Forget The Phony Pension Accounting, Here"s How Much Your State Pension Is Really Underfunded

The phony assumptions that go into calculating public pension underfundings in the United States are a frequent topic for us.  As our readers are aware, state pension administrators are given fairly wide leeway to simply pick a discount rate out of thin air.  Of course, since pensions are nothing but a massive stream of future liabilities that stretch out into perpetuity, every 100 bps increase can substantially, and artificially, lower the fund"s reported underfunded level. 

In fact, we estimated the impact of higher discount rates on underfunding levels in a post entitled "An Unsolvable Math Problem: Public Pensions Are Underfunded By As Much As $8 Trillion"...here was the result:

Fortunately, we"re not the only ones that see through the ridiculously phony assumptions that go into duping retirees and taxpayers as the team at American Legislative Exchange Council (ALEC) has just dropped a report which reviews the financial health of public pensions all over the country if you toss out their 7.5% discount rate and replace it with a risk free rate...

Faulty accounting and reporting methods obscure the magnitude of unfunded liabilities. Partly in response to the devastating impact of the Great Recession, the Governmental Accounting Standards Board (GASB) made two significant changes in 2012 (Statement No. 67, Financial Reporting for Pension Plans and Statement No. 68, Accounting and Financial Reporting for Pensions) to the methods used for measuring the financial health of pension plans. GASB intended these changes to increase transparency, consistency, and comparability of pension information. Public pensions are now required to report their assets and liabilities using a standardized actuarial cost method, to disclose investment returns, and to include unfunded pension liabilities on state balance sheets.

 

Unfortunately, states have found ways to work around these requirements and paint an unrealistically rosy picture of their pension funding status.

 

The Center for State Fiscal Reform at ALEC analyzes the annual official financial documents of more than 280 state-administered pension plans using more realistic investment return assumptions in order to gain a clearer picture of the pension problem. The unfunded liabilities of each pension plan are revalued using a discount rate equal to a risk-free rate of return, best represented by debt instruments issued by the United States government. This year"s study uses a risk-free rate of 2.142 percent, derived from an average of the 10- and 20-year U.S. Treasury bond yields over the course of 12 months spanning April 2016 to March 2017. Based on these revised investment return assumptions, we report on total unfunded pension liability, unfunded pension liabilities per capita, and the funding ratio of these plans.

...and as you might expect, the results are fairly bleak.  In terms on aggregate underfunding, ALEC figures our taxpayer-funded pension ponzis are roughly $6 trillion underfunded, or roughly 2-3x worse that the often-quoted $2-$3 trillion underfunding calculated by state pension administrators.  Meanwhile, using ALEC"s discount rates, the state of California is nearly $1 trillion underfunded by itself.

So, what is your personal share of these massive public liabilities?  Well, if you"re in one of the 10 bottom states it"s anywhere from $25,000 to $45,000.  Of course, that"s the liability for every man, woman and child so the typical American household (with 2.57 residents) in those states is on the hook for $67,500 - $115,650.

Finally, and perhaps most shocking of all, ALEC found that when using a risk-free discount rate only 1 state pension in the entire country was more than 50% funded.

ALEC"s full report can be reviewed here:

The Moment The Market Broke: "The Behavior Of Volatility Changed Entirely In 2014"

Earlier today we showed a remarkable chart - and assertion - from Bank of America: "In every major market shock since the 2013 Taper Tantrum, central banks have stepped in (even if verbally) to protect markets. Following the Brexit vote, markets no longer needed to hear from CBs as they rebounded so quickly that CBs didn’t need to respond." As a result, buy-the-dip has a become a self-fulfilling put.

The immediate result of this dynamic has been two-fold: i) investors now buy every dip, or as Bank of America notes, "Investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha.", and ii) selling of vol has become a self-reinforcing dynamic, in which lower VIX begets more vol-selling by "yield-starved investors", leading to even lower VIX as the shock that can reset the feedback loop is no longer possible, and thus the strike price on the Fed"s put can not be put to a market test.

These observations prompt BofA"s derivatives expert Benjamin Bowler to ask the rhetorical question: "volatility: new normal or bubble?" and answer: "It"s a bubble." Indeed it is, but absent the abovementioned market-clearing shock, it is difficult, if not impossible to anticipate what can burst this bubble.

In the meantime, the market has spawned some spectacular distortions, including the following observation: "As one measure of volatility, the Dow Jones Industrial Average traded in its tightest trading range since 1900 this year." Here is Bowler:

While asset valuations are not at life-extremes, volatility is. In 2017 the Dow traded in a 110yr record tight trading range, the VIX hit all-time lows, and US equities reversed from sell-offs at near their fastest pace in 90 yrs. Investors no longer fear risk but love it, as it’s another opportunity to harvest “dip-alpha”. Volatility across asset classes has decoupled from uncertainty. Even if seemingly irrational, apathy to all risk has been the right trade and an impossible trend for most to fight – the definition of a bubble.

A bubble, he adds, "induced by years of heavy handed central bank influence, where investors have learned that it has not paid to panic." Bowler asks readers to consider the following:

As one measure of volatility, the Dow Jones Industrial Average traded in its tightest trading range since 1900 this year

Near 90yr records are occurring in the speed that US equities are recovering from dips

The VIX is near 26yr lows despite political & policy uncertainty recently near 26yr highs

Gold call options price less than 1 in 100 chance of rising North Korean tensions in the face of rising North Korean tensions

The above leads Bowler to concludes that "while there is active debate about whether risk-assets like equities and credit are overvalued, it is much harder to argue that currently depressed volatility levels are unsustainable when near 100yr records in terms of low vol and the lack of persistence of any shock are being recorded."

So when did the market "break", and when did the behavior of volatility change so dramatically?

This overarching question has been plaguing Wall Street strategists for much of 2017. In July, we presented one answer from Deutsche Bank"s Aleksandar Kocic who pointed out the divergence between the economic policy uncertainty index and the VIX, which took place roughly in 2012, prompting the derivatives expert to conclude that something "snapped" roughly around that time, or as Kocic said, sometime in 2012 it was as if the markets “lost their capacity to deal with uncertainty.”

Bank of America takes a somewhat different approach, and instead of looking at the divergence between volatility and news - or shock - flow, highlights the moment BTFD became religion.

According to Bowler, "the nature of volatility since 2014 has entirely changed, with volatility shocks retracing at record speed. Investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha." This is demonstrated in the following stunning chart which not only shows that every VIX dip is now just an opportunity to buy it, but that the market"s "fragility" is at an all time high based on the surging frequency of vol spike events, which in turn, and paradoxically, reassure investors that a central bank backstop can not be too far away.

BofA is hardly the first to point out this phenomenon: almost exactly one year ago, it was JPM"s "quant wizard" who highlighted precisely the same, if not through the perspective of VIX but the overall market response to recover from "shock" events:

It appears that the time horizon of macro traders has shortened, likely as a result of increased participation of machines and algorithms that are quicker to adjust to significant events and can eliminate trading activity of slower investors. Consider for example the US elections - traders in Japan registered a 5.4% Nikkei drop on the 9th, followed by a 6.7% rally on the 10th, while S&P 500 investors did not register a significant close-to-close move over the election (due to market hours difference). These two days were enough to shift the volatility regime (usually calculated from closing returns) for the whole of 2016 for the Japanese equity market, and leave it unchanged for S&P 500 (e.g. think of rebalancing needs of a hypothetical risk parity fund, or a short volatility strategy based on Nikkei vs. one based on S&P 500). We also noticed that for a number of significant catalysts this year (Brexit, US Election, Italy Referendum) broad expectations were wrong both on the outcome and the directionally forecasted impact. It is possible that the lack of market reaction (or a reaction that went against the accepted narrative) was in part driven by investors’ reluctance to transact (“two negatives equal a positive”).

Ah yes, the infamous "investor reluctance to transact", which has only gotten worse as we hinted in our "trader paralysis" post, and which Goldman demonstrated vividly just last month when the bank showed that hedge fund turnover has now dropped to an all time low as virtually nobody trades anymore.

Whatever the reason behind the broken market, however, whether it is central banks, machines, algos, risk parity funds, vol-targeting strategies,  self-reinforcing "Pavlovian" dynamics, or simply traders no longer trading, the question is what comes next? While we will have a more detailed breakdown in a subsequent post, here are Bowler"s three questions, and several answers of what to expect in 2018:

As we enter 2018, three questions are top of mind when it comes to volatility:

1. Is 2018 the year when vol begins to normalize, or is this the “new normal”?


2. As low vol threatens to sow the seeds of the next crisis, how will this end?


3. Where does vol go in the longer-run; can we ever see the old-normal return?

 

Vol likely to rise off extreme lows; ’87 crash unlikely, but so is VIX averaging 20 While we will look at each question in more detail in turn, the short answers are:

1. Higher not lower vol: We think 2018 is most likely to see higher (not lower vol) as the Fed builds more “ammunition” in terms of rate-hikes leaving them less sensitive to financial market conditions (i.e. pushing the Fed put strike lower), and as CB balance sheets peak in 2018.


2. Vol bubble more likely to deflate than explode: While the risk of “fragility” shocks due to positioning and feeble liquidity is high, we think the level of leverage today, which is lower compared to the last time vol was this depressed (2007), does not present the same risks as then.


3. Vol to remain low vs. long-run average: However, to the extent we remain in a low inflation/low rates environment, we may also remain in a lower than normal vol environment. So while VIX near 9 is an unsustainable bubble, VIX at 20 (the long-run average) may also be unsustainable in a slower growth world.

And BofA"s conclusion:

What to watch for? In a world slaved to rates, inflation remains key

 

From a macro perspective, we continue to believe unexpected inflation is the kryptonite for volatility. Inflation presents a “triple whammy”, first driving economic vol higher, destabilizing bond markets (and putting bond/equity correlation at risk), but importantly handcuffing central banks from being as sensitive to financial markets. In other words it both drives fundamental risk higher and significantly impairs the protection markets have become dependent on. Rising rates vol is key to watch.

 

How bad can it get? From here Aug-15 shock likely but ’87 crash is improbable

 

Interestingly, while the world is hyper-focused on how big the “short-vol” trade is, history shows that any liquidity shock large enough to create an equity bear market (20% fall in equities, similar to 1987 or LTCM crisis) provides a forewarning in terms of rising volatility first (look for S&P vol to double from 10 to 20). Fragility shocks (similar to Aug-15) that happen without warning remain the bigger risk today in our view.

 

So, how do you trade this? Long “vol beta”, cheap options for direction

 

The most important question is, how do you trade this environment where investors have given up on risk (or have learned to love it as buying dips has been “free money”). Evidence of a “bubble in apathy” is strong, and we believe it is unsustainable. However, the problem with any bubble is not recognizing you are in it but rather timing its end. Hence the key is finding trades that will profit from a change in environment but carry well and hence don’t require perfect timing. The beauty of today’s low vol is that it can be cheap to own optionality (for example for upside stock replacement) which affords the benefit of not having to time when markets may peak.

 

Does this mean short vol is a bad idea? No, but it needs to be smartly managed

 

Importantly, believing that today’s low vol is unsustainable does not mean all short vol positions are bad. Don’t forget, owning any risk asset (equity, credit etc.) is a short-vol trade. The key is finding the best short vol opportunity (highest risk-adjusted returns), while managing downside risks appropriately. Harvesting rich vol risk-premia is key to funding cheaper long vol positions elsewhere.

Goldman: The Last Time This Happened Was Just Months Before The Start Of The Great Depression

Ah Goldman, never change.

One week after Goldman"s chief equity strategist David Kostin predicted a three-year bull market of "rational exuberance", lifting his 2018 S&P price target from 2,500 to 2,850 rising to 3,100 in 2020, and stating that should the exuberance turn "irrational", the S&P could rise as high as 5,300 by the end of 2020, another Goldman strategist, Christian Mueller-Glissmann, has decided it may be a good idea to play bad cop and cover all bases.

And so, in a report released on Tuesday "The Balanced Bear - Part 1: Low(er) returns and latent drawdown risk" this now bearish Goldmanite warns that in the medium-term, the two likely scenarios are either i) a "slow pain" deflation scenario of low yields and high valuations "which persist as macro is stable but there are less windfall gains from rising valuations and less carry - as a result, returns are likely to be lower across assets", or ii) a "fast pain" drawdown scenario in which there is "either a material negative growth or inflation/rate shock, or a combination of both, which drives a drawdown in 60/40 portfolios."

For those confused, don"t worry - you read it right. While on one hand Goldman is predicting nothing but blue skies for the "medium-term" of the next three years, predicting no recession and double digit equity upside, at the very same time, the very same Goldman is also forecasting either a "slow" or "fast" pain scenario, which while different, share one thing in common (as the name implies): "pain."

No surprise, Goldman talking out of both sides of its mouth, the only question being while the client-facing "research" is obviously crap and meant to get clients to do the opposite of what Goldman"s prop traders are doing, it remains debatable on what side Goldman"s prop is axed. Is the bank pulling a CDO and shorting everything it sells to its clients, or has the bank assured further S&P upside, even as valuations no "longer make sense" to quote, well, Goldman?

We don"t know the answer, nor do we care. For those who do, here is Mueller-Glissmann summary:

We think a period of low(er) returns (scenario 1) is more likely than a full-fledged bear market in 60/40 portfolios (scenario 2), at least in the near term. But there will likely be a balancing act with slowing growth and rising inflation. And at current low yield levels and with the ‘beginning of the end of QE’, bonds might be less effective hedges for equities and are likely a larger drag on balanced portfolios. And rising inflation could move the central bank put ‘more out of the money’, requiring a larger ‘growth shock’ for central banks to ease policy. Also current easing options are more limited for central banks as rates are still low and QE purchases have only just been reduced.

 

And once the balanced bear comes, it might be larger and faster. Duration risk in bond markets is much higher this cycle and vol of vol in equities has increased since the mid-80s. While we think investors should lower duration and run higher equity allocations in scenario 1, they should consider hedging at least the risk of smaller equity drawdowns in the near term. We like shorter-dated S&P 500 put spreads. In part 2, we intend to explore different strategies to enhance balanced portfolio returns while managing drawdown risk in case of a bear market.

Ultimately, like every other forecast to come out of Goldman, it"s garbage: want bullish, read Kostin; want bearish - either a little or lot - stick to Glissman. Just remember to use your friendly, Goldman salesperson who will gladly collect the trade commission whatever you do.

That said, there was one useful data point in the 26 page pdf: a chart showing that not only are we nearing the longest 60/40 bull market without a 10% return drawdown, but that the last time we were here was sometime in the late 1920s... and the Great Depression would follow in just a few months.

As Goldman observes: "we are closing in on the longest 60/40 bull market in history - there has been no 10% drawdown in real terms since 2009. A passive long-only balanced portfolio has delivered attractive risk-adjusted returns since the 90s. A favourable ‘Goldilocks’ macro backdrop, supported by the ‘Great Moderation’ and the central bank put, has boosted returns in both equities and bonds. However, after the recent ‘bull market in everything’, valuations across assets are as expensive as they have been this century, which reduces the potential for returns and diversification in balanced portfolios.

Some more statistics:

We are nearing the longest bull market for balanced equity/bond portfolios in over a century - a simple 60/40 portfolio (60% S&P 500, 40% US 10-year bonds) has not had a drawdown of more than 10% since the GFC trough (8.7 years) and has delivered a 143% return (11% p.a.) since then.

And when was the last time a balance portfolio had such a tremendous return? Goldman answers again:

"The longest run has been during  the Roaring 20s, ending with the Great Depression. The second longest run was the post-war ‘Golden age’ in the 50s - the 90s Boom has been in third place but is now fourth, after the current run.

In other words, one would have to go back to some time in early 1929 to be looking at the kind of returns that a balanced "60/40" portfolio is generating today.  In fact, the current period of staggering returns without a 10% total drawdown is now 8.7 years. How long was the comparable period in the 1928s? 9.1 years. Which means that if history is any guide, the second great depression is just around the corner.

Yale"s Endowment CIO Has Some Really Bad News For Public Pensions...

Public pensions all around the country like to play a clever little game that allows them to drastically understate the current value of their future liabilities and therefore pretend that their ponzi schemes are something other than insolvent frauds.  Of course, we"re talking about the artificially high discount rates that pension boards consistently use to understate their net underfunding levels...a topic that we"ve written about frequently over the years.

Alas, at least in the opinion of Yale"s Chief Investment Officer David Swensen, those 7.5% annual returns that pensions love to rely on, even if they"ve never managed to actually achieve them, are going to be increasingly difficult to hit over the coming years.  As Swensen told Bloomberg, despite achieving a 13.5% annual return over the past 32 years, he is now preparing university officials for much lower returns averaging around 5% for the foreseeable future.

The investment chief, who was interviewed by former U.S. Treasury Secretary Robert Rubin, also said he’s expecting lower returns for the university’s endowment, which he’s run for 32 years with a 13.5 percent average annual rate of return.

 

For the past 12 to 18 months, Swensen said he has been warning university officials to expect much lower returns in the future, as little as 5 percent annually, which would be down from previous assumptions of 8.25 percent.

 

“It’s not a very popular change,” he said. “We’re victims of our own success.”

Meanwhile, as we pointed out a couple of months ago (see: Pension Ponzi Exposed: Minnesota Underfunding Triples After Tweaking This One Small Assumption...), the state of Minnesota recently provided a beautiful illustration of exactly what happens when public pensions decide to ditch their inflated discount rates for more realistic assumptions...their net underfunding tripled to $50 billion...here"s more

from Bloomberg:

Minnesota’s debt to its workers’ retirement system has soared by $33.4 billion, or $6,000 for every resident, courtesy of accounting rules.

 

The jump caused the finances of Minnesota’s pensions to erode more than any other state’s last year as accounting standards seek to prevent

governments from using overly optimistic assumptions to minimize what they owe public employees decades from now. Because of changes in actuarial math, Minnesota in 2016 reported having just 53 percent of what it needed to cover promised benefits, down from 80 percent a year earlier, transforming it from one of the best funded state systems to the seventh worst, according to data compiled by Bloomberg.

 

The Minnesota’s teachers’ pension fund, which had $19.4 billion in assets as of June 30, 2016, is expected to go broke in 2052. As a result of the latest rules the pension has started using a rate of 4.7 percent to discount its liabilities, down from the 8 percent used previously. As a result, its liabilities increased by $16.7 billion.

Unfortunately, lower returns was only part of the bad news that Swensen had for U.S. investors as he described the current disconnect between "fundamental risks that we see all around the globe with the lack of volatility in our securities markets" as "profoundly troubling."

David Swensen, Yale University’s longtime chief investment officer, said the lack of market volatility in the current geopolitical environment is a major concern and warned that another crash is possible.

 

“When you compare the fundamental risks that we see all around the globe with the lack of volatility in our securities markets, it’s profoundly troubling,” Swensen, 63, said Tuesday during remarks at the Council on Foreign Relations in New York. That “makes me wonder if we’re not setting ourselves up for an ’87, or a ’98 or a 2008-2009,” he said, referring to previous market crises.

 

“The defining moments for portfolio management” came in those years, “and if you ignore that you’re not going to be able to manage your portfolio,” Swensen said.

 

Asked why Yale’s uncorrelated assets are higher now than in 2008, he said, "I’m not worried about the economy so much, what I’m concerned about is valuation."

Of course, we"re sure these warnings will provoke pension managers all around the country to promptly reassess their optimistic return assumptions and adjust future pension benefits accordingly to preserve the solvency of their funds for future generations of pensioners...

CalPERS Calls The Top: Largest Public Pension Fund Mulls Dumping $50 Billion Of Stocks

Is the largest public pension fund in the United States getting ready to dump about $50 billion worth of stocks?  According to a new note from Bloomberg, CalPERS" board is meeting for a workshop today in Sacramento to discuss asset allocations for the upcoming year which could include a doubling of the fund"s bond allocation from 19% to 44% which would be funded with a massive $50 billion sell down of equities.

Calpers is looking at a menu of options for its fixed-income target ranging from the current 19 percent to as much as 44 percent, according to a presentation for a board workshop in Sacramento coming up Monday. Equities could be cut to as little as 34 percent from 50 percent. Stocks were the best-performing asset class in fiscal 2017, returning almost 20 percent.

 

“The markets have had a pretty good run and it’s possible Calpers staff is thinking this might be a good time to lock in some of the gains,” Keith Brainard, research director for the National Association of State Retirement Administrators, said in a phone interview.

Unfortunately, as we"ve noted before (see: CalPERS Board Votes To Maintain Ponzi Scheme With Only 50bps Reduction Of Discount Rate), a shift toward higher fixed income allocations may require a simultaneous decrease in the fund"s discount rate assumptions which could drastically increase contribution requirements from various public employers all around the Golden State.

“We’ve cut the return expectation to the point that employers are screaming, ‘We can’t afford it. We can’t afford it,’ ” Jelincic said. “I personally would be willing to take on a little more risk.”

 

The average allocation for public pensions is about 23 percent to fixed income and 49 percent to stocks, according to Nasra data.

 

The Calpers board is scheduled to vote on the allocation in December. Almost all of the fixed-income and stock holdings are managed in-house while more complex assets, such as private equity and real estate, are overseen by outside consultants. Allocations to private equity and real assets would stay at 8 percent and 13 percent, respectively, under all scenarios under consideration.

 

The allocation revisions occur every four years. Calpers is working to provide for a growing wave of longer-living retirees.

Of course, while a more conservative asset allocation may be warranted in the current bubbly equity environment, often logic is quickly dismissed by politicians when it"s implementation could expose a massive ponzi scheme that has been hiding in plain sight for decades and risks the financial solvency of local and/or statewide government entities. 

This battle between math/logic and politicians has played out numerous times in states all across the country and somehow we suspect that "math/logic" will continue to lose...better to bury your head in the sand for a couple of more years and pretend there is no problem.

"How To Forecast Markets": A Departing Top JPMorgan Strategist Reveals What He Learned After 30 Years

One of the most popular JPMorgan analysts, traders and commentators, Jan Loeys, head of global asset strategy and author of the weekly "The JPMorgan View" piece is moving on (to a different, non-client facing part of the company), and is using his last weekly address to JPM clients to recap the main lessons he has learned over his 30 year career.

For those carbon-based traders who still trade on the basis of fundamental analysis, inductive reasoning, and discounting, and forecasting the future - instead of merely relying on the fastest laser-based algos to react to the news or hoping for central bank bailouts - we have excerpted the entire piece, and are excited to note that while Loeys may be leaving, he will be replaced by two of our favorite JPM analysts and commentators, Nikos Panigirtzoglou and Marko Kolanovic, who under John Normand will take over as JPM"s new Cross-Asset Strategy team.

So, without further ado, here is the latest, and last, from JPM"s Jan Loeys, explaining "What have I learned?" after 30 years of doing this...

What have I learned?

How to forecast markets?

• The theory and empirical literature of Finance are the best starting point as they deal directly with asset prices. Next are macro economics and statistics. Markets are not Math or Engineering, but a forever learning and adapting system with all of us observing and participating from the inside. Quantitative techniques are indispensable, though, to deal with the complexity of financial instruments and the overload of information we face. Empirical evidence counts for more than theory, but you need theory to constrain empirical searchers and avoid spurious correlations.


• The starting point of Finance is the Theorem of Market Efficiency which posits that under ideal conditions what we all know should be in the price. Only new information moves the price. Hence, it is changes in expectations about the future that drive asset prices, not the level of anything.


• How to forecasts view changes? The good news is that changes in opinions about fundamentals such as growth and inflation tend to repeat. This is one driver of momentum in asset prices, and is likely driven by the positive feedback between risk markets and the economy that forecasters naturally find very difficult getting ahead of.


• I live by Occam’s Razor: If you can explain the world with one variable, don’t use two. This keep-it-simple rule does not deny that reality is complex, nor does it say anything about simple minds. It forces one to focus on the most important fundamental drivers of markets and to cut out the clutter. It reduces the risk of becoming a two-handed strategist.


• The mode and the mean. There is a fundamental difference between an asset price and a forecast. A forecast is a single outcome that you consider the most likely, among many. In statistics, we call this the mode. An asset price, in contrast, is closer to the probability-weighted mean of the different scenarios you consider possible in the future. When our own probability distribution for these different outcomes is not evenly balanced but instead skewed to, say, the upside, the market price will be above our modal view. Asset prices can thus move without a change in modal views if the market perceives a change in the risk distribution. An investor should thus monitor changing risk perceptions as much as changing modal views.

• Do markets get ahead of reality? They do, yes, exactly because asset prices are probability-weighted means and the reality we perceive is coded as a modal view. Information arrives constantly and almost always only gently moves the risk distribution around a given modal view. Before we change our modal view of reality, the market will have seen the change in risk distribution and will have started moving already.


• Are some markets faster than others? I hear frequently in one market, say equities, that they are monitoring other markets, such as credit or bonds, for early signs on what stocks will do. But I hear the reverse frequently in the bond world. I do not like either view and just assume that all markets react at the same speed as they see all information at the same time.


• Levels or direction? In our business, we are asked to forecast asset prices and returns. I have found this very hard but fortunately have had the luxury to be able to stick to forecasting market direction rather than outright asset price levels. In markets that are close to efficiently priced, what we know is already in the price and we cannot really use that same information to make a coherent case for an asset price level that much different from today. All I have been able to do is to make a case that there are mild-to-decent odds in favor of the market going in one direction rather than the other. We have been much more successful in forecasting direction than actual asset price levels, and it is the direction that is more important for strategy.


• Top down or bottom up? In assessing the outlook for a market or an economy, should you start judging individual countries, sectors, and companies and then add them up to the overall market, or should you start from the top down? As a macro strategist, I naturally think top down, arguing I sit on top of a tall building, seeing where all the traffic and capital is going. But I know that from that high up, I do not see any potholes. For that, I have been relying on my local analysts to tell what conditions prevail on their street. And they in turn ask me what I can see from high up. I have found that it is the dialogue between bottom-up and top-down thinking that is most fruitful. Our economists do this quite well: they start the global forecast from the country level up, but then look at a host of global signals to put pressure on the bottom-up forecasts.


• The US as the indispensable market. Applying this top-down thinking, should we therefore start strategy at the global level and then drill down to regions and sectors, or should we follow the more common approach of starting with the USD market and economy, and then analyze the rest of the world as a spread market? I have done the latter. This is not only because we have the longest return series in the US and the US market and economy have been more stationary than others, but also because dollar assets are half of the investable world as many non-US entities both fund and invest in dollars.


• Rules versus discretion? You need both. I have tried to have logical arguments to buy or sell certain assets, based on Finance. And I have tried to corral evidence that the signals I use have in the past had the assumed impact on asset prices. Each of these then became a rule, of the form: If X>0, buy A, and vice versa. As we collected these rules, and published them in our Investment Strategies series, the question came up naturally whether we should not simply make our investment process driven by a number of empirically proven rules, and to banish any discretion (emotion?) from the process. Over time, we converged on a mixture of the two as pure rules ran into the problem that the world is forever changing, partly as every one else figures out the same rule and then arbitrages away the profit, and partly as economic structures and regimes similarly change over time in a way that we cannot capture with simple rules.


• Much as I have been talking a lot about cycles, I do not think of the world as a stationary system described by a set of parameters that we steadily get to know more about. Instead, as economists we think of people constantly optimizing their objectives, under the constraints they face. Aside from truly exogenous shocks to the system, the main difference between today and yesterday is that today, we know what happened yesterday and that information allows us to constantly fine tune and thus change our behavior. That is, we constantly learn from the past, much to try to avoid making the same mistakes. At the macro level, this means that the system is constantly evolving. As Mark Twain said, “History doesn’t repeat itself, but it often rhymes”. As investors, we should look at the market as billons of people all learning and adapting. The best investors are those who get ahead of this by learning faster and understanding better how others are learning.


• Expectations are adaptive. Markets should be purely forward looking into the future and treat the past as just that, the past. The problem we have is that the only information we receive is from the past. Ages ago, a debate raged in economics on whether expectations for say inflation are rational, or adaptive. The term rational was meant to denote that investors plug in all the info they have into their model of what will drive the future and derive from that the most efficient forecast. That is, investors do not slavishly extrapolate the past. True in principle. But we also find that as new information arrives, all of it past, investors constantly update these rational priors as new data steadily challenge them. In effect, then, market expectations for future fundamentals on earnings, inflation, defaults and such come close to adaptive, moving averages of past performance.


• Risk premia are about risk and uncertainty. This sounds obvious, but is frequently overlooked. It means that even when nothing surprising is happening, that by itself is surprising against markets that are priced for a certain volume of surprises. When nothing happens and data come out as expected, the market updates in an adaptive sense its uncertainty, and risk premia come down.


• Flows, positions, and supply and demand. Economics teaches us that supply and demand determines price. That is true also for asset prices, and explains the high interest in information on flows. Applying this dictum is not easy, though, as we cannot measure future intended supply and demand, aside from governments’ budget plans. All we measure ex post is transactions at a price that then equated supply with demand. For every seller in the past, there was a buyer, with the price moving to create this equilibrium. Only the movement in prices can tell us whether intended demand exceeded or fell short of supply. Given that we know how prices changed, flow data do not tell us much more.


• I have a different gripe about position surveys. If you tell me that you are long or OW asset class X, then I must conclude investors are long and advise you to sell. You know that, and thus should not tell me that you are long. I thus do not “trust” survey data.


• This is not to say that flow and position data are useless. We instead find that more detailed understanding of how different types of investors, each with their own restrictions and objectives, interact with the plumbing of the system, has allowed us to make better investment decisions. It led us to start 10 years ago a dedicated Flows & Liquidity weekly managed by my colleague Nikos Panigirtzoglou that is one of our top three publications by readership.


• Central banks and QE do not “cause” asset price inflation. It is often argued, and our own language has come dangerously close to it, that easy money by central banks has massively and artificially inflated asset prices and that a QE unwind will thus deflate them. I do not like to think in those terms. Easy money may be the proximate cause of high asset prices, but is not the ultimate one. All central bankers try to do is to search for the non-inflationary equilibrium level of rates driven by the supply and demand for capital as well as inflation expectations. In this cycle, higher global savings from EM and corporates, depressed capital spending, consumer delevering and public sector austerity have created a surplus of savings over investment that is the real cause of low interest rates and high asset prices. If central money was too easy, we would have also seen much faster growth and higher inflation, which we did not get.


• Market volatility is not a mystery but should be thought of as fundamental volatility, of growth, earnings, inflation, plus technical forces which are largely due to leverage, positions, market plumbing and such. Another way of looking at vol is as a function of the number of shocks and surprises hitting the system, the propagation and contagion forces around them (mostly leverage) and the shock absorbers that counteract them (largely central banks).

Where is alpha?

• The Theorem of Market efficiency, which implies investors can’t beat the market, implies that asset prices will follow random walks, with drift and that asset price changes will be white noise, with no serial correlation. There are thus only two possible inefficiencies to be exploited: positive serial correlation, which we call Momentum, or negative serial correlation, which we call mean reversion, or Value (to become valuable, asset prices need first to go down, or fundamentals need to improve faster than the price). It is an empirical question which dominates where. At the asset class and sector level, we have found that Momentum dominates, while within the fixed income world, Value is more important.


• The Theorem of Market efficiency assumes frictionless markets. Hence, cross-sectionally, we need to focus on areas where there are frictions due to different regulations, business practices, or investment objectives. Most profitable for me have been differences between currencies and industry segmentation between HG and HY, EM and DM, and bonds and equities.


• Across time, market momentum at the macro level has been the best way to earn excess returns. I discussed above how some of this is due to the momentum in view changes. More fundamentally, in open markets, we frequently face a Fallacy of Composition according to which rational and equilibrating behavior at the micro level becomes destabilizing at the macro level. The free market is very good at motivating entrepreneurship and rational behavior at the micro level, but is subject to constant booms and busts at the macro level. Central banks try to control this instability through counter-cyclical policies but can’t undo it all.


• Trade the risk bias. Even when markets price in exactly our modal views, I find it useful to consider how prices will move on new information and then try to position on any skew in the outlook. If I find that a particular price or spread will move a lot more on bullish than on bearish news, then I will position bullishly. This works at the portfolio level if I can combine different unrelated risk biases.


• Is there now so much information that everyone sees at the same time that alpha is dead? To some extent, yes, as reflected by the inability of the hedge fund world to offer better returns than a simple bond and equity portfolio with the same volatility over the past 10 years. Still, while alpha is weaker, I don’t think it is truly dead, as allocation across asset classes is still working well, even as it seems harder to earn alpha within asset classes.


• Is passive investing destroying alpha? No. it should actually make it easier if a lot more investors choose to allocate passively and therefore leave opportunities to the reduced number of active managers. I do feel the move to passive is largely within asset classes (i.e., stock picking) and that the arrival of liquidity passive products (ETFs) has made active asset allocation a lot easier. I think many managers have moved from active stock picking to active asset allocation.


• How to analyze risk? Risk is not the same as past vol, but the surprise that will hurt your portfolio. I have never found it useful to make long list of all the things that can go wrong over the next year. Instead, I start from the premise that the big risks that will have an impact at the macro level almost always start as small ones. I have called these local brush fires, of which there are always a bunch and of which I need to decide which will become a wildfire. This does not solve the problem fully but at least reduces the number of risks to monitor.


• Geopolitics? I have generally ignored these risks, primarily as I do not have a model to understand or project them. When they do become market relevant, they typically hit us so fast that is too late to do much about them.

How to put it together?

• I like a Lego approach to TAA of one trade at the time. In theory, an active money manager should translate their ideas into expected returns and risks and then use portfolio optimization to calculate an efficient frontier of the highest return portfolios by levels of risk.


• I started that way decades ago as a young strategist and ran into numerous problems of how to assess all the necessary return, volatility and correlation parameters over multiple horizons. I found that the more assumptions you have to make, the greater the probability of putting in numbers for which you have no idea. The well-known Black-Litterman approach tries to deal with this from a Bayesian point of view, starting with the parameters implied by market outstandings, but I had problems with why these parameters would make sense, and how to dynamically change portfolios on constantly incoming new information and ideas.


• I then moved to greatly simplify my process of converting views into portfolios in two ways. First was to postulate that any active portfolio is a passive benchmark portfolio plus a number of zero sum deviations of under- and overweights against that benchmark that I think about as indifferent to what benchmark is used. That allowed me to separate the active overlay portfolio from the underlying benchmark and give each global investor the same OW/UW advice, irrespective of their benchmark.


• The second simplification was to think of each single active view as a single trade that needs to stand on its own, with its own drivers and logic. If the latter turn, I exit the trade, without changing the other trades.


• Does that mean I ignore correlations? Yes and no. When building a portfolio of active trades, I start with a target overall active risk (e.g., 1% VaR). The lower the correlations between my different trades, the higher the VaR I can allocate to each individual trade. But as we actively turn off trades and add new ones, I will not constantly move the whole portfolio around.


• This is partly as I find correlations unstable and hard to forecast. The past correlation between two assets or positions depends on what was driving them. Bonds rallying because of monetary easing will be bullish for stocks and the equity bonds correlation will be positive. Bonds gaining because of low inflation on weak growth will correlate negative with equities. I am very wary of extrapolating past correlations and will generally not base recommendations on them.


• Sizing risk by track record and hot hands. It is not only important to have the right trade on but also to make sure to have the right amount of risk allocated to each. I start with a target amount of tactical risk which I think about in Value of risk, in dollar terms or percent of AUM. I then decide whether today is a good time to take a lot of risk, or a bad time. If we are been on a roll making money, then we probably have a better sense of the direction of markets and I then take more than average risk.


• Next comes deciding where to take this risk. I look here at track records, both long term and more recent. I have found over the past 30 years that certain areas are “easier” to make money than others. They are broad asset allocation (risk on, risk off), cross country in bonds and FX, and credit spreads. The harder ones are bond duration, and country and sector selection in equities. I aim to make sure I generally take more risk in the easier areas.


• Finally, I check where we have been doing better more recently. At times, we have a cold hand in certain areas, and I then reduce their risk budget until performance picks up, and vice versa. In effect, I assume momentum in success.


• The conflict between consistency and diversification. Given how efficient markets generally are and that I do not really have superior information, I try not to get too cocky about my ability to beat the market. I assume my success rate for any individual position will be only just over 50/50. How then to get a portfolio with a success rate that is well above 50/50? The trick is to choose positions and OWs/UWs that are not correlated to each other. That is easier said than done because our mind naturally veers to creating consistency.


• I have found only one way to create diversification in trades, which is to make them go through different brains and ways of thinking. As a research strategy CIO, I had to make sure I do not dictate all trades, as they would otherwise become highly correlated. Instead, it is important to allocate trading decisions (on paper in our case) to different individuals and ways of thinking.


• How long to hold on? I find it nearly impossible to hit the exact top to take profit on a winning trade and thus had to make a choice between exiting while still going up, or only after it is already going down. Most of the time I find myself selling on the way down, and have rationalized this by the observation that we are generally underestimate how far a market can go when we have the direction right.


• What is the right investment horizon for active positions? It is almost a truism that successful trades end up becoming longer lived than expected, while bad ones becomes shorter-lived. Beyond that, I find that asset classes with positive feedback with fundamentals, like equities and credit, have much higher longevity (quarter to years) than markets with negative feedback, such as bonds and currencies (weeks, maybe months). This is why our bond floor always feels so short-termist versus our equity floor. It took me a long time to recognize that this makes sense.


• How frequently to adjust your portfolio? In theory, every time new information arrives or asset prices move. This is not practical. I have been doing it monthly, but the beauty of our Lego approach and the usage of different brains in our paper portfolio with each managing a different trade is that we are effectively changing small parts here and there of the portfolio virtually on a weekly, if not daily basis.

Final thoughts

• Cherish your errors. I have learned ten times more from being wrong than being right. Once you make a mistake, go public with it, analyze it in detail, and learn from it.


• Be your own devil’s advocate, and spend most time with people who do not agree with you, or who have a different way of looking at things. Not always easy as being with like-minded people is more comforting.


• Regrets? None really. I have been extremely fortunate having come to JPMorgan at the right time, the right place, with the right mentors and the right great colleagues to learn every day from the right clients. And the journey, and the lessons are not over. Thank you so much! You made my 30 years, and counting.

"The World"s Largest Sovereign Wealth Fund Is Investing With No Valuation Model"

There are several quotable observations in Eric Peters" latest Weekend Notes, in which the One River Asset Management CIO looks at last week"s melt-up euphoria in markets...

Hope all goes well… Abe wins landslide, Nikkei soars to 21yr high. Xi Jinping is named in China’s constitution, cementing his place alongside Mao, equities jump. House Republicans pass $4trln budget resolution, lifting hopes for a $1.5tlrn tax cut/reform. Despite devastating hurricanes, US Q3 GDP expands 3%, S&P 500 hits record high. VIX 9.80. Biggest Nasdaq 100 daily gain in 2yrs. Bezos becomes world’s richest man, +$10bln on Friday to a $93bln net worth. Such a stunning rise, a synchronized global triumph, unrecognizable from the 2008 cataclysm that produced so many waves.

.... muses on Albert Einstein"s philosophy of happiness, observes the dilemma facing Elon Musk when it comes to auto sales in China, but most notable is his take on modern capital allocation and investing by the $14 trillion pool of 401(k)s and IRAs, which he calls "the world"s largest sovereign wealth fund", and which finds itself forced to invest in such assets as Tajikistan and Iraqi bonds because the traditional framework preached by the MPT is no longer applicable, and as a result "the largest SWF on earth is investing with no valuation model but for the rear-view mirror."

Here is the full excerpt:

Fallujah

 

“It’s a monolith,” he said. “It essentially operates as a single investor, like a sovereign wealth fund,” he continued.

 

“In fact, the US 401k and IRA savings is collectively the world’s largest SWF.” From the 1978 creation of the 401k, that pool has grown to $14trln. The early adopters were baby boomers, and their holdings dwarf all others; a combination of decades of contributions and capital gains.

 

“The firms that help Americans invest their retirement savings use the same models. They all utilize the same inputs, and produce the same outputs.”

 

“Walk into Schwab, or any competitor, and ask for your target asset allocation,” he said. “You’ll discover that the dominant input is your age. It’s a robo-advisor style of investing.”

 

The older you become the more bonds you should own relative to stocks. “They boast thousands of portfolio simulations, stress tests.” They explain how the methodology is scientifically proven and based on Modern Portfolio Theory.

 

“But MPT requires that you build a robust framework for estimating future asset class returns and correlations. And they have no such framework.”

 

“Without a robust framework for estimating future returns, these 401 advisors turn to the past to estimate future returns,” he explained.

 

“Do you want to know why money is flowing into emerging market bond funds?” And I nodded. “Because the machine tells retirees that they return 13% a year.”

 

Grandpa tucked a little Tajikistan into his portfolio last month (10yr bonds auctioned at 7.12%).

 

Grandma loaded up on Fallujah (Iraq auction yielded 6.75%).

 

“The largest SWF on earth is investing with no valuation model but for the rear-view mirror.”

One Trader Warns: "Don't Confuse Risk-Asset-Buying With Calm"

CNBC"s Joe Kernen nonchalantly commented this morning that "Dow futures are indicated higher... Just like every other morning," and that just about sums up the current utopia as consumer and business surveys spike irrepressibly in line with a seemingly unstoppable meltup in US equity markets. However, as former fund manager Richard Breslow warns this morning, investors should avoid confusing risk-asset-buying with calm.

Via Bloomberg,

Watching the markets playing out the latest version of what passes for investing these days, you have to wonder if traders have finally found religion. I don’t mean all those times we prayed with all our heart that a bad position would be saved. Or even, heaven forgive us, for something bad to happen which would be good for moi.

Rather, when all other analysis seems to have failed, there’s this curious yet understandable, belief that God will provide.

After all, what else sensibly explains the unceasing rewards from the accumulation of risky assets, despite serial reminders that all may not be as copacetic as the price levels insist is the case.

This is really just one manifestation of the more earthly, you can’t fight city hall. A twist in a post-vigilante world, which can’t bear not to believe that the authorities will deliver what our financial market investing thesis requires, while at the same time being utterly incompetent. Or worse. Tax cuts, structural reforms, peace and goodwill will inevitably be revealed as the true driver of these asset prices. How we get there, nobody knows.

Yet, be careful before you decide to dedicate your life to this religious path and conclude financial analysis is an archaic rite from a time before the great QE deluge. For in the highly unlikely event your personal deity does indeed follow the business section, it is far more important to remember that the Lord also works in mysterious ways.

It has been unarguably true pedal to the metal has been a great way to go. You know that’s true when people tell you, investing works best by not opening your account statements and being distracted. And in fact, pure risk trades have not only done great, they haven’t done anything wrong. Set the autopilot and enjoy your satellite radio. What’s not to like? And that’s been a very profitable point.

Models, by the way, are much better than humans at thriving in this type of environment. They love momentum and long-term stable correlation matrices. So then, what’s the bad news? I’ve no idea there is any for the moment. This isn’t one of those sell upon receipt of this pronouncement pieces. Except. Except, at this point in the economic cycle, it’s worth thinking long and hard why sovereign bond yields are this pathetically and worryingly low. This no longer looks like risk-parity trading but survival training.

Global growth is pretty good. Tapering and rate hikes are coming. And we aren’t in a world where endemically low growth and rates is a foreordained outcome, no matter who tries to peddle that story. But rates refuse to rise. And this goes way beyond the vagaries of the Phillips Curve, for which there are endless explanations.

This is the portfolio commingling of risk-asset buying to stay in business and bond-buying because, in reality, it’s impossible to ignore the front-page news. We get periodic episodes where one set of problems recedes from our consciousness as we move onto the next perceived crisis.

But receding isn’t at all the same thing as having been fixed. And it does add up with the cumulative risk eventually rising exponentially.

Equities will do their thing until one day they violate enough technical levels that they don’t force everyone to buy. That’s unlikely to happen today.

So everything is great, right? Not really.

Until bond yields start to move back from levels that scream calamity, don’t confuse risky-asset buying with comfort or contentment. This level of rates needs a lot more explanation than continuous monetary policy largesse.

Hard Assets In An Age Of Negative Interest Rates

Time is the soul of money, the long-view - its immortality.

Hard assets are forever, even when destroyed by the cataclysms of history.

It is the outlook that perpetuated the most competent and powerful aristocracies in continental Europe, well up through World War I and, in certain prominent cases, beyond; it is the mindset that has sustained the most fiscally serious democratic republic in the Western world, that of Switzerland (as demonstrated in this article).

In this view, the stewardship of money, formerly known as “banking,” is a serious matter of serious wealth management and not a weird-science lab experiment of investment products ultimately designed for hedge fund managers’ tax arbitrage schemes.

More than ever the focus on hard assets is a dire call to arms given the deformed market culture of central banking monetary magic. Despite the early promise of the Trump presidency to reinvigorate the economy, the United States remains mired in economic stagnation built up over so many years of debt-driven policies, easy-money policies, and the ZIRP fiasco fostering a bizarre-world situation in which the actual economy is doing poorly while the market is soaring. In such an environment, the allure of the centuries’-old tried and true has never had more appeal.

In a word, the hard asset vision is about building wealth outside the stock market. It refers to three main strategies overall: 

1) land ownership and/or farmland, forestry and agriculture

2) gold, other precious metals, and certain base-metal commodities, and

3) The (Old Masters/Classic Modern) art market.

Where this last is concerned, we mean art as investment and not art-as-commerce, such as that which contaminates today’s insipid and overpriced world of ‘Balloon-Dog’ bad art. The auction world of Rembrandt and Picasso; of El Greco and Gerhardt Richter has been on a tear, is smashing records, and cannot be ignored as an excellent safe-haven vehicle, as outstanding works of art traditionally always have been.

To begin with, physical gold and precious metals remain an investment enigma despite being market-leading performers for the past seventeen years. Gold is a must-have portfolio asset amid the aggressive debt levels and monetary debasement that have so unhinged the market. Silver, for its part, in addition to its prestige status, also has innumerable industrial applications and throughout the precious-metal bull market since 2000.

Russia, in this context, is leading the charge in the long-view outlook. For the past three years, the Bank of Russia has been the world’s number one stacker of gold, and, thus far in 2017, has taken the lead position among international central banks in buying the commodity.

At its current pace, Moscow will unseat China for the number five spot of gold-holding nations by the first quarter of 2018.

Currently, the gold-to-GDP ratios of the world’s leading powers are: Russia 5.6%; the Euro Zone 3.6%; the U.S. 1.8% and China 1.5%.

Yet countries buying up gold versus investors who do so are two different worlds. Ninety-five percent of the world’s gold is held as a wealth store.

In other commodities, zinc and copper have been the big movers. Zinc, the key galvanizing agent, claimed the status of the best performing metal last year. Copper began its resurgence in 2017, and in late August of this year, a host of commodities broke out of multi-month consolidation patterns. Nickel and cobalt are also coming into the spotlight as metals essential to the rapidly growing lithium ion (Li-ion) battery sector.

The art world lags not too far behind that of precious metals in terms of history’s preferred storehouses of value as protection against uncertain times. Art as investment has long been a favored strategy of the European elite since, effectively, the High Middle Ages and has never gone out of style. In modern times, the phenomenon of an ever-growing collectors’ base and less supply of museum quality works has been accepted as a meaningful way to protect investors’ cash during economic difficulty. Though continually eclipsed in the media by the brasher contemporary art market, Old Masters (and Classic Modern—the great 20^th century works) have shown stable, often spectacular, results over the past ten years with both categories reaching record-breaking highs.

Art, to be a safe haven, must be an investment and not a whim - just as it was for the Liechtenstein family who acquired Leonardo da Vinci’s Ginevra de Benci so many centuries ago. In the wake of the World War II near-bankruptcy of that eponymous principality (whose monarchs were not and are not supported by taxes), that painting was the first of the major, big-ticket art sales of the 20^th century, when it was sold to Paul Mellon and The National Gallery of Art in Washington DC. Ginevra continues to hang there today (and to date, is the only Leonardo painting in possession of the United States).  While the average investor may not be in a position to store wealth in a Renaissance master or a Picasso, there are always the underrated gems or the new discoveries that can and will bring in the most unexpected of windfalls decades down the line.

Finally, farmland is seen by many as an excellent addition to a precious-metal portfolio. As Jim Rogers predicted in early September, fortunes will be made in agriculture “and when an industry breaks full faith, even mediocre people make a lot of money” in that sector. Hard asset investors continue to include farmland in their portfolios “for a combination of income generation, diversification and inflation-hedging”. Historically, farmland, like forestland in continental Europe or Latin America, has been a unique asset class demonstrating low-correlation to traditional asset classes, and which performs well as inflation rises.

Cash reserves, land as cash, the endless applications of Nature’s resources to industry; the prestige, privacy, and long-term value of beautiful art: such has been the outlook of the hard-asset philosophy.

Today, that cult of independently-minded investors will laugh all the way to the bank - precisely by avoiding the paths laid out, and so horribly deformed, by those very banks.

Eric Peters: "One Day Your Investment Style Will Blow Up: Will You Fold Or Double Down?"

Sunday morning brings us the traditional Weekend Notes from One River CIO, Eric Peters, whose panoply of topics under discussion today include systematic investing, economic forecasts, Fed reaction functions, Twitter algorithms, bond yields for the new abnormal, fear and greed, and of course "Rocket Man."

Below are several excerpts from his latest weekly note:

Anecdote

“Whatever investment style you adopt will blow up someday,” said the CIO. “When that day comes, will you fold or double down?” he continued.

We were discussing systematic investing. I see its future dominance and am building my firm accordingly.

“If you’ve surrendered control to a machine, how will you make that decision?” he asked. Before I could answer, he supplied his own. “I’d rather practice making decisions along the way so that I’ll either avoid the blow up or at least understand my strategy in the crisis.”

That’s a credible position to take on the matter; for years I took it myself. But time changes most things, ourselves in particular. Day by day, month by month, we’re different people. Humble, hubristic, stubborn, objective, greedy, fearful, certain, confused, euphoric, depressed, and every imaginable combination thereof.

The two greatest advantages of developing decision-making algorithms are that they allow us to consistently be our finest selves, and they can apply our process across more markets than a single human ever could. But the difficulty of distilling profound complexity into a set of robust rules leads many practitioners to cut corners - which takes the form of choosing rules that worked in the recent past for seemingly arbitrary reasons, and building algorithms without sensible risk-mitigation to avoid its corresponding costs.

Such strategies put their investors at risk of catastrophic loss in exchange for a pile of pennies, and/or tend to make money in every time period except for the future.

But such pitfalls are not machine error, they reflect human weakness, and are thus common to both poorly designed discretionary and systematic strategies.

Because ultimately, every conceivable form of successful money management requires the experience to identify rules that tend to make money over time, and the introspection necessary to come to know our finest selves.

Bonus #1: Peters on bond issuance in the "illiquidstan" market:

Tajikistan issued 10yr bonds this month. Less than 1bp of mankind can locate Tajikistan on a map. Nearly all are Tajiks.

But the bonds paid 7.125% which is roughly what pensions need to prevent insolvency. Bahrain issued $3bln of 12yr paper at 6.75% ($15bln of bids). Iraq issued $1bln at 5yrs at 6.75%. Belarus issued 10yr paper at 7.63%. And Ukraine issued $3bln of 15yrs. $1.6bln rolled existing paper that nearly defaulted 2yrs ago when investors wrote off $3.6bln in debt and delayed payments for 4yrs.

This new issue yielded 7.37%.

Bonus #2: Rocket Man

“Did he really call me Rocket Man?” cried the chubby Korean kid. “Yes he did Rocket Man,” said some nervous sycophant in a cheap suit, saluting his Dear Leader.

“Did he call me a scared, barking dog?” barked earth’s most powerful man, typing a tweet. “Woof!” answered the President’s pack. “He called me a suicidal madman on Twitter!” stammered shorty, combing his black bouffant. “He said he’d tame Trump with fire?” asked The Donald, incredulous, swirling his sweep.

“He tweeted North Korea would be tested like never before!” screeched Kim, pounding the table, knuckles mere dimples, baby fat.

“He said he’ll detonate a hydrogen bomb over the Pacific?” asked our entertainer in chief, excited, knowing a sensational season opener when he sees one.

“Shall I go thermonuclear?” asked the itsy bitsy dictator. And his generals glanced left, right, unsure. “Shall I do it?” he screamed. The garden gnomes stood motionless. “Tell me, shall I mention Trump’s little hands?” asked Kim Jong Un, dead serious. They shook their heads in perfect unison; such a devastating insult would surely end 3.5mm years of human evolution. “Dear Leader, such an insult must be saved, savored,” pleaded his generals. “Very well, I’ll call him a dotard!” cried the child.

“Kim called me a dotard! A dotard! What the hell does that even mean?” whispered the steward of earth’s largest nuclear arsenal. An Ivy League intern explained, “Mr. President, it’s actually pronounced DOE-turd, and it’s a middle English word used by Shakespeare that means an ageing imbecile…” The Donald cut him off, “You’re fired!”

The room fell silent, the enormity of this unexpected crisis sinking in. You see, dotard is the kind of nickname that just might stick.

But at least the risk of nuclear Armageddon had receded. Because of course, it’s simply not possible to end civilization amidst such buffoonery.

15 Risk Management Rules For Every Investor

Authored by Lance Roberts via RealInvestmentAdvice.com,

Last week, I was discussing the rather “Pavlovian” response to Central Bank interventions which has led investors into a false sense of security with respect to the risk being undertaken within portfolios.

This got me to thinking about “risk” and reminded me of something Howard Marks once wrote:

“If I ask you what’s the risk in investing, you would answer the risk of losing money. But there actually are two risks in investing: One is to lose money, and the other is to miss an opportunity. You can eliminate either one, but you can’t eliminate both at the same time. So the question is how you’re going to position yourself versus these two risks: straight down the middle, more aggressive or more defensive.

I think of it like a comedy movie where a guy is considering some activity. On his right shoulder is sitting an angel in a white robe. He says: ‘No, don’t do it! It’s not prudent, it’s not a good idea, it’s not proper and you’ll get in trouble’.

On the other shoulder is the devil in a red robe with his pitchfork. He whispers: ‘Do it, you’ll get rich’. In the end, the devil usually wins.

Caution, maturity and doing the right thing are old-fashioned ideas. And when they do battle against the desire to get rich, other than in panic times the desire to get rich usually wins. That’s why bubbles are created and frauds like Bernie Madoff get money.

How do you avoid getting trapped by the devil?

I’ve been in this business for over forty-five years now, so I’ve had a lot of experience.  In addition, I am not a very emotional person. In fact, almost all the great investors I know are unemotional. If you’re emotional then you’ll buy at the top when everybody is euphoric and prices are high. Also, you’ll sell at the bottom when everybody is depressed and prices are low. You’ll be like everybody else and you will always do the wrong thing at the extremes.

Therefore, unemotionalism is one of the most important criteria for being a successful investor. And if you can’t be unemotional you should not invest your own money, period. Most great investors practice something called contrarianism. It consists of doing the right thing at the extremes which is the contrary of what everybody else is doing. So unemtionalism is one of the basic requirements for contrarianism.”

It is not surprising with markets hitting “all-time highs,” and the mainstream media trumpeting the news, that individuals are being swept up in the moment.

After all, it’s a “can’t lose proposition.” Right?

This is why being unemotional when it comes to your money is a very hard thing to do.

It is times, such as now, where logic states that we must participate in the current opportunity. However, emotions of “greed” and “fear” are kicking in either causing individual’s to take on too much exposure, or worrying that risk is too high and a crash could come at any time. Emotional based arguments are inherently wrong and lead individuals into making decisions that ultimately have a negative impact on their financial health.

As Howard Marks’ stated above, it is in times like these that individuals must remain unemotional and adhere to a strict investment discipline.

RIA Portfolio Management Rules

It is from Marks’ view on risk management that I thought I would share with you the portfolio rules that drive own own investment discipline at Real Investment Advice. While I am often tagged as “bearish” due to my analysis of economic and fundamental data for “what it is” rather than “what I hope it to be,” I am actually neither bullish or bearish. I follow a very simple set of rules which are the core of my portfolio management philosophy which focus on capital preservation and long-term “risk-adjusted” returns.

The fundamental, economic and price analysis forms the backdrop of overall risk exposure and asset allocation. However, the following rules are the “control boundaries” for all specific actions.

1. Cut losers short and let winner’s run. (Be a scale-up buyer into strength.)


2. Set goals and be actionable. (Without specific goals, trades become arbitrary and increase overall portfolio risk.)


3. Emotionally driven decisions void the investment process.  (Buy high/sell low)


4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly, trend. While a “rising tide lifts all boats,” the opposite is also true.)


5. Never let a “trading opportunity” turn into a long-term investment. (Refer to rule #1. All initial purchases are “trades,” until your investment thesis is proved correct.)


6. An investment discipline does not work if it is not followed.


7. “Losing money” is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)


8. The odds of success improve greatly when the fundamental analysis is confirmed by the technical price action. (This applies to both bull and bear markets)


9. Never, under any circumstances, add to a losing position. (As Paul Tudor Jones once quipped: “Only losers add to losers.”)


10. Market are either “bullish” or “bearish.” During a “bull market” be only long or neutral. During a “bear market”be only neutral or short. (Bull and Bear markets are determined by their long-term trend as shown in the chart below.)


11. When markets are trading at, or near, extremes do the opposite of the “herd.”


12. Do more of what works and less of what doesn’t. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)


13. “Buy” and “Sell” signals are only useful if they are implemented. (Managing a portfolio without a “buy/sell” discipline is designed to fail.)


14. Strive to be a .700 “at bat” player. (No strategy works 100% of the time. However, being consistent, controlling errors, and capitalizing on opportunity is what wins games.)


15. Manage risk and volatility. (Controlling the variables that lead to investment mistakes is what generates returns as a byproduct.)

Currently, the long-term bullish trend that began in 2009 remains intact. The correction that began in early 2016 was temporarily cut short by massive, and continuing, interventions of global Central Banks. There is a limit, of course, to the efficacy of those interventions.

A violation of the long-term bullish trend, and a failure to recover, will signal the beginning of the next “bear market” cycle. Such will then change portfolio allocations to be either “neutral or short.”  BUT, and most importantly, until that violation occurs, portfolios should be either long or neutral ONLY.  

The current market advance both looks, and feels, like the last leg of a market “melt up” as we previously witnessed at the end of 1999.  How long it can last is anyone’s guess. However, importantly, it should be remembered that all good things do come to an end. Sometimes, those endings can be very disastrous to long-term investing objectives.This is why focusing on “risk controls” in the short-term, and avoiding subsequent major draw-downs, the long-term returns tend to take care of themselves.

Everyone approaches money management differently.

This is just my approach and I am simply sharing my process.

I hope you find something useful in it.