Debt and wealth in a monetary system, part 2: discounted valuation issues in a declining frame with inequalities.

We are presently building up conflicts within the asset price frame:

  • Conflicts between asset values and GDP flows and their growth rates;
  • Between asset prices and return expectations;
  • Between human capital values and the distribution of those values and their impact on the overall wealth equation with respect to future consumption risks as well as asset pricing via increased asset focus of flows due to distribution dynamics;
  • Within portfolio structure and relative to the liquidity and capital security dynamics of liability streams. 

All of this tied to the relationship between frame transitions, emergent properties and structural imbalances and unconventional monetary policy focused overly on asset price support.

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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.

No need to worry!

I recently came upon an article entitled “What You Can Do About The Upcoming Stock Market Crash”.  The title was tongue in cheek and perhaps unfortunately so given recent events.  Nevertheless, it made a number of important points about the difficulty of knowing when a market is at its peak and when a market is at its lows, and of knowing in which direction and by how much a market is going to move at any given point in time.  Much of this I agreed with, but not all:

When you think about it that risk and fear will always be there no matter how far the market goes up, down, or sideways. So what can you do?

Be prepared for a crash at any time. If you need to withdraw money in the next few years or you want to cushion the blows, then you need to diversify your portfolio with enough bonds, cash, or other assets that won’t fall along with the stock market.

Once you figure out what is right for your current situation you don’t have to worry about what happens because you are controlling the risks instead of letting them control you. That means you are safe to invest your money today and start earning your way to the freedom you want for yourself and your family.

Points 1 and 2 noted above are more or less correct, but the last point I have emboldened is where I diverge.  You are never ”controlling” risk, just diversifying it relative to return, and if possible, its covariance, itself a function of risk.  You cannot control risk, only minimise its impact through structure.  You are certainly not safe to invest your money today and there is no guarantee that you will earn your way to freedom. 

Return is an important consideration when accepting risk and many today who use simple mean variance models assume that expected returns are invariant and that risk is only volatility around this return.  In a general equilibrium, random, independent price movement model it does not pay on average to delay or defer investment (any benefit is purely attained by chance), but even here you are hostage to the probability distribution since the expected return in Monte Carlo land is only the average of many outcomes, some of which turn out to be quite disastrous from any level.

But expected returns do matter and while timing your investment to maximise your returns and minimise your losses is impractical and impossible for the market as a whole to do, making value judgements about market valuations and economic cycles to inform you of the boundaries of return and its significance is I believe worthwhile if you possess the expertise..  Where people run into trouble is where they either lack the knowledge and expertise to make the type of judgements needed to define the boundaries of expected return, and its impact on structure, as markets and economic cycles mature or react to market falls and meteoric rises as if one is the end of the world and the other its never ending bliss.

Deferring new risky investment at high market valuations is a value call and a discipline, but it is an act which relies on knowledge of the significance of valuation differentials.  It is one of my concerns that “we” have been taught that we should invest in markets at all times irrespective of the valuation, the cycle and the specific characteristics of either.  One of the reasons the world has been through innumerable crises since the late 1990s is because we have ignored significant accumulating structural economic and financial imbalances and the differential between asset valuations and economic fundamentals.  In a well balanced world we could probably ignore valuations and invest at will, ignoring volatility. 

But then again context is everything.  While one may not invest/sell at cyclical highs/lows there is little reason to sell all (high) and then attempt to reinvest all (lows) at perceived key turning points.  Portfolios should adjust to the relationship between valuation risks and the time frame of their liability profiles and it is here where we need to pay attention to valuation risks since these do have material impact.   As markets rise returns fall and the risks to the ability of assets to meet future needs increases, and vice versa.  When returns and risks pass barriers of significance that is where changes at the margin need to be made.  It is therefore not a question of timing but of tangible discipline and its benchmarks.

And, of course, I believe we are in the middle of a very long period of global economic and financial fragility, so safe is a word I would eschew for some time.

How far can we defer the next asset price crisis? Depends on how fat the tail of the distribution is!

I have blogged on fundamental liquidity issues recently and one point that I want to bring out is that the greater the divergence between asset values and GDP and the greater the divergence between broad MS growth and GDP growth, especially in slower growth frames, the “fatter the tail of the distribution”.  

Volatility at one level is a measure of the sensitivity of an asset’s price to new information, shocks to the system/de facto changes in the energy of the system.   It reflects changes in demand flows for assets which can reflect changes in risk preferences and risk/return expectations.   In a general equilibrium volatility is meant to be a static physical characteristic reflecting the fundamental nature of the asset and its relationships, but we do not currently have general equilibrium relationships and volatility is not a stable measure of anything.

Essentially when we have excess asset focussed money supply growth (EAFMS) amidst a slowing growth frame the “accumulated liquidity in” decisions exceed the “present value of future liquidity out” (PVLO) decisions.  In a sense liquidity (at its heart a function of the relationship between asset allocation decisions and C/S/I/P decisions) becomes more sensitive to short term  changes in demand flows and risk/return expectations, risk preferences and other factors.   As the ratio of EAFMS to PVLO rises so does the natural volatility of the system.

Why the tail?   Why not volatility at 1 standard deviation?  During periods of excess monetary flows demand changes are not in totality covariance issues (ie. relative attractiveness of one asset to another) but absolute flows that suppress relative price reaction.   In other words we see a fall in volatility throughout most of the distribution.   All the while the system due to EAFMS/PVLO imbalances becomes more sensitive to changes in flows, preferences, expectations and shocks.  

Given that the system because of its imbalances becomes more sensitive to small changes in any one factor, the bigger the divergence noted in paragraph A the greater the probability of an extreme risk event.   The greater the accumulated liquidity in to PVLO the larger the tail: the risk event and its probability increase. 

In reality, from a given point on, we can effectively discount the rest of the distribution in any analysis as a dynamically widening tail is merely a statistical constraint on the way we should be viewing risk.  We are only exposed to the wider risk distribution if forces suppressing risk remain influential.  

Critical perspectives on US Market Valuations 2…includes 17 charts

Many say that lower interest rates should raise asset valuations by lowering the rate at which future income streams are discounted.  This may be fine for high quality government bonds where coupons are fixed, but is not necessarily the case for equities where we are dependent on future flows (earnings, dividends, economic growth, CAPEX). 

What is the major determinant of long term real equity returns?  Earnings growth, and long term earnings growth is dependent on real economic growth.  If we look at real growth rates they are falling, and have been falling for some time.  This is part of the reason why interest rates have been falling; that is to accommodate falls in nominal and ultimately real flows.

The following shows annualised annual growth rates over rolling 15 year time frames (in other words geometric returns) compared to the Shiller Cyclically Adjusted PE ratio:

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A wider narrative is needed to fully frame risk for longer term investors

I read Dan Bortolotti’s “3 Reasons to ignore market downturns” last week and the more recent Jonathan Chevreau’s “If you can’t take the pain of plunging markets, don’t watch”.

They both pass some genuinely rationale advice…if you have a long term portfolio structured cognizant of risk then there is no point in reacting to a boundary you have already accepted you will cross numerous times.   But just what are the boundaries that you have accepted and just what are the risks since it is the context in which the statement is made that matters?

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My submission to the CSA re Risk Classification disclosure

Re: CSA Notice 81-324 and Request for Comment – Proposed CSA Mutual Fund Risk Classification Methodology for Use in Fund Facts

The part must relate to the whole and the whole to the part and the both must know of it:

The CSA in their consultation paper fail to explain how the risk classification methodology proposed for use in the point of sale documents is to be used by investors to make informed decisions, and how advisors are to use the same to determine suitability.

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What is investment risk?

“What is investment risk” is both simple and complex and in order to assess the information needed to assess risk we first of all need to qualify the world view of risk and return and then the model we are using to manage the risks and their impact. All this is beyond the subject matter expertise of the individual investor and why point of sale documentation can only ever inform about the broad nature of risk and return but never be sufficient to allow the investor to fully own the decision. Ownership of the transaction decision resides with ownership of the process and the significance of risk assumed with respect to risk via structure, assumptions and costs.

At a very basic level, risk is what happens to a price between two points in time and the impact of that movement in price – it can be both positive and negative.  But what gives rise to risk is more important than a mere list of risk factors, or indeed a narrow quantitative measure of risk.

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Standard deviation may not tell the whole story but it does tell a story

In terms of risk, a prior positive demand flow (+ve standard deviation) has more impact on liability risk in an out of equilibrium world, so that arguments that suggest that a statistic that fails to focus only on the downside is meaningless are incorrect.

Way back when the world was more enamoured than today about standard deviation I openly discussed its weakness in terms of managing liability risks.  This was primarily to do with the fact that mean variance optimisers did not incorporate liabilities into the portfolio construction (optimisation process) and ignored relative and absolute valuation issues. 

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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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Stocks are never cheaper..according to the Federal Reserve Bank of New York

“We surveyed banks, we combed the academic literature, we asked economists at central banks. It turns out that most of their models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years. But how do they reach this conclusion? Why is it that the equity premium is so high? And more importantly: Can we trust their models?”

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