Bazerman's power of noticing - investment wisdom

One of the leading scholar on leadership and decision making is Max Bazerman who has produced another good book on practical decision-making, The Power of Noticing. His simple observation is that to become better decision-makers we need to increase our power of noticing. Too often we do not see the details in front of us, or what may not be in front of us because we are over-focsued.

Daniel Kahneman's work on fast and slow thinking develops the concept of WYSIATI, "What You See Is All There Is". Our focus only on what is immediately available is a critical bias in our thinking. Bazerman describes an opposite problem, WYSINATI, "What You See Is Not All There Is". You have to focus on noticing what is not there or what you may be missing. Our bounded awareness creates a more decision-making environment. For Kahneman, the answer is thinking slow. Bazerman takes as slightly different view. The answer is improving our power of noticing.

All investors have to realize there are impediments to noticing. Some of those are institutional. We create environments where noticing or looking outside of the box is frowned upon. Call it institutional blindness. There is motivational blindness and conflicts of interest with looking. Leadership is more than just doing a better job of observing but forming a culture of noticing. There should be no predictable surprises. Forgetting hindsight bias, noticing should eliminate phrases like, "why am I always surprised by that" or "I should have seen that coming."

Form our perspective, the best investment solution for noticing is constant research, measurement, and rules. Having a system of what is known frees time for looking at new research and creates a culture of analysis. An irony with any rules-based system is that its success is through constantly looking for ways to improve the system. Slow thinking and noticing to always determine whether the rules as odds on favorite. 

Fed mechanics - More important than ever for investors

In the 80's and 90's understanding the Fed was all about reading the tea leaves of unknown behavior. The focus of analysts, Fed watchers, was on the lack of Fed transparency. Firms hired former Fed economists to get the inside scoop on what was going on in the FOMC. You did not see minutes and you did not get clear answers on policy. It was all about reading the tea leaves.

With limited transparency, much of the Fed discussion concerned creditability; could the Fed send clear signals through clear policies that showed its intentions. The instruments and the mechanics of the Fed were very simple. The Fed would raise or lower the Fed funds rate through open market operations. (I am eliminating the period of monetary targeting which was more confusing than a true change in rate changing policy mechanics.)

2015 will be a very different year because the mechanics of monetary policy will be more important than ever before. It will be important to know not only what the Fed will do but how policy will do implemented. The microeconomics of policy will be very relevant for banks, dealers, and money funds The rate on excess reserves, the reverse repo rates, the structure of the balance sheet, the lending behavior of the Fed, bank regulations, Fed forecasts, and transparency from policy statements will all play a part. Looking at just the Fed funds will not be enough. Similarly, the Fed cannot just raise the Fed funds rate and assume that the balance sheet will adjusted through separate set of objectives. Investors will have to spend more time learning the arcane dynamics of money.

Policy transparency and forward guidance is still a major area of uncertainty for investors. Clarity is still in short supply, but the added dimension of Fed mechanics uncertainty will test the skills of any rate sensitive investor.

Big trends of 2014 - think of asset classes

The big story for hedge funds has been the return of managed futures, not that it ever left the investment strategy choice set, but 2014 has proved managed futures to be an effective strategy relative to many other hedge fund styles.  Managed futures is still mainly a strategy of trend-following. Hence, its success will be tied to big trends.

To break down the story of its success this year, you have to focus on the major market trends. Nevertheless, individual market trends at usually not enough to drive performance. You need to have asset sectors make big moves and this what made 2014 special. On a more micro level, big fund returns are made when the most liquid markets have a move. It not enough to have a big move in a single illiquid market. Diversification will dampen the effect of a one market trend.

Here were the big moves for the year. 

• The return of currency trading. With a significant number of G10 currencies declining more than 10% over the year, it was a great year for currency trading. Given the relatively low volatility for the asset class, it does not take as great a move in price to create profitable trends. The long dollar basket was able to generate consistent performance with volatility still being in the low end of the multi-year range. The drivers of expected tightening by the Fed and loose monetary policy in Japan and QE in Europe created a perfect trend environment.

• The big oil move made the energy sector another winning sector. The oil market declined from year highs of over a $100 per barrel to current levels of $55 which is close to a 45% decline in price in about six months. These intense trends just do not come very often. At current volatility this was more than a two standard deviation event. Heating oil and RBOB gasoline saw similar declines in price over the same time. The exception was with natural gas which declined in the first half of the year before rebounding. In this case the oil complex was a good short trade across the product board. 

• Equity indices continue to provide trend opportunities. The market trends for equity indices were generally upward for the last year, but there was a significant difference based on the geographic region. The S&P 500 was up 13.4%, but the European STOXX 50 gained only 4.58%. The Nikkei gained 10% for the year. However, the trend was interrupted by significant reversals such seen in October markets.

• Bonds also showed trends even at low overall levels. The bond rallies for most of the year were the surprise event for many forecasters. However, changing yield curve dynamics meant that picking the right maturity was an important part of a generating sector profits. The gain in the long bond (US) was almost three times as large as the 10-year (TY) futures. Short-rates were not an area of for profitable trend except if trade were made out the curve beyond 18 months.

• Commodity markets required more skill to generate gains even with a number of markets showing strong ranges within the year. The success in commodity trading was more dependent on trading less liquid markets like softs, cattle, and hogs. For example, coffee moved higher by over 50% and cotton saw a decline of over 50% from its intra-year high. Cattle and hogs both saw retreats from large earlier in the year trends. The strong trends in the grain markets saw significant intra-year reversals. For example, corn rallied close to 20% until May only to drop 40% until October and then see a 20% rally. These reversals will cut into any trend strategy. Soybeans and wheat followed a similar pattern. The ability to take profits and reverse positions was the key to commodity success. 

• The metals markets generally trended downward but the behavior was not as straightforward as obviously seen in the energy markets. Again, the success with trading metals was based on the market choice. General sector exposure would not be enough for highly profitable trend trading.

So which markets will be the trend drivers for 2015? The true trend-follower will be very straight-forward with an answer.  You just don't know. Trend-following is non-predictive in the sense that it does not make forecast but follows what the market prices provides. There is only one prediction; trends will happen at some time and in some markets. 

Answering the big questions of 2015

Calculated Risk suggested that there are ten big questions to be answered for 2015. I agree with the list, but I also think there are some additional key questions that have to be addressed. Any investor should think about what should be their answers to these questions; however, forecast at your own peril. The one think we have learned through our systematic trading is that macroeconomic forecasting can be a fool's game. The key is to stick with what the market is telling you and just determine the current state of the world and not try to move to forecasts that are subject to error.

Here is the list of key variables that have to be forecast and some of the major impediments that will face sustainability.

Economic growth - The third quarter growth caught everyone by surprise, but also was within earlier expectations that the second half of the year would be a lift-off period. The question is whether US economic growth will be at the old normal or the new normal in 2015. Can the output gap closed? Unfortunately, the gap between growth and market move is often not strong.

Employment - You have to go back to the 1990's to have an employment year like 2014. 200,000 jobs a month has cut into the backlog of unemployed but the issue is whether there is enough growth to sustain the 200,000 months.

Unemployment - The unemployment rate has fallen faster than what many have forecasted. In fact, it has fallen so fast to 5.8% that the Fed is now focused on slack in inflation as a guide for policy. It is hard to believe that 2015 will continue to see this number decline.

Inflation - US inflation is below the 2% target and heading south on falling oil prices. The question is when will we see the magic 2%. The only way this is possible is for oil prices to increase and growth continues at the rate seen in the third quarter.

Monetary policy - The first increase is expected in mid-2015, but there is enough uncertainty that a delay should not catch the market by complete surprise.

Oil prices - OPEC thinks oil prices will stabilize at the higher price of $80, but the marginal producers are non-OPEC members. The only way for prices to rise is for producers to find current prices worthy of a shutdown in production. This will only occur if there there is further strain in the energy sector with increasing credit problems.

Residential investment - The investment rate for 2014 was below 2% and not like the double digits of the last two years. For new residential investment, the market will have to see prices moving up at the rate seen over the 2011-2013.

Housing prices - The rate of increase in the Case-Shiller index was about 5% for 2014. Not bad for this market, but less than the stock market. If rates are moving higher, it harder to thing the housing prices will return to double digit numbers.

Housing inventory - The inventory numbers are starting to move higher. The dynamics of housing is such that we do not know the real supply that will be available at any price. Many homes have been held back from the market, so it hard to forecast inventory changes.

Wage increases - We have economic growth. We have rising employment. We have tightening in labor, but we do not have increases in real wages. It is hard to see how growth can be sustained if real wages are stagnant.

Bonus questions -

Europe growth - No fiscal policy and and unclear monetary policy makes it hard to determine whether we will see any robust growth in this region.

Japan growth - Abenomics has gotten the stock market higher and the year has fallen nicely but this all to get growth higher.

Chinese growth - The 800 pound economic gorilla will drive commodity markets and capital flows, but how will this work if growth is below 7%.

We may have opinions on these markets but we think that few of the consensus forecast will prove to be true in 12 months. This is the normal situation regardless of how many times we play the end of year prediction game.