When beta is wrong…and by implication expected return, risk and covariance..

One of my many issues with modern portfolio theory is that it assumes not only that markets clear but that supply and demand are also optimal.

In a low growth environment where asset prices are being pushed upwards through quantitative easing, modern portfolio theory tenets becoming increasingly irrelevant for efficient asset allocation in risk return space and a serious risk to effective withdrawal management.  In such an environment we have to be very careful in our assessment of beta and the risks both allocating to and away from it present.  

One of the things that I drew attention to in my Capitalism in Crisis reports of 2007 (1, 2) and 2008 was that we had excess money supply growth that had become increasingly asset focussed in the 20 years to 2007, and indeed since 2009 asset prices and implied returns and volatilities have become even more heavily influenced by monetary policy.

No longer is the real economy the predominant force in driving prices forward, no longer is the market or beta a valid and rationale/impartial equilibrium force in setting valuation relationships.  

In a world where money supply growth is increasingly portfolio focussed, the less we can rely on beta (the market) to properly value assets in risk and return space.   In fact, we have not been able to rely on beta for some 16 years or more (1996/1997 onwards): that is monetary demand for assets has been well out of equilibrium with the real supply of return.  

In periods of intense asset focussed /portfolio allocated money supply growth you cannot rely on modern portfolio theory inputs -  implied risk, return and covariance – to determine appropriate asset allocation and safe withdrawals.    You need to go back to fundamentals and adjust risks to valuations and correlations (step back and look at absolute valuations as well as price relatives) to come up with realistic risk/return relationships and hence pricing and allocation.  

The problem is that not many asset or portfolio managers actually stand back and assess their position with respect to the market/beta, and happily transact, inefficiently, all the way up and down.   This is performance risk, which is the risk of not wanting to be out of the market when the market is going up, irrespective of the long term risks to return. 

In the real economy we have individuals deciding how much of their income they will set aside for current expenditure (and companies in prior periods how much wages and salaries to pay, how much to reinvest and distribute), and where and how much they invest depends on their preference for holding cash in the portfolio.  As the economy grows, money supply growth should tend to expand at a rate of real growth + consumer price inflation (an MS to facilitate the increase in supply + the lubricant the economy appears to need).  If the proportions in which individuals save and consume and allocate remain constant, the market value will increase at more or less the same rate.  If the supply of money for one reason or another increases (out of stable growth framework) and people use this increase to allocate to assets (increasing broad MS was allocated to US consumers via home loans and home equity loans in the 2000s) and even to reduce their preferred allocation to cash within their portfolios, the supply and the price of assets may rise at above the level of real growth + inflation.   Where money supply growth becomes increasingly asset focussed we start to form bubbles because the total value of debt and the price of equity move above the net present value of future real growth in GDP.

For a more detailed analysis of linear and non linear dynamics of money supply growth and asset prices, please read my 2008 report on the subject

At the moment we have a vast and ongoing increase in the monetary base (narrow money) which is essentially a vast increase in the market’s cash holdings.  In order to reduce the cash allocation to the preferred % of the portfolio, investors will need to bid up the price of assets.   In a low growth environment where asset prices are being pushed upwards through quantitative easing modern portfolio theory tenets becoming increasingly irrelevant for efficient asset allocation in risk return space.

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