Tuesday 31 August 2010
Wednesday 25 August 2010
Friday 20 August 2010
In a recent article  Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.
I. Investing based on mean reversion will be less compelling
II. Risk on/risk off fluctuations in sentiment will continue
III. Tail hedging becomes more important
IV. Historical benchmarks and correlations will be challenged
V. Less credit will be available to sustain leverage and high valuations
Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.
However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.
As long as markets continue to follow the second implication (as they have done since time immemorial) and flip flop between irrational exuberance and the depths of despair, then mean reversion (at least in valuations) is likely to remain the best strategy for long-term investors. (This also highlights the apparently contradictory nature of the first two implications that the authors point out). We don’t require long periods of time at equilibrium for mean reversion strategies to work, rather (and considerably less onerously) we simply require markets to pass through the equilibrium periodically.
As always, investors need to be mindful of the context of their investment decisions. It is always possible that we are standing on the brink of a shift in the level to which asset valuations mean revert. But that has always been the case. Only careful thought and research can work to try to mitigate the dangers posed by this threat. After all, if investing were both simple and easy, everyone would be doing it.
The third implication that tail risk hedging will become more important is and always has been true (much like the second implication). The prudent investor should always pay attention to tail risk – the new normal doesn’t alter that.
Ever eager to please, the ‘engineers of innovation’ (or should that be the ‘architects of destruction’?) are happily creating products to serve the new bull market in tail risk. Deutsche Bank is launching a long equity volatility index, while Citi has come up with a tradeable crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Strangely enough, Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. Even the CBOE is planning a new index based on the skew in the S&P 500.
However, any consideration of the purchase of insurance should not be divorced from a discussion of the price of the insurance. Cheap insurance is wonderful, and clearly benefits portfolios in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand!
You should really only want insurance when it is cheap, as this is the time when no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset ... a path to the permanent impairment of capital. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves your dry powder for times when you want to deploy capital, and limits the downside.
So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffett said, holding cash is painful, but not as painful as doing something stupid!
In summary, the new normal may pose some issues for investors who have never bothered to study history (which is, of course, littered with many, many ‘new normals’). However, for those with perspective, prudence, patience and process, many of the same ‘eternal’ rules are likely to govern the game as they always have, come rain or shine. In essence, many of the implications are less the new normal, and more the old always!
 Uncertainty changing investment landscape, Market Insight, 2 August 2010
Thursday 19 August 2010
Wednesday 28 July 2010
Why anyone would care what any bank thought of attempts to regulate it remains beyond me. One of the major problems of Basel 2 was that banks were allowed to use their own risk models to value assets. This is akin to asking kids to mark their own homework, one shouldn't be surprised when they report they got 100% correct.
Talk about not learning from mistakes. Hasn't anyone heard of regulatory capture?
Tuesday 27 July 2010
Very interesting response to this paper, I have rarely been called a moron more often.
Others have accused me of talking my book, presumably wanting QEII to drive the markets higher, frankly given the stocks we own the last thing we want is yet more speculative demand for junky stocks!
Thursday 22 July 2010
In the past I've talked about the need for cheap insurance, and the benefits that this can bring to a portfolio in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand! You should really only want insurance when it is cheap, as this is the time when the no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset...a path to the permanent impairment of captial. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves the dry powder for times when you want to deploy capital, and limits the downside.
So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffet said holding cash is painful, but not as painful as doing something stupid!
Wednesday 7 July 2010
The sheer hubris of many in the economics profession never ceases to amaze me. Take for instance a recent paper by Kartik Athreya of the Federal Reserve Bank of Richmond entitled “Economics is Hard. Don’t let Bloggers Tell You Otherwise”. In a move that is eerily reminiscent of the controversial talking Barbie of the early 1990s who fatefully uttered “Math class is tough”, Athreya’s short paper essentially lays out a quite staggering claim :- that economics should be left to those with a PhD in the subject!
Athreya describes himself as “a worker bee chipping away with known tools”. He goes on to say “writers who have not taken a year of PhD coursework in a decent economics department…cannot meaningfully advance the discussion on economic policy”. You’ve got to love the ‘decent’ in that sentence – it reeks of intellectual snobbishness of the highest order.
In fact, Athreya’s ire isn’t limited to what he sees as uninformed debate, he seems to object to anyone who attempts to make the policy issues of the day clear even if they have a PhD. He pejoratively describes both Paul Krugman and Brad DeLong as “Patron saints of the Macroeconomic Policy is Easy” movement.
He argues that we won’t expect particularly informed discussion on the causes, consequences and treatments for cancer from non-Oncology specialists, so why we would we expect non-specialists to offer any useful debate on economics.
However, the analogy is false. Modern medicine is based on scientific principles and follows an evidence based approach. Even then some estimate that the majority of published findings in medical journals are false!
Economics starts from a far worse place. It isn’t a science, and often seems more interested in twisting the facts to fit a theory rather than the other way around. In fact, as Nassim Taleb has pointed out, economics is more akin to medieval medicine than its current practice, “Medicine used to kill more patients than it saved – just as financial economics endangers the system by creating, not reducing, risk.”
The idea that what we need is more ‘worker bees’ gaining their PhD’s from conducting ‘angels on a pin head’ like work based on minor alterations to previous research makes me want to cry. Where were the warnings from the orthodox economics establishment ahead of the global financial crisis? Oh, that’s right there weren’t any.
Indeed many of those who warned of the problems ahead did so because they weren’t constrained by the kind of training that an economics PhD suffers. I did my own training in economics a long time ago now, it included a fair amount of equation bending but I was incredibly fortunate that it included generalist topics such as Marxian and post-Keynesian economics, subjects that are oddly absent from the vast majority of syllabi.
In many ways economics as it exists today is largely a victim of learned helplessness - a phenomenon was first documented by Martin Seligman in the 1960s. He was working with dogs (dog lovers look away now) and studying conditioning when he came across something interesting. Seligman was subjecting pairs of dogs to nondamaging but painful electric shocks. However, in each pair of dogs one animal could put an end to the shock by simply pressing the side panels of its container with its head. The other dog was unable to turn off the shock. The electricity was synchronized, starting at the same point for both dogs, and obviously ending when the dog with the control turned off the power.
This gave the each of the pairs of dogs a very different experience. One experienced the pain as controllable, while the other did not. The dogs which had no control soon began to cower and whine (signs of doggy depression) even after the sessions had stopped. The dogs which could control the shocks showed no signs of this behaviour.
In the second phase of the experiments dogs were placed in box with a low wall separating the container into two. One side (the side on which the dog started) was electrified. To avoid the pain the dog simply had to jump the low wall. The dogs which had controlled the shocks in the first round quickly learned to jump the wall. However, the around two-thirds of the dogs who had no control in the first round, simply laid down and suffered the pain, they had learned to become helpless.
Modern day economics is much like these poor animals. Many economists have learnt to become helpless. They would rather lay down and whimper and whine about how unfair the world is, and mutter that everything would be alright if only people behaved like their models, than seek to look outside the narrow confines of their obsession with rationality and mathematics to see if others might just have some useful insight.
The age of the specialist (people who learn more and more about less and less, until they know absolutely everything about nothing) has proved to have some fundamental flaws. Three cheers for the generalists!
 For more on the weird and wonderful versions of Barbie that have graced the shelves over the years see http://shine.yahoo.com/channel/parenting/11-bad-barbie-ideas-1312923/?pg=8
 Atherya does have the sense to point out “Taken literally, I am almost certainly wrong.”
 John Ioannidis (2005) Why Most Published Research Findings Are False. PLoS Med 2(8): e124. doi:10.1371/journal.pmed.0020124
 Taleb (2007) The pseudo science hurting markets, Financial Times, 23 October 2007
Just for the record, I now work as memeber of the asset allocation team at GMO. However, the views expressed on this blog are entirely mine, and mine alone. They in no way reflect the views of GMO.