Jerome Brunner - Logic and narrative go together

 

Jerome Brunner, one of the towering figures in psychology and cognitive learning, developed a simple cognitive theory through framing experience into two models, propositional and narrative. Propositional thinking focuses on logic and formality, while narrative is based on storytelling. Narrative is emotional and needs to be personally convincing. It is the narrative that holds the propositional logic together as a useful tool. Simply put, we cannot develop theory and logic in a vacuum; instead, we use narrative as a tool to support our thinking or convey it through stories. The narrative provides an emotional connection.

We can use that framework to think about how stories are conveyed on Wall Street. Nothing is done through a review of model results. No talking head refers to a model. The models are condensed into a concise story or narrative. The narrative can provide a connection that is not present in a model. 

Perhaps an extreme, but Fed independence is not presented as a formal problem in time inconsistency, but as a fight for control over a policy lever. The acquisition of a firm is not described in terms of numbers, although a price is associated with the purchase. There is a discussion of strategic advantage and how the whole will be greater than the sum of the parts. 

See also:

Narrative and investing - Follow the facts

Financial globalization is determined by state actors

 

State and the Reemergence of Global Finance: From Bretton Woods to the 1990s by Eric Helleiner is a fascinating book on the politics of international plumbing. As a macro person, I focus on models and price relationships, rather than regulation or international relationships across countries. This book highlights the significant impact of global policy choices by states on markets. This should be viewed as obvious, but we often focus on innovation and market forces as the drivers of change; however, it is frequently the will of the state that is the major contributing factor. Financial globalization was not an organic change to the international order but was orchestrated through the policies and dictates of state players. This was a different perspective that I did not fully appreciate. 

Clearly, the world is being reset with respect to trade through tariff policies; however, we cannot forget that the world can also change through policies that impact capital markets and flows. Capital markets may have a greater impact on inter-country dynamics. While we have not seen capital flow policies change directly, the talk for a weaker dollar is clearly having an impact on flows. The sanctions placed on countries also have a flow constraint. We have not changed policies on capital controls, but the weakening of international organizations has spillover effects on capital flows. Financial globalization or deglobalization is in the hands of policymakers, and should be given more attention by all in finance.

Return stacking - an easy approach for return enhancements

 

Return stacking is not hedging. Return stacking is not a solution to higher returns. Return stacking is a means of efficiently using capital through mixing core assets with the benefits from futures margin structures. It is a variation on portable alpha strategies, or portable beta by another name. An investor gets capital efficiency through gaining exposure in futures for a core asset. The unlocked capital can then be used to buy another asset. See "Return Stacking &Portable Alpha: An Investor's Guide".

The core approach can allow capital to be used to create a better return-to-risk trade-off efficiently. Of course, the choice of the stack will determine the return-to-risk. The foundation of this work is based on choosing assets in the stack that are uncorrelated.

Private equity payoffs - Set of options

 

The return profile for private equity is one of the critical investment issues for many institutional investors. This will also become a crucial issue for retail investors if many of the large PE firms have it their way. We need to go back to basics and look at the pay-off structure for private equity, and the graph below provides valuable insight. This chart is from the new paper "Analytic Valuation of Private Equity Investments". 

Notice that four distinct pay-offs form a real option. If you cannot pay the borrowing costs, the investor makes nothing. Once the costs are covered, the investors make money until the invested capital is returned, and the GP then receives his fees. Afterward, the investor receives the excess. You have to clear hurdles to receive the next set of cash flows. There are failures which impact this pay-off, and the investments are illiquid and take, on average, 5-7 years to return capital. This is a long-term option on the quality of management to provide a return above the cost of capital. 

Toynbee on history - can relate to finance

 

From Toynbee on Toynbee: A conversation between Arnold J Toynbee and GR Urban. 

...in both physical science and in the study of human affairs, the test of the difference between what is chance and what is law - regularity - is one's conception of the structure of non-human nature and the structure of human nature. 

FInance is the search for regularity

...history being the victor's propaganda.  - Urban 

A fact in history is not really something concrete like a brick or a stone, that you can pick up and handle; a fact is manmade in a sense  - it is the result of a selection from the raw material... Homo sum humanum nihil a me alienum puto - the spectator is also an actor.

In finance, we select our facts. 

...Italian philosopher Croce as saying that all history is contemporary history... every human being is situated in a point-moment of time, and he can only observe the universe from this shifting point-moment. 

Our view of finance changes with time.

History is what historians write, not what actually happened, because it is only through the cognitive process of the historian that we can read meaning into an otherwise random accumulation of facts.  - Urban 

In finance, we search for meaning through our point of view.

What if Treasury bonds are not a safe haven?

The convenience yield associated with Treasuries has declined. The safe haven effect for Treasuries has also declined when measuring the reaction during the COVID pandemic. The most pressing question is why Treasuries are less of a safe haven. Researchers have focused on the supply of Treasuries as the leading reason. There is a premium paid for the safe asset if there is a threat of a shortage. If the supply of Treasury increases, the threat will be reduced, and more importantly, there is a risk that the safe asset will lose its value. There will be a desire to find alternative safe assets. 

Since the Great Financial Crisis, there has been a doubling of the debt to GDP in the US. Additionally, there has been a more than fourfold increase in the total public debt from $8 to $36 trillion. That is a lot of safe assets. If there is less need for the safe asset and if investors believe the safe assets are less safe, then the convenience yield will go down and the relative cost of financing will increase. 

If the safe haven effect falls, there will be a search for substitutes, and the cost of Treasury funding will increase.

The convenience yield for Treasuries

The safety associated with Treasuries means that it has a lower yield than comparable bonds. A simple way to measure this convenience yield is through the spread against AAA-rated bonds. The convenience yield or premium you are willing to pay during a crisis will rise, but what seems to be a trend is the decline in convenience yield over the last ten years. We are at the lowest convenience yield since the mid-1990s. The interesting point that has been noted by several researchers is that the convenience yield during the pandemic was much lower than the GFC or the tech bubble. 

The question on the mind of many is whether Treasuries have lost their safe-haven status. Many are now saying that the significant increase in Treasury debt is softening the safe haven effect. It is unlikely that it is gone, but it seems to be muted. What is its substitute? It could be gold, but there is not enough of the real asset to make up for the Treasury demand. It is not likely to be Europe, so what is the new safe haven?

 

BlackRock suggesting higher allocation to hedge funds

The BlackRock Investment Institute announces that investors should increase their allocation to hedge funds. It is not clear what the rationale is for this increase. Equity markets are overvalued and bond yields are not expected to move lower. Private equity is facing liquidity issues. Hence, hedge funds are a safe haven by default. As a diversifier, hedge funds may do the job, but the story should be more nuanced. Stock-picking has improved with market dispersion, but many hedge funds have relatively high betas. If the market moves lower, hedged funds will likely also see lower returns, albeit muted. 

The choice of hedge funds and the allocation are related to a market view. If there is a view that equity and bonds will not perform because of the macro environment, investment strategies should be focused on managed futures and global macro. For equity exposure, market neutral should be preferred. 

However, there is a bigger issue associated with fund flows. If there is limited alpha, what will happen to returns if there is a major increase in fund flows into hedge funds? There has not been enough work on the flow effects on alpha returns. More money chasing the same number of opportunities will lead to lower returns. Part of good investing is being in strategies before the "big money" enters the trades. 

The current problem with government statistics

In contrast to physics, there is no estimate of statistical error within economics in spite of Oskar Morgenstern’s book, On the Accuracy of Economic Observation. The problem of error in economic observations is still a widely neglected problem. The various sources of error that come into play in the social sciences suggest that the error in economic observations is substantial. As the error might be substantial, this paper argues that the usefulness of econometrics becomes questionable. - Philipp Bagus Rey Juan Carlos University

The multiple news stories about the change in leadership and the BLS miss the key point that we are facing with macroeconomic analysis. We are only as good as the data that we use. If there are significant errors with the underlying data used to make macro decisions, there will be greater market inefficiency. Major revisions will reduce he trust in the numbers. Minor modifications will help investors refocus their attention on this data. The market reaction to any announcement will decline. It is not that the market will make wrong judgments based on the data, but that no judgment will be made at all. There will be less market reaction on any announcement date, yet there is likely to be greater misallocation of resources. 

Gold and the problem of fiat money

 

The US government has consistently tried to marginalize gold, and has all of the focus on the dollar, but that only works if we behave ourselves. If we add a lot of debt on top of a fiat currency, it doesn't work.” - Chris Walen

I have not been a gold bug, nor will I change, but there is a problem with fiat money. Money is a store of vlaue because people believe it is a store of value. It is a matter of trust. The safe asset is a safe asset becasue it is belived to be a place where value is maintained.

The literature on safe assets does note that the safety is a relative concept. If there is too much of the safe asset, there will be a decline in that asset's safety value. When that happens, investors will look for other safe assets. If those other safe assets have a problem of excess supply, there will be a demand for real assets that offer safety and limited supply. 

The increase in gold demand is a response to the excess supply of Treasuries based on the large US budget deficits. The safety of Treasuries is being eroded, so there is a search for alternatives.  

Apple in China - a very important read

 

If you want to learn about the complexities of trade and geopolitical relationships, read Apple in China. This is a long book with a lot of inside details about Apple, but only through a long history of the development of manufacturing to meet the strong need for Apple products can you appreciate how we got to the current place in trade wars with China. With a desire just to meet demand, Apple invested heavily in Chinese suppliers. Other firms could not deliver what Apple needed. 

It was a one-way street with Apple demanding extraordinary goals from its suppliers. In exchange for these demands, they provided significant knowledge and support, but eventually, Apple became too dependent on their suppliers and the handout from local governments. Tied with strong demand for Apple products, the China-Apple relationship flipped with China through suppliers, customers, and the government wagging the dog. With all of the knowledge transfer, suppliers were able to support local companies that now compete against Apple. 

The ties with China were expedient but now have an edge where Apple may not be in charge of its destiny. There are no easy solutions for relocating manufacturing from China without significant financial costs. While the author does not write about the future, Apple has some very hard choices to make and it may not be able to weather this trade storm

The quantity theory of money still exists

 

Tim Congdon authored a new book, The Quantity Theory of Money: A New Restatement, last year. It is a historical retrospective of the classic quantity theory of money with some new twists. It is not a easy book for those who are not familiar with the long history of money. It takes a number of twists and turns on why some explanation do not work, but in the end, Congdon again emphasizes that money is at the heart of any discussion of inflation. 

The key insight is that money will impact not just the bond market which is the traditional view in the classic IS-LM modei but will also affect othe asset markets and goods markets. Money seeps into everything we do. We have to also focus on broad money, and how it affects asset purchases and goods purchase decisions. The link between money and credit is a better description of how it impacts transactions nd prices than the simple Friedman money multiplier.  

The inflation post-COVID should not have been a surprise for anyone who follows the money trail.

A very important book even for finance people - Autocracy, Inc.

 

I don't often comment on non-finance issues, but I was moved after reading Autocracy, Inc. by Anne Applebaum. This was not an emotional feeling, but anger that the autocrats of the world are forming connections to maintain their power in their respective countries. These autocratic connections are thwarting democratic movements around the globe. Applebaum provides good descriptions with substantial evidence on how dictators want to work together for their common benefit. 

The solutions to this problem are not obvious; however, there needs to be some form of international order and coordination between Western democracies to ensure that the global behavior of dictators does not rule over others. A coalition of democracies needs to actively engage in efforts to stop autocratic coordination. Obviously, this is being done, but the efforts have not been strong enough. 

The next credit crisis - student loans again?

Corporate spreads are at all-time lows and household finances seem to be in good shape, but there is one area of concern - student loans. There was an extended moratorium on student loan payments during the Biden Administration due to the COVID pandemic, but that is in the past. Borrowers now have to pay up, and the bailouts are not there. The result has been an increase in delinquencies. This is especially the case for older borrowers who are nearing retirement. We are not at a crisis, but this is an area of concern that impacts spending and the ability of these consumers to take on any other debt. 

HedgeIndex July performance - generally on track

 

We look closely at the HedgeIndex Liquidity Alternative Beta indexes that are replications of the HedgeIndex Composite Index returns. As a liquid alternative, investors can get a quick look at performance before many hedge funds report their monthly returns. 

Returns were positive except the managed futures index, which continues to have a difficult time finding trends in the major futures markets. If there are no trends, the trend index will not make money. The other strategies continue to show positive gains. Nevertheless, the Liquid and Global Strategies are a weighted average of the other strategies and have been pulled lower in 2025 by the managed futures performance. 

While the SPX generated a return of more than 2% for the month, these liquid alternatives have a lower volatility than the market beta. The LAB indexes performed better than the low volatility index, which returned a negative 29 bps this month. These indexes are not supposed to beat the major risk factors but should add diversification to any portfolio. The equity LAB indexes performed better than the fixed income composite.

A Simple rulle of thumb on trading - the 3M's

 

"Markets always trading the 3Ms… Macro, Momentum, and Misfit trades" - Michael Hartnett BofA.

I like this short description of trading because it covers almost all you need to know. Trade the macro or at least have the macro determine the asset allocation. Trade the momentum or the trends because this is a risk factor that usually works. Trade the misfits or the outlier anomalies that are away from fair value. This is it. This is all you need to know as the base case. From there, the real work begins on how to make this work with actual trades.