216 Systematic Investor Series ft. Alan Dunne – October 30th, 2022

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing, and learn about the most dependable and consistent, yet often overlooked investment strategy. Welcome to the Systematic Investor Series.

[00:00:23] Niels

Welcome, and welcome back to this week’s edition of the Systematic Investors Series with Alan Dunne and I, Niels Kaastrup-Larsen, where each week would take the pulse of the global markets through the lens of a rules based investor. If you’re new to the show, I hope that today’s episode will trigger your curiosity enough to check out the back catalog and listen to the past episodes you may have missed, like last week’s episode with Cem, where we discussed some pretty big news from the volatility space, as well as whether investors should go for volatility or trend following strategies if they want to protect their portfolios. 

Also, I would like to encourage you to listen to the midweek episode where Cem and I were once again joined by natural resource expert Adam Rozencwajg for a really important conversation about the current energy crisis and where we focused more on the demand side of the crisis this time. Also, Adam shared the news of the new oil put that the US government has implemented, so to speak. 

Anyways, Alan, it’s great to have you on the podcast this week. How are you doing? How are things in Dublin? Are you ready for Halloween? 

[00:01:25] Alan

Oh, I am indeed. Yeah, I’m very well, thanks. There are lots of kids running around in the locality here, dressed up.

I’m not dressed up myself, but looking forward to the weekend. A long weekend here. 

[00:01:40] Niels

Have you seen on Twitter, there’s a lot of AdWords for Halloween costumes and they’re all like members of the FOMC Committee. Have you noticed that?

[00:01:47] Alan

I hadn’t seen it. Who would you be dressing up as the Chief Powell?

[00:01:53] Niels

Oh, I’m not sure. I’m not sure. Hopefully none of them, but there we are. 

Anyway, it’s good to hear that you’re doing well and we have, as usual, what we at least think are some good topics lined up and and then we’ll see where we go with that. As usual, I’m going to try and run through a little summary. Of course, it’s the second last trading day of October.

We are recording on Friday, and it is a little bit hard to pick from all of the events that have taken place during this month. It’s another month for the history books, in some cases, like the short tenure of the UK Prime Minister, Liz Truss, and the earnings of Meta/Facebook that just seems to have fallen off a cliff, and where the stock is now down about 75% from its high. They’re in good company, of course, as Amazon predicted, the slowest ever sales growth. 

That stock has fallen as much as 21% in after hours trading yesterday, and it slid about 14% today in pre-market trading. If the pre-market losses hold, that’s about 143 billion in value, that would’ve wiped off the company and the stock would register the biggest drop since April of this year.

Of course, last night’s news that Elon Musk finally became the owner of Twitter, may turn out to be pretty significant news. We also have US mortgage rates topping 7% this month. That’s the first time in 20 years. And while all of that is going on, Fed officials are maintaining their resolute hawkish stance ahead of next week’s meeting, laying the groundwork for interest rates reaching 5% by March, 2023.

That seems, at least according to economists serving Bloomberg, to lead the US and the globe into some kind of recession. Now, economists expect the FOMC to announce 75 basis points on Wednesday, to be followed by half a point in December, and a quarter point in the following two meetings.

Perhaps the biggest news, that most people don’t talk about, is the US export ban of microchips to China, which I think actually is worth watching. We’ve also had some energetic bear market rallies during October, like the one we had early on in the month, which didn’t turn out to be that much, but we’re trying again this week. So we’ll see how that goes. Of course, right now, there are still bear market rallies. What about you, Alan? Anything that you have been looking at, noticing during this month of October? 

[00:04:29] Alan

Yeah, there’s so much going on in different dimensions. So, there’s a lot to touch on. I think it’s interesting, as you say, we’ve had this choppy recovery rally in risk assets since the middle of the month. It’s interesting, we had the CPI in the middle of the month and that was the bottom for the market. We had one of those positive reactions to seemingly bad news. That used to be a great trading signal in the past – when a market didn’t go down on what was negative news. I dismissed that a little bit, this time around, because we’ve had a number of these episodes in the last year or so where the market did one thing one day and then reversed the next day.

But so far that is looking like a pretty good signal that maybe the market had factored in a lot of the negative news around inflation. Obviously, we’re in the midst of a corrective rally so far at the moment. I think, as you say, it’s really interesting the shift that we’re seeing on the technology side, and the really pessimistic news out. I think it’s a year to the date since Facebook changed to become Meta, and that hasn’t gone well for them, you’d have to say.

Equally, I was reading, during the week, that there are a number of companies scaling back on driverless cars and investing in some of these technologies. It really strikes me that a lot of the optimism that had propelled these stocks to such lofty heights (going back a year), that sentiment is really changing now.

Obviously, there’s much less liquidity in the market, and that’s clearly a factor along with that as well. I think the other thing that’s interesting is, just looking at the bond side, obviously, we seem to have a little bit of an exaggerated move at the really long end.

I think it’s something that we might get on to later in terms of liquidity, but there is a growing sense of less liquidity in the treasury market. We certainly saw more extreme moves in the 30-year, and a little bit of steepening between 10s and 30s in the last while, which I think is interesting. I’m not sure if that’s just liquidity driven or reflecting more of a premium being into the long end as well. That’s something I’m certainly starting to monitor a little bit more closely. 

[00:06:55] Niels

Yeah, I think we’ll talk a little bit about that later. 

Now, this is definitely a plug for my own Twitter account, but I really will encourage people to go and find my Twitter account. I don’t do much on Twitter, but I did retweet something today that I really hope people will go and watch. It’s a small, short video about how Jim Cramer has talked about Facebook and Zuckerburg throughout the last few years, including his comments, and I must think that the last ones came yesterday after the earnings that were announced the day before. It is hilarious, I have to say. I really hope people will go and pick that up, and watch it for the 60 seconds or 90 seconds that it lasts. 

Yeah, there are definitely some things we’ll talk about, some of the stuff that you just mentioned. For me, sitting here with about one and a half days left of the month, in terms of trading days, it looks like it’s a bit of a coin toss really as to whether we are going to finish as an industry in the red or in the black for the month. Meaning so far it’s pretty close to flat. I imagine at the end of this week, unless something unexpected happens in the last few hours of trading. Actually it’s a story of two tails.

This month we had the first three weeks of October pretty much going according to plan with the same kind of trend following themes that we have been seeing the last few months, and which have taken long bonds down significantly as well as many of the currencies against the US dollar, and that’s been primarily the driver of returns.

Then last Friday the Wall Street Journal, who are the preferred way for the Fed to leak information about their plans, brought an article that suggested that the Fed is now thinking about thinking about pausing their rate hikes or at least slowing them down. I think that’s actually what’s ignited this recent rally – put a fire under some of these assets like bonds. 

They are up five big points from the low, but they’re still down 23 big points since July. You had currencies against the dollar rallying. Equities, they’re up now about 10% from their lows in October. There have definitely been some pretty big moves. Actually, I think equity markets are now more volatile than trend following returns on a monthly basis, it seems. They’ve had a few, 6%, 7% up and down moves this year, which is usually only reserved for trend following, I would say. 

Energies have also been pretty interesting in October. Nat gas is down about 15% for the month and the Dutch, so that’s the US Nat gas, the Dutch Nat gas (tongue twister), Dutch Nat gas is down 66% since the peak in late August. Wow. 

These are really meaningful reversals, I would say. Overall, I’m pretty impressed with what I’m seeing, and what CTAs are looking like so far in October, which I’ll come to in just a few minutes. Overall, I do think that trend followers have lost some money in fixed income this month. Maybe metals, possibly equities and currencies. Then we may have made some money in energies, in grains and in softs, so far. My own trend barometer, interestingly enough, has been on the lower side for the last couple of weeks. It is finishing yesterday at 39. It is suggesting maybe a tiny bit of a negative return.

If we look at what the numbers are so far at the close of business on Wednesday (because I don’t have Thursday, but Thursday probably was a down day for sure for trend followers and CTAs). The BTOP 50 is pretty flat for the month now up 19.6% for the year, SocGen CTA Index down 26 basis points up 25.75% for the year.

The Trend Index is down 75 basis points up about 34.5%, and the SocGen Short Term Traders Index is down 32 basis points up 12.6% for the year. Contrasting that this month, the MSCI World is up 6% so far, but down almost 22% for the year. The S&P Total Return Index is pretty much the same, up 6.8%, down 19.6% for the year. The World Government Bond Index, they’re up 10 basis points this month. That is the first time in a very long time, good for them.

Anyways, So, we are going to talk a little bit to begin with we’ll kick off with your perspective, I think, for October. I don’t know what you’ve noticed about the month of October and how broad you want to go. 

[00:12:04] Alan

Yeah, I think it’s interesting that, as you say, performance hasn’t been too bad, really. It has been a reversal month, or at least kind of a choppy recovery in equities. In some of the bond markets, probably, the net change is still in the direction of the major trend over the course of the month, certainly, as I say, to the long end of the US. But, in some markets you will have seen pretty notable reversals. The UK would be the obvious example. The last time I was on, we were in the midst of the sterling and gilt crisis. Obviously, we’ve had a change of leadership in the UK since then, and a pretty notable rebounding cable from, 103 back up to touching 116 now.

Sterling yields touched at, I think it was close to 5% before coming down to 4%. I can easily see where individual managers, if you had more or less exposure in those markets, you could certainly be outperforming or underperforming. Equally, as you say, we’ve had a pretty mild October here in Europe, and obviously that’s a big influence on the Nat gas prices.

I think one of the contracts traded negative for a few hours yesterday. So, again, with choppy reversals there. The last time I was on, I was saying that cheap trend had done very well this year. I often look at the SocGen Trend Indicator as an indication of that. So it is a good year for cheap trend, but it’s a tough month. So, the SocGen trend indicator is down over 6% this month. 

[00:13:52] Niels

What’s the year to date on that, Alan? 

[00:13:54] Alan

I’d have to pull it up. It’s about, I think from memory, 48%, 50%, something like that.

[00:14:01] Niels

Okay, yeah, it’s actually a horrible return for that. The indicator has a really horrible track record. It might be an interesting indicator to look at, but… 

[00:14:11] Alan

It’s an interesting one because if you look back at it (I looked at it before), it tracks the performance of the SocGen Trend Index very closely up until the point when it was launched as a replicator. 

[00:14:25] Niels:

Exactly. 

[00:14:25] Alan:

Which is what you expect for something that you are trying to fit to the data and, obviously, it’s subsequently underperformed substantially. But it is just one trading signal, the 21/20 day moving average cross. Of course you’d expect it to underperform a diversified set of trading signals.

It is one of a few quick and easy ways of capturing a cheap tend indicator. As I say, yeah, very much a reversal month. From a performance perspective, if you look at US mutual funds where you can get daily data, generally negative across the board, managers down between 1% to 3% generally. So, not too bad in the context of a very strong year. 

[00:15:11] Niels

Yeah, absolutely. I don’t know, maybe we should have done a little bit of historical analysis, whether October is usually a good month or a bad month for trend following. It could be fun to track those things. Yeah, the year continues to produce surprises and opportunities and I think, generally speaking, as we talked about, so far people have navigated this environment extremely well.

Speaking of trend following, not that we are going to talk trend following all of today. People who are less interested in trend, if there are one or two of you out there, then rest assured there’ll be some other stuff we’re going to talk about today. 

You brought a topic along which is somewhat topical, you could say, because a lot of people are asking right now and looking at this space and saying, “Okay, if I do want to go into it, what’s the right allocation?” So, you’ve thought about this question. 

[00:16:13] Alan

I was actually doing some work recently with an investment team, part of a wealth management firm, who are literally going through that process of reviewing their allocation to trend following and thinking about what’s the right size of the allocation in a portfolio.

I guess, as you say, a lot of investors will be going through that thought process now, on the back of what’s been a very strong period of performance and thinking about, okay, should we have more of this or do we have enough, et cetera. It’s interesting that anybody who’s worked in the managed features industry would’ve seen plenty of slide decks of materials that showed the benefit of adding managed features and trend following to a multi-asset portfolio, or to an equity portfolio, or to a 60/40 portfolio.

For a long time, you could show that adding trend following or managed features to, say, an equity portfolio increased the return, reduced the volatility, reduced the max drawdown, improved the skew, et cetera, and improved it across all of the metrics.

Then there was a period, in the last decade, towards the end of the last decade, because of the very strong performance of equities over that period, if you did the analysis again it didn’t quite show all of those benefits. Yes, it would certainly improve the sharpe ratio and reduce the draw down. But in absolute terms, the return might have been reduced. This was a bit of a concern to some people because there’s this perceived opportunity cost of allocating to trend following and managed futures. 

Anyway, if you bring it forward to the current situation now, largely on the back of obviously the very strong performance we’re seeing this year (and a tough performance of traditional assets), if you now redo the analysis, going back to say 2000, adding trend following to either an equity portfolio or a multi-asset portfolio, does increase the return, reduce the vol, improve the sharpe ratio, and lowers the max drawdown etc. That was the initial observation, but it did get me thinking about how that analysis does vary over time.

If you were to think about trying to optimize what’s the right allocation to trend following, that’s also something that varies over time. If you go back and run the numbers now, like a very simple analysis of say a three asset portfolio or a three strategy portfolio, equities, bonds, and trend following. If you run that back to 2000 and optimize to maximize the sharpe ratio, actually the allocation of trend following comes at about 48%, which is obviously way above the typical allocations that you see. Interestingly, if you went back and did that analysis back in 2019, it was still pretty hefty. 

It was for the two decades of 2019, it was the sharpe maximizing allocation to trend would be 37%.Also of interest, if you just ran that analysis for the decade of 2010 to 2019 actually you wouldn’t have allocated to trend following. The allocation to the diversifying benefits wasn’t enough to outweigh the better risk return profile of bonds and equities over that period.

So, it does very much highlight that the question of trying to optimize the allocation to trend following is very much a backward looking measure, and it’s going to be very sensitive to what timeframe that you choose, because if you were to redo the analysis, say, based on the performance since 2020, you’d have an enormous allocation to trend following. 

It got me thinking, what are more sophisticated ways of doing this? In the industry we would never position it from the perspective of optimization anyway, the whole point about trend following is that it’s a strategy that’s very adaptive and that by allocating it to it within your multi-asset portfolio, you’re increasing the robustness of your portfolio because you have something that’s fundamentally different that will operate in a very different environment to other assets.

That brought me to a paper that I came across recently from two analysts at GIC. GIC is the sovereign wealth fund of Singapore. They’ve written this paper in conjunction with MSCI. Actually, MSCI has developed a macro model, or a model for quantifying macro risks. The title of the paper is, Building Balanced Portfolios For The Long Run and New Framework For Incorporating Macro Resilience In Asset Allocation.

It’s quite an interesting paper. They highlight two shifts that we’re seeing in the world right now. One is the rise of private assets, and the second is that we’re into a very changed macro environment – obviously much more macro uncertainty. What they do is that they use that for a justification for saying, if you were going to try and construct portfolios based not on backward looking measures such as, sharpe optimization, et cetera, but instead you were taking a more fundamentally driven forward looking asset allocation approach, what you’d want to do is to try and construct an asset based on how assets might respond to different types of macro environments and different macro risks. 

That’s the approach that they’ve taken in this paper. They talk about five key longer term risks that could play out and they highlight that. If you look back at the markets and the economy over the last two to three decades, it tended to be demand shocks that dominated markets. 

One of the offshoots of demand shocks is that when you get a demand shock, it obviously means that the outlook for growth tends to be weaker. It means that policy makers are likely to respond with lower rates. It tends to support this negative correlation between bonds and equity.

In an adverse demand shock, equities go down, and bonds go up and vice versa. What we’ve been living through in the recent past, we experienced much more supply shocks. We had that with Covid, we’ve had it with the war in Ukraine. Going forward, if supply shocks were to be much more prevalent on the landscape, which I think is reasonable, how would that impact different markets?

They also look at policy shocks, trend growth shocks, real rate shocks. Then what they do is they use the MSCI to model how different asset classes would perform in these different types of shocks. Obviously you could debate that. There is a high level description of the model but they don’t go into the ins and outs of the various sensitivities.

The upshot of it all is actually that they also suggest moving away from the traditional 60/40 portfolio to build macro resilience. They do, interestingly, have allocations to private equity much more to TIPS, to private real estate as well. Interestingly, no allocation to trend following or managed futures.

I thought it was an interesting approach, there is a lot of merit to the approach, but curiously these types of strategies didn’t feature when, from our perspective in the industry, we would see one of the core benefits of having trend following or managed features is in boosting the robustness of a portfolio and having the adaptability to be able to respond to different shocks. Interesting perspective. 

[00:24:41] Niels

Yeah, quite a lot to comment on really. First of all, I just want to say I don’t think we’ve ever had a demand shock for trend following, unfortunately.

There never seemed to be any real strong demand and plenty of supply actually. That being said, again, going back to your initial part of this, about how to build an optimal portfolio between stocks, bonds, and managed futures trend following. A couple of things are brought to mind.

One is it reminds me of a conversation I had many years ago in the Top Traders Round Table Series, actually, where I was sitting with three of the biggest consultants in the world discussing this. Of course we know how important consultants are as the gatekeeper for these pension funds to allocate to various assets including trend following.

They all said, and it’s on record, that their models of course, completely confirm what you said. That the allocation to trend following should be so much higher than any pension fund would even consider. Of course they could never show that to their clients because they would be somewhat laughed out of the room and probably not get the mandate.

It is true. This is why it’s so frustrating, because of all the evidence, I often say there’s never been a white paper written that does not confirm the benefits of adding trend following to a portfolio. It has been quite a few decades by now since we had the first from John Lindner in 1983, talking about the benefits of adding managed futures to a stocks and bond portfolio. That’s one thing. 

Now, I also get this question asked that you just pointed to, and of course you’re absolutely right. You can have different starting points and you get different results, et cetera, et cetera. We approach it from a slightly different point of view because whenever you decide to make a change to your portfolio, and say for someone who’s maybe so far only have had stocks and bonds, including trend following is a big shift because you have to reduce some of your stocks and you have to reduce some of your bonds most likely, and you have to include trend following. 

The question is, of course, how much? We said to ourselves, “Why not try and do this by finding two extreme starting points?” Actually what we decided was to find four. We said, “Okay, what if you did it right before the tech bubble burst, or what if you did it right after?”

The low, which I think was in March 2002, or something like that, or October 2002. Or what if you did it right before the great financial crisis starting in 2007? Or if you did it at the end of it in March of 2009? That I think, actually, is not a bad way of doing it because one, (and I was going to ask you about this), what’s the minimum number of years you need to do any kind of meaningful analysis on portfolio construction?

You can’t just say, “Let’s start in 2019.” That’s completely meaningless. Maybe even 10 years is meaningless because you can have one regime in 10 years. My starting points are not too different from yours. When you said 2000, I’m saying, “Okay, let’s do it at the beginning of the tech crisis bubble and then again starting in 2007.” It gives us at least 15 years in both. 

What’s super interesting about it is that first of all, (and these are from memories because I don’t have the number in front of me), but in the tech bubble, if you started before or after… (of course we are using our own performance track record as this managed futures part, not the SocGen Index, we’re using our own program) The allocation to us, essentially (so trend following), is the most consistent one. Meaning it doesn’t change a lot, whether you did it before the crisis or after the crisis. The big difference is between the stock and bond allocation. 

Again, to me, that goes to suggest that it really needs to be a core allocation in your portfolio. If you go and you do it now, and we are talking in the fourth quarter of 2022, and you do it for the great financial crisis, it is interesting, (you also alluded to an example of that), in fact, there’s only two assets it will select now and that’s going to be equities and trend following. 

It’s not even going to include bonds, either before or after the great financial crisis. They’re completely out because they haven’t really made any return since the crisis. If you did it two years ago, there would’ve been a bond allocation. I’ve done this every month for a long time now, so I know how it’s changed.

What I will say is that the most consistent part of that portfolio is still the trend following part. It’s again, the equities and the bonds that are shifting much more. However you slice and dice this, I think that one, trend following, (and I’ve obviously said this for a few decades by now), I think it is essential for every portfolio to have it. I don’t think people need to worry so much about, “Oh, is it 17% or is it 27%?”

Frankly, rule of thumb, 20%, 25%. It’s probably good enough. Then you can do whatever you want with your equities and your bonds. Clearly, I think common sense would’ve dictated that bonds shouldn’t be a very large part of your portfolio when it was yielding pretty much nothing or even negative in Europe. I think that’s common sense.

Even if you’d stayed with it you would’ve slowly rebalanced and gotten out of your bonds and so on and so forth. I guess my point is it does not have to be so complicated.

[00:31:08] Alan

No, I think there are other things you can do. Obviously there’s lots of different models like Black-Litterman, all of that type of stuff, you can do to get a bit more forward looking but a basic forward looking perspective would be, as you say, obviously when bond yields were at zero or 50 basis points, you’re expected return over to over the long term from holding those assets was 50 basis points.

There is a slightly more attractive outlook now on bonds, obviously with yields here. Against that, obviously the bond equity correlation has gone from being, (I looked at it), it was -.2%, I think between 2000 to the start of this year and now it’s +0.2% this year.

That’s diminishing that benefit. Equally then, on the managed future side and the trend following side, those returns, obviously within managed futures, you’ve got a cash element as well. The returns over the last two decades have been developed or been produced with cash rates of about 1.5% on average.

Now we’re up to, 4%, 4.5% at the short end of the US curve, or we will be pretty soon. You could construct forward looking estimates of returns based on expected returns plus cash, and building in the revised yields that you’re getting in treasuries and equities.

[00:32:36] Niels

You know, you’re making a great point here, Alan, because I think this is something that people will sometimes think about and say, “Well, hang on, maybe we now need to reduce some of our other allocations and move into bonds and get that 4%. But the beauty of trend following is that you are going to get that automatically because 90%, or 85%, or 80% of the money we get into our strategies we don’t need for margin purposes. So, they’re just sitting (hopefully) in a safe place earning a decent yield. So, that’s the beauty, you’re not losing out, you’re not missing out even if you were to allocate to trend following over fixed income.

As I said in the beginning no one has ever written a research paper to suggest the opposite, but I am surprised, to some extent, that the article you mentioned doesn’t even include this, especially if it includes things like private equity. I think we’ve been around longer than private equity, frankly.

(0:33:46) Alan

It did get me thinking. I don’t know enough about how GIC runs their portfolio. If you’ve got 800 billion and you want to allocate… 

(0:33:58) Niels

It could have something to do with MSCI since they’re the sponsor of this paper. Maybe you never know.

(0:34:06) Alan

Maybe there’s an element of that to it. 

(0:34:09) Niels

I’ll just say to everyone, I will link to this paper in the show notes, so you can definitely go and read it.

[00:34:15] Alan

I thought there was a lot of good stuff in there. Particularly from the perspective of taking a forward looking approach as opposed to backwards and managing to pass volatility. I thought there was maybe a little bit of a lack of imagination.

Some of what we’ve talked about before about the potential risks that we could see. They had the five major risks which are fairly broad, but you could imagine other factors, not just obviously they talk about a weaker growth environment on an ongoing basis, but from the perspective of equities, that the split between capital and labor and the returns to labor could rise. That’s not something that got captured within there. 

The other thing is, withstanding the fact that they said, “Don’t be backward looking.” They did do a backtest, over the last 50 years, to see how the portfolio would do. Which made me think why just think about the risks we’ve seen over the last 50 years and how would that portfolio do in a very deflationary environment? I’m not sure that was fully factored in. 

I think it’s interesting when you develop something like a macro model and quantify macro risk. The very fact that you do that might lull you into thinking that you’ve captured all of the relevant risks and you can solve for it. Whereas, maybe a more simplistic approach of saying, “Let’s find a strategy that can help the portfolio regardless of the different types of shock,” something like trend following. 

[00:36:01] Niels

Alan, in a few minutes we’re going to talk about one of the upcoming interviews that you had. In that conversation is a person who has essentially been working with central banks, and basically what he’s saying is that we should be aware, (or at least in his opinion, and he warned them about it), they’re using the wrong models. Which is scary that even at a central bank, they’re looking at the wrong models. 

My point is, I find it interesting that a lot of these firms are coming out with these “forward looking models,” because if you just go back in history and you see how much has happened that none of these models seem to have been able to forecast anyways. How many times has a central bank forecasted a recession or whatever? Probably zero. 

I don’t personally care much for these “models,” because I think the future is unpredictable. I think the last 12, 24 months have shown us and given us all the proof we need to know about that. Sometimes I think it can be overly complicated and I think a common sense approach, with a decent allocation to various areas, is fine. 

Anyways, you brought another article that I also will link to in the show notes, but as I haven’t read any of the two, frankly. I’ve been a little bit busy coming into month-end. Tell me about that one. 

[00:37:39] Alan

This is very much in the same vein or very much linked to this idea of thinking about forward looking risks.

I just came across a piece from the McKinsey Global Institute who have published a report recently called On the Cusp Of A New Era. It’s very much in the vein of, I guess, what a lot of people are saying at the moment which is that we’ve had a period probably from, they dated from 1989 to 2019, which was a very distinct period in economic and market history.

There are signs that we’re transitioning out of that era into a different era. They have the idea that there are ‘earthquakes’ at different points in time, such as in World War II, then put the foundations in place for a particular era. The postwar boom, they labeled from 1944 to 1971, and then obviously you had to break down into a monetary system at that time. Then a new era, an era of contention (they call it), between 1971 and 1989. Obviously, then you had the fall of the Berlin Wall, et cetera, and the move into the era of markets in 1989 to 2019. The suggestion that we’re in the midst of a move into a new era on the back of a number of earthquakes. 

Earthquakes being obviously Covid, the war in Ukraine, the rising geopolitical risk, the concerns about energy scarcity, et cetera. Certainly, there is, as I say, that sense that neoliberalism has run its course, that there’s concerns around that in terms of inequality, that free markets can’t run unfettered.

As well, we had this disinflationary trend, in that period, that now seems to be over. It is very much in line with similar work I would say in this space. Obviously there’s the work the Fourth Turning, Neil Howe’s work, which I know you’ve talked about before. Equally, Ray Dalio has written pieces on this before on the idea that you have, (his one was about different paradigms in markets, paradigms that often run for a decade or a couple of decades), often what you get is that there’s a predominant ideology or belief that permeates everything, that works up to a point.

Then you see there’s perceived success and stability, but that, in itself, is laying the foundations for the destruction and the breakout. If you go back to 2019, you had a period where unemployment around the world was low.

You had low inflation, asset markets at multi-year highs. Seemingly things looked pretty good on the surface, but at the same time you had record high central bank balance sheets. You had record high debt levels, you had rising geopolitical concerns. You had this concern about global warming, et cetera.

In a sense that the fault lines are now breaking. We’re in the midst of this earthquake that’s setting the stage for the new era. 

[00:41:21] Niels

Yeah, I know we’re going to tease next week’s episode that’s coming out. I actually want to also tease another one that’s coming out in a couple of weeks.

I just recorded it a couple of days ago. What it’s about in a sense is, I personally believe that there are cycles, I think there are business cycles. I think there are all kinds of cycles, and of course Howard Marks has written a whole book about cycles.

I do think they exist. I’m not clever enough, myself, to forecast them or use them for anything as such other than I am trying to make myself aware of some of them – the more important ones, because they very often match up with these big turning points. I think it’s definitely worth paying attention to, and some people will call it regime change. That’s fine. 

You might just define it as different types of cycles. One of them, the one we talk mostly about, is this 40 year interest rate cycle. Which frankly, if you look at it, interest rates peaked in 1981, and at 40 years you get 2021. Lo and behold, that’s pretty much where we had the low in interest rates.

They might still work, these cycles. So, I think one can’t ignore them, which makes me very optimistic about this whole divergent systematic trading strategy that we spend so much time talking about. I think in the cycle that we are in now, where markets will become much more volatile. Like you said, a couple of months ago, after Jackson Hole, where Schnabel, from the ECB had come out and said, “We’re going from the great moderation to the great volatility.” That’s coming from a central banker, and so I think it’s right. 

As I said earlier today, if you look at just the volatility on a monthly basis in equity returns, they’ve almost taken over the kind of volatility we deliver in trend following, because we don’t normally deliver plus 5%, 6%, 7%. Equities are, at the moment (let alone some of the other markets that we talk about).

[00:43:58] Alan

I think what’s interesting about this as well is, as you say, we picked up on a lot of these themes as well at Jackson Hole. Obviously, McKinsey is not the only one writing about this.

I think the way they’re presented is quite interesting, and they talk about it in five different dimensions in terms of the shifting world order; how technology has evolved in those different eras, and how it might evolve in the future; demographic forces, resources, energy utilization, and capitalization on the financial side. I would say they have a lot of interesting stats in there. They have lots of interesting perspectives, but lots of people, certainly, as you say, Jackson Hole, there was not just Schnabel, but the general manager from the BIS spoke as well about how the global economy will be supply constrained going forward. Interestingly, I was thinking, do you see evidence of that in the markets?

Do we see evidence of that being priced into the markets yet? I’m not sure that we do. In a lot of the commentary that you still read, there’s still this view, “Oh, the CPI is going to come down next year, just on base effects, disinflation, and commodity prices.” 

There is a comment in the McKinsey report about how demand shocks are very often linked to psychology, shifts in behavior, but supply shocks are physical and will play out much more slowly over time. These are shocks that are evolving at the moment, the trend towards nearshoring and rejigging supply chains. It’s almost the fact that you don’t see a monthly report on this in the same way as you do in the jobs data that means it’s hard to quantify. It’s hard to keep it at the forefront of investors’ minds. I do think they’re significant, but I’m not sure if they are fully factored into markets. I’m not sure they’re factored in to any great degree. 

[00:46:04] Niels

I think, actually, and I’ve been talking about the risk of inflation for probably a couple of years now, way before a lot of people were even thinking about inflation coming back and most likely poo-pooing the idea that it would come back. I think this type of inflation, or this new regime that we are in is, not least, linked to inflation or the resurgence of inflation. I do think what makes it different is, I think it’s this unpredictable inflation we’re having.

Meaning, no, you can’t write a report every month saying, “Yeah, this is where we are, we’re heading this way,” because I think we’re going to be heading all sorts of ways, both up and down. That’s going to drive markets in unpredictable ways as well. 

You and I remember, back in March of this year, after what happened in Ukraine, people were pretty much saying, “Oh, this commodity supercycle is here. It’s going to just go up from here.” After a few weeks it really turned, and as I mentioned earlier, we’ve seen things like Dutch Net gas fall 66% from its high. This is pretty meaningful. So, it won’t be easy.

This is also why I think being fundamentally driven in your investments, right now, is going to be incredibly hard, if not impossible. Not that I think it is great in the first place, but I do think these rules-based strategies will have the upper hand. At least that’s how I feel about it.

You mentioned the BIS, so let’s jump into the next point, because we want to tease the podcast episode coming out next week a little bit. It is with a very special guest, someone who’s worked at the OECD, The Bank of England, the Bank of Canada, and the BIS. It is William White, or Bill White, as we call him. Yeah, just a few takeaways, Alan. Without stealing his thunder.

[00:48:11] Alan

Yeah, let’s not do a summary. Just in case people don’t know Bill White, to be honest, after we recorded I felt a bit bad that maybe we didn’t give everybody a sense of the weight that Bill White holds in global economic circles.

It only came up in the conversation that we were having with him afterwards, because we talked about central banks, and central bankers, and do they have the same credibility? Then, obviously Ben Bernanke got the Nobel Prize recently, and he (Bill White) was too humble to mention it during the podcast.

Adam Tooze, who writes a blog or a chart book, that’s a great resource, he wrote a piece talking about how it had been quite controversial. Basically the point on that was (taking a bit of a tangent) that I think Bernanke got the Nobel Prize for proving, in model terms, that you can get these banking crises.

It was very much for developing the technical underpinnings that can prove, from a theoretical perspective, that something that we know has actually happened can happen. It was like, why would you give somebody a Nobel Prize for something so theoretical when there are people around the world, such as Bill White, who have been poo-pooing the over reliance on models and have been much more prescient in their predictions. Back in 2007 he used to oversee the publication of the BIS annual report, and in 2007 they basically warned about the leverage in the system and the risk of a financial crisis.

Adam Tooze actually said, “If anybody should have got the Nobel Prize, it should have been Bill White.” We probably should have started off with that in retrospect in the podcast. Yeah, really fascinating. We touch on so much really interesting information.

I suppose the overall philosophy that Bill White has (and this is a guy who’s been an economist at the very highest level, at the Bank of England, Bank of Canada, BIS, OECD), is that the markets and the economy, it’s a complex adaptive system. 

[00:50:45] Niels: 

I seem to have heard that word before on this podcast, that complex adaptive system.

[00:50:50] Alan

This is the point, he obviously is not a proponent of trend following, but we made that link fairly quickly about how trend following could be a solution to a system that has those features. That’s just it, it’s the system is inherently unstable.

It’s the hubris of central bankers, from time to time, who think that they have solved it and think they maybe understand it. Obviously we’ve seen that in the last 12 months. We went from the Fed, with their flexible average inflation targeting, to coming out and saying, “Actually we don’t understand inflation very well.”

I couldn’t recommend listening to Bill strongly enough. We could have gone on for much longer. It’s actually pretty sobering stuff as well. There’s no mad forecasts, I would say, but certainly an overall framework that he presents that would have you pretty worried that we’re going to see some volatile times ahead.

[00:52:00] Niels

Yeah, absolutely. It’s one of the best conversations we’ve had on these types of topics for sure. It is a must to listen to without a doubt. Of course I’m sure Rich, down under, will be cheering for joy when he hears Bill White talk about complex adaptive systems. Which is, of course, is one of his terms that he likes to talk about when it comes to trend following.

All right, sir, let’s round it off with you said you put in your notes here a little bit of some unforeseen consequences of QE. 

[00:52:42] Alan

Yeah, sorry. I mean that’s obviously linked to one of the very famous pieces Bill wrote was a piece 10 years ago called the Ultra Easy Monetary Policy and the Unintended Consequences.

You know anybody who wants to read anything from Bill White to get a sense of what he’s written, that’s one of the things. It’s interesting now, as we look at markets, what we’re starting to see is very much that. Obviously we have had, recently, extreme volatility in gilts and in TIPS markets in the UK.

These are the features of complex adaptive systems that you hit at various points in times, tipping points and thresholds, where the market can go parabolic, or you’ve got basically participants who are short gamma (to use the options terminology) and start pushing the market and reinforcing the trends. It’s just interesting that we’re seeing that.

Also, it’s interesting that, in the last while, central bankers are having to respond to that to much greater extent. We had the Bank of Japan intervening in dollar/yen, last Friday. We had local Chinese banks reported to be selling dollar/renminbi during the week, which people took as indicative of possible PBOC intervention.

We had Janet Yellen, this week, talking about concerns about liquidity in the treasury market because we’ve been seeing much larger moves there, and much larger bid offer spreads. JP Morgan Index of Market Liquidity is down at its lowest levels for a number of years. I think we’re very much seeing, playing out now, as central banks withdraw this stimulus, some of these unforeseen consequences of QE that Bill Whites wrote about around 10 years ago.

[00:54:32] Niels

Maybe Janet Yellen was listening to last week’s episode with Cem, because we talked exactly about some of the risks that he’s seeing in the option markets, and really a drought of liquidity, which usually is not a good sign. I will say (we obviously have mentioned this before), that generally speaking, futures markets are the most liquid markets going through these types of crises.

Let’s hope that’s also the case this time around. Some of these “liquid markets” can become quite illiquid. Which of course is also why I’ve been somewhat cautious about embracing the idea of alternative markets in trend following strategies. I think actually being on exchange, trading liquid futures, is (for the long run) a safer bet.

That is another discussion. Alan, I think we’re going to round it up there. I think we’ve done well covering some different themes. Any last parting Halloween words from you? 

[00:55:35] Alan

No, I think that’s very interesting. Always great to catch up. Happy Halloween everybody.

[00:55:40] Niels

Yeah, absolutely. Of course, I think in exchange of Alan doing all this research, finding these articles, maybe we could ask that you leave a rating and review in iTunes and Spotify, Amazon, because it really does help the podcast reach more people. We would be ever so grateful for that Halloween gift.

Next week I’m joined by Rob, so that could be another scary conversation, frankly. He always has some good topics as well. Of course, if you have questions for Rob, you can email them to info@toptradersunppluged.com and I’ll do my best to make sure that they get an answer from our UK friend.

From Alan and me, thanks ever so much for listening. We look forward to being back with you next week. In the meantime, take care of yourself and take care of each other. 

[00:56:34] Ending

Thanks for listening to the Systematic Investor Podcast series. If you enjoy this series, go on over to iTunes and leave an honest rating and review, and be sure to listen to all the other episodes from Top Traders Unplugged.

If you have questions about systematic investing, send us an email with the word question in the subject line to info@TopTradersUnplugged.com, and we’ll try to get it on the show. 

And remember, all the discussion that we have about investment performance is about the. And past performance does not guarantee or even infer anything about future performance. Also, understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us, and we’ll see you on the next episode of the Systematic Investor.