PhD’s and computers explain market volatility since 1980

Richard Bookstaber’s 2007 work, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, examines the huge increase in stock and bond market volatility since 1980. He notes that GDP volatility has shrunk while market volatility has increased. And if you graph the S&P 500, especially the year-to-year change, the massive increase in volatility is obvious.

Bookstaber, who has a PhD from MIT, writes that before the rise of computer trading, investment banks tended to hire college graduates who were also former athletes because managers thought they had the right temperament to handle the stresses of trading. Then computers came along and of course they need models to work with. Who had better models than PhD professors at universities? So the banks loaded up on PhD’s to create models for computer trading.

Bookstaber provides an insider’s account of the victories and tragedies of investment banking and arbitrage trading from the mid-1980s on because he labored in the trenches as a risk analyst, much of the time with Salomon Brothers. Two things stand out to Bookstaber: computer trading and innovation.

Goldman Sachs rains on Trump honeymoon

Traditionally, a new president enjoys a “honeymoon” period during his first few months in office but it seems that Goldman Sachs doesn’t like tradition. The investment bank tried to puncture the euphoria in the stock market over Donald Trump’s victory by issuing a sober forecast of what the US can expect from his regime next year. Their conclusion:

The prediction comes as part of the team’s annual not about the top ten market themes for 2017. Theme No. 1: Utter disappointment.

Actually, the theme was closer to “more of the same.” GS thinks stocks are pricey already and the economy won’t improve enough for profits to relieve some of the altitude in valuations. They are probably right and things might actually get worse if we get the long overdue recession.

The bond market's head fake

The bond market fell this week, wiping out gains for the year. Some blame it on Mario Draghi’s comments after an ECB meeting in which he expressed indifference to volatility in bond markets. If it is true that Draghi’s statements motivated the selloff, it shows how fragile is an investing philosophy that is based solely on what central banks do. Such investors are terrified of rising interest rates but want to remain fully invested until the last bell. Of course, anyone investing in bonds or stocks at these altitudes should be as nervous as a long-tailed cat in a room full of rocking chairs.

Gross shocks conventional wisdom

Bill Gross told investors this week to

Beware the Ides of March, or the Ides of any month in 2015 for that matter. When the year is done, there will be minus signs in front of returns for many asset classes. The good times are over.

Gross is the legendary bond fund manager who left the company he founded, PIMCO, for a job as a portfolio manager at Janus Global Unconstrained Bond Fund, so most people pay attention when he writes. The prediction came inside the January Investment Outlook for investors. But for the mainstream financial media, he might was well have expelled foul smelling gas at a crowded party. The media quickly pointed out how contrarian his forecast is. For example, the Bloomberg reporter wrote: 

Burned by Bonds

Austrian economists can get forecasts wrong, occasionally. Many were wrong about inflation when the Fed stuffed its balance sheet with junk bonds. Inflation has remained asleep except in asset markets. That wrong forecast gave some of us a jaundiced outlook for bonds. The reasoning went that higher inflation and a greater demand for loans would force interest rates higher in 2014, and when interest rates rise the price of bonds fall. Also, the Fed was trying to go sober after multiple shots of QE. So I stayed away from bonds this year because the fall in value would erase all of the benefits from the interest earned. As a result I missed out on a great opportunity.

While most of the world was fixated on the choppy stock market, bonds were as stealthy as 007 while soaring. The October 20 Wall Street Journal (page C1) reported that the Wasatch-Hoisington U.S. Treasury Fund earned 28% for investors this year. Lacy Hunt, the fund’s chief economist, said, “I don’t think the Fed is going to raise rates. All they can do is hold rates here for longer and longer time periods.”

So where did Austrians go wrong? First, they didn’t take Hayek and Mises seriously when they warned against assuming the quantity theory of money works mechanically.  The monetarist Milton Friedman influenced too many Austrian economists. The quantity theory states that increases in the money supply will lead to consumer price inflation. That is always true, ceteris paribus, but things are never ceteris, let alone parabus. Many things can break the link between increases in the money supply and prices. Most importantly, we should temper our expectations of the quantity theory with the subjective theory of value. As Mises wrote, people may not always respond to increases in the money supply in the same way. That is the principle of subjectivism applied to money, something Mises is most famous for.

Swedes help with timing

Anyone not a mainstream economist has recognized the awesome blindness of the profession to the approach of the latest financial crisis and its impotent policies afterwards. I recently finished a book published last year that not only explains why mainstream economics failed but promotes good economics, the Austrian kind, and provides another tool for telling the future.

Thomas Aubrey, the author of Profiting from Monetary Policy and founder of Credit Capital Advisory in the U.K., consults businesses on how credit creation affects global asset prices. Aubrey begins by detailing the devastation of the crisis on pension funds. Not only did many funds lose money in the crisis, but the low interest rate monetary policies intended to restore the economy have inflicted more damage and will lead to many failing in the future. Aubrey doesn’t mention the life insurance industry, but it and millions of retired people are suffering for the same reasons.

Entrepreneurs in the Big Short

Michael Lewis is the bestselling author of many books, but the first one I have read is The Big Short: Inside the Doomsday Machine, which is about the financial crisis of 2008. Lewis’ economics is terrible, but I still recommend the book.

First the terrible part: Lewis doesn't understand good economics, by which I mean Austrian. From the book I would guess he doesn't know much mainstream economics either. If readers really want to understand the mechanics of how the crises unfolded I would recommend Slapped by the Invisible Hand by Gary Gorton. In a nutshell, it was an old fashioned bank run in which depositors got scared that their deposits were in danger and pulled their money out of the bank. Only in this case the depositors were money market mutual funds, pension funds and insurance companies and the banks were the large investment banks like Lehman and Bear Stearns. But what even the Slapped authorGorton doesn't tell readers is that the run began because of the collapse in the price of housing. It wasn't lightening out of a blue sky.

BIS Pushes ABCT Draws Fire

ABCT investing offers financial advise derived from the Austrian business-cycle theory, so to be confident in that advise investors need to be confident in the theory. The most visible institution promoting the theory today is the Bank for International Settlements (BIS). The BIS is the central bank for central banks based in Basel, Switzerland. Just as the Fed in the US coordinates the exchange of funds for commercial banks, the BIS acts as a clearinghouse that coordinates the international transfer of funds between the central banks of nations. 

Claudio Borio and William White of the BIS have used the ABCT for years to analyze events and create policy. Recently, the bank created a minor storm in the world of economics and central bank policy with the release of its 84th annual report. The report asserts that the loose monetary policies of the world's central banks as well as fiscal policies of governments have failed and continuation of those policies will prove harmful. Mainstream economists trashed the report. Martin Wolf of the Financial Times descended to juvenile language. Gavyn Davies, also of the FT,  wrote of the report,

The Bank for International Settlements (BIS) caused a splash last weekend with an annual report that spelled out in detail why it disagrees with central elements of the strategy currently being adopted by its members, the major national central banks. On Wednesday, Fed Chair Janet Yellen mounted a strident defence of that strategy in her speech on “Monetary Policy and Financial Stability”. She could have been speaking for any of the major four central banks, all of which are adopting basically the same approach.

The Mysterious Case of Missing Inflation

When the Fed dramatically expanded its balance sheet after the latest recession began, many economists expected to meet high inflation barreling down the road. Fear of inflation helped send the price of gold to $1,800 per ounce. Instead, inflation has been very mild and Europe is flirting with deflation. What happened?

Of course, Austrians needed Hayek and Mises to remind us that the quantity theory of money shouldn't be taken mechanically. Someone has to borrow money and spend it in order for lower interest rates or QE to increase the money supply. The state borrowed and spent in the hyperinflation in Germany during the 1920’s. And the US government borrowed and spent during the 1960’s and 1970’s to create high inflation.

Today, the government borrows to maintain spending while spending increases are relatively small due to high existing debt and political opposition to increasing debt. Businesses aren’t borrowing because high taxes and massive regulation raise the profit bar to pole vaulting levels. So people are borrowing to invest in assets such as real estate and the stock market or exporting newly created money by investing overseas or buying imported goods.

Julien Noizet at spontaneousfinance.com informs us that banking regulations are directing lending to real estate. In “A new regulatory-driven housing bubble?” Julien explains the effect of risk weighted assets (RWA) on lending:

Basel regulations are still incentivising banks to channel the flow of new lending towards property-related sectors. A repeat of what happened, again and again, since the end of the 1980s, when Basel was first introduced. I cannot be 100% certain, but I think this is the first time in history that so many housing markets in so many different countries experience such coordinated waves of booms and busts.

So far we’ve had two main waves: the first one started when Basel regulations were first implemented in the second half of the 1980s. It busted in the first half of the 1990s before growing so much that it would make too much damage. The second wave started at the very end of the 1990s, this time growing more rapidly thanks to the low interest rate environment, until it reached a tragic end in 2006-2008. It now looks like the third wave has started, mostly in countries where house prices haven’t collapsed ‘too much’ during the crisis.

The Basel regulations require banks to hold more reserves for riskier loans. The safest loans go to governments, which carry a zero risk according to Basel. Real estate carries the next lowest risk. Business loans are among the riskiest and force banks to keep more cash idle.

One of the latest casualties of the Basel regulations has been the Bank of England’s Funding for Lending Scheme. The scheme set aside funds for loan to small and medium enterprises, but as Julien writes,

Since the inception of the scheme, business lending has pretty much constantly fallen… According to the FT: Figures from the British Bankers’ Association showed net lending to companies fell by £2.3bn in April to £275bn, the biggest monthly decline since last July.

The Basel accords pretty much guarantee that lending in the future will go mainly to governments and real estate, not so much to businesses. Most governments in the West are trying to limit spending, so for the foreseeable future we can expect repeated real estate and stock market bubbles and little CPI price inflation. That makes bonds a better prospect when real estate and the stock market are in bubble territory, but it also makes gold less attractive.

Of course, I could be wrong, so always hedge. 

Markov Confirms ABCT

Greg Davies and Arnaud de Servigny offer a different take on diversification in their book Behavioral Investment Management: An Efficient Alternative to Modern Portfolio Theory. Chapter 6, “Representing Asset Return Dynamics in an Uncertain Environment was the most interesting chapter to me, and the one that adds confirmation to using the ABCT as a guide to timing the market. 

Modern portfolio theory tells investors to diversify their portfolios at least between two asset classes, stocks and bonds. A simplistic summary of the method is to use the statistical measure called standard deviation to assess the risks of asset classes and diversify according to risk. But in reality, advisers have found that a fixed ratio, say 70% stocks and 30% bonds, often works better without requiring as much work. 

Size Matters

Size matters in investing as much as in other human endeavors. Bigger is better for most activities; Goliath usually defeats David. But financial economists have known for decades that small is the new big: investing in smaller firms increases investor returns a great deal over investing in the Blue Chips. Eugene Fama had to add firm size and value investing, to the Capital Asset Pricing Model to make it work. 

Recently the journal of the American Association of Individual Investors carried an article in its January issue on the subject of firm size, “Exploiting the Relative Outperformance of Small-Cap Stocks” by John B. Davenport, Ph.D., and M. Fred Meissner. The conclusions are striking:

• Small caps outperformed large caps 51% of the time between 1926 and 2012, but realized a cumulative excess return of 253%.

• Investors have higher probabilities of capturing small-cap excess returns in times of economic expansion immediately following recessionary periods.

• Small-cap sectors realize higher returns than large-cap stocks when the large-cap sectors are in favor.

What is ABCT Investing?

Almost everyone has a blog today, so why would I bother to add my teaspoon to the deluge? I did so because I found a hole in conventional investing wisdom which I think needs plugging. I’m not the little Dutch boy who stuck his finger in the hole in the dam and saved the village below. But I think I have a perspective on investing that few others share and which could help people rescue their nest eggs from tragedy.