Nothing Good Happens Below the 200-Day Moving Average ft. Mark Rzepczynski

[00:00:01] 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] Alan

Welcome back to the latest edition of Top Traders Unplugged where each week we take the pulse of the markets from the perspective of a rules-based investor. It’s Alan Dunne here this week sitting in for Niels, again, who’s gone on his travels and delighted to be joined by Mark.

Mark, how are you doing?

[00:00:40] Mark

Good. How about yourself?

[00:00:43] Alan

Very well, yeah, all good here. Spring sunshine is continuing in Dublin so we’re happy with that. How has all the stateside kept?

[00:00:52] Mark

Well, Boston is starting to get a little bit warmer. We got blue skies out here, you know, some of the flowers are coming up. So, spring has come.

[00:01:02] Alan

Very good. Good stuff. Yeah, yeah, absolutely. So, a lot going on in markets, an interesting time. We’re coming up towards pretty much the end of the quarter, so it’s certainly been an interesting period. Very choppy, I think, fair to say, across a number of asset classes. So, we’ll get to that in terms of performance in a little bit.

But we always start off asking, you know, what’s been on your radar lately?

[00:01:26] Mark

Well, I start with a quote from my grandmother.

Not that she was a great trader, but she used to warn me when I’d go out, you know, because she lived with us when I was growing up, she goes, “Nothing good happens after midnight.” And that always comes to mind because when I look at financial markets, I’ll say that nothing good happens below the 200-day moving average.

[00:01:52] Alan

Pretty good.

[00:01:54] Mark

Yeah, as soon as prices get below the 200-day moving average, people’s psyche changes. I think that there’s a different sense of sentiment. You start seeing more selling. Volatility changes a little bit.

So, I don’t know why it’s the 200-day moving average, but once you hit that, it seems like things change.

[00:02:17] Alan

Interesting. I mean there is the age old, you know, the debate around technicals and is there a merit in it? But you’re right, it does seem to be it to 200-day moving average because it gets so much attention in the media. Is that it, that it’s a flip of a switch to highlight that something fundamentally has changed?

[00:02:38] Mark

You know, I think it’s just like one of those long-time indicators. Just like when stocks hit new highs, people behave a little bit differently. But we’ll sort of say that this is not applying to all markets right now.

And I think we’ll talk about this in a little bit. So, we’ve got, let’s say, the US general stock market, S&P, NASDAQ, they’re below the 200-day moving average. If we start looking at sectors, we’ve got some that are way above 200-day moving average.

You go to the European Stock market, we’ve got a very different type of market. So, what it tells us something about rotation. It tells us something about where the sentiment is changing across markets. And that clearly, then, is reflected in people’s behavior because people say, well, if I’m down below the 200-day moving average, well maybe I have got to start revising my portfolio. I’m going to have to start thinking about what I might sell.

On the other hand, you say, okay, there is other stuff that looks like they’re performing well. Maybe I should start to look to increase the exposure on that side.

[00:03:51] Alan

Yes, for sure. And I think that’s something we will get into in a bit more detail as we go through the conversation. And, as you say, there are many, I suppose, different pictures, I guess, when you look at the trends and the technical picture across global markets, there’s certainly some divergences there.

So, maybe just to touch on trend following and manage futures performance, at the outset, to get that out of the way. So, on the month, The SocGen CTA index is now down 25 basis points. The SOC gen Trend index down a little bit over 1%, 1.07% and year to date. And obviously, that’s the Q1 SocGen CTA index down 2.23% and SocGen Trend index down just over 4%. So obviously a negative start to the year, a negative quarter. And we’ve touched on the drivers in terms of the choppiness, obviously in equities and fixed income and reversals in some commodity markets in February. Any other observations yourself, Mark, in terms of CTA and trend following performance in Q1?

[00:05:07] Mark

Well, I think that we’re early in the whole trend revising change. So, let’s go back to our initial comment about you know, 200-day moving average. Well, we had the US stock market that sort of crossed over and went below the 200-day moving average in the quarter. And there’s a view that, well, trend following is down, something’s wrong here. Well, what we find is that it takes time for some of these revisions and trends to then actually be adjusted in the portfolio.

So, trend followers, which are more intermediate term, they’ll start to lower their exposure in some markets, increase the exposure. And what we find out is that when there’s the transition period, there might be underperformance. And if the new trends start to last longer, then we’ll start to see the outperformance of CTAs relative to long-only assets.

[00:06:08] Alan

Absolutely, yeah, so, I mean, I think that’s certainly the view. We’re in that transition phase where, as we’ve been highlighting on many of the podcasts, uncertainty is unusually high. We’re seeing a lot of obviously new policies coming in.

So, maybe that’s a good place to start in terms of the kind of the impact of those policy changes on markets at the moment. Obviously, tariffs has been the big theme in Q1, and it has been very much kind of on/off, on/off and more on than off, I guess, towards the end of the quarter.

But I mean in terms of thinking about how managers, how markets respond to that, and kind of looking through all of the policy impacts, how do you think about that?

[00:06:56] Mark

Well, first, on tariffs in particular, what’s very interesting is that it now matters what are the contract specs that you trade if you’re in the commodities markets? So, are you looking for New York delivery versus London delivery?

So, if you see that there’s a tariff gap for some of the metals between New York and London, you see a gap in gold prices even though their tariffs won’t be affected by gold. So, now what happens is that while a lot of CTAs might say, or a lot of managers say, like, well, one contract is the same as another. You know, let’s just look at liquidity as the main driver.

Now you have to sort of say, well, let’s look at what are the delivery provisions. Where is delivery? Where is the market centered? And those things start to have an impact on how you construct your portfolio or what you might see in performance.

[00:07:56] Alan

Yeah, for sure. Obviously, we’re seeing that in copper, in particular, isn’t that right? LME copper lagging and obviously New York copper touching all-time highs during the week.

[00:08:04] Mark

Yep.

But I think that the tariff is just a representative of the broader issue which, I think is what we’re seeing is that impact of uncertainty in markets. And I’ll start this with the whole idea that most recessions are manmade because of bad policy decisions or bad choices by market participants and not from old age. So, when you think about a recession or a recovery, you can almost think of it in a mortality table. It ages and then, as we get older, and older, there’s more likelihood that something could go wrong with our “economic health”. And if something goes wrong with their economic health, then it’s more likely that then that recovery is going to die.

So, what is driving the economic health right now, which you touched on, is the tariffs. But the broader issue is uncertainty. And we’ll sort of say that uncertainty is manmade, in this particular case, because it’s not uncertainty about what are the crops going to be? It’s not uncertainty about what is going to be consumer demand per se? But it’s uncertainty about policy.

And so, we’ll say, that’s a choice that’s being made. So, as opposed to that it’s something that’s exogenous, that’s being thrust upon us.

[00:09:40] Alan

Yeah, that’s fair to say. I mean it is interesting. There is the argument that, I mean you mentioned that the economic cycle tends to die because of policy errors. There is a view that the cycle has got longer because the economy has become more service oriented. And historically some of the swings in the economic cycle were driven by the inventory cycle which is very much a manufacturing goods kind of cycle.

And obviously, if you go back to the last kind of economic cycle or expansion, it was one of the longest, I think, right through the last decade and it was only ended by Covid. You could argue different arguments, that some people would say well it would have ended anyway. But I mean, ostensibly Covid was the end of it.

But as you say, you can have kind of more manmade economic downturns. And sometimes you hear the expression, we might risk talking ourselves into a recession, which is a bit kind of like what it feels like we’re experiencing now where let’s talk about uncertainty. And then uncertainty does obviously have real economic impacts because people, I guess, postpone investment and postpone consumption decisions.

So that seems to be the scenario, the potential scenario now.

[00:11:02] Mark

There are a couple things we know about the post World War II period, that one, recoveries have been longer, two, the amount of time that we spend in recession is less. So, if we look at the mortality table, or a life expectancy of recovery, if you look at Pre World War II, post World War II, we’ve done a pretty good job.

So, we don’t make a lot of forced errors, a lot of policy mistakes, that doesn’t mean that they don’t occur. And that’s the important issue to remember is that just because we’ve made fewer errors in the past doesn’t mean that we won’t make errors in the future. And that could just be a matter of unintended forced errors. And unintended forced errors, in this case, I would say, are uncertainty shocks.

[00:12:01] Alan

Yeah, I mean people throw the word uncertainty around a lot, but I guess, what is the uncertainty at the moment? I guess that one of the reasons it’s so striking is that you’ve got uncertainty around the actual action, and you’ve got uncertainty around the impact of the action. Would you agree with that? I mean, from the perspective of that Trump has been quite erratic. You know, tariffs were on, then they were off, they were delayed, they’re back on. And then it’s not clear, is this a bargaining tool, or is this the end game?

So, that leads to a lot of uncertainty as to what does this look like? But then also, we haven’t had these kind of policies for a long time, so the actual economic impacts of them are much disputed. And then, obviously, because of that, we don’t know how the policymakers in central banks are going to react. So, I suppose it’s kind of uncertainty cubed, maybe, in that sense.

[00:12:57] Mark

Right. Well, taking a step back is that we want to make a distinction between risk and uncertainty. And this is an age-old problem that some people thought we eliminated. But we’ll sort of say that risk is countable, which is measurable. It’s what we look at when we sort of say there’s volatility.

Now a lot of people use the word risk and uncertainty interchangeably, but we’ll sort of say that we’re making the argument that there’s a distinction between the two.

Will say that risk is what is countable in the markets, which is based on just the statistical measure of this spread or the deviations away from the mean squared. Okay, so it’s a countable measure. When we talk about uncertainty, what we’re saying is that this is something that’s not countable.

There are now uncertainty indices which they look at: like, the number of news reports talking about monetary policy, the number of news reports that might talk about policy changes in government spending.

So, we’ll sort of say that by looking at the count of stories and the amount of words about uncertainty, about the words of policy changes, that we can then use like large databases, from news organizations, to start to count or measure what is normally non countable, which is the volatility. So, in that sense we’re making a separate distinct difference between these two.

And if you look at some of the research that has been found and even some of the work that I’ve done, if you look at these uncertainty indices, you’d say that it is a separate factor from volatility. And when you think about our volatility, our volatility is often backward looking because we have to count data, or returns from the past, and then look at the volatility. So, that’s in the past. And then our assumption is that the risk that we count in the past will then apply to the future. It doesn’t always happen.

Uncertainty is saying, I don’t know what’s happening with certain policies. And so, therefore, it creates an environment where it’s ambiguous what will be like the regulation that I face? What will be the monetary policy that I might face? What will be the tax policy or fiscal policy I have, or what is the trade policy? So, the idea that it’s not clear what the environment I’ll live in is different than the risk in the market.

So, we’ve had a spike in VIX, it’s come down. You look at the VIX term structure, it’s inverted. So, we have high volatility in the front end and then we have lower volatility longer.

But if you look at, for example, these uncertainties indices, the measure of tariff uncertainty is through the roof. If we look at just overall global policy uncertainty, that’s also at the highs, it’s similar to what we saw during the pandemic in 2020.

So, we’ll sort of say that these two are distinct and different.

[00:16:22] Alan

Yeah, I mean, that’s interesting. I mean, but I guess one of the things we say about trend following and managed futures technical analysis is the idea of price discounting all the relevant information. And, you know, trend followers followed the price for that reason. So, I mean, taking that perspective, at the moment, and because we’ve got so much noise, so much uncertainty, and taking, maybe, the perspective of the wisdom of the crowds, if you look at what the price is telling us, what would you say from that, looking at the price? So, what is the market, would you say, telling us about all of the noise that’s going on?

[00:17:12] Mark

Right. Well, let’s look at the US Stock market, which might be a perfect example. It’s telling us that, given this higher level of uncertainty that’s different and distinct from risk, we’re saying that I want to be more cautious about how much money I’m going to put into risky assets.

We’ll sort of say that Europe also faces uncertainty, but Europe’s ideas is that they’ve talked about like, well, we’re going to increase our debt financing in some sense. We have the ECB that’s being more accommodative and more easing.

So, while there’s uncertainty about what’s happening in geopolitics and different regulatory policies, we’ll sort of say that there’s more certainty about what’s happening in Europe than there is in the United States. So, what we see, when there’s higher uncertainty, is there generally will be a view that you’re going to reduce your exposure to risky assets.

Now, uncertainty could be both good and bad. As I always sort of say, when you think about the whole idea of fat tails and distributions, fat tails, this is like you get a big prize at Christmas, okay, A big box and it’s ticking. It could either be a clock, a new watch, or it could be a bomb. You don’t know. So, it could be either one of the tails.

But, given this higher uncertainty, then there’s generally a movement away from risky assets. So, that’s on the financial side. There has to be a higher risk premium associated with holding risky assets.

When you look at the real economy, if you are going to make an investment decision, you want to say, well, if I don’t know what the tariff situation would be, I don’t know what tax policy will be, I don’t know what monetary policy may be, maybe I’ll hold off my capital expenditures. If I’m a consumer, and we see this in some of the sentiment numbers, maybe I might be more cautious on making large purchases of non-disposable goods.

So, now, what you’ll also do is that you’ll see that then there’s going to be a slowing of decision making in terms of a dollar/cost average. So, if I’m going to make an investment decision, instead of saying, well, I’m going to rebalance all of my portfolio at once, I might say well I’ll start to slowly rebalance given this uncertainty.

So, what does that mean for trend followers? It’s that in a high uncertainty environment, where people rotate assets to those that are less risky, there’s going to be opportunities. In a high uncertainty environment, where there’s going to be more caution and slower behavior of both hedgers and speculators, that means is that there’s more likely to be sort of autocorrelation in the time series, which means that there’s more likely to be trends.

Now, the problem comes in that all of our trend followers, when we’re all either explicitly or implicitly, we’re all signal to noise traders. And all quants are signal to noise traders.

And when we say that they’re signal to noise traders is that we’re looking at a signal, and then we have to discount that by noise. So, if I have a shallow trend but the noise has increased, it could be an actual volatility or this uncertainty. Then what happens is that I might actually have to take smaller positions because the return to risk ratio is lower. Or, if let’s say, I had a trend that was relatively strong but now the noise has gone up, well then my signal to noise ratio has gone down. Which means that I might have to cut back my exposure because the reward I’m getting for the risk that I take may not be the same as what it was three months ago.

[00:21:35] Alan

That makes sense, obviously. And we’re seeing that in equity markets. Higher risk premium mechanically should mean future earnings are discounted at a higher rate, which would justify lower stock prices. So, that’s true. I mean bonds I guess have been kind of rangy, up and down. So, you could see some flight to quality there. And obviously, gold, I guess, has been the standout trend maybe of late. And you can draw certain inferences from that. I mean, is that uncertainty? Is it geopolitics? Is it inflation? Does it matter?

It’s a trend, I guess, is what trend followers would say.

[00:22:19] Mark

Well, gold is a really interesting case because there are certain knee jerk responses that we have to gold. And one is this fact that, well, if inflation goes up, I’ve got to have more purchases of gold.

So, inflation has gone down and yet we still have, now, the new highs in gold. So, there has been some recent research by Earp and Harvey, Campbell Harvey, and they’ve looked at the gold market, and they’ve done this in the past, and so, what they showed us is that there’s been a sort of change in the market based on gold ETFs.

So, because we’ve made it cheaper to actually transact in gold, the financialization of gold, that [makes it] easier for people to demand gold and push prices up. And the other issue that we have is that there’s been a lot of buying by central banks, especially in the case of China.

And what we’ll sort of say, and I’ve been thinking about this issue a little bit more deeply, is that one of the key issues in macro finance right now is, what is a safe asset. And so, whether the supply of safe assets is large enough, let’s say, in treasury bills.

Now you could think of a safe asset in a broader sense in that I want to have an asset where the government can’t appropriate it, or I could probably hide my wealth from sanctions. That’s what central banks may be doing. There may be other people that are buying this as an alternative safe asset because it’s harder for governments to be able to get at your gold.

[00:24:07] Alan

And maybe just taking this uncertainty topic, and from the perspective of model building quant traders, I guess the uncertainty is just, it’s a feature of the market. I mean you mentioned uncertainty being a different factor to volatility, which makes sense. It’s also just, I guess, a feature. I mean, from the perspective of quantitative investors, quantitative fund managers, the models don’t know that uncertainty is higher. They’re just looking at either the price series or the macro data.

I mean that just the nature of it or is it something that, I guess, quant traders should try and specifically allow for, do you think?

[00:24:58] Mark

Well, this is of course one of the age-old questions, should you adjust models or not? And should you chase models with constantly tinkering. And we know from trend following, for example, that regardless of all the tinkering you have, if you look at the long, long data that we have, intermediate trend following seems to work best.

So, if you want to tinker, as long as you use a Bayesian as your prior or your base, stick in the intermediate area because that’s going to always serve you well. Sometimes the long run will do better and sometimes the longer term trends will do worse.

Short term is somewhat ephemeral, but you stick in that intermediate range, plus or minus a little bit, you’re going to do well. I think that this is one of the key issues that we have with just overall quant traders in general and their use of information.

And so, there have been some researchers that have talked about that there are two types of traders. That’s interesting. As always, we break everything into dualities. Everything has to be two, there has got to be two types. But the two types, is [based on] how they use information.

We’ll say that a quant is more of a searcher and an adapter. So, what he does is he takes a large database and then he can say, how do I search through that database, find factors that I think that are significant, then adapt them and optimize them, given all of the information I have. So that you’re constantly searching for the optimized choices that you make.

On the other hand, a discretionary trader is an expert. He’s saying, I’m not going to be searching for an optimal solution as much as I have a view of the world. And then when I process the information, especially the information that’s non-countable – so, the information that I can gain or I can manipulate as an expert.

So, now let’s look at the environment we faced. If you have a lot of uncertainty, then behavior may change. Which means that systematic links may be broken or they may change. We find this with a lot of regime work. Which I think is very important in the quant area.

So, what we do is we find out that there may be behavior of certain risk premium or certain factors that do well overall, but they may have periods where they do better or worse based on the regime. The simplest regime that we always have Is let’s say look at the business cycle, So, we can look at the inflation cycle as the regime.

So, what you could also sort of say is that there are uncertainty regimes. And, if we have an uncertainty regime, then we might say that behavior differs in that regime. And so, therefore, some of the systematic links that we normally see will change. We should then adapt to that.

The problem comes in when we look over history. How many of these regimes do we actually have? So, how many high uncertainty regimes do we have? And can we go back and look in history and sort of say that this particular regime that we see, of high uncertainty across a lot of policy variables, has it ever occurred in the past? That’s up for debate.

[00:29:00] Alan

Yeah, I mean it’s very hard to say. I mean it’s only been a few months, so I mean, it feels like this has been a drawn-out process, but, in the grand scheme of things, not yet. And obviously, the market impacts were the opposite for the first… In December we had the Trump trade, we had equities up, we had I think gold down. So pretty much the opposite of what we’ve seen since the first few months of the year.

I mean, granted, what you’re saying about structural shifts, potentially, in a new regime, that aside, I mean, is an environment like this, I guess better or easier for a systematic process? I mean, in terms of cutting through the noise, I guess you’re talking about discretionary managers being experts.

It would strike me as being a particularly difficult time to kind of evaluate policy and kind of predict policy. But what are your thoughts on that? Is there anything we could say with any degree of confidence?

[00:29:59] Mark

Right, well, going back to, the dichotomy we had between the quant searchers and adapters, the optimizers and the experts. If you believe that the environment here is uniquely different, meaning that we can’t really point to other periods in the past like this, then we sort of say that you’d want to discount the quality of experts.

What you can sort of say is that they don’t have expertise for the simple reason they have no past experience where they could call upon to say this is how we’ve seen this event in the past, this is how the market will react, and this is what we need to do. Now we could theorize about this as an expert, but we may not have countable data which we can use.

Under that, while we have more information, and there may be a regime change, let’s just say that I might have a bias to sort of say that you want to load up on more quant traders because they could say, well, I’m just going to let the data speak for itself. I’m not going to worry about what policymakers are saying to the news. That may not be what they say in Twitter. All I’m going to do is look at what is actually happening into the price action. And this is for trend followers or even non trend followers. So, in a world where you sort of say, what would we like policy makers to do? And you say, that they do what you say, and say what you do.

If we don’t know whether that’s occurring, then it would seem as though let’s look at the second best solution, which is let’s follow how markets are behaving and what they’re telling us.

[00:31:53] Alan

Yeah, that’s true. I mean the other dimension here is the fact that we have feedback loops, which I guess complicates the picture as well. And one of the, I guess, features and discussion points of late is, is there a Trump put and where is it? Because it seems unusual for politicians or a president to be not unhappy with stock prices going down and seemingly complacent or unworried about the possibility of recession.

So, the market is kind of skeptical and kind of thinking, well there might be an about turn at some point. Obviously, if there’s not, if stock prices continue to go down, that creates feedback loops into the real economy and possibly into monetary policy as well. So, feedback loops I guess are important too, which makes it even more difficult to account for.

[00:32:57] Mark

Another way to put this is that if we were having an academic discussion with economists, they would sort of say, we always want to know what is the government’s (and let’s say the central bank’s) reaction function? So, if I understand the reaction function, then I can know where the put is. If I don’t know what the reaction function is, then this is where we call uncertainty.

So, we’ll sort of say that at different times, in monetary policy, we often talk about the Taylor rule as a simple measure of monetary policy. That would be a form of a reaction function.

So, now let’s look at the specifics of monetary policy and, using that as an example of uncertainty, you say, well, what is the Fed’s reaction function? Well, we have higher consumer sentiment about inflation over the long run. It’s probably above 3%. We have survey work that has actually said that consumers are really concerned about inflation. And they actually sort of said, if they had their way, they would like to have inflation at about 0.2%, not 2%. So, now, with the Fed, after they heard all the survey data, the conclusion that they had is that, well, we didn’t do a good job of explaining why we need to have higher inflation – because that’s good for us as policymakers.

So, if you look at what the consumer wants, they want 0.2%. They’re expected to have 3%. We’ve got a Fed that you know, sort of cut. And they said, oh, we might delay cuts, but they cut in December. They had the 50% cut in September. And if anything, you might argue that this is a time to, you know, raise rates, or at least you want to consider that because you are still nowhere close to 2%. So, what is the reaction function?

A further example of uncertainty is the fact that they have the quantitative tightening. We’ve gone from $25 billion to $5 billion a month. It will start in the not-so-distant future. And you sort of say, we’re closer to 3% than we are to 2%. We know that quantitative easing was to try to get the economy boosted and, in some sense, get inflation higher.

Now we’re sort of saying is, well, what we want to do is we’re still way over the Fed balance sheet prior to the Covid pandemic of 2020. But we want to slow down our quantitative tightening from 25 to 5 because we think that this is important as a policy measure. So, that creates more uncertainty.

[00:36:06] Alan

We’ve spoken a lot about uncertainty. I mean, obviously there are some obvious points to sum up by saying, obviously get reflected in markets in terms of risk premia, etc. You know, we’re talked about whether it lends itself more to discretionary or systematic trading, the difference between risk and uncertainty.

Taking it all together, you know, uncertainty is elevated. What should investors take away from that, would you say?

[00:36:35] Mark

Well, there are a couple things. What’s going on is that if you are someone who doesn’t expose yourself to alternative investments, one would be to say that you want to reduce your exposure to risky assets. If you sort of say that because you’re risk averse, and we’ll say that there’s also aversion to ambiguity, which is probably more representative of uncertainty, you’d sort of say that you want to try to move to safe assets. So, we’ve got higher T-bill rates. So that’s really not that bad.

But then you sort of say that if you do that, then you cut off your potential gains under this uncertainty environment. As we’ve talked about, that uncertainty could be both good and bad. You know, we’re focusing in on the downside of uncertainty because we know that the financial shocks are asymmetric.

If there’s a downward shock, it’s going to have a much greater (or negative shock), it’s going to have a much greater impact on markets than it would be if there’s a positive shock. So, you say, well, what’s the next best alternative instead of just going straight to cash? How can I participate if this uncertainty is actually positive? Now what suggests is to increase your exposure into alternative investments.

And it seems as though that, you know, from some of the research that I’ve seen recently, if you increase your exposure to trend following, that’s going to be a positive because one, you’re trading both assets from the long and short side, you can then be able to participate in case something goes bad or if it goes well. So, we’ll say it has more variable beta. The second is that you can increase your exposure in the set of markets you choose. So, not only are you exposed to the US, but you’re exposed to currencies, you’re exposed to commodities, you’re exposed to European markets.

And the fact that there’s a disciplined rule that, for example, like when we talked about my grandmother’s rule of staying out over midnight. Well, a trend follower would say, well, if the trends are going down, you have got to reduce your exposure. And if you looked at this as just as a simple case, they would probably catch… And I think some of the trend followers have done a good job of catching the rotation across sectors or across the globe in equity markets.

And you know, we’ll sort of say that large brokerage firms have been tracking what they consider trend following exposure. They probably do an okay job. They may not be as good as if you could do this on your own. But it shows that there has been a change in the exposure or the overall equity beta for CTAs in this first quarter.

[00:39:44] Alan

And the equity beta has come down and it’s now more biased towards overseas equities. Isn’t that it?

[00:39:53] Mark

Yeah, and in fact, this is exactly what you want. And what we find is, and let’s go from a more of a behavioral level. Whether it’s individual, an individual that’s being advised by an RIA, if it’s a pension that has a committee, when you have high uncertainty, the committee will probably be biased, or most people are going to be biased to take no action. Given its high uncertainly, let’s just stick with what we have. Because I don’t know what’s happening.

And so, if you have a model, it’s going to say, well, since that model is looking for the price trend, that model is usually looking through that price trend and it’s going to discount it by the volatility, to some degree, either in the position size or the signaling itself. They would sort of say, well, if I see that there’s a time that I should be rotating in European markets in equities, well, we’re going to start to increase our European equity exposure. We don’t care about the uncertainty which just sort of said the signals are telling us this.

And I think that if you looked at the end of last year, in December, we had sort of like Trump euphoria. And we’ll probably sort of say that there is a new hope of American exceptionalism and we’ll probably sort of say that there is more pessimism in Europe.

If you started to follow the price action in January, you sort of said, well, I’ll discount all of this and I’ll just make that rotation, which would have been a positive.

[00:41:37] Alan

Good stuff. I mean we’ve covered a lot on uncertainty. I know you add another topic which is maybe somewhat related, but not obviously, and that’s the whole idea of curiosity, and curiosity as a characteristic in fund managers, or market participants and the importance of this. So, I mean, what inspired this thought?

[00:41:59] Mark

Well, let me put this way, I’ll start with this, that we’re having this podcast. It’s still in the morning, in Boston. This is one where we should be sitting by a fire, bringing out the drinks, and having more of a casual conversation, you know. So, we’re going to go a little bit far afield, but I think it’s important, you know, sort of a bigger meta question.

So, I was out visiting some friends and my son, who’s an MBA at university in Notre Dame, and one of the economics professors, a friend of mine, who said, would you like to have a dinner with a couple of our bright students? I said, sure, love to find out what they’re doing.

So, one of them is going to a large commodity trading firm. Another person was going to… Two people are going to investment banks. Another one was going to a multi strat. So, they’re all accomplished, all fairly nice people. So, they’re all smart. But then I asked a question as I walked away from the dinner, did they seem curious?

And I went and had breakfast, the next day, with another friend of mine who’s a Confucius scholar. I asked the friend, I said, look, you’ve been teaching for, you know, a number of decades. Do you think that students are more, or less curious than you thought, you know, 40 years ago? And it could be sort of ageism. But he said he thought that they were less curious.

And so, I asked the question, and I pose this to almost any manager. How can you teach curiosity, or how important is curiosity with choosing a manager? And, if you want to be very practical, how do you make someone more curious?

And so, Alan, I’m going to ask you the question because we’re sitting by the fire with our drinks. How do you think you could… How would you actually measure whether a manager is curious?

[00:44:09] Alan

Yeah, good, good questions. I mean, definitely one for a late night by the fire with a few drinks.

I mean, I think there’s a few things. There is a school of thought that around the world there’s more of kind of a trend or desire for deterministic outcomes. I mean, that people are less tolerant of the gray area, and it’s either black or white. And so, I’m wondering, has that been reflected in the students, that the answers are A or B, but there’s maybe not a curiosity to look for potential gray areas or solutions? So, that maybe that’s just one thing.

Can you teach curiosity? I’m not sure you can teach it. You can probably cultivate it somewhat, I would have thought, in some shape or form, I’m guessing. I mean, it’s an interesting question. How important is this in all of the characteristics when assessing managers?

Is it more important than open-mindedness or other important characteristics? I think it’s definitely relevant. I mean, yeah, certainly you don’t want people who are… I mean, it’s classic. You like managers who have conviction and confidence, but not at the detriment of being open minded to the fact that they could be wrong in their analysis, I would say. So, it’s certainly important. But where does that rank in the hierarchy of manager qualities? I push that one back to you.

[00:45:42] Mark

So that is an interesting question. Do you want a manager with conviction, or is that more important than a person who is open minded or curious? Well, I really don’t know the answer.

And it’s almost interesting because you often have to evaluate a manager within, you know, let’s say you meet him for an hour, you read some newsletters, you get a pitch deck. It’s almost as though, if they come in and say, like, you know, Alan, I just don’t have a lot of the answers here. I’m curious on a lot of issues, but I don’t know if I have the answers and I want to be open minded to what is the right solution. You probably sort of say like, I respect him but I don’t know if I’m going to give him money.

But the curiosity thing is I did come through and the conversation jogged my memory of something that I read in an article, and I read a book about this. There’s a book called Visual Intelligence and it’s by a woman named Amy Herman. And you say, well, what does visual intelligence have to do with money making and quant trading?

And what she did is that she’s an art historian. And so, she actually was working on a project where she would train New York City police detectives on how to become more observant and then ask better questions. And the way she would do it is that she’d take them to the Met, the art museum, and show them a painting and then ask them to describe what they saw.

And some guys were very literal. They’d say, well, I see this person, they’re wearing a blue suit. And then someone else says he’s got a certain background. And then she asked him to say, well, what are the assumptions that you make when you make these observations, or can you separate your biases from the facts of what you see?

And all of a sudden, I sort of said, like, this is a really good skill that you’d want to have managers to have, or at least your researchers to have. Can they separate what they see from the facts versus what the bias is that they bring? And have they honed their skills of observation, which is sort of an outgrowth of your curiosity.

If you’re curious, then you’re going to sort of increase your skills of observation. If you have better observational skills, then you might find things that other people don’t see.

Because, in some sense, if you and I went to the art museum and we looked at the same painting, when you think about that as that painting is information. So, I see the information, you see the information. The information is fully disclosed. It’s all on the canvas. But the two of us would see something very different between the two of us.

[00:49:00] Alan

Yeah, that’s true. And I mean, I’m struck by that, at the moment ,in terms of, obviously, the policy dynamics that are playing out in the US and more broadly. Obviously, if you bring up one kind of ideological lens to that, you might see it in a different way than if you approach it with another ideological lens. And that’s one thing.

But I mean, to pick up on a couple of things that you say. I mean, there is the idea of, I think it’s from Druckenmiller, strong conviction, but loosely held. So that’s kind of that idea. You do want conviction, but at the same time, you’re keeping it in your mind concurrently that, you know, there’s a good chance it’s wrong, even though you have high conviction about it. So, not everybody has maybe the mental dexterity for that.

And then obviously, as you say, as well, I think, you know, there is a skill in trading of that creativity, of being able to see things differently and even to, you know, investing more generally. Obviously, if you see the world, the opportunity as the same as everybody else, you’ll be positioned the same way and your portfolio won’t be any better. So, I think there is that creative element to it as well.

And I think, as you say, if you ask a lot of questions or are trained to ask a lot of questions, that in itself cultivates a curiosity. So, I think all of those are relevant. Yeah, I mean are quants more curious than discretionary traders?

[00:50:38] Mark

Some.

You know, I will sort of say that you know, if there is one takeaway before we change topics here, I want to make sure I highlight that if all of the listeners remember one thing, it’s what you said, not what I said. And that’s the one that says, like Druckenmuller, you know, I have strong opinions weakly held. Which is sort of like the whole idea of curiosity in a nutshell. You should have conviction. You should have strong opinions, this is what you believe or this is what you see. But if someone comes with new facts or shows you different sets of facts is that you can change your mind.

I think that’s critical. The second thing is that eliminating ideological biases is that nowhere in our discussion today that we mentioned any politicians names. And it’s almost as though there is no need for names. What you want to do is just let’s look at the policies, let’s look at the price action, let’s look at where the fundamental trends are going.

So, in terms of a framework, first we look at price trends, then we look at fundamental trends, then we look at the regime, then what we sort of say is like, where are valuations, are there extremes, where are there potential mistakes that are being made? And then what’s the sort of signal to noise or trend to noise ratio and all these things?

If you use that as sort of like a rubric on how to look at things, you’re going to do pretty well.

And you know, in terms of whether it’s an expert discretionary trader or quant… There was Andy Grove, who used to run Intel, and he wrote the one book that I always love, Only the Paranoid Survive. Which I think is a great title for any book, but for anybody who’s in financial markets, only the paranoid will survive. But he had this didactic approach that he’d always ask one more question. So, if someone said, I said, well, we’re going to do this. And he goes why? And they say, because of this. And he goes why? He’s asking one more question about that.

In some sense, if you follow that process, and if you can’t get good answers, then you have to sort of say, well, where can I stop, where I do have reasonable answers that I can be comfortable with?

And so, in some sense, the trend followers said, well, when they ask the question of, ask one more question, they asked a question, well, why prices? And then they’ll say, well, what fundamentals? But they say, I don’t know what the link is between fundamentals and price. So, therefore, I’ll assume that price is all the information. I’ll stop there. Others will say, I can go one level deeper, or I could look at second order effects. So, depending on what type of person you are, that will determine the type of trading you’re actually going to do or engage in.

[00:53:57] Alan

Very good, conscious that we’re moving along in time. There was another topic that you had that I was curious to get your thoughts on and that’s the whole area of portable alpha. It’s definitely a topic that we’re hearing more and more about. It’s been an approach that’s been around for a long time. It has kind of come and gone a little bit, but it’s kind of made a comeback coupled with some other terms like return stacking, et cetera.

So, when you see the current renaissance for portable alpha, what’s your perspective?

[00:54:33] Mark

You know, I think that there’s been an ebb and flow in portable alpha and part of it has been that it’s not the portable portion that’s the problem, it’s the alpha portion that has been the problem.

So, oftentimes, or sometimes, the products on the alpha generation of the portable alpha haven’t produced what people wanted. But when you think about it, one of the number one things that we want to try to do, and we sort of see the inevitable flow or tide of where finance is going is, how do I increase the efficiency of my trading, how do I increase the efficiency of my use of capital?

And what we’ll sort of say is, third, how can I decompose my returns better so that I don’t think about asset classes, but I think about factor exposures? And I think that the portable alpha is the extension, the natural extension of the movement towards the factorization of markets, not the asset allocation of markets. So, if I can think in terms of factors, then I can say I have a basic core. It could be cash, it could be bonds, it could be stocks. And then on top of that, what I want to do is I want to change the mix of my factors that I have or exposures.

And so, if I could take bonds, when you think about it, a bond is a combination. If it’s a corporate bond, it’s a combination of Treasuries plus the spread. And the spread represents, they will call it the risk premium associated with credit.

So now, why do I always have to have that risk premium of credit attached to a bond? I could take my Treasury exposure and then use that as the underlying instrument and then put some portable alpha on top of that and basically sort of say, instead of going from Treasuries to corporates, I could take my Treasuries and then I could use that as collateral to put trend following on top, or I could put on momentum, or I could put on some other risk premium.

So, in some sense, what I have to think about is that I’ve got these building blocks of cash, bonds, stocks, and then on top of that I have a certain amount of risk premium. And portable alpha allows me to now mix and match my risk premiums with an underlying asset. I think that’s very compelling.

And I think that the prices have come down, so the market is more competitive. I think that the product offerings, in terms of alpha, are better. And so, I think, overall, that for large institutions, this seems the much better way to sort of run a portfolio than maybe what we’re seeing in some of that, where you give all of your cash directly to a manager.

[00:57:45] Alan

Yeah, absolutely. I mean, I guess there are cyclical and secular considerations to it in the sense that I agree, you know, there’s a greater appreciation of the importance of capital efficiency, et cetera, driving this. But also, I mean, it does appear to be maybe a symptom of the market environment we’ve been in with the S&P doing whatever. It’s been 15% annualized at least for five years, probably for 15 years. So, when you combine anything with the S&P it looks fantastic. So, I mean, it will be interesting to see how durable it is. But I definitely agree with you around the capital efficiency point.

[00:58:34] Mark

So, we started with my grandmother, so we could end with her too, God rest her soul. You know, when stocks are above the 200-day moving average and they continue to be above there, then you just want to have your beta exposure. You don’t really need to talk about portable alpha because you don’t need the portable alpha because you just have your equity exposure and that’s enough.

And in fact, if anything, if you sort of take some of your equity exposure and then say, I’m going to use the S&P 500 and put a portable alpha on top of it, well, that’s actually going to be a drag versus just holding the exposure outright.

So now, we’re abstracting from the risk structure issues. But, in some sense, now that we have a number of assets that are below the 200-day moving average, you could sort of say well, maybe the vanilla isn’t what I want to do. Maybe I should start to say, the cost of paying up margin, using that stock as collateral for a portable alpha strategy, maybe this makes a little bit more sense given that the directional beta that I’m receiving is declining.

[00:59:57] Alan

Well, good stuff. I mean, I think portable alpha is a hot topic at the moment and definitely on everybody’s radar. So, I think we will hear more and more about that and come back to that topic again. But I think we’re up on time.

So, next week Niels is back, so he will be here to take any questions. So, send your questions through.

From Mark and myself, and from all of us here at Top Traders Unplugged, thanks for tuning in and we’ll be back soon with more content.

[01:00:32] Ending

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