Dollar moves reversing liquidity crisis and expressing money growth differences

Investors should be concerned about the value of the dollar, but a portion of the current dynamics are normal. In the short-run, a crisis will create a run on safe assets which will push the dollar higher as investors move to Treasuries and avoid risky assets. Once this liquidity crisis subsides, the excess dollar demand will reverse. The reversal will usually be more pronounced with advanced economies than with emerging currencies given the higher EM risks. We have seen this liquidity stress process work through current financial markets. Dollar swaps with the Fed are no longer necessary to provide liquidity. Beyond the liquidity crisis, the relative macroeconomics will rule dollar moves.

Regardless of the liquidity crisis effect, the dollar is likely to continue to weaken as long as Fed monetary policy is relatively easy versus other major central banks. The favorable dollar interest differential especially versus advance economies has collapsed. While a monetary approach to exchange rates may be a poor forecast in the short-run, the current size of Fed balance sheet expansion is a blunt signal for currency markets. 

Given that many goods and services are priced in dollar, the current decline will support higher product demand. The dollar is still above post-GFC levels, so a gradual decline may mot be threatening to global financial health. Additionally, the dollar decline is euro focused and has not been seen in emerging markets.

Concerns about the dollar also have to be tempered or measured through which lens is being used to discuss currencies. We will note that the dollar-euro exchange rate does not represent the dynamics of the dollar in general. The Fed dollar indices are traded-weighted not capital flow weighted. We have provided the weights for the advanced and emerging Fed dollar index. We will note that the Fed advanced economies dollar index will differ from the ICE DXY futures-based dollar which has an over 55% euro weight. It matters which dollar you are discussing. Watch but don't panic. 

What does it take to win in equity markets? - Watch your factor risk exposures

Tracking factor performance can enlighten, yet it seems confusing in 2020. In a pandemic slowdown, a growth portfolio has done over 2.5 times better than the market portfolio. The momentum factor has done over 2 times better. Those two results may seem out of the ordinary. However, if you equally weighted your portfolio, returns would have underperformed the market portfolio by 10+ percent. A high beta portfolio underperformed by about the same amount as a low volatility factor portfolio, and the high dividend factor would be down over 30% relative to the  market benchmark. 

The current lesson; go big with large cap growth and momentum even in a recession. Of course, that is not the right lesson, but it is the lesson being reinforced with current returns. There will be momentum crashes and thee will be revisions of growth, but the timing and process of this market adjustment is not at all clear. For those who have diversified factor risks outside of growth and momentum to reduce market risk, you will have to wait for the benefits.

Smart investors not immune from my-side argument bias

We want smart money managers to run our investments, but it is hard to define what smart means. There is formal reasoning or mathematical skill, but when we say smart, we are focusing on the ability to grapple with arguments associated uncertainty.

An important topic in education is measuring this informal reasoning, or the ability to make arguments to support or reject a proposition. Formal reasoning is defined as the use of logic and mathematics with fixed or formal premises. Informal reasoning focuses on inferences with ill-defined premises and associated with open-ended questions. Most of the problems we face require informal reasoning. Most of the investment problems we face are not analytical, although we would like them to be, but require informal reasoning for poorly defined questions. Unfortunately, most have a problem with formulating opposing argument against our existing point of view. 

A my-side argument skill is the ability to generate numerous arguments for your existing point of view. An other-side argument skill is the ability to develop alternative arguments against your point of view. Any investor will need my-side argument skills to justify his actions, but a great investor has to have other-side argument skills. He needs to argue both the pro and con of an investment thesis. This is a skill that is difficult to teach and measure and may not be correlated with raw cognitive ability. 

What has been found with extensive testing is a my-side bias, the tendency for people to evaluate and test evidence in a manner consistent with our own opinions. We look to confirm not deny our beliefs. The my-side bias is uncorrelated with cognitive ability as measured by SAT scores.  Smart people do it as well as those with less smarts. The my-side bias seems to be negatively associated with more education, but it does differ by beliefs and topics of domain which suggests that individuals have strong belief biases.

Breaking existing belief structures is one of the most important skills for any worthy investor. This even applies for those who are systematic traders like trend-followers. We like the trends that are consistent with our beliefs. We dislike the trends that seem contrary to our beliefs. This bias is why trend followers often don't mess with their models through overrides. You may change a model but don't just select the trades that suit your view of the world from your model. Of course, this can apply to any modeling approach. Fight the my-side views and learn to embrace the other-side and follow the odds even if contrary to your beliefs.  

Volatility and uncertainty both declining - Good for investors

The stock market has been moving higher on almost any good news so there is little reason to add to this euphoria; however, it is worth tracking some characteristics that risk and sentiment. The VIX is following expect after a shock; a slow decay to normal. We are not there yet, but the processing is occurring even with rising uncertainty concerning the November election. 

What is driving the decline in VIX is a decline in economic uncertainty as measured by the news aggregation from the index created by the academics of the Economic Policy Uncertainty website. They have increased their offerings of indices to include an equity market uncertainty index that is focused on news related to the stock market. It is scaled to the VIX and uses economic, market, and volatility counts in major newspapers. A comparison with the VIX shows that there are uncertainty news spikes correlated with the VIX. These spikes are usually short-lived with longer VIX decay. 

The recent economic uncertainty index spike was stronger and longer lasting than usually. The index decay suggests that there should be a corresponding decline in market option volatility as seen in the VIX. As long as the uncertainty is declining, the VIX should follow the same pattern.