Correlations, volatilities and expected returns as the monetary tide reverses flow..

I note comments by El-Erian over Central Bank’s inability to suppress volatility as a bigger risk than China and I would agree although I would qualify this in terms of the immediate asset price risk.   Asset focussed money supply growth and asset price relatives (relative to GDP growth and income growth as well as its distribution) are all deeply negative for asset markets when liquidity dynamics, amongst others, change.

Recent commentary by Zero Hedge on the winding up of Nevsky Capital is also worth reading: the Nevsky Capital report suggested that a disciplined structure can no longer be counted on to realistically manage risk and return given the uncertainty of an increasingly skewed distribution of possible outcomes in an environment worryingly distanced from fundamentals/exposed to unconventional monetary policy; liquidity dynamics in the market place also impacted.  

Another interesting piece of data shows the 10 year rolling returns on commodities that I found in a tweet from @zatapatique.

I have written on the issues of excess asset focused money supply and liquidity for some time (relevant posts of mine).

Many portfolio management structures depend on expected return/correlation/standard deviation assumptions that would be very much exposed to a break in the direction of money flows towards assets.  All statistical measures of risk and co variance are drawn from the impact of monetary demand flows for assets.  In an environment where monetary policy is accentuating flows to asset classes as well as expanding the quantity of money and reducing the supply of certain asset classes the natural flow response to risk and return in the environment are muted.  As unconventional monetary policy recedes, additions to the quantity of asset focussed money and interest rate support reverses, the natural flows not only start to reassert but the prior excess flows adjust to the new environment.  We get a break out of trading ranges and covariances.

This is all incredibly risk and uncertain for those dependent on traditional statistical measures of asset price sensitivities and covariances.

The Golden Age of Canadian stock market and other returns may have passed for now…..

The golden age of stock market returns for Canadian investors looks to have ended sometime in 2007:


Adjusted for inflation, the S&P/TSX has literally only provided returns for those able to take advantage of the significant dips in valuations post 2000:


If we look at annual returns for holding periods of 10 and 15 years we can see capital gains in decline:


For those investors unfortunate enough to be paying through the nose for closet indexing mutual fund investments, the real capital returns are likely to be lower still, and more so after tax.  The golden age looks to have peaked in and around 2007.   This is around about the same time that debt and GDP growth took their separate routes.


If equity markets and commodity prices remain depressed they are clearly going to detract from economic momentum going forward and may well exacerbate the latent fissures in the residential property market that we already know off (i.e. high consumer debt loads and historically high valuations). 


Wage and salary growth has also been on a slide:


So yes the drop in market valuations is a concern given the accompanying commodity price weaknesses and other structural risks that have built up in the Canadian economy over the decade.  This will likely raise the odds of much more aggressive monetary and fiscal policy.

This is more or less a follow up from a December 2014 post:

Is Canada’s Mini Golden Age behind it?

And in the context of the above, this is worth a read –

Share buybacks..quantitative easing, secular stagnation and the risks of Myopic Share Virus..

The point about share buybacks is that they sit uncomfortably in a widening narrative of increasing inequality, weak income growth (worse at lower income levels), falling economic growth rates and disturbing trends in both human and capital investment. The backdrop to the narrative and one that threatens to envelop it as one are the burgeoning asset and debt markets, whose rise is at odds with the weakening fundamental growth prospects of many developed economies. Asset markets and hence debt are being supported, yet the fundamental underpinning to their longer term valuation, investment and growth in real incomes is being weakened. At some point the two, economic reality and asset market capitalisation will need to meet.

Continue reading

Is Syria the catalyst?

Markets have advanced quite well over the year and margin debt has scaled new highs.  The Fed looks as if it is close to scaling back its QE and the uncertainty over the impact of this on asset prices has been making minor waves.  The Syrian issue has impacted the market today, and while it is impossible to forecast any economic or financial impact of an escalation, because this really is an unknown entity, the real question is to what extent will the Syrian variable in the equation influence short term money, that may have been mulling other factors, to pull out now.   

Volatility, China and QE instability

QE may have reached its limits, that is the stability it brought to the financial system may now have passed its inflexion point, overwhelmed by the relationship between portfolio focussed money and the supply of real returns: volatility may now dominate as asset prices become increasingly sensitive to real fundamentals. In other words the inherent leverage of QE risks negatively impacting asset prices, whereas before it provided support.

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Valuation Perspectives

John Hussman has been beating the drum (‘till his hands bleed…) about the risks of current market valuations in his weekly commentary

I think, supporting this message, it is worthwhile paying attention to historical relationships;  at the moment, while the water is pushed to one end of the bathtub, and the line is indeed high in this respect, it tells you little about how much water the bathtub actually holds and the relative stability of the dynamics.

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“It’s time to reset your investment assumptions”..says the Globe and Mail. But is it, and should it be up or down?

Is it really time to reset your return assumptions downwards? A Rob Carrick articlein the Globe and Mail suggested that it might be so.

Revising return assumptions down after poor stock market returns is a Bete Noire of the financial services industry.  All other things being equal, and depending on your paradigm, you should be revising them up after a period of poor returns.

But you cannot revise upwards if your return assumptions were too high to start with. If you have relied on historical average returns or risk premiums to set return expectations you have also more than likely failed to adjust for cyclical and structural risks in markets and economies. Continue reading

What return assumptions can we expect going forward?

The major driver of stock market returns, all else being equal, is earnings growth, which while not totally equivalent to nominal GDP growth, tends to exhibit similar rates of growth. 

Gross revenue should more or less increase at the same rate as expenditure based GDP growth, even though earnings growth will differ due to changes in corporate taxes, depreciation factors, cost cutting and productivity factors.

From December 1966 to December 2011, real US earnings growth (source Shiller data) rose by some 1.85% per annum, while real GDP growth (BEA data) has been some 2.02% – all figures are geometric averages.   Nominal GDP growth had averaged 6.65%.   

Total real return, going forward, based on this data would be 1.85% per annum + the dividend yield (close to 2%).  So for say the US, if the future were to represent the past, we would expect non compounded real returns of 3.85% per annum: compound real returns would differ, but not everyone receives compound returns, especially those living off their assets.  Continue reading

Don’t worry, here comes the three horsemen of the apocalypse!

Ambrose Evans-Pritchard has neatly summed up some industry think in his latest piece, “Global banks see market rally on Greek exit”. 

But this type of industry thinking is also likely to scare away the retail investor, through rational cognitive dissonance or otherwise. 

Apparently, we are set for a big rally, once Greece leaves the Euro, as Central Banks the world over pump yet more liquidity into the financial system.  This will either be via LTRO Repo type (temporarily exchange your securities for cash) transactions or the better for the banks and sovereigns, QE (buy your duff securities for a price you would not be able to dream of otherwise). 

Here is my very quick, write it as you think it, opinion on this “play”. Continue reading

“Counting on the Fed to perpetually float returns is a mug’s game”

When looking at the current health of world stock markets, it is critical that we bear in mind the structural paradigm in which we observe: the only reason the financial system remains in place and markets are “healthy” is the vast amounts of government and central bank support.   The title to this post comes from Richard Fisher President of the Federal Reserve Bank of Dallas:  He also makes the following comments: Continue reading

Are we at a key psychological moment in the market place?

I rarely get drawn into technicals, but I thought with the S&P 500 crossing back below its 50 day moving average, after having briefly risen above its 200 day moving average, that the chart looked very similar to April/May 2008: this was when the market crossed above its 50 day and almost touched its 200 day moving average, only for the market to move lower during the summer and collapse in the Fall. 

That said, I do not think you need technicals to realise that the market is exposed to very severe risks, risks which are increasing in intensity daily.

Also, something which I think may be relevant: the average investor is getting extremely unnerved by the market gyrations and the traumatic events in Europe.   It would not take much for more investors to pull the plug and head for the hills. 

Why do I think this? I have spoken to a number of individuals, who during the 2008/2009 crisis held their resolve and doubted (robustly I might add) many of my own concerns, who are now on the verge of pulling out and are expressing significant concern. 

Things have changed and investor perceptions are much more fragile and weary.   I am not saying that people should pull out, but I think this may be what is about to happen.   We have reached a key psychological moment in the markets.  Things need to get better quickly, otherwise…..