A World of Suboptimal Choices
It's never easy when bonds and stocks decline at the same time, but despite the much-publicised death of the "risk parity" strategy, I don't think the past few weeks' price action qualifies as decisive evidence. After all, the S&P 500 is down a mere 0.6% from its peak in the beginning of June, while US 10-year futures are off only 1.5%. In writing this, though, I remember that many punters in this business use leverage. This acts as an accelerant not only for the volatility of their PnLs, but also for the speed with which a meme can take hold in the peanut gallery. I sympathise with the plight of bond traders in Europe where the dislocation in yields has been particularly nasty. When yields are near zero, or even negative, the relationship between small changes in yield and prices is brutal. This is even acuter in Japan, where the BOJ might soon have to actually defend that 0% target on the 10-year yield, to avoid an accident in the domestic asset management industry. In the U.S., the 10-year yields has been less dramatic, but big enough to raise questions about whether we have made a switch from a flattener to a steepener.
The combined woes of stock and bond prices arguably is the price we pay for seeing them go up at the same time on the wave of central bank liquidity. So, what are poor investors to do?
Cash is a call option on volatility
The plight of investors who find both stocks and bonds too expensive—or suffer when they both decline in value—reminds me of one former SocGen strategist Dylan Grice's Popular Delusion notes from 2011 in which he makes "The case for cash." Professional investors will be either seething or rolling their eyes at this point. Even if they wanted to hold cash, it is difficult for them to do so. Mr. Grice is well aware of this.
Telling investors you find cash an attractive investment is about as big a faux pas as you can make. It might even be on a par with telling your wife her rear end looks big in those new jeans. Just because it might be true doesn’t mean you should say so.
Thus some of our clients are explicitly forbidden to allocate more than 5% of their portfolio to cash, while others with more flexible mandates nevertheless feel philosophically compelled to hold as little cash as possible. They feel that their clients don’t pay them to sit in a supposedly ‘dead asset’. But such mandates – perceived or real - effectively push investors towards owning risk assets at virtually any price, which is surely nonsensical.
This is fundamental stuff in the world of investment management, but it also has profound implications. For example, the fact that most investors can't sit on cash for longer periods offers investors who can a crucial advantage towards the end of the financial cycle, at least in theory. The money quote from Dylan's piece is the following:
"Cash has one important endowment which is too frequently unrecognized: a hidden optionality derived from its relative stability. In other words, the holder of cash has an effective option to purchase more volatile assets if and when they become cheap. Thus, a willingness to hold cash when there are no obvious alternatives is the simplest way to ‘get long of the tails’, and therefore the original ‘long-vol’ strategy."
The allure of cash as the quintessential call option on volatility also tells a cautionary tale, though. Dylan wrote this six years ago suggesting that the S&P 500 was much too expensive and that the willingness to hold cash—no matter how painful—was critical to investment success. Needless to say, that didn't really work out. Cash gives investors optionality, but it can also be a source of brutal underperformance in a world where a short volatility position effectively is the new black. In any case, I chose to revisit Dylan's piece because I think the idea is crucial, not to point out a suboptimal investment call. If you went through my old notes you could find plenty of those! To restore the relevance of Dylan's idea it is interesting to note that one of investment world's most prominent punters recently raised his cash position to its highest level since the financial crisis.
The idea of holding cash as a way to mitigate investment risk in a world where stocks and bonds are positively correlated is closely related to another of my favourite investment ideas; Christopher Cole's musings about how all investors are short volatility and what to do about it. I have said it before, but it bears repeating. Mr. Cole's piece about volatility and asset prices remains the most profound and important investment strategy research piece that I have ever read. It is difficult to summarize it with one quote, but the following comes close;
An interesting and perhaps inconvenient truth for MPT [modern portfolio theory] is that bond prices do not always move in the opposite direction of stock prices. MPT has been built on the basis of anti-correlation between bonds and stocks. But is there a risk of a paradigm shift? Recall the concept of the impossible object. Is it possible to enter into an environment where stocks and bonds collapse together? (…) If stocks and bonds decline together, investors will definitely want to own volatility.
Dylan Grice suggests that owning volatility can be achieved via holding cash, while Mr. Cole's advice is a little more intricate. He suggests that volatility can be owned by treating it as an asset class on its own. If you do that, you trade volatility like you would trade a bond—over a curve—or a commodity with a spot and futures markets. This offers an interesting perspective on two of the most common misconceptions on volatility, which remain prevalent in the market to this day.
Shorting volatility via synthetic ETFs or even worse, writing put options to achieve yield is a disastrous way to augment your portfolio's returns. It is the definition of picking up dimes in front of the steamroller, even more so than the yen carry trade, which was the original source of this metaphor. Mr. Cole takes no prisoners.
Amateur traders are enjoying the Fed-induced liquidity spree by shorting volatility through ETPs, and they all believe they are geniuses for doing it, but in actuality they are more like the shoeshine boy of the past.
Similarly, the notion that you can own volatility by being long synthetic long VIX ETFs or the dreaded short equity index funds is equally bonkers. There is nothing mean-reverting about having exposure to VIX even though it might look like that when you peruse the spot price chart. I am not saying that these things can't be usual, but many investors buy them as if they were free options on the market going down. That doesn't exist. In short, these things lose money in a flat market, and in particular in markets that slowly grind higher.
Why is all this important now?
Maybe we can look back on this essay in five years—with Spoos at 5000—and say that all that worry about stocks, bonds and volatility was much ado about nothing. But once in a while, it is useful to remind ourselves how to prepare for a change in the investment landscape.
We have been used to a world in which the combination of external surpluses and QE/ZIRP in Japan and the Eurozone have made it difficult for other central banks pursue their independent policy goals, no matter their domestic fundamentals. The idea that the Fed is struggling to get traction with long rates even with a timid hiking cycle is an offshoot of this. But much more extreme versions can be found in the immediate vicinity of the ECB where the Riksbank, the SNB and Denmark's central bank have been forced to take serious evasive action to avoid being flooded with excess liquidity from Frankfurt. I think this trend is structural, and in part linked to population ageing. But I am open to the idea that it has a cyclical component too, which is exactly what Detroit Red over at Macro Man is referring to when he says;
We are currently witnessing a reflexive process unwind. When countries were engaged in a currency war racing to devalue, one central bank devaluing their currency would in turn indirectly force a relative tightening of financial conditions of another country. In turn, the second country would have to ease monetary conditions, creating a positive feedback loop.
Now, we are on the other side, where central banks have realized that financial conditions might be too loose and asset prices are noticeably overvalued. So now what? We now have started an unwind of the reflexive process with a positive feedback loop in the other direction. One country raises rates attempting to tighten, thus making the financial conditions of the other countries relatively looser - as a result, the other countries must then be forced to tighten.
This is a clever interpretation of recent price action compared to the idea of some kind of covert hawkish coordination among global central bankers. But should investors take either of these themes seriously?
We have certainly seen a shift. The Fed is raising rates, which usually continues until something breaks and in the Eurozone, the economy is now doing so well that the ECB is being forced—kicking and screaming—to contemplate how to reduce accommodation further. In Japan, Abenomics appears to be working, albeit slowly, and the key question is whether the BOJ is serious in defending yield target—which would require more QE—or whether it will nudge it higher if Bund and U.S. 10-year yields start to push global rates higher. In principle, I agree with the idea we're getting close enough to the exit of global unconventional monetary policy—in this cycle—that markets should care.
The normal sequence is that policy makers become anxious over high asset prices and/or overconfident in the strength of the economy, which leads to a mistake. The economy and markets take a dive, which pushes us straight back into the arms of the creators of global liquidity. In the introduction to my essay on Christopher Cole's piece on volatility—linked above—I mused about the consequences of a shift in global monetary policy.
If central bankers were to secretly convene in a room to decide to apply a dose of Volcker’s medicine the fallout would be devastating. Such hawkish coordination may seem a ludicrous proposition, but the margin between blunders, policy errors and deliberate policy changes is a blurred one. Having your success as investor depend on central bank policy may seem a merciful alternative to the chaos that prevailed first in 2008 with the global financial system on the brink of collapse and then later in 2012 with sovereign defaults and break-up fears in the eurozone. However, if central bank intervention and economic volatility are joined at the hip then it suddenly looks like much more like a Faustian deal.
It makes sense to fear a sudden change in central bank policy. But the present environment remains one in which policymakers, as far as I can see, are still scared about even a slight mishap. In other words, this idea of a coordinated move towards a more neutral policy stance is yet to be tested by a real challenge from financial markets. I will happen eventually I guess. For now, I am reminded of an investor committee meeting at a large asset manager, which I attended recently. The conversation quickly converged on whether bonds or stocks were most attractive. Most agreed that both were expensive, which led us to the inevitable conclusion that investors now find themselves in a world of suboptimal choices.