether industries were contestable as a means of determining whether there was a monopoly. 

The work on information, game theory, and contracting was linked to the more classic work in industrial organization through Jean Tirole who developed a more comprehensive framework for industrial organization to explain oligopolies, monopolies, monopsonies, and competition. This unified framework also provided a framework for price discrimination, the vertical integration of the firm, and tackled the reason for government intervention and regulation.

So, what does this have to do with hedge funds? The hedge fund industry is not special. It is subject to the same issues and problems of any other industry. Firms attempt to solve information and transaction costs problem to increase profitability or provide alpha for clients. Hedge funds compete for funds, so they have to focus on strategic decisions to improve their position relative to other firms. The hedge fund industry may have started out as a group of artisans, skilled managers, but are now vertically integrated and structured to gain an information edge and will become more horizontally integrated to improve their diversification and stabilize cash flows. We can learn from other industries to explain hedge fund and money manager behavior.

AI-Powered Financial Scholarship - This is scary

 

This is one scary paper for anyone in academic finance, AI-Powered (Finance) Scholarship. It is scary not because of a specific conclusion but because an AI program can not only generate and test new investment signals but because it can also wrap it up in a nice working paper suitable for publication. These AI papers may be better written and presented than papers done by humans. Ouch, this is a game changer. 

This paper destroys a lot of academic finance and is the ultimate data mining paper delivered in nice publishable form. Think about it. We have gone from the search for factors that form a factor zoo to now mining all indicators. The authors mine over 30,000 potential stock return predictors form accounting data and apply the "assaying anomalies" protocol to generate 96 signals that pass the protocol test and benchmarks these results against a large group of known anomalies. 

We have moved from a world of p-hacking and atheoretical research which does not need careful thought and formation of hypotheses to a world where we can have AI run the research and write the paper. This will put academics out of work - sort of. They will have to reinvent who they are and what they do. 

The LLM generates papers that given signals creative names, custom introductions to provide a justification for the signals, and incorporate citations to support the work. The authors provide a cautionary note that this is the ultimate form of HARKing - Hypothesizing After Results are Known.

Conditional beta using LASSO adds value

We know that betas are not stable. They are time varying and may change based on fundamental factors associated with the firm as well as changing risk across the business cycle, yet we do not seem to focus on conditional betas. In the new paper, "Conditional Betas", the authors focus on comparing several econometric and machine-learning method to test asset pricing models and market anomalies. If we better measure or control beta, we should see fewer market anomalies and an increase in explanatory power for asset models. These tests will allow us to measure the relative valued-added of choosing better machine-learning technics. 

The comparisons shows that firm-level LASSO method provide improvement over more traditional econometric techniques. The LASSO method is a technique that add a penalty term to a linear regression that forces or encourages to some coefficient to be zero and focuses on the most important values. The penalty is one the absolute value of the slope. (Ridge regression will have a penalty based on the squared value of the slope.) If we penalize the marginal coefficients, we will reduce overfitting and make the overall regression easier to interpret. This will be helpful when there are a lot of potential predictors.

A LASSO regression is easy to interpret and generate and when applied to panel data, it generates coefficients for the three and four factor models that make intuitive sense.

Different forms of backtests - A review

There are different forms of backtesting and a short paper provides the pros and cons of each, See "The Three Types of Backtests". This is a good summary of the types as well as the quality of simulations and backtests through several key issues. It provides a reasonable checklist of what an investor should do when conducting or reviewing a backtest. 

This serves as a good complement to my paper “I Have Never Seen a Bad Backtest”: Modeling Reality in Quantitative Investing in The Journal of Investing. 

How world trade has changed - the real issue

 

While the US has been focused on tariffs, the real issue is the change in world trade between the US and China. Raising trade barriers will not solve this problem. A strong dollar with a decline in manufacturing with China being a strong export producer has changed how the world trades. Mexico and Canada make up about 40% of all our imports and exports, so this is one area that we must get right.

Trade is an important reflection of US power and hegemony, so a policy of trade isolation will diminish the power of the US around the world. 

The convenience yield for Treasuries have fallen with supply

There has always been a convenience yield with Treasuries, or that is the belief by most investors. A closer look suggests that this is not case. When there is more Treasury supply relative to GDP, the convenience yield can become negative especially for long-term bonds.

The US Treasury enjoys the special position that it may be able to issue debt cheaper than other countries given the unique position of being a reserve asset with safety and liquidity. This exorbitant privilege creates a convenience yield; however, there may be limits to the degree of privilege or convenience yield based on the supply in the market. The paper, Convenience Lost, shows that the fiscal expansion in the US has led to a fall in yield difference the maturity-matched overnight index swap (OIS) rate and Treasury yield. Since there is greater risk with longer-term Treasury yields, the authors find that the convenience yield decline has been more pronounced with longer-term Treasures. 

The convenience yield demand curve is downward sloping and greater for long-term Treasuries. This change in the convenience yield is useful for explaining relative yields as well as the potential for portfolio allocations.

 

Douglas North - we need to think more deeply about institutions

 

I have been focused on the older work of Douglas North, the Nobel prize winner, as part of a longer piece of work on economic growth and competitiveness in the EU. There can only be a significant increase in growth if there is a change in the institutional structures within Europe. The rules of the game matter, so the study of these rules and how they form an economy are critical. The rules both formal and informal place constraints on behavior and what can be achieved. You cannot generate growth if the institutions and organization is not in place. 

North was part of a school of thinking that institutions and organization are developed to cope with the problem of transaction costs through information gathering, monitoring, and behavioral constraints. How do we form institutions that can improve market efficiency through reducing transaction costs and enhancing production? How will firms and agents organize in response to these institutions? 

Given that institutions and organization change slowly, growth will be path dependent. Our growth is impacted by the choices made decades ago, so we have to be careful on changing the rules of the game and we cannot expect an immediate response to new rules and institutions.

While I have been thinking about macro growth, institutions and organization impacts quant investing. There is the belief that knowing the institutions does not matter; however, we need know how trading occurs and how transaction costs impact performance and behavior. The institutional context for price behavior does impact trend and momentum and the response to new information.

Chinese Capitalism - An evolving story

 

This book on the Chinese economic system focuses on the pre-GFC period that represents the big take-off in Chinese growth. The author is extremely careful with his work and shows that many our assumptions on the growth drivers are either wrong or misplaced. Huang, an MIT professor, focuses on the rural entrepreneurism of the 80's is the key growth driver and the switch to urban growth that was more state-sponsored was at the expense of greater rural regulation. 

The institutional framework drives incentives and behavior, so making arguments about the drivers of growth without looking closely at the detailed policies will lead to mistaken conclusions. While we are looking at economic history with Capitalism with Chinese Characters, there are lessons to be learned for today. The slowdown in China growth and fall in the stock market is closely related to the policies that promote entrepreneurship. If we change those incentives, the markets will respond in a way that will diminish growth. 

Hedge funds and as a nexus of contracts

 

What is a hedge fund? The finance perspective focuses on what it does. It is a single or set of strategies that can be represented by risk factors. The hedge fund is a delivery mechanism for the packaging of risk factors with alpha. The hedge fund is an investment vehicle for receiving alpha. It serves the purpose of providing risk premia and alpha to a set of customers, yet this story focuses on the delivery of products and services and not what is the entity called a hedge fund.  

We can go a little deeper using modern corporate finance which states that a corporation is the nexus of contracts that reduce transaction costs for investing. We can us the theory of the firm from Jensen and Meckling and whole school of researchers on transaction costs. 

This description provides us with a rich framework for thinking about the hedge fund. It is a set of contracting arrangements for the delivery of alpha to clients. The generation of alpha is expensive. It requires gathering and processing information. It involves the trading which leads to a set of costs that must be controlled to deliver the alpha. It must control traders and managers, so they follow a set of rules within an investment policy agreement. Obviously, there are issues of asymmetric information and principal-agent problems for how is monitoring and oversight provided when money is released to the hedge fund from the investor client.

The simple story is that an investor gives money to a manager to generate return, yet the success of this objective may only be achieved through a set of contracting relationships that control behavior and costs. This issue has not been fully explored by the marketplace. How does the hedge fund structure along with skill create alpha?

Who is responsible for the corporation?

Corporation: An enginous device for obtaining profit without individual responsibility - The Devils' Dictionary, 1911 

The Devil's dictionary is so funny because it often hits us with the truth. Who is responsible for the modern corporation? Is it the managers? It is clear that after the GFC the government was unwilling to make individuals responsible for the wide housing fraud. The shareholders provide incentives to managers but are often unwilling to discipline managers except if they do not drive earnings higher. The Jensen-Meckling view of making managers accountable as owners through stock and option grants seems to have been abused by many. Shareholder votes are hard to use as method to impose specific behavior. The question is whether the large corporate has gotten too big to be controlled by any individual with responsibility for their actions. 

Labor, Capital and Technical Change - where are we going to get innovation outside of AI

"If God had meant there to be more than two factors of production, He would have made it easier for us to draw three-dimensional diagrams." - Robert Solow c. 1950.

We always think in the two-dimensional space of labor and capital, yet if we want to truly grow an economy we have think about technical change and innovation. This is the third dimension. We have learned a lot about innovation and technical change since the early days of the Solow growth model and the Cobb-Douglas production model, yet innovation is still the great challenge for economist because it is the link to productivity. 

We have seen different Asian models of growth and observed that it is often cheap labor or capital that is doing the heavy lifting. Once the cheap factor is exhausted, we must worry about innovation and the institutional systems that will driver technical change. Innovation is either driven by a black box that we cannot control or is fully understood, or it the observation that the status quo institutions will have to change.

Commentary on economics - Need to closely observe

"Catch a parrot and teach him to say, 'supply and demand', and you have an excellent economist." Irving Fisher, 1907. 

If economists wished to study the horse, they wouldn't go and look at a horse. They'd sit in their studies and say to themselves, "what would I do if I were a horse?" -  attributed to Ely Devons by Ronald Coase. 

These are two phrases that throw shade on economists. Yes, if you can get an economist to focus on supply and demand he will get most of any problem right. Of course, the problem is that defining supply and demand is harder than you think. It is more than words.

Ronald Coase is still under appreciated by most economists and those in business. He is not easy to understand but answering problems of contracting, institutional arrangements, and transaction costs are critical to understanding why and how financial markets work. The only way to understand the economy is to go out and observe what consumers and businesses do. You can start with theory, but better to first just look and see.

NFIB survey optimism with uncertainty

Small business tell us a lot about the direction of the economy since they represent a significant portion of US employment. The optimism has shot up since the election to the levels since during the first Trump administration. This indicator can tell us something about the direction of small cap stocks. However, we have seen a large spike in small business uncertainty which will offset some of the optimism in terms of real action by firms. The uncertainty should come down as we better understand current policy. The optimism will stabilize if the promised policies are followed. 

Data miners vs experts - A new view

 

Very interesting idea suggests that the proliferation of new data or "data abundance" affects the allocation of capital between quant and non-quant asset managers where the quants are "data miners" and the non-quants are "experts". This is a novel way of thinking about information flow and analyst behavior. See "Equilibirium Data Mining and Data Abundance".

Data miners, the quants, search for predictors and then select those that have the highest precision. The experts have a fixed ability to generate trading signals based on their expertise. The data miners gain signals through a search process and thus will be more fluid or have changing precision based on the choice of signals.This framework helps to distinguish between the effect of lower computing costs and greater data availability. 

The conjecture of the authors is that data abundance will raise the precision of the best predictors which will cause the quants to search less intensively for new predictors. This process will make quant performance more disperse which leads to less capital. The authors also show that more data will increase price informativeness which will lead to a reduction in average asset manage performance.

This is an important paper to help distinguish between the behavior and choice between quants and discretionary fund managers in the context of the flow of data and information.

Inflation perceptions - seems like consumer know better than the Fed

 

The Fed seems to view that it has turned the corner on inflation, yet we are still above target. The PCE inflation has been rising for the last three months and is above 2.5%. The CPI has also been rising for the last 3 months with the current number at 2.9%. The problem has not been solved, and we see to be in a sticky period of inflation above target. It appears as though September was an outlier, and the Fed made a mistake at cutting 50 bps in September. 

A recent survey looked at how consumer think about inflation and there seems to be strong opinions on the negative aspects of inflation. See "Why Do We Dislike Inflation?". Consumer clearly believe that it diminishes purchasing power and wages do not seem to match the increases in inflation. Hence, there must be costly adjustments to budgets and behavior especially for low-income groups. Inflation hurts financial assets and reduces savings and there is little trust that wages will keep up with the price changes. The anger about inflation is directed both at government and business with the government being over 3 times more likely where the anger is placed. Consumers also think that inflation hurst our international reputation, decreases political stability, and decreases social cohesion. This is some very interesting food for thought and suggests that the Fed and government in general should more closely listen to consumer views.

Risk attitudes differ across countries

 

Why don't we see more venture capital investing in Europe? One simple reason is that investors may be more risk averse in Europe relative to the US. See "Cross-country differences in risk attitudes toward financial investments" for some interesting comparisons across countries. Two conclusions were drawn on micro data across 15 countries. One there are significant differences in risk aversion, and two, these subjective risk preferences have much greater explanatory power on risky holdings than measures of market performance and volatility. The following graphs provide a good picture of the differences across countries. For a specific benefit, there is less perceived risk for those in the US versus many other countries. This is for all levels of perceived benefit. Additionally, the predicted financial risk attitude for the US is higher than many other countries.

These differences help explain why many start-ups find financing in the US. There is a greater willingness to take risk.

Inflation preferences - The big disconnect

There is a large disconnect between the inflation preferences of consumers and those of the central bank. The general population would like to see lower inflation - much lower than the 2% target, so it is no surprise that current inflation rate is not making consumers happy. Consumers have a preference for inflation at .2% which is lower than the magic 2% of central bankers. See the paper "Inflation Preferences". 

Consumers focus on the fact that inflation reduces real wages and that it also reduces the purchasing power of their money balances. Both as good strong economic arguments. So if consumers have a strong preferences for lower inflation, why does the Fed persist with its view that 2% is the necessary target especially when consumers are not making judgments that are irrational? 

So, what should the Fed do given this strong consumer preferences for lower inflation? The authors realize that the Fed has two choices: one, adapt to the preferences of consumers and bring down the inflation target, or two, influence consumer preferences by educating them on the benefits of having higher inflation. 

This is a weird paper that seems to advocate that the Fed just needs to inform consumers that their life would be better if they suffered an erosion of their real wages and purchasing power because it would make the Fed job easier to reach their dual mandate of controlled inflation and full employment. Consumers just need to be educated on why the consistent pain in losing purchasing power is better than higher unemployment. I want to see Chairman Powell talk to the America people and tell them it is necessary for them to accept the Fed preferences over their own view and experience.

A book that provides structure on cultural wars of today

 

I have been trying to better understand the cultural dynamics that have caused significant conflict in the US and beyond. As an economist, I spend my time worrying about debt, inflation, and growth, yet the news media focus is often on cultural issues as the driver of thinking.  I need a text to help navigate what is going on without the usual left or right bias. I was recommended, We Have Never Been Woke; The Cultural Contradictions of a New Elite and was surprised by the different perspective of the author.

The foundation idea is that a new “woke” elite uses the language of social justice to gain more power and status for themselves and their enhanced elite status does not translate into help for the marginalized and disadvantaged. It is a cynical perspective, yet to resonates with the simple view that most individuals are interested in their own status and power first and helping others second. 

Language can generate status and serve as an exclusionary mechanism. Status and elitism may only serve to further generate social and economic inequality. Is that always the case? Certainly not, yet the good intentions for being a social justice advocate embedded in language and symbols may also have the impact of creating more status for individuals without helping those that need it most. Musa al-Gharbi writes a book that that is richly detailed and footnoted and unfortunately, sometimes filled with jargon, yet his argument is compelling, albeit sad.

The focus on the Eurasian continent

 

Hal Brands provides s history of the geopolitics associated with the Eurasian continent over the last 100 years. While the history was interesting and a quick read, it centered more the European politics during the 20th century and now the switch to a focus on China. It did not spend much time on the development of the Russian empire which has always focused on trying to dominate the Eurasian continent. 

Now it is China who is trying to dominate this land mass. To some degree the US is a digression to this long struggle and core Europe is also a marginal player in these geopolitical dynamics. 

This is a Russia-China story first and world politics story second. In an effort to protect its western border, Russia has made a pact with China, yet solving one problem will create a new problem on its eastern reaches. There is a new partner mix between Russia and China that will define the next decade of the 21st century. 

Unfortunately, most analysts do not seem to be overly concerned about this changing balance which will impact the supply of key natural resources. Brand provides a nice recap of Eurasian politics, but it does not stretch the imagination of what is and what will be.