It’s the day before the September FED and BOJ meetings. While all eyes are on Central Bank actions and speeches that will be out in the open tomorrow, the lull today should provide a few moments to go back to first principles of investing in stocks, bonds, cash, and on portfolio construction and risk management.
So let’s really get back to basics to the “alphabet” of investing. For many of us with little kids, teaching them how to read starts with A is for Apple, B is for…etc. It is also a great way to think about investing.
With all the focus on Central Banks and the confusion they may have created with new theories, the basis for investing in the equity markets comes down to one simple thing: if firms create value, and people line up to buy that value (real or perceived), then the firm’s value and its stock goes up. For a market caught in a sharp downdraft just a couple of days ago from contradictory Fed-speak, the announcement of Apple’s new phone and the continued demand for a newer version showed that inventions, production and especially consumer demand are doing just fine. Call me an optimist, but by virtue of being peripherally connected with two leading scientific universities, I can say that innovation is alive and well.
The flip side of the coin is the creation of “anti-value” from over-reliance on promises. “B” is for Bonds (with a capital B), and at least in my investment playbook at their current pricing level, “B” is also for “Bogus” investment since they are based on a promise of perpetual money-printing. No wonder that when yields rose sharply last weeks, investors who had bought bonds as investments premised on the promise of low yields forever bailed. But Bonds do have insurance like benefits. Bonds at negative yields are actually insurance, which is their one redeeming factor, but only if the provider of that insurance is credible and the pricing of the insurance is sensible. When that credibility comes under question due to changing academic dogma, it is a lot to ask investors to anchor themselves to the insurance policy. Hence the angst over fluid Fed speak that has become a spectacle unto itself.
C is both for Central Bank Communication, Correlation and Convexity. As discussed, focusing on central bank communication is certainly nerve bending, and at the end of the day, a “complete waste of time”, as my friend Stephen Jen put it recently. I think Investors are better off by, (1) investing in companies with awesome products, (2) managing their portfolio risk and leverage, (3) doing other, hopefully socially productive things with their time that is saved. In the long run, value comes from growth and innovation, and by all metrics there is still plenty of it out there.
Correlation breakdown between stocks and bonds, and even stocks and the Yen (long thought of as a shock absorber on volatile days) was the talk of last week. As the threat of rates rising went up, stocks, which have benefited from the present value effect (future cash-flows being marked up due to the lower discount rate), also fell. Suddenly, it looks like there was no place to hide. At very low yields or very high yields, one should expect correlation between core assets to switch signs, like it has started to do.
Then there is D for Diversification. Given the breakdown in correlation, we are likely entering another period where diversification as a source of risk-management is likely to prove weak. In our analysis, switching just the stock-bond correlation from its five-year history to what was just observed over the last month results in almost doubling of portfolio volatility and “value at risk”, which are both metrics used by risk managers.
D is also for Divergence. It is not entirely surprising that given the Fed’s desire to raise rates, it is the only major Central Bank where the probability of a rate cut (as computed by Fed Funds futures) is close to zero. With markets and geopolitical risks abounding globally, every other country’s monetary policy has a non-negligible probability of a rate cut! For instance, Brexit’s aftermath has resulted in a bias of almost a 30% cut in rates in Britain by December. The same is true, though the magnitudes are different, for Canada, Australia, and Japan. The question begs itself – what if an unexpected negative shock were to occur? Could the rate rise expectations be replaced with no change, or even a cut sometime next year?
Skipping a few letters, watch out for “T” for Technology shifts. In just the last few months that we have been setting up our new firm, I am amazed at the multi-fold increase in automation and efficiency for investments that is available to everyone. New technology has removed the barriers to entry for investment managers, though some of the barriers have gotten harder to cross as regulation (perhaps justifiably) has increased. We learnt in our philosophy undergraduate classes that paradigms shift, and it takes people time to adjust to new paradigms. In investment technology, paradigms have already shifted. Machines are doing a lot more of the investing, trading and even thinking. And machines think differently than humans. As in chess, the combination of humans and machines – “augmented reality” is likely to prove superior to either machines or humans working solo. If you have a teenager you probably have not missed how real new augmented reality games are. And to the frustration of “old-school” value investors, the spillovers from this new technology into investing is likely to be game-changing. At the end of the day, this has resulted in persistence of momentum (machines are biased to do more of what has been working as compared to humans who are biased to think about reversion to the mean). Just don’ be surprised that once markets start to move, they don’t pause easily.
So for robust investment decisions, go back to A, B,C D’s and maybe T. And in the short run, forget the last letter in the alphabet. Central Bank decision making today are more akin to watching the Zebra. Funny looking, striped, and hard to understand and domesticate and lean on to for portfolio construction. Good luck betting on them.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.