SI359: Trend Following in a World That Loves Bubbles 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] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor Series with Mark Rzepczynski and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules based investor. Mark, it is wonderful to have you back this week. It feels like it’s been a while. I know it’s not been longer than usual, but how are you doing?

[00:00:42] Mark

I’ve been busy. I was actually just, earlier this month, in China for my daughter’s graduation from Peking University, PKU. So, I had a chance to be in China first time in about six years or so and it was a wonderful experience.

[00:01:01] Niels

Yeah, yeah, I’d love to hear a little bit more of that. I’m sure that’s probably what’s been on your radar lately then.

But anyways, we do have a very nice lineup of different topics thanks to you, so I appreciate that and those we will be tackling in just a few minutes. But before we do that, going back to my usual question to kind of catch up with you. What have you been kind of focusing on since we last spoke? I guess your China trip sounds like a natural place to, to start.

[00:01:34] Mark

Well, the China trip was a great opportunity to see a country that is obviously important not only to the United States, but to the rest of the world. And we’ll just sort of say that the amount of growth in that country and, we’ll call it, their innovation is very noticeable in terms of just the cars you have (let’s say there’s a lot of great EV cars on the market),the buildings, the institutions of higher learning.

But probably the one thing that we talked a little bit about before we got started here was the fact that it really has turned into a digital economy, at least for the major cities, in the sense that you don’t need currency to walk around Beijing, you just need a phone and you need to have Alibaba Pay or WeChat. But other than that, you know, I did not see any currency, the paper money. So, they really are very much advanced in the financing and the transaction flow of money.

[00:02:46] Niels

It’s fascinating you mentioned that. In fact, I’ve been mentioning some China facts, the last couple of weeks, as I’ve come across them on the show. But one thing when you say this thing about, it’s amazing how digital the country has become, and nobody pays with cash anymore. Denmark, where I’m originally from, is also incredibly digital.

And just like in Spain recently, Denmark had an outage of the main electronic payment system only a couple of weeks ago, which not only meant that you couldn’t pay with your cards in Denmark, but all the people traveling abroad using Danish credit cards or payment cards could not pay with them either. And I kind of think it really also shows the flip side of being digital and nobody has any cash anymore.

I do understand why maybe governments would like us to pay with cards and digital all the time. But I will say that it has a weakness as well.

[00:03:56] Mark

Yes, we’re vulnerable to the electron.

[00:04:01] Niels

We are. All right, okay.

So, what’s been on my radar is just some random things I’ve come across, except some of them you will also probably have noticed yourself. But the first one is a little bit kind of a curveball. So, my question is whether or not you actually play golf, Mark.

[00:04:21] Mark

I was saying I do swing the sticks occasionally.

[00:04:25] Niels

Okay. Do you live far away from a golf course? Like within a mile? Maybe a little bit.

[00:04:31] Mark

Mile and a half or so. So, not too far.

[00:04:34] Niels

Okay, all right, you know, this is actually good news. I’ll tell you why. So, yesterday I was listening to a podcast on longevity. You know, how we can live healthier, how we can live longer, and they were talking about some of the hidden risks. I think we kind of know about them. We probably don’t do much about it, really. One of them is microplastics. So, you know, why should we drink water out of a plastic bottle? Probably not a good idea. And also, one thing actually that was kind of alarming is how much plastic is released when we drink hot coffee or hot tea in a paper cup.

Like we get at our usual Starbucks outlet, whatever. That’s something I’m going to reconsider for sure. But then the expert, the guest on the show, mentioned something that I had never heard about this before. Apparently, according to a new study that just came out, there is 126% higher risk of getting Parkinson’s disease if you are living within a mile or so of a golf course. And this is apparently linked to pesticides. I imagine, too, they use them to keep the golf courses.

And it turns out that when scientists do experiments on mice, say for example on, for example, Parkinson’s, they don’t want to introduce Parkinson’s disease into the mice. They’re actually giving them pesticides. And that’s why there is this link between how close you live to a golf course and the chance of, of getting Parkinson’s.

I thought that was pretty alarming, but I’m glad you’re outside the 1 mile that they mentioned, but maybe some of our other listeners might need to reconsider that. Anyways, little bit of a left field.

Now, of course, yesterday’s decision of the Fed (we are recording Thursday), so, yesterday was Fed Day. Of course it was interesting to note that you had two dissenters, Waller, Bowman, who were in favor of a rate cut. Of course, it’s not so surprising when you know that they are also the candidates that Trump is looking to replace Powell with.

So, no surprise on the decision, although I did listen to some of the press conference and it didn’t sound like the chairman was in any hurry in any way of cutting rates, despite all the pressure that he’s getting. And that, you know, was kind of interesting because then I saw this news article today where they reminded us about the good old times.

And so, the good old times was when Fed Chairman could actually tell the politicians exactly what they had to do in order for the Fed to lower rates. So, one example they mentioned is in 1990, with Alan Greenspan, who told Congress that he would lower interest rate, but only if they cut the deficit.

That’s kind of interesting. And the other example they mentioned is from 1985 with Paul Volcker, who even gave them a specific number.

He told Congress that the Fed, you know, would cut interest rates if they cut the deficit of about 50 billion. It’s a very specific request to Congress in order to lower interest rates.

So, that’s a completely different world that we live in today where the Fed is very… Well, the shoe is on the other foot, I guess, at the moment, where they’re certainly not saying anything like that to the president. That’s for sure.

The final thing (and you can comment on this afterwards) that’s not really a question – a question or thought. But the other thing, of course, that I guess we maybe should mention, if people have noticed it, is that there was a historic drop in the price of copper yesterday, the US copper, I should say, of about 20%. And actually, I think it continues a little bit today.

And that has related to another change in Trump’s tariff policy that basically sent the market down by about 20%. And then finally, also yesterday, I think we got another company now worth more than 4 trillion and that’s Microsoft. The sleepy giant is suddenly worth more than most companies in the world. So anyways, those were my sort of radars. Any thoughts on some of this?

[00:09:08] Mark

Well, I think the issue of Fed independence is something that’s just overhanging a lot of thinking, especially in the fixed income markets. It’s interesting that the Fed may not… They’re, they’re in a tough situation because if they believe that inflation is going to be going lower, and so they say, well, we don’t need to, then what’s going to happen is, probably, because they’re expecting this, we’re going to be slowing down in the economy. But on the other hand, if you sort of say that the economy is doing robust, then you expect that inflation is going to be higher. So, we’re in this sort of complex period where it’s not really clear what will happen with the economy.

And so, some sense, Chairman Powell is taking a precautionary motive or he’s sort of saying, I want to be cautious because I don’t really know whether we’re going to be in a growth economy or slowdown economy. I don’t know if we’re going to have prices passing through tariffs or not. And this is a complex issue.

But more importantly (and I think that this will be one of our key topics for discussion), timing is everything. We may have a pretty good idea of what may happen, we just don’t know when it’s going to happen or how long it’s going to take before it gets resolved or it actually shows its itself within the economy.

[00:10:43] Niels

Well, let’s do a little bit of a trend following update, and since we’re recording on the last trading day of July, the 31, I think we should probably spend just a few minutes and, and sort of talk about our early takeaways from this summer month.

I was looking firstly at sort of market moves in the most common in a CTA portfolio, liquid financial and commodity markets, just sort of the month-to-date changes. And there has been some decent moves. You know, oil complex in general has been pretty strong, sort of price-wise, up about 10% as we speak for the month.

You obviously have the equity markets that have continued to do well. And so that’s going to be a positive for sure for CTAs. The fixed income markets are certainly more mixed, more muted.

US markets are slightly down for the month, or US futures I should say. But generally speaking, I don’t think fixed income is going to be a major decider for how managers are faring. Currencies, of course, are interesting. I think this week, actually, probably is the strongest month… sorry, strongest week for the US dollar since 2022. And I think the dollar index is up about 3% so far this month. So that’s a bit of a turnaround.

So that’s probably has not help CTAs as the dollar has been weak for a while but I wonder how much damage it’s done. I’m not entirely sure. And then of course we get to some of the other commodities that are always interesting to follow. Grains continue their downtrend. So, I think that’s a positive for many managers.

As I mentioned copper, that’s not going to be a positive because it had broken out to the upside and then suddenly you get a 20% drop. But it will be interesting to see maybe how differently it may have impacted different types of trend following manager’s strategies.

So, I’ll be you know, watching out for that when we get the numbers. Let me give you the indices and then you can kind of comment, from your perspective, what you think has been going on lately in our industry.

I should say my own trend barometer actually finished yesterday at 55 so that’s a pretty good reading, slightly increasing over the last ten days or so. Although yesterday’s probably a down day thanks to things like copper and a few other things.

But anyways, as of Tuesday, the 29th, the BTOP50 was up 67 basis points in July and it’s down only 2.6% for the year. The SocGen CTA index up 85 basis points, down 6.82% for the year. SocGen Trend up 1.25, down 8.88 for the year. And the Short-Term Traders Index up 0.5ish%, and down 4.76% so far this year.

In the traditional world the MSCI World Index was up, as of yesterday, 1.72% in July, and up 10.5% for the year. The S&P US aggregate bond index is down 0.25%, up 3.6% for the year. And the S&P 500 Total Return index is up 2.62% as of last night in July, and up almost 9% so far this year. What are your thoughts? What are your takeaways from recent Performance trends, the environment?

[00:14:27] Mark

Well, two parts. One, I think that it’s important to realize for our major asset classes, which are equities and fixed income, there’s a very different behavior between those two that overrides a lot of what occurs in models. One is that equity markets are extrapolative so that, usually, they’re going to continue on in a longer-term trend. And part of this is, we’ll call it, equity investor optimism. So, we’re extrapolating out some positive news in stocks and that’s been occurring since almost the post liberation day.

On the other hand, fixed income markets are often mean reverting. So, they’re going to move to some extreme and then they mean revert in terms of how they behave. And so, what we’re seeing is that the fixed income markets are still in a mean reverting mode. And by that, we know that yield curves have to be slightly upward sloping. In general, the inversion of yield curves for years, when we had QE, was more of an anomaly as opposed to normal behavior.

So, what happens is that we’re seeing this in the actual behavior of markets right now – extrapolative on equity markets and more mean reversion or more range bound in the fixed income markets because they’re still trying to sort of say how do I sort of move to a fair valuation. And for fixed income the fair valuation is always, what is expected inflation? Which you know is coming down.

But let’s say, even if it’s 2.5% plus, you know, what is the expected growth? If we say expected growth it’s going to be (we had 3% top line for the second quarter), let’s say it’s 2%, 2.5%. Well, then we’re going to sort of say, you’re going to look at for a 10-year around 4.5% to 5% which is where we’re at right now. So, you always have to think in terms of in those markets, you know, extrapolative versus mean reverting.

And then the other markets are seen to be very much affected by the complexity of tariffs and the complexity of what’s going on international trade flows.

[00:16:55] Niels

So, Mark, I’m going to take a slightly different approach to that topic. Not that I prepared anything, but when you talked about it now it remind me about a conversation I had a few weeks ago with Nick Baltas, I think it was, and I think we he was reviewing a paper by Antti Ilmanen (as far as I remember), from AQR on this topic about, you know, bonds and equities, they’re kind of two different things.

But you know, the conclusion was a little bit different, as far as I recall, because even though we think about fixed income as being more mean reverting, in fact they kind of trend better and vice versa. Even though we think of equities as being something that always goes up to the top right corner, actually, from a trend following perspective, they’re not that great.

And if you look at performance in the last, say 20 years of managers in general, pretty sure you would find that equities has not been a great sector to trade while bonds has been pretty good. Do you recognize that? And how would you explain that maybe versus what you just mentioned?

Because I think that might be there might be what we think about the markets, i.e. equities, growth, they always go up, and we think about bonds as being some kind of stable equilibrium staying at a 5%+/-. But in actual fact, as a trend follower, they operate a little bit differently and therefore we get very different results into those two sectors.

[00:18:34] Mark

Well, this is an ongoing problem for any modeler because I think what you commented on is correct, surprisingly, while we think of equities as an extrapolative market (and I believe that to be the case, so, the long term trend is going to be following growth plus you might, but you might have these sudden stops for higher short-term volatility), surprisingly, most people think it should be very easy to trade trends and equities given its extrapolative behavior, when in reality it’s actually sort of harder than what you think.

Alternatively, we sort of think of fixed income as mean reverting. Which it is because you sort of say there’s a valuation and bonds. Which we know is associated with growth term premium plus expected inflation. Given the lower volatility, once the Fed starts to move or starts to follow a policy of either raising rates or following rates, it seems as though that there’s more trending behavior. And you could make more money in fixed income because you’re following the Fed and the Fed behavior.

Now, what’s really going on here? What you’re really picking up in fixed income on “trend” is the long policy movements of a central bank. And I think that a research area that I’ve been focusing on for a long time has always been who are, what are the macro structure in the economy? And by macro structure I mean who are the players?

And when you say, “who are the players,” it’s who’s the dominant player in fixed income, who’s the dominant player in equities? We’ll probably say that the dominant player in fixed income is still central banks, even more so than what it was in the past. So, consequently what you’re really picking up is the trend in central bank behavior.

Now that’s the scary part because if this Fed or central banks are such dominant players, then we’re subject to the whims of the central bank and when it wants to change its view.

[00:21:02] Niels

Could we go as far as saying well actually what we may be picking up (and this is not thought through at all, but I’m just going to throw it out there), maybe we’re picking up even more so the trends in inflation and actually those trends tend to be much more consistent, gradual than central bank policy for that matter. Is that what we’re really picking up do you think?

Because I mean I, I mentioned that bonds have been better to trade for trend followers, but haven’t been better for the last two years, that’s for sure. Equities haven’t been great either because of these, you know, short-term V shaped corrections, but certainly bonds.

And actually, even in July, I think there’s a lot of flipping around in fixed income exposure within trend following. But do you think it’s even more so just kind of long-term inflation trends we’re picking up?

[00:22:00] Mark

Well, you know, if you’ve listened to me over the last couple of years, you probably have picked up on that I’m a closet macro trend follower as well as a price trend follower, that macro trends lead to price trends. So, price trends are a description of what’s happening in the underlying economy. So, if inflation is going up, we’re going to see fixed income going up and that’s the trend that you’re actually picking up on. So, if inflation is coming down and then yields are coming down, that’s what you’re picking up on. So, I agree with that.

Now, while I’m saying that I’m a macro trend person, X post I could always sort of find this association ex ante when I’m trying to predict. It’s much harder to do this, to try to see exactly where the direction and the underlying macro is going.

[00:23:04] Niels

Well, let’s jump to your topics and I’m going to try and tee it up, but I’ll really let you drive here. I mean, 2025 has given us something rare, you could say. Maybe you could say it’s consensus without real conviction. Recession risk is probably low, inflation is subdued, and yet nobody really seems to trust this calm that we are seeing right now. So, what’s really changed, the world or just the stories that we tell about it?

[00:23:37] Mark

Well, there are two things that are really going on or I like focusing on. One is, (and I think that there’s been some articles in the Financial Times about this) the fact that we’re facing more sudden stops in the economy. Which means that instead of having longer periods of high volatility or that you have these sudden stops in the economy based on a certain event, it causes a high degree of uncertainty. We’ll see that then the markets will have a large move. Then, within a relatively short period of time, that uncertainty is resolved or reversed. And then what we see is that the sudden stop, stops. So that has really had an impact on trend followers and overall market behavior.

So, what’s the perfect example? We’re only in July, so it’s a six month span. We started out the year and most people thought that maybe we were going to be in a recession in 2025. It only got worse when we had some tariffs. We had tariff liberation Day where you see a huge market decline and then we’ve had a huge reverse almost to the point (which we’ll talk about in just a second) that people are now thinking about equity bubbles as opposed to what we were thinking at the beginning of the year, that we are on the verge of equity collapse.

So, what we’ll sort of say is that we’re in a period of higher complexity. And what complexity will mean is that the number of factors, that are necessary or needed to explain what is going on in the economy and markets, is much greater than maybe what we saw in years past. So, we say, what are the factors?

If you could sort of say, gee, I need to have some idea of growth, expected inflation, term premium, I could cover most of what’s going on in bonds. So, it’s a relatively simple model. So, if you could sort of say I need to know a little bit about what earnings are. I need to know what interest rates are.

I could have a pretty good idea what’s happening in equity markets. It seems as though that we have a higher level of complexity than what we’ve seen in the past.

[00:26:05] Niels

Yes, absolutely. Well, I’m going to let you drive through some of these topics that you have. I just wanted to tee up the first one where you wanted to talk about what’s changed in the world. But do continue and then I think you might want to drill down a little bit further into markets, and so on, and so forth.

[00:26:25] Mark

Well, we’ll talk about markets in just a second. But along with this complexity is the fact that what is the real problem that we are facing? And we’ll say, in a macro sense and then also on a, we’ll call it, trend follower sense is the timing of events. And what I mean by that is that should tariffs have an impact on pricing earnings in the economy and should those tariffs actually be negative?

I think most people and most economists would agree the answer is yes. The question is we don’t know when or we’ll say, we’re not sure when. We could sort of say that it’s the same with a lot of the uncertainty we’re facing. We think that that’s going to have an impact on investment, it should impact on the economy. We just don’t know when.

And so, what we’re seeing is that we probably have more agreement about what should happen, but we have less agreement about when it will happen. And I think that what we find is that if you want to make money, whether it’s on following trends or just following macro events, it’s the timing more than the actual. The why is not as important but the when is the more important.

[00:27:49] Niels

But in a world like that, Mark, it seems like the only thing you kind of can do, as an investor is really kind of going back to portfolio construction, then making sure that you have something that is truly diversified, including trend, hopefully.

[00:28:08] Mark

Well, I think this is one of the key issues that has started to resonate with me is the fact that there have been a few people, and I probably would sort of say I follow this to a degree that good portfolio construction is based on a ‘do nothing’ principle. And a ‘do nothing’ principle will say, find your weights and leave it alone.

So, I will sort of say that if you followed an equity bond allocation at the beginning of this year and if you sort of said, well, okay, I think I’m diversified. Should I maintain this diversification? If you did that through the first half of the year, you probably would be better off than trying to react to tariffs.

And then similarly, when you think about a ‘do nothing’ plus strategy would be to follow trends within your overall portfolio. So, ‘do nothing.’ And that means, if the trend is going higher, continue to hold or to keep your exposure in a certain asset. On the other hand is the ‘do nothing plus’ strategy which is, you know, do nothing plus trend.

If markets are going down, well, then what you should do is to continue to reduce your exposure to that particular asset. The simple reason is that’s what the prices are telling you. So, in a complex world, this is it. First, it may be the simple strategy of doing nothing works, and second is, if you want to sort of do something in that world, follow a ‘do nothing plus’ strategy which is to follow the trends.

[00:30:03] Niels

Yeah, I think actually you sent me a quote also, in terms of this complexity versus simplification point. But when I look at it, I mean, there’s so much going on at the moment. And in one sense you can say, well, this is kind of normal. There’s always something that markets will react to. But changes in the markets at the moment, let’s call it this year or this quarter, whatever, I mean, where do you think maybe things are changing? Because something seems just very rangebound at the moment.

Maybe there are kind of the early signs of certain things that might actually lead to much bigger price trends hopefully, I guess. But what are you seeing, and what you say, you wrote to me in the sort of how the markets are changing. What are you seeing at the moment?

[00:30:57] Mark

Well, you know, I think that the key, and what I’m seeing in markets, is the fact is that there’s always a quick reaction to now policymakers and specifically President Trump. And we’re not going to make a value judgment about his style other than the fact that if you’re, we’ll sort of say generally politicians have been taking the view, ‘I’m going to be somewhat cautious in my statements. When I make a public pronouncement it’s going to be very muted.’ And the current environment is leading politicians to be less muted in their statements and that causes the market to react quicker which causes these sudden shocks.

When we have these sudden shocks, on the other hand, then you’re going to have a spike in prices. If you’re a systematic trader, you can’t sort of say, ‘well, I’m going to discount that information. I have to react.’ And then that reaction causes you to move away from your sort of ‘do nothing’ approach.

And then that means that you’re going to have to rebalance your portfolio. You know, for a trend follow your rebalancing because you might get stopped out or a change in signal. And then you find out if, let’s say, that there’s a reversal of those statements then you’ve got to do that all over again.

The problem we’re facing is that markets seem to be less liquid today than what they may have been in the past. And we’ll sort of say that’s on two levels. And this is with the macro structure. One is the role of governments.

So, one is that we’ve had very active central bank behavior. Two, given the size of sovereign debt, not only in the United States and others, the supply of debt is much larger and larger so then the amount of exposure or risk that dealers have, who are making markets is… They don’t have enough capital to make the markets you need to provide liquidity.

So, an interesting study that I saw recently shows that over the last 10 years or so the bid/ask spread, in most markets, has actually tightened. So, we’ve got a tighter bid/ask spread. And so, by most measures, if you told me I had a market that had a tighter bid/ask spread, I would say it’s more liquid – the liquidity is higher.

But what we find out is also that we’re having periods of higher kurtosis fat tails. So, where the bid/ask spread gets really large, there could be more skew. If you look at the underlying, you know, what is the amount that you could trade at the bid/ask spread that number is probably more volatile.

So, you’d say I can make a market at this spread, you know, in normal times of, it could be a 100 by 100, and then what we’ll sort of say is that, at other periods, all of a sudden liquidity disappears. Now, if liquidity disappears then you’re going to get these sudden stops and you’re going to have, all of a sudden, an increase in your trading costs.

Now, why is that so important for trend following? Generally trend followers are liquidity takers, not liquidity providers. So, if you’re going to be buying on the way up, then what happens is that you’re going to be taking liquidity, so someone has to supply it.

So, what happens is that’s going to have an impact on your returns because the transactions cost that you’re paying is much higher. If there are more trend followers then you’re going to have more people maybe doing the same thing, albeit not at all the same time.

But you have liquidity takers on the other side and then you have dealers who are under capitalized, one. You have highly concentrated players, which are the central banks, two. And third, the composition of the dealers are such that, well, they’ll provide liquidity in a very competitive basis until they think that they’re not going to make a return on making markets, at which times they disappear – all of a sudden they disappear. Then you’ll have this lack of liquidity or pockets of illiquidity that’s going to have an impact on your behavior.

It’s a lot going on here, but oftentimes you won’t see that in sort of the topline performance numbers. But the real battle by systematic traders, trend followers in particular, is how do we control or manage our transactions costs because that’s a place where you know the cost could be fairly significant on an annual basis. And if, let’s say, you have a year where performance is not as great, transactions costs and the cost of liquidity that you have to pay could be a significant portion of the overall return that you receive.

[00:36:25] Niels

Yeah, no, I agree with that. And actually it is something we discussed last week on the show with Andrew and Tom, and certainly Andrew has a lot of focus on that at the moment. So, I do think it’s something we may come back to on the show for sure.

I want to go off script, so to speak, a little bit. I noticed, in your notes, that you kind of mentioned the dollar. But I want to take it in a slightly different direction where it’s not about the dollar, you know, where it’s heading or anything like that. That’s not my point. But I was listening to another podcast and this is about a topic that I don’t know anything about, really. I’m hoping you might know a little bit more than I do. But it’s something I think is hugely significant and I think we need to learn more about this.

And that’s the current changes in the legislation about stablecoins and how that might change the way say, for example, the US funds its deficit; say, for example, how a lot of the sort of the banking system and also a lot of the private sector, how they fund themselves, where it doesn’t have to go through, you know, banks per se anymore. I don’t know if this is something you followed.

I don’t know that it will have an impact on the dollar as such. You know, obviously it’s looked upon as a safe assets. It’s been a little bit weak lately, but probably, you know, not to be too concerned about at the moment.

But this stable coin, I wouldn’t call it a revolution just yet, but this stablecoin evolution that’s happening I find very intriguing. And it’s almost like very quietly, away from the headlines, Scott Bessent is kind of rewriting how the monetary system is being done, maybe not just in the US. Is this something that has caught your attention at all?

[00:38:35] Mark

I did have a discussion with a close friend of mine concerning this very topic. So, to tee it up a little bit more, specifically, is that right now there are about $280 billion in stablecoin. If it truly is a stable coin, then for every dollar that exists, there should be some dollars or some safe asset behind that. And usually it’ll be treasury bills.

So, the idea is, oh, well, we’ve got $280 billion of new interest in treasury bills that we didn’t have before. So therefore, is that we need to push stablecoin because this will be a mechanism in which we could be able to help finance our debt. Because for every stable coin, there’s going to have to be someone holding, or the issuer of the stablecoin will have to hold treasuries. And then that’ll be sticky money that we could finance.

Okay, that’s a great view of what you’d like to see happen. But in reality that’s not really what’s happening. So, one is that you have to view it that if the money is going into stablecoin, is it coming out of normal banking transactions that has already occurred within the financial system?

So, if, let’s say, that you usually would go through your bank to make payments and now you’re using stablecoin, well, it’s the bank that might be holding the treasury bill before as part of their reserves. So, what you have to look at is what is the amount of money that’s being brought into stablecoin that was somehow, we’ll say, either in the black market or was not in the traditional banking system? We don’t know what that number is.

So, the amount of net increase in treasury holdings, if that’s the argument you want to sort of pin on why you like stablecoin, we really don’t have a good idea what that number is. So, it could be a much smaller number because in some senses that most stable coin is that there’s the uses are coming from two places.

One is that there could be black market activity that was occurring with currency that’s now occurring with stablecoin or crypto. That may still be a small portion because in some sense there is a ledger where you could track where people are using the money for. The other, you know, major use would be as a means of payment for places where the current banking system is extremely expensive.

So, you know, I think that our cost of making a transaction in the US is low. In other countries it may be slightly lower. If we go to the emerging market countries it’s extremely high to either pay with a check, even to pay with a credit card. The fees that you’re going to see on those are much greater. There’s slippage in the economy because there’s float that’s being taken advantage of that you don’t have if you’re the transactor.

So, in some sense, the stablecoin may have a usage case for when there’s high transactions. Unfortunately we have to ask the question, in a perfect world you would like to have a place where you could be able to hold your money in a money market fund, make a payment with a very cheap transaction and you receive the interest on the money market fund. If you’re holding a stable coin you don’t get that interest. It’s the stablecoin issuer that’s actually making that interest.

So, in some sense, there’s another place where this is actually becoming more interesting. I think it was J.P. Morgan and Bank of New York that have said that they’re going to start to tokenize sort of money market funds so that then it could be easier to collateralize.

What you really want to have is the ability to tokenize or to have a digital ledger for money market funds so that you could be able to sort of keep your interest but then still be able to use your money market funds as a means of collateral. And you could use that and still receive the interest. That’s probably more important. And what that does is it allows, you know, sort of money market funds to behave more like a safe asset. Which is the critical issue that some researchers have talked about, but is really important in our overall discussion about the financial health of credit and financial markets.

[00:43:52] Niels

Now you’ve mentioned the word bubbles, and I’d like to return to that. I think you might have some more to say about that. But one of the things, when I think about bubbles, and I think about my 40 years in this industry, I think about bubbles as something we kind of feared because there was always going to be something nasty happening after a bubble. I guess people in the tech bubble will remember that. And the 85ish percent that the NASDAQ dropped since then.

Now we live in a world where I feel that bubbles have become much more normal. And even though we think of things as being in bubble territory, I mean, there are so many things that you could say are that. So, it just doesn’t have quite the same effect, at least not on me, when I think about it. So, the question for me is not so much whether they exist, they probably do. But should we think of them differently? Should we even care about whether it’s labeled a bubble or not? And that’s kind of for general investors, but for trend followers, maybe we have an even different perspective on bubbles. What are your thoughts?

[00:45:12] Mark

It’s a good point. I’m not going to be so glib as to say we need to embrace the bubble, but we’ll probably sort of say that the term is overused. But that being said, what I found, when I look at the first six months of the year, is that we went from a period where we thought that the equity markets were going to be in a great decline, the world was a little histrionic, the world was going to come to an end because of tariffs and slow growth. Now if you look at in July, there’s been a number of stories that all talk about the, well, the equity market is in a bubble.

How did we go within a short period of six months from a doomsday scenario to a bubble scenario? So, that’s a separate question and that’s an issue of narrative. But we know that bubbles exist.

But if we look more closely at bubbles, we spend a lot of time and there’s been a lot of research on bubble crashes. What we find is that when you look at extreme price movements is that usually they last longer than what we expect, that’s one. And second is that oftentimes there isn’t a complete reversal of the bubble. So, in some sense there was a certain level of truth in the bubble. So, what we really have to worry about is two parts.

One is that markets are overvalued, and two is that there are continuing stories or the narrative that markets are overvalued, we’re in a bubble, but we still continue to believe that prices are going higher. That’s the worst case scenario that we have. So, we sort of say that everybody agrees that there’s a bubble but we’re going to continue to do this behavior or further buy into the bubble.

Now, what do you need for a, for a bubble? The best analogy is that we use a fire analogy. And a fire analogy is that you think about this that the market structure is your oxygen, your heat is speculation, and then the fuel is leverage. So, if anything it’s harder to get leverage right now. We probably have the liquidity to have bubbles and speculative behavior is up.

Now, if you’re a long-only investor, what you want to try to do is, at some point, avoid bubbles. The question is, when?

So, there has been some work by Professor Jarrow from Cornell, a longtime researcher on a lot of different topics. And so, he was trying to look at this bubble issue and he said, well, maybe a way to do this is that you look at past price extremes, be able to look at the statistical behavior of the prices and say, if it goes sort of parabolic, or it goes more exponential, at some point you sort of say that you just get out. Okay, so you ride a bubble until you get to a point of extreme and then you get out.

I don’t know if I like the story, but he said that this is one way in which you could play the bubble if you’re a long only guy. Now, you know, when to get out is the $64,000 question. His math says is that you can find that point. I don’t know if I agree with that.

But from a trend followers perspective it’s interesting because we’ve seen some interesting cases in the last couple of years where bubbles have existed and it’s been extremely profitable for trend followers. A perfect example is cocoa. You could look at orange juice. You could sort of say that the gold market currently, now there may be some underlying fundamentals that have been very positive.

But from a trend follower we could sort of say you want to try to be an embracer of bubbles because it’s a trend, you identified a trend, you could continue to follow that trend. And then you sort of say that if the market reverses or the bubble starts to reverse, well, then what you’ll do is just get out because your signal will tell you to get out. Or alternatively, if you have a stop loss, you could sort of say, okay, I’m riding this bubble. If there’s a reversal that hits my stop loss, again, I get out. So, there’s two ways.

Third is that if you sort of say that the market is at some extreme that I think that there’s a problem with liquidity, I could just then get out. Which would be the Jarrow version that I ride it until I think that I’ve hit to the extreme and then I sort of cut my exposure. That would be somewhat discretionarily harder to actually build into the system.

But from a trend followers perspective, you say, I don’t care if there’s a bubble or not. I don’t care if the bubble bursts. I don’t care if it continues on for a longer period of time. I will follow the trend and then systematically get out. And, and when you think about something I followed fairly closely is the cocoa market.

This was a bubble, but then it didn’t fully reverse, it then came, it reversed, and then we had another big bout of cocoa going up. You can look at the fundamentals that suggested that this made reasonable sense.

Now what happens is that regulators have a big problem with trend followers and bubbles because they think that speculation actually forces the bubble higher. Interesting work that I was looking at is that you found that if you look at the commitment of traders in the cocoa market, you know, when the market was still going up, a lot of the long speculative behavior actually left the market before the bubble reached a high. So, speculation was actually down. Because of higher volatility, people took exposure off before it reached a high. So there are other reasons for why the market reached a higher point.

So, I would sort of say that, from a trend followers perspective, you want to embrace or love the bubble. Unfortunately, you’ll have regulators that will say that they’ll blame you for being the cause of the bubble.

[00:52:13] Niels

Yeah, that’s very true. We see it, especially in commodities over here in Europe, certain countries where many investors won’t be able or allowed to invest in funds that trades commodities because they think inherently that we are part of the reason why commodity prices, from time to time, goes higher, and we’re the cause of that.

Let’s leave bubbles aside. There are two other, I think, main topics that you wanted to touch on. Maybe three actually. And just in the interest of time, I’m going to ask you to select what you would like to talk about.

One was, and I don’t know if we talked enough about this complexity issue that we are seeing at the moment, there was also something about thematic investing without a theme that you mentioned. And then also risk, you know, is it a feeling, is it a factor? Which one do you think you would most likely want to dive into?

[00:53:11] Mark

I’ll hold off on risk as a feeling versus a factor because I think that’s a longer topic. And let’s talk a little bit about complexity because I think from a lot of your listeners who may be either thinking about buying a systematic investor or being a systematic investor, the complexity issue is the number one issue. And so, I love the word complexity only because it fits within the my VUCA framework which you know, that I bring up occasionally.

[00:53:43] Niels

Absolutely.

[00:53:44] Mark

Which is the volatility, uncertainty, complexity and ambiguity. But what there has been is a number of researchers, especially Kelly from AQR and Yale University, who have looked at this complexity issue. Now, his argument is that you want to make models as complex as possible, meaning use as many factors as you can. Because what you find is by using more factors then what you’re going to be able to use is some machine learning. In particular, you can use random forests or other types of approaches. And what happens is that even though you may not be able to sort of come up with an explanation for why all those factors are necessary, that at the end they’re better predictors. And that as a model builder, you don’t really care about “the econometrics of why,” all you care about is the prediction.

So, he would argue that we want to increase and embrace complexity, in our model building, given we have the techniques, the computing power and the data to be able to do it. I’m simplifying in some sense. On the other hand, we have the more traditionalists, we’ll say. The traditionalist would say keep it simple. This complexity will lead to overfitting. This is going to be problematic.

So, if anything, we should avoid the use of too many factors and we should keep the factors limited so that we can say these are the ones that are most important. Only focus on those. That means we may do poorer, in a given period of time, but in the long run will do and do better.

This has come up in a number of different issues. I think that Frank Fabozzi did an interesting paper on fixed income/equity correlation, and he looked at about 135 factors. He was able to show that he could group some of these things. He gets a pretty good number in-sample. Albeit, simple models actually do really well and will get you, say, 90% of the way.

So, the added factors, they contribute but they don’t add substantively to your overall prediction. But then he said, again, if you’re using, say, different techniques in the prediction, having more factors is actually a good thing.

So, we’ll sort of see that there’s the traditional academic community who is probably driven or focused on econometrics where you need to have a specific model. They started to embrace machine learning to say let’s add complexity. There probably are systematic managers who say, well, how do I still keep it simple as the key driver? And I think that this is really one of the major themes that we’re going to see for all systematic managers is how much complexity should I add to a model? This is really an important issue that we’re going to have to face.

Now the reason why this is so important is because there’s another stream of research that we’re starting to see more and more discussion about, that is causal inference. And the causal inference is when it’s said, let’s make sure that we only add factors that we know that we think cause an impact on stocks or cause impacts on the market. If we can’t find or measure the causal influence, then don’t use that factor. So, what they’re saying is that it’s not so much simplicity, it’s not so much complexity, it’s a matter of making the right causal inference.

So, what you’re going to see more and more in the next year or so, more discussion about this issue of simplicity versus complexity. And that’s going to show up in research papers. It’s going to show up in how people present their modeling.

And second, we’re going to see much more work on this idea of causal inference. Can you tell me the factors you use? How do they actually cause an event so that we can actually make good predictions?

[00:58:35] Niels

You know, I mean, it’s a fascinating area and it’s also a topic we discussed last week, actually. Now, I think for many people, both really on the manager side, but also on the investor side, I think complexity can be somewhat seductive. Meaning that we may mistake model sophistication, if we call it that, for better market understanding. How do you think about that?

I mean, is that where the real risk lies, that we think, oh, yeah, by doing all of this extra work, we now know much more about how these markets operate? But in fact, we don’t. But we just don’t see it until it’s too late.

[00:59:21] Mark

Well, you know, this is the problem with overfitting. When we train the models, we can say, aha, there’s this relationship that I didn’t see before that I need this extra factor. The question comes in (and we go back to our issue of timing), is what may be important in one period may be less important in another?

So, I did some work on housing markets about different models and whether they can explain housing behavior. And what happens is that the coefficients or the models that you use at a given point in time are fairly unstable. So, the stability of your coefficients is constantly changing. In some sense, the more complexity you have, the more likelihood you’re going to have this problem of instability.

So, I didn’t get to my quote for the day, but the one that I found interesting in the last month is, “Knowledge is a process of picking up facts. Wisdom lies in their simplification.”

So, if we apply that to models, knowledge is our process of picking up more factors, but the wisdom lies in their simplification. And so, I think that while I embrace more the machine learning techniques, I embrace that our goal is always prediction, at the same time, I sort of say, how do we keep it simple? And in some sense, I don’t know if there are many more factors we can find. The question is, are the techniques that can extract the relationships or the stability of those relationships better right now?

[01:01:09] Niels

Yeah, Mark, these were some great topics. I’d like to finish off with a couple of just observations that I thought of during our conversation. Things that I, you know, they’re not strictly directly linked to what we’ve talked about. Maybe they are.

So, the first one, it’s this thing about, you know, we are looking at history when we develop these models, but we’re obviously developing models for a completely uncertain future. Now, I still feel very strongly about trend following, of course, and in particular because it really is designed to handle an unknown future. We’ve seen that for decades. And it’s the fact that it’s adapting along the way, and I think that’s such a really powerful part of trend following.

And I have said, over the years on this podcast, that I think we need to imagine the unimaginable. And I do feel that the world is changing significantly at the moment, not least with this AI revolution that we are seeing. And then I came across something, again, I’m not entirely sure where I read it or heard it, but it was fascinating. And I think it’s within the last… It’s certainly within this year.

I think Japanese scientists have been able to beam from space the power of the beams from the sun essentially down to Earth to extract energy.

And I’m just thinking (and I know this is completely left field for us to talk about), what if this means that in 10 years time, 20 years time, I don’t know, we suddenly live in a world where energy doesn’t cost anything because we’re just getting it beamed directly from space? And how would that change the world we live in? Because again, right now, energy is kind of the structure of everything. It’s so important, we know that, for everything we do. We could talk about AI as well.

And we say, well, all these things will change dramatically in a few years. And the jobs we thought of right now as being secure, well, they’re just being replaced and we should all get used to not having to work, maybe, and just get paid something. How are we going to spend our time?

It’s something that is so far out that you and I, right now, and the people listening to us think, you know, that’s never going to happen, but it may happen. And so, I think this is very interesting.

This is also why I’m so passionate about trend following and this adaptive approach to investing, not predicting anything. We’re just going to go with the flow. I think that process really is so useful and important for all portfolios.

So, this is just a thought. I don’t expect you to comment or have any thoughts on that. But then I was also reminded, while you were talking about this trip to China that you had, about something I also found fascinating.

Another news story I picked up is something called dark factories. I don’t know if you have heard about the term, but apparently in China now there are a lot of dark factories where everything is done by robots so they don’t even need to turn on the light in the factory. And I just found, wow, I mean, it’s extraordinary really. So anyways, not sure what you’re going to do with this as we wrap up, but I’d love to hear your first sort of thoughts.

[01:05:01] Mark

You know, doing this for a long time and always constantly looking at, trying to say how do I add whether it’s macro factors or trying to add more complexity or at least trying to do that because you want to see, can I create an edge?

You still go back and I think that you make the great point, I don’t know what the future will hold next year, next six months, next five years.

So, the only thing I could do is still embrace the idea that prices are primal and that whatever the future is, that starts to evolve, will be revealed in prices. So therefore, I should just follow the prices. And so, I say I don’t know what the cost of energy is going to be. I don’t know who’s going to be the dominant economic player. I don’t know who’s going to be President.

I don’t know what the Fed is going to do, but I do know that it will be revealed in prices and my job is to try to find out about that revelation as quickly as possible.

[01:06:09] Niels

Yeah, absolutely. By the way, did you see any dark factories, Mark?

[01:06:14] Mark

No.

[01:06:15] Niels

Have you heard about the term dark factories?

[01:06:19] Mark

Well, I will sort of say that my final point is that, you know, some of the EV cars there, some of them… I was in one or two taxis from some of the Japanese manufactured cars and they are nice cars. I liked it. So, waiting for them to come to market here. That may not happen but I’m waiting for that.

[01:06:44] Niels

Absolutely, well, this was wonderful, Mark. It’s really, really great to have you back. Love the way you think about these concepts and how you share them. So, I really appreciate that.

And, of course, for all of those listening to our conversation today, if you feel the same, head over to your favorite podcast platform and leave a rating and review. It helps the show and it motivates all the co-hosts to come back every week and deliver some interesting insights for sure.

Next week I’m joined by Alan, so that will be also very interesting without a doubt. If you have some questions for Alan that I should bring up, email them to info@toptradersunplugged.com and I will do my very best to get them answered.

Anyways, from Mark and me, thanks ever so much for listening. We look forward to being back with you next week and until next time take care of yourself and take care of each other.

[01:07:46] 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 past, 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.