The message from gold's generational breakout

Preface: Explaining our market timing models 

We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

 

 

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don't buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

  

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)*
• Trend Model signal: Neutral (Last changed from “bullish” on 15-Nov-2024)*
• Trading model: Bullish (Last changed from “neutral” on 28-Feb-2025)*

* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent and on BlueSky at @humblestudent.bsky.social. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.

Subscribers can access the latest signal in real time here.

A Generational Breakout

In case you missed it, the price of gold staged a generational upside breakout relative to both the S&P 500 and the 60/40 balanced fund, as measured by Vanguard’s VBINX (bottom two panels). On an absolute perspective, gold already broke out of a cup and handle pattern at 2100, indicating significant upsid0e potential. From a cross-asset perspective, past breakouts have coincided with periods of severe financial stress.

 The full post can be found here.

What the surge in gold tells us about the stock market

Even though it’s still early in the year, my bullish call on gold has worked out well (see 2025 High Conviction Idea: Gold). Gold has reached an all-time high in all currencies. In particular, it broke out to a new high in the Swiss Franc (CHF), which is regarded as a hard currency, and the Chinese Yuan (CNY), which is reflective of Chinese demand.

 
Beyond the bullish outlook on the yellow metal, here are the asset return implications.

 

The full post can be found here.

How to navigate the mid-cycle expansion

It's been over a year since the stock market bottom at the height of the Pandemic Panic. The market consensus has evolved from an early cycle recovery to a mid-cycle expansion, as evidenced by the BoA Global Fund Manager Survey.

What that means for investors? Here are the key questions we focus on:

• What's the outlook for the S&P 500?
• What will be the market leadership?
• What's the outlook for commodities, Treasury yields, and the USD?

The full post can be found here.

Time to take some risk off the table

After turning neutral in January and then bullish in early February, the Asset Inflation-Deflation Trend Model has moved back to a neutral position, indicating that my model portfolio should take some risk off the table.

To give more color to the change, consider the view from the three Axis of Growth, namely China, Europe and the United States. I would characterize the outlook for China as the most cautious; Europe as moving from bullish to greater uncertainty; and the US as experiencing slow and steady growth.


A cautious Chinese outlook
As regular readers know, the Trend Model relies primarily on commodity prices as an indicator of global growth and inflationary expectations. Commodity prices have been rolling over, as shown by the chart of the CRB Index below.

The commodity complex is highly sensitive to Chinese growth and there have been much concern about the near term trajectory of China's growth outlook. Indeed, a glance at the Shanghai Composite confirms the level of investor nervousness as that index as moved into a minor downtrend.

Next in Hong Kong, the Hang Seng Index has confirmed the weakness observed elsewhere as that index is in the process of breaking a key technical support level.

Similarly, the commodity and Chinese growth sensitive Australian Dollar is in a downtrend, indicating weakness.

I could go on, but you get the idea about the market judgement of China's near-term growth outlook.


More uncertainty in Europe
In Europe, the ECB's action through the use of LTRO has removed the immediate threat of a banking meltdown. As a result, the markets have enjoyed a relief rally that began late last year.

In the short term, however, much of the good news appears to have been priced into equities. As I indicated last week (see Europe takes one step back?), worries about Spain are beginning to surface and the normal back-and-forth negotiations are showing up on the stage of European Theatre. The latest act is now beginning to spook investors.

The European equity indices have broken down out of the uptrend that began late last year and appear to be consolidating sideways. Note that this is not necessarily bearish, but a sign that the markets need to either correct or digest its gains from last winter.

Other signs of stress are showing up in Europe. The chart below shows the relative performance of European Financials against the market. After rallying through a relative downtrend in January, which would indicate that a Crash is off the table because of ECB support, the sector began to consolidate sideways. Most recently, the Financials exhibited a relative technical breakdown, which is a sign that the market believes that financial stress is rising again.

America: Steady as she goes
Across the Atlantic, US equities continue to hum along and grind upward in a steady and well-defined uptrend.

I pointed out that the health of this bull has changed from being dependent on central bank liquidity to one that depends on the American consumer (see This bull depends on the US consumer). The chart of Consumer Discretionary stocks relative to the market shows that this sector remains the market leaders - and the health of this bull depends on the American consumer.

(This chart also underlines the importance of the NFP release this Friday to the continued health of this equity bull.)



What does this all mean?
Putting it all together, I interpret the model readings as telling that of the three regions, one is strong (US), one is consolidating (Europe) and the third is weak (China). This is not a sign to panic, but to become more neutral in your asset allocation and risk budgeting decisions. Within the riskier portions of the portfolio, I would be inclined to tactically tilt towards US and US Dollar denominated asset classes.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Are Treasury bonds a crowded long?

How crowded is the long Treasury trade? Anecdotal evidence suggests that the trade is becoming a crowded long. Ed Yardeni recently wrote:

Last week in Kansas City, one of our long-only accounts was especially concerned that the Endgame scenario is upon us. We discussed the best way to preserve capital in such a calamitous environment. The conclusion was to load up on the US dollar and US Treasury bonds, the scenario that seems to be working so far this week.

What does the data show?
Let's go to the data. Global Macro Monitor showed this chart of who is funding the US deficit. While the latest data shows that there are certain a lot of fund flows into US Treasuries from domestic and international investors, levels are similar to levels seen in 1Q 2010 and below the panic levels seen in the 3Q and 4Q of 2008.

What about hedge funds? These charts from Mary Ann Bartels of BoA/Merrill Lynch shows that large speculators, or hedge funds, are nowhere near a crowded long in the long bond.

What about the 10-year note? This chart shows that while large speculators have been buying the 10-year note, they are also nowhere near a crowded long.

This chart below shows the relative performance of the 30-year Treasury ETF against SPY. Again, it shows that while long bond returns are somewhat stretched relative to equities, relative performance levels are similar to the levels seen during the Summer of 2010 and far below the end-of-the-world levels of the Lehman Crisis.

Conclusion: While investors may be rushing into US Treasuries, the safety trade is nowhere near a crowded long, which indicates that risk-off trade has more room run.


Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Wait 8 years for a new bull?

USA Today recently asked How will Baby Boomers' retirement affect stocks?

I may have an answer from academia. Further to my post about anxious and volatile markets, John Geanakoplos, co-author of the paper entitled Leverage cycles and the anxious economy, also wrote another intriguing paper called Demography and the Long-Run Predictability of the Stock Market, with Michael Magill of the University of Southern California and Martine Quinzii of the University of California at Davis.

In this study, Geanakoplos et al related demography to long-term stock returns. They found that P/E ratios were correlated to the ratio of middle-aged people to young adults, otherwise known as the MY ratio. When MY rises, the market P/E will tend to rise and when it falls, P/Es tend to fall.

If the conclusions of the study are correct, then we should see a continued fall in P/E ratios with a long-term bottom in stock prices forming about 2018, or eight years from now.

Back to the '70s
Recall that the previous anxious markets paper that I cited indicated that current macroeconomic conditions called for volatile markets in the aftermath of the economic crisis. This latest paper suggests that we are gripped by a secular bear market until 2018. Putting it all together, the current environment is reminiscent of the 1970s, which was gripped by inflationary fears, slow growth, volatile markets and flattish equity returns.

The chart below of the Dow Jones Industrials Average shows that, since the Second World War, the market has been gripped by two episodes of secular bull markets to be followed by secular bears. The secular bulls were characterized by a substantial advance lasting over a decade while secular bears were marked by sideways markets lasting over a decade.

These studies are also consistent with the big bear charts at dshort.com, where Short shows the progress of the stock markets following the Great Depression and Japan’s Lost Decades.

Flat markets mean flat returns
Investors who accept such a scenario need to change their approach to investment policy. The buy-and-hold approach, long espoused by investment advisors during bull markets, will result in subpar returns in range-bound periods. Flat markets mean flat returns.

During secular bear markets characterized by flat returns, investors need to use dynamic asset allocation techniques such as the Inflation-Deflation Timer model to capture the swings of a flat market.

Anxious markets = Volatile markets

Recently the IMF warned of the risks of hot money flows to emerging markets, otherwise known as "emerging asset" markets with limited liquidity. "Emerging asset markets" is a term coined by Ana Fostel and John GeanakoplosI in a paper entitled Leverage cycles and the anxious economy. In that paper, the authors detail “anxious economies” and how Minsky Moments (my term, not theirs) occur in them:

We distinguish three different conditions of financial markets: the normal economy, when the liquidity wedge is small and leverage is high; the anxious economy, when the liquidity wedge is big and leverage is curtailed, and the general public is anxiously selling risky assets to more confident natural buyers; and, finally, the crisis or panicked economy, when many formerly leveraged natural buyers are forced to liquidate or sell off their positions to a reluctant public, often going bankrupt in the process. A recent but growing literature on leverage and financial markets has concentrated on crises or panicked economies. We concentrate on the anxious economy (a much more frequent phenomenon) and provide an explanation with testable implications for (1) contagion, (2) flight to collateral, and (3) issuance rationing. Our theory provides a rationale for three stylized facts in emerging markets that we describe below, and perhaps also explains some price behavior of other “emerging asset” classes like the US subprime mortgage market.

The authors studied “emerging asset” economies, i.e. emerging markets, but they note that their analysis is applicable to some of the smaller liquidity constrained markets such as “the US subprime mortgage market”. In the paper, they introduce the concept of the “anxious economy”:

This is the state when bad news lowers expected payoffs somewhere in the global economy (say in high yield), increases the expected volatility of ultimate high yield payoffs, and creates more disagreement about high yield, but gives no information about emerging market payoffs. A critical element of our story is that bad news increases not only uncertainty, but also heterogeneity. When the probability of default is low, there cannot be much difference in opinion. Bad news raises the probability of default and also the scope for disagreement. Investors who were relatively more pessimistic before become much more pessimistic afterward. One might think of the anxious economy as a stage that is frequently attained after bad news, and that occasionally devolves into a sell-off if the news grows much worse, but which often (indeed usually) reverts to normal times. After a wave of bad news that lowers prices, investors must decide whether to cut their losses and sell, or to invest more at bargain prices. This choice is sometimes described on Wall Street as whether to catch a falling knife.

They go on to model how financial leverage exacerbate the booms and busts to create Minsky Moments in an anxious economy:

Agents are allowed to borrow money only if they can put up enough collateral to guarantee delivery. Assets in our model play a dual role: they are investment opportunities, but they can also be used as collateral to gain access to cash. The collateral capacity of an asset is the level of promises that can be made using the asset as collateral. This is an endogenous variable that depends on expectations about the distribution of future asset prices. Together with the interest rate, the collateral capacity determines an asset’s borrowing capacity, which is the amount of money that can be borrowed using the asset as collateral. The loan to value (LTV) of an asset is the ratio of the asset’s borrowing capacity to its price. The haircut or margin of an asset is the shortfall of its LTV from 100 percent—in other words, the fraction of the price that must be paid in cash. The maximal leverage of an asset is the inverse if its margin. The leverage in the system, like the other ratios just mentioned, is determined by supply and demand; it is not fixed exogenously…

The underlying dynamic of the anxious economy—fluctuating uncertainty and disagreement— simultaneously creates the leverage cycle and the liquidity wedge cycle; that is why they run in parallel. Since leverage affects the liquidity wedge, the leverage cycle amplifies the liquidity wedge cycle. So what does collateral, and the possibility of leverage, add to the liquidity wedge cycle already discussed? It generates a bigger price crash, not due to asset undervaluation during anxious times, but due to asset overvaluation during normal times. This may lead the press to talk about asset price bubbles.

While the dynamic described by Fostel and Geanakoplos was intended to describe smaller emerging market economies, their description appears to sound an awful lot like the American and European economies in the current environment of rising concerns about sovereign debt.


Higher volatility ahead
One of the conclusions of the paper is that during and in the aftermath the downleg of the crisis, volatility is high because of a heightened liquidity wedge:

We define the liquidity wedge as the spread between the interest rate optimists would be willing to pay and the rate pessimists would be willing to take. As we shall see, the liquidity wedge is a useful way of understanding asset prices. When the liquidity wedge increases, the optimists discount the future by a bigger number, and all asset prices for which they are the marginal buyers fall. The liquidity wedge increases because the disagreement between optimists and pessimists about high yield grows, increasing the desire of optimists to get their hands on more money to take advantage of the high yield buying opportunity. The portfolio and consumption effects create a liquidity wedge cycle: as the real economy moves back and forth between the normal and the anxious stage, the liquidity wedge ebbs and flows.

The observation about higher volatility is consistent with my comments about rising volatility and the implications for investment policy. The chart below from Macquarie Research illustrates the environment of rising macroeconomic volatility.

Wayne Whaley of Witter & Lester has observed the same effect.

Jonathan Tepper of Variant Perception has commented on the same thing.

Examine investment policy assumptions
In the current environment of heightened macroeconomic volatility, which imply higher investment risk and uncertainty, investors need to re-think their approaches to investing and asset allocation. Buy-and-hold allocations may be suboptimal under such circumstances.

Inflation vs. deflation, revisited

I have written extensively before about the inflation vs. deflation dilemma. There are huge stakes and risks involved for investors. Get the call right and you’ll be a hero; get it wrong and you’ll be the goat.


Why are gold and US Treasuries rallying?
Now more and more people have weighed in on the debate. The Economist/Buttonwood blog recently asked the question "why are both gold and US Treasuries performing so well?" One would suppose that their returns should be polar opposites of each other. The answer is that the inflation and deflation views are increasingly becoming bifurcated among investors [emphasis mine]:

Martin Barnes of Bank Credit Analyst, a research firm, points out that the direction of official policy (low rates, quantitative easing, big deficits) looks inflationary but the economic fundamentals (a big output gap, sluggish credit growth) look deflationary. Faced with this dichotomy, investors who buy both Treasury bonds and gold are not displaying cognitive dissonance. They are just hedging their bets.

Inflation risks from the US printing presses
James Hamilton at Econbrowser believes that the current environment is deflationary, but he is worried about the seemingly inevitability of inflationary policies down the road:

The source of my concern about long-run inflation comes not from the expansion of the Fed's balance sheet, but instead from worries about the ability of the U.S. government to fund its fiscal expenditures and debt-servicing obligations as we get another 5 or 10 years down the current path. Just as many analysts have had trouble seeing how Greece can reasonably be expected over the near term to move to primary surpluses sufficient to meet its growing debt servicing costs, I have similar problems squaring the numbers for the U.S. looking a little farther ahead.

The way that I would envision these pressures translating into inflation would be a flight from the dollar by international lenders, leading to depreciation of the exchange rate, increase in the dollar price of traded goods, and possible sharp challenges for rolling over U.S. Treasury debt. We've of course been seeing the exact opposite of this over the last few months, as worries in Europe and elsewhere have resulted in a flight to the dollar and the perceived safety of U.S. Treasuries. That appreciation of the dollar has been one factor keeping U.S. inflation down. So any inflation scare is clearly not an incipient development, but instead something we'd possibly face farther down the road.

Developments are policy dependent
David Merkel at Aleph Blog wrote about the Social Security time bomb [emphasis added]:

There are no good solutions now. Budgetary cuts and tax increases reduce the possibility of government default. They also will tend to slow the economy, unless the tax increases stem from cutting cheating, and the budget cuts affect only things that are a fraudulent waste.

Once you reach the point of no return, it doesn’t matter what prescriptions one follows — failure is coming. One can shape the type of failure, but not that there will be failure.

All that said, there are still options, though none of them are good. Will the currency be inflated? Will the government default? Will taxes be raised dramatically? I don’t know. Be alert; be ready. The endgame is here; we will see what moves the government makes.

I agree with Merkel. The government seems unwilling to make the hard choices so the collapse is coming. The kind of collapse is entirely dependent on policy…and we have no idea which path the authorities will choose (or humorously, what the consequences are, hat tip to Crossing Wall Street).


Buy-and-hold asset allocation = riding a salt-n-pepper ride at the carny
For investors, Cassandra does Tokyo draws the parallel of the current inflation/deflation situation to being on a "salt-n-peper" ride at the carnival, a musical metronome, the Newtonian pendulum, or the sand-weighted Punching Dummy:

Humanity, in general, their households, and their sovereign and corporate institutions alike will undoubtedly take hits - many hits, and from all sides - but life will go on, and as in post-war Europe, Lebanon, Argentina, Turkey, Serbia, and other seemingly unimaginable examples to our unpracticed imaginations, it will rebound and rise again, in fits, starts, almost randomly lurching to' and fro', before balancing upright again - if only to have the collective shit kicked out of it yet another time...

Under such a volatile environment, preserving financial staying power will be of utmost importance. Fixed buy-and-hold asset allocation solutions will doom an investor to mediocre returns in such conditions. Investors need to go back to basics and rethink their asset allocation assumptions. It's time to stay flexible with the use of dynamic asset allocation techniques such as the Inflation-Deflation Timer model to survive the coming crisis.

Asset allocation: Back to basics

In the June 2nd edition of Breakfast with Dave (free registration required) by Dave Rosenberg of Gluskin Sheff, Rosenberg writes:

The name of the game is to focus attention on strategies that:

• Delivers income (including dividend growth, hybrid funds and corporate bonds since company balance sheets are in fine shape);
• Minimize volatility and emphasize on capital preservation in a secular bear market (true long-short “hedge fund” portfolios), and;
• Commodities (precious metals as a “buffer” in a financially unstable world; and industrial commodities to take advantage of (i) the secular growth dynamics in Asia, and (ii) repeated rounds of currency depreciation inevitably lead to trade protectionism and “security of supply” constraints, which tend to benefit basic materials.

I have the greatest of respect for Dave Rosenberg. In the current environment of economic uncertainty and volatility, this is the most reasonable asset allocation that I can think of. However, there are a lot of macro risks out there, namely an implosion in Europe, a hard landing in China, risks to the US banking system from another round of residential mortgage resets, from commerical real estate, an imploding muni market and others. Depending on if and how things implode, a portfolio that focuses on income bearing securities may be a source of instability.

I believe that Rosenberg intuitive understands the weakness of a buy-and-hold allocation as he went on to quality his statements in the following way:

This by no means suggests that now is the time to load up on resources seeing as they are cyclical in nature and prone to sharp short-term swings — but commodities are in a secular bull market so these periodic spasms offer nice long-term buying opportunities. Defense stocks — hardly politically correct but I don’t claim to be a saint — should also be considered seeing as global military conflicts tend to follow suit, if history repeats itself, in the context of these global financial crises (Turkey is all of a sudden a big power broker, and not necessarily in a very stable fashion). Investors should focus their attention on the currencies and government bonds of countries whose public balance sheets are truly AAA rated — low debt ratios, low primary or structural deficits and with stable banking systems: these would include Canada, Australia, New Zealand, Norway, Sweden and Switzerland.

Towards a new asset allocation framework
James Montier of GMO recently wrote a research article that expresses my view in a much more articulate fashion on asset allocation.

Typically, analysts derive an efficient frontier based on the past performance, volatility and correlations of returns of different asset classes. From this efficient frontier, it is said that and investor can trade off between risk and return to build an “efficient portfolio”.

While many believe that diversification is the only free lunch to be had, many of the effects of diversification disappear when you need it the most – during panic episodes such as we saw in the Lehman crisis, the Russia crisis, etc. The basic assumption in a buy-and-hold asset allocation is that correlations and volatility estimates are stable. What happens when return correlations converge to 1 as they do during panic episodes?

Putting it in geek-speak, Tony Cooper wrote the following in his National Association of Active Investment Managers' 2010 Wagner award winning paper entitled Alpha Generation and Risk Smoothing using Volatility of Volatility [emphasis mine]:

In traditional asset allocation vovo [volatility of volatility] has a cost. As an example, consider a balanced-fund manager who uses, say, bonds to reduce the volatility of a fund which contains equities. Or a financial planner who assesses the risk tolerance of a client investor and proposes, say, a 60-40 equities-bonds mix. The traditional way of managing these investments is to look at the long term historical volatility of the component asset classes to decide the proportions to invest in. Usually no consideration is given to the vovo of the asset classes and no constant volatility target is set. So the investor or manager with a static or reasonably constant 60-40 mix has to suffer the varying volatility of the markets. sometimes sleeping well at night, occasionally not. In order to ensure that the worst volatility is minimised the asset allocation will have erred on the side of conservative. This will have cost returns.

The chart below shows the level of volatility in the OECD leading indicator, which point to an environment of rising macro volatility. How stable are asset return correlations and asset price volatility estimates under these conditions?

Volatility of OECD Leading Indicator

Montier made more points about the problem with static buy-and-hold framework to asset allocation, including:

• Confusing risk with volatility
• Not considering valuation risk, or the instability of the equity risk premium
• How benchmarking alters manager behavior

He also points out a whole host of other important issues. Go read it all.

Back to basics
Fixed asset allocation makes good sense in secular bull markets. In a secular bear market or in a range bound market, fixed allocations will be of little use and will result in subpar returns.

I would suggest a back to basics approach to portfolio construction. The first step is to look at the problem from an analytical point of view instead of relying on estimates of volatility and correlation based on historical data. Why is X correlated or uncorrelated to Y and why? Look for causality (e.g. when interest rates rise, bond prices fall) instead of historical correlations.

Think about how different assets behave under different macro risk scenarios. Where does an investment asset lie on the risk vs. safety scale?  As an example, consider the tradeoffs between equities vs. default-free government paper. For example, are emerging market equities more or less risky than developed market equities given the higher secular growth exhibited by emerging market economies? My answer: in the long run, EM is probably less risky than traditionally perceived but in a meltdown scenario, they are more volatile.

If you are reaching for yield, where do REITs sit on the risk vs. safety scale? How would they behave in a market panic?

As a second step, you can then assemble a portfolio based on sensible estimates of diversification effects.

For bonus points, you can move from a fixed allocation buy-and-hold framework to a dynamic allocation framework based on forecasts of risk, using a combination of factors such as valuation, momentum, sentiment, etc.

The perils of short sales

When I discuss the Inflation-Deflation Timer model with other investors, I have sometimes been asked why I don’t use the model output to initiate short positions, instead of switching to another asset class. (To review, the model is an asset allocation model that uses trend following principles to switch between asset classes, namely commodities, the inflation hedge, US Treasury long bond, the deflation hedge, and equities, the neutral position.)

Cutting to the chase: Investors, i.e. market participants with relatively long time horizons, shouldn't go short for risk control reasons. Simply put, asset classes tend to be more volatile when they are in bear markets and rallies tend to be vicious, such as the current one in response to the European rescue package. Thus, the investor pays for higher returns (even if he is right) in the form of higher volatility. Short sales are more suitable for traders seeking to make a directional bet for short-term profit, or for hedgers, e.g. paired trading.


Short positions are more volatile
Since the Inflation-Deflation Timer model is based on trend following principles (see previous posts on trend following models here, here and here), I illustrate my point about why I don’t go short by applying a trend following model based on 50 and 200 day moving averages to the S&P 500. The rules for the backtest are:

Bullish signal: Index > 50 day MA > 200 day MA (long index)
Bearish signal: Index < 50 day MA < 200 day MA (short index, if allowed) Neutral signal: Otherwise (cash)

For the purposes of this exercise, let's assume that execution is done the day after a signal is given at the closing price and there are no commissions or trading costs. If the model goes to cash, a 0% return is assumed. Returns on the S&P 500 are total returns, as proxied by SPY. The chart below shows the results of the backtest, which began on December 31, 1999 and goes to the present. For the entire period, a buy and hold strategy would have returned -0.2%. If you had used the timing model only to go long, the return would have been 0.5%. A long and short strategy performed best at 2.7%.

When I look at these results, several conclusions can be made. First, these classes of models are good at avoiding much of the brutal downdrafts of bear markets. The long only strategy beat the buy-and-hold strategy by 0.7%, but downside volatility was significantly lower than the benchmark. While the long/short strategy was the best, that performance was achieved at the price of much greater volatility. The incremental volatility was experienced during periods when the model went short, i.e. during bear markets.


Bear markets are more volatile
This study leads to the conclusion that bear markets are more volatile, which should be intuitively obvious to traders. After all, the VIX Index, which is a measure of implied volatility, tends to rise when the stock market is falling.

I did a quick check if the rising volatility effect was true in other asset classes. The chart below shows the standard deviation of different asset classes for different assets over differing time periods: DJIA (from 1928 to the present), AGG as a proxy for the US bond market (from 2003) and the CRB Index (from 1999). [Yes I know the time periods are different and I am not exactly comparing apples to apples, but I want to study the behavior of different asset classes during bull and bear phases.] I defined a bull market as when the index was above its 200 day moving average and a bear market as when it was below.

The chart shows a consistent pattern: bear markets tend to be more volatile than bull markets. Technicians have an adage that confirms this observation: "Bottoms are events. Tops are processes." In other words, the price action at bottoms tend to be emotional, spiky affairs - which is what account for the volatility.

Short sellers profit from falling markets, but bear markets are more volatile. Even if the shorts are right, their higher returns come at the price of greater volatility.


Buy the negatively correlated asset instead
In an asset allocation model such as the Inflation-Deflation Timer, a better way to get higher risk-adjusted returns is to move into a more favorable asset class when the trend following model flashes a “go short” signal. For instance, an investor can get better risk-adjusted buying the negatively correlated asset, such as the US Treasury long bond, instead of shorting commodities when we see a “deflation” signal.

That's the path to a higher return that lets you sleep better at night.

Seven fat cows

Remember the biblical story of Joseph and the seven fat cows?



For commodity bulls, this may be the era of the seven fat cows. In a recent article, Cynicus Economicus points out that the world has seen an imbalance between the supply of resources and labour:

[T]he availability of oil per worker has seen a significant decline. In such a situation, there must be a consequence. If a worker in country A increases their utilisation of oil, then a worker in country B will have less oil available…

In such circumstances, the resources will flow to the labour that utilises the resource in the most cost effective way, and where there is the commensurately high return on capital.

Notwithstanding all of the fiscal and monetary stimulus, he believes that resource prices are on an upward trajectory. This may mean, that at an extreme, we may see a seven in front of gold or oil prices (and I don’t mean $700 gold or $70 oil).


Followed by seven skinny ones…
Don’t think that scenario has a happy ending, however, as the seven fat cows are followed by seven skinny ones (see my previous comment here). Commodity inflation would inevitably followed by a deflationary collapse caused by massive demand destruction.

James Hamilton, who blogs at Econobrower, wrote extensively on the connection between oil prices and economic growth [emphasis mine]:

When I first began working on my Ph.D. dissertation in 1980, I was intrigued by the fact that the oil embargo of 1973-74 and the collapse in Iranian oil production after the revolution in 1978 were both followed by global recessions. But when I called attention to the fact there had been a sharp increase in the price of oil prior to 6 of the 7 postwar U.S. recessions up to that point, the general response was one of skepticism.

By the time I was presenting evidence of this relation at various seminars in 1981-82, the Iran-Iraq War had produced yet another shock to world oil markets and the NBER declared that the U.S. experienced a new recession immediately on the heels of the previous downturn, meaning that the evidence had now become that 7 out of 8 recessions had followed oil price increases…

We received some more evidence on this relationship when Saddam Hussein invaded Kuwait in August 1990, causing oil prices once again to double and coinciding with the 9th postwar recession. The price of oil also shot up before the 2001 recession. Add in the conjunction of the oil shock of 2007-08 with our current economic pickle, and my count is now up to 10 out of 11.

Inflation and recession?
Gregor MacDonald at gregor.us believes that we are likely to experience higher volatility in commodity prices as the world economy oscillates between the forces of commodity shortages and deflationary growth:

We have very likely been in an inflationary recession for nearly two years now, with massive deflation in housing and yet stubbornly higher food, energy and health care costs–the latter well above the price levels of just a few years ago. The risk, in my view, is that both trends now accelerate. And, that we experience next something more akin to an inflationary depression.

For now, we are seeing the start of a commodity friendly environment that may culminate in a hyper-inflationary blowoff, especially if the world loses confidence in the USD.

By all means get on for the ride on the hard-asset train, but don’t forget to get off when you get to your station.

As a reminder, I have a weekly commodity email newsletter for those who are interested. It’s free and I promise that I’ll keep your email address to myself. Drop me a line at cam at hbhinvestments dot com if you are interested.

Another Children’s Crusade?

In P&I there is an extensive discussion of the pros and cons of a core/satellite asset structure vs. a portable alpha structure for pension fund assets. My questions are:

• Portable alpha overlaid on what benchmark?
• How do you define core?

PBGC in trouble
In the meantime, I see in the news that the former head of the Pension Benefit Guaranty Corporation has refused to testify before the Senate and asserted his Fifth Amendment rights. He was to be questioned about his relationships with Wall Street firms and their relationships with PBGC.

By the way, PBGC's deficit has tripled to $33.5 billion.

What a mess.


A Children's Crusade?
As I indicated before, until pension funds have clearly benchmarked their liability structure and the factor sensitivities of that benchmark, the task of managing assets is may be as fruitful as the Children’s Crusade.

If you are not sure of where you are going, how will you know if you get there?

A new paradigm needed for pension management

In light of extremely weak returns for capital, there has been a spate of articles about how pension fund liabilities may be the next shoe to drop. Looking at the some of the sample headlines, the outlook appears dire:

• Recession Drains Social Security and Medicare
• Global pension tension
• Pension death spiral
• Fat pensions spell doom for many cities

Flying in a snowstorm without a map
Despite the trillions of pension fund assets around the world, what has puzzled me over the years is the utter lack of sophistication in the models used to model DB (defined benefit) pension liabilities. Until plans begin to better understand how their liabilities behave, we are likely to lurch from one crisis to the next.

Unless we understand how liabilities are likely to behave, investing the assets is like flying around in a snowstorm without a map.


A sample defined benefits plan
Typically, the pension plan has a board of trustees. The Board periodically undertakes an actuarial study of the liabilities of the plan. They may, at about the same time, conduct a study of the structure of the assets. At the end of the day, the Board compares the value of the assets to the value of the liabilities and pronounces the plan to be in surplus or deficit (and the value of the surplus or deficit).

A typical DB plan pays benefits based on some formula of final year(s) service, e.g. you get x% of the average of your last five year’s compensation. The amount may be subject to some inflation indexation, e.g. benefits will increase annually up to 60% of inflation, etc.

Total pension liability is the sum of the net present value (NPV) of currently retirees’ benefits, which is based on some mortality assumption of the retiree population, interest rates and inflation rate, and the NPV of the current workforce. The value of currently retirees is relatively simple to model, but I believe that current actuarial models do not accurately model the value or volatility of current workforce’s pension benefits.

To model the NPV of the current workforce’s pension benefits, the actuary looks at the age demographic of the working population and benefit formula. He then makes some assumptions about the workers’ annual salary increases and attrition rates (how many people die, get fired, leave their jobs, etc.) He then takes some interest rate and discounts those pension benefits back to a net present value to arrive at an answer.

Before I get flames and hate emails, I recognize that this is a gross simplification. Nevertheless there are a number of problems with this approach.

The model has few inputs: In classical economics, the three standard factors of production are capital, labor and rent. Workers’ wages are mostly a function of the relative demand for and productivity of labor and capital. Where is the productivity factor in this model?

The model is highly interest rate sensitive: Once you’ve assumed that wage increases are based on some standard formula, the only serious input into the equation is the discount rate and the inflation rate. Interest rates and inflation rates are highly correlated as inflationary expectations is a driver of long rates.


Are pension liabilities just interest rate sensitive?
Because of the assumptions built into these liability models, many pension plans that adopt an asset liability management (ALM) framework wind up with a very high fixed income allocation.

Are pension liabilities just interest rate sensitive?

If so, there would be little need for equities or other asset classes in a pension plan. I believe that pension liabilities are modeled incorrectly. This creates problems not only with the valuation of pensions, but with understanding their volatility and sensitivity to changes in economic conditions. Moreover, it lessens the effects that pension plan sponsors have played using differing return and discount rate assumptions to manage the stated value of pension fund shortfalls.


How not to fix the pension time bomb
If I am right, here are some ways of not fixing the pension plan time bomb:

Asset liability management: The principles of ALM have great merit – which is to model and manage the asset-liability surplus or shortfall. But how can you create an ALM framework when your liability model is broken?

Change from a defined benefits plan to a defined contributions plan: While changing from a DB to a DC plan gets future pension liabilities off the balance sheet of the organization, it doesn’t solve the macro problem if we don’t understand how pension liabilities behave. How do you advise individuals on how to manage their retirement assets if you don’t have the proper framework for modeling their pension liabilities? Is a 60/40 asset mix appropriate? Are life cycle funds even the right paradigm? If not, then will these potential pension shortfalls come back to bite us as a society when retirees wind up on social assistance?

These are all thought provoking issues. I would be interested to hear from any pension fund and actuarial professional who believe that I’ve gone off the deep on this. Please email me your comments at cam at hbhinvestments dot com.



Addendum: While we are on the topic of pensions, David Merkel at Aleph Blog has some interesting, though politically unpalatable, solutions for Social Security and Medicare. These are issues that need to be raised.

DB pension woes are plans' own fault

Recently there has been much comment about problems at defined benefit pension plans - how underfunded they are, how they are the "next shoe to drop" in the financial crisis. Here is an example from Leo Kolivakis posted at Naked Capitalism.

Here is an equally fascinating earlier analysis from Leo Kolivakis:

Plan sponsors had two choices. They could retain the 60%-40% asset mix but fund at the minimum and run the risk of deficits in market down turns. Most of them never believed that their companies would ever go bankrupt and so they did not think they were putting their members’ financial lives at risk.

Or they could invest solely in fixed income assets. This removed the asset-liability mismatch and resulting windup risk but it also meant lower long-term investment returns. Lower returns meant either increased contributions in the order of 30% or 30% lower benefits or some combination thereof.

Pension plans were deliberately running asset allocation mixes of 60-40 (stocks/bonds) because it was the cheap thing to do and not for risk control (asset-liability matching) purposes.

In other words, much of the problems today at DB plans were the result of past decisions. The chickens have come home to roost.

The Third Way in the inflation/deflation debate

The inflation vs. deflation call may well be the call of the decade for investment policy. On one side are the inflationists, who argue that all this fiscal and monetary stimulus is bound to create inflationary pressures once the world economy begins to recover. On the other side are the deflationists, who argue that the de-leveraging process has unleashed powerful deflationary forces.

There may be a Third Way out of this debate – and that Third Way is even more scary than either of the scenarios contemplated by the two factions.


Do you believe Warren Buffett?
The conventional economic view is exemplified by the likes Warren Buffett. In his latest letter to Berkshire shareholders, he wrote [emphasis mine]:

This debilitating spiral has spurred our government to take massive action. In poker terms, the Treasury and the Fed have gone “all in.” Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.

The Federal Reserve is well aware of these concerns. In a speech on April 14, 2009, Ben Bernanke stated that:

I can assure you that monetary policy makers are fully committed to acting as needed to withdraw on a timely basis the extraordinary support now being provided to the economy, and we are confident in our ability to do so.

Avner Mandelman of Giraffe Capital suggested that the Obama Administration is positioning Paul Volcker in the wings for a liquidity mop-up once the financial crisis is over. It is unclear, however, how much political will there is to take the pain once it is clear that an economic recovery has begun.


Deflationists: Proof by counterexpample
When I went to school back in the Dark Ages, math classes had a technique of “proof by counterexample”. Conventional wisdom holds that all this stimulus is going to result in inflation some time down the road.

Japan is the proof by counterexample. During the Lost Decade, the Japanese government spent like crazy and the BoJ adopted a policy of quantitative easing. Debt to GDP ballooned. The government built roads to nowhere. Yet the economy didn’t recover.

One of the leaders of this deflationist movement is Richard Koo, whose webcast is long but well worth watching. He argues that as long as government spending displaces consumer spending (because consumers are saving and not spending), there will be no inflation. The appropriate policy in this case, according to Koo, is for government to spend until it hurts and spend some more.


The Third Way: Down the hyperinflation road?
Simon Johnson, formerly of the IMF, wrote a disturbing article about the current financial crisis that compares past emerging market crises to the current one [emphasis mine]:

[T]o IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out...

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders…

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Johnson’s contention is unless the government of the day is willing to take on the entrenched elites and force them to take the pain, the path of least resistance is rising inflation and possibly hyperinflation.

Certainly America’s elites have enjoyed some very good times. William Hester of Hussman Funds has documented the elevated levels of profit margins in this past economic cycle, which indicates the bulk of the gains were tilted towards the suppliers of capital, as opposed to the suppliers of labor.


How real is the American Dream?
The classic measure of income inequality is the Gini coefficient. High Gini coefficients for the U.S. is well documented. In of itself, this is not necessarily a bad thing as high gaps between rich and poor could serve as a strong incentive for wealth creation. However, an OECD study also showed low social mobility in the U.S., as defined by the correlation of the Gini coefficient of parent and offspring, compared to more “egalitarian” countries like Denmark and Norway. High Gini coefficients combined with low social mobility indicates that elites are entrenched and the American Dream is only a dream.

Wall Street is the new elite
Today, the best way to get into Treasury or the Fed seems to be to work for Goldman Sachs. Nobel laureate Joe Stiglitz complained about the entrenchment of the Wall Street/Washington axis:

“America has had a revolving door. People go from Wall Street to Treasury and back to Wall Street,” he said. “Even if there is no quid pro quo, that is not the issue. The issue is the mindset.”

Wall Street has become the new elite.


The Argentina/Mexico/Russia solution?
Stephen Roach warned of reviving the Debt Frankenstein to revive America, which only would only serve to stretch the current economic imbalances. This appears to be the consensus of policy makers around the world and lead us down the Third Way hyperinflation path. Such a path would likely result in an era of rising inflationary expectations, to be followed by a deflationary collapse.


Signposts to watch for
Right now, there is widespread discontent with Wall Street. The question of whether that level of dissatisfaction leads to real reform is the key to resolving this issue. These are mostly social attitude indicators and difficult to quantify. Here are some signposts that I would watch for in the months to come:

Do the tax protests gain any traction? Recently there were calls for “teabag” tax revolt protests. I interpret these as a backlash from the Establishment elite to try to retain power. Redressing either the Horatio Alger style opportunity implicit in the American Dream through high social mobility or redressing the level of Gini coefficients in the U.S. are signs that the elites are losing power. Other signs to watch for: do conservative commentators like Larry Kudlow gain or lose followers?

Do any American politicians say the S-word? The willingness of Americans to change their attitudes will be another important milestone in the road to restructuring and reform. For many years Americans have been conditioned to get something for nothing. American were content to trade U.S. debt for cheap Chinese goods. Not once did George W. Bush mention the word “sacrifice” when he began the Global War on Terror. Today, the U.S. faces trillion dollar deficits and Barack Obama is not preparing the country for the tax hikes (remember the “sacrifice” word) to come. One commentator went even further and suggested that this will doom his second term.

What happens to inflationary expectations? Watch the pricing of TIPS and inflation swaps. The current picture is inflationary expectations dropped late last year and they are now on an upswing. Levels, however, are not as elevated as they were a year ago.


Base case: inflation
At this point, my base case is inflation and a repeat of the 1970s sideways market in equities. However, I am watching these indicators carefully and I am willing to be persuaded otherwise.

If you are interested, I have begun a longer email list for inflation bulls. There is no cost and I will keep your email address to myself. Drop me a line and sign up here.

Don't confuse correlation with causality

One of the first things that I learned as a quant is “don’t confuse correlation with causality”. Unless there is a direct relationship (e.g. interest rates go up, bond prices go down), statistical correlations don’t necessarily hold up.


Correlations move around
The folks at Bespoke have an interesting study showing the correlations of different asset classes and sectors over two time frames, one longer and one shorter. In the short term, S&P 500 sectors have become slightly more correlated with each other. The Yen has become more correlated with virtually all assets while Treasuries have become less correlated.

The lesson of this study is: asset correlations move around. In this case, U.S. Treasuries have become a much better diversifier to U.S. equities in the short run. Which correlations should an investor rely on when building a portfolio?


Understand the fundamental case
My inner quant tells me to ignore the short term figures as the time frame is too short to matter. My inner fundamental investor tells me to figure out why the correlations are moving around. In fact, there may be a perverse causal relationship at work with asset classes that show negative correlations. Here are some examples:

• EAFE (1980s) – International equities were sold as diversifiers as they exhibited low correlation to US equities. Money moved in and eventually correlations rose.
• Emerging markets (1990s) – Emerging markets were sold as diversifiers to US and international equities. Even during periods of stress, their correlations were historically low. Money moved in and correlations rose.
• Hedge funds (starting about 2000) – Hedge fund returns were uncorrelated to equities, especially during the post-Tech Bubble bear market. Money moved in…