Volatility and the Unknown

Volatility and the Unknown – Trey Taylor – June 4, 2017

 

It is not possible nor sensible to form predictions into the future. However, in times when current conditions present dubious forecasts, it is imperative to keep in mind our perspective. As Mark Twain pens in The Gilded Age: A Tale of To-Day, “History never repeats itself, but the Kaleidoscopic combinations of the pictured present often seem to be constructed out of the broken fragments of antique legends.” While Tulipmania or Black Monday will not identically reoccur, we can use such events to learn from the past and evaluate proper risk-return principles to develop our guide to current market conditions. Although the future is always unknown and unforeseeable, if we incorporate historical experiences with forward-looking expectations we may analyze such scenarios.

Between 1950 and 1960, economists used adaptive expectations theory which formulated business and consumer expectations based on past experiences and suggested change will occur slowly. However, since people hold more information than just past data, adaptive expectations theory was relatively misleading. In response to such outlook, John Muth established an alternative, rational expectations theory, which forecasts expectations using all available information. In retrospect, any expectation can be put in one of two buckets; what was predictable and what was unpredictable even looking back. Anticipated events such as the Dot.com Bubble or 2008 Financial Crisis, while unforeseen events include Black Monday or the Flash Crash. However, we must also consider the third type of occurrence. As Donald Rumsfeld ex-Secretary of Defense famously said, “there are known knowns; there are things we know we know. We also know there are known unknowns; we know there are some things we do not know. However, there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” While Rumsfeld might sound like a hyperbolizing politician, these events are relevant to risk. There are known risks which we can and cannot quantify, and there are also risks are unknown that we can be able to quantify and but also cannot quantify. After the 2008 Financial Crisis, a new paradigm for pricing risk has developed, and the next unknown unknown is further eminent. While adaptive expectations have allowed for variable change and shifting expectations, predictions may also artificially create optimal estimates using goal seeking prediction models based on faulty conclusions. In fact, the rise of big data leading to the use of algorithms and fin-tech instruments have extended rational expectation theory. Such models have changed our perception of risk by hiding structural problems with imperfect models that remain untested during recent recessions. Attempting to understand recession probability is nearly impossible as evidenced by Graph 2 that even the Dallas Fed can not properly model recessions probability.

A recent article by investment management firm PIMCO, “Pivot Points” put forth their probability model to evaluate such future market conditions. The article announces, “if history is any guide, we believe the probability of a recession sometime in the next five years is around 70%.” If this is the case, we must consider such scenario. I analyzed three five-year time frames of growth, followed by two-year downturns. As depicted in Table 2, the years 1995 through 2000, 2002 through 2007, and post-2009 S&P 500 shows periods of boom. Conversely, during the Dot.com Crash of 2001 and 2008 Financial Crisis brought years of decline. The five-year growth during bull terms averaged 192%, while bull periods saw a negative 51% decline. From this boom-bust model along with the numbers presented by PIMCO, I project a mean expected return of negative 23% within the next five years. While this exercise uses imperfect past historical data, the results show if these modern scenarios duplicate past price action then this deserves our attention.  Evaluating current expectations, we can theorize on miscellaneous macroeconomic shifters as well. In the next five years, United States fiscal policy should include tax cuts as well as increased spending. We can assume that the FED will begin to normalize balance sheet and increase interest rates. International concerns include Italian Banks, Greek debt, and continued Brexit fallout uncertainty. Concerns of Chinse economic collapse buoy in the horizon but Xi Jinping’s defect New Silk Road poses uncertain time horizons. Bilateral trade deals with China, Russia, and other nations project to widen trade policy as President Trump seeks to reduce the deficit. Again, the rise of the quants has also held an undeniable effect on markets. These models predict all known variables bridging the past, present, and future estimates and continue becoming more efficient. Skeptics argue that evidence using historical back testing will prove to be ineffective in the long run despite short-run profit due to underpinned structural risks. Indeed, these assumptions are not fact, but we can use such assumptions as macroeconomic expectations. Indeed, some tranches will fall flat, yet asset allocation contains the advantage of shielding risk from overweight market conditions and identifying markets that will outperform. Recent low volatility figures may provide a blueprint moving forward.

The Volatility Index evaluates this differential between the perception of the world and as it exists. As evidenced in Graph 1, Volatility sits at its lowest point in years and dubiously mirrors 2007. Whether this represents an eerie lull or not, what is certain is the unknown market expectations have peaked. Unusually low volatility has paved the way for questions about unknown and unquantifiable events. What is unforeseen is real growing threats to our economy gone unpriced within the market. The risk-reward paradox is critical when understanding that risk compensation for with reward one to one. Greater risk should see higher expected returns. However, this much has failed to come true in current markets. While a projection of a recession based on such problems is nearly impossible and timing, the market is a near fatal task. However, tactical asset allocation can take advantage of current conditions, good or bad. The role of such strategy is not to predict the future but to identify mispriced risk.

To evaluate unknown conditions, we must prepare for unknown unquantifiable risks when evaluating what we can forecast. While charting unknown territory, the influence of adaptive versus rational expectations, understanding historical models within present day, and understand volatility as a metric are important considerations. Overpriced assets usually contain market identified risk and thus should include such compensation. As further evidenced in the volatility index and explained the scenario analysis, unknown and uncalculatable systematic risk are not being rewarded.  Eminent geopolitical, economic, and unknown risks are peaking while the Volatility Index is flat. Rising concerns around debt and credit default are real drivers of uncertainty. Thus, mispriced markets are evident. To reiterate Mark Twain’s thoughts, history does not repeat itself, but it sure does rhyme. Although the next five years will contain an inevitable market shift, allocation and models should reflect pragmatic expectations. Uncertainty about the future will remain, but the answer is where risk fully reciprocates return.

 

Graph 1

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Table 1

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Graph 2

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Works Cited

Cole, Chris. “BULL MARKET IN FEAR.” (n.d.): n. pag. 23 Oct. 2012. Web.

“Federal Reserve Economic Data | FRED | St. Louis Fed.” FRED. Federal Reserve Bank of St. Louis, n.d. Web. 30 May 2017.

“The Gilded Age.” Google Books. N.p., n.d. Web. 02 June 2017.

Graham, David A. “Rumsfeld’s Knowns and Unknowns: The Intellectual History of a Quip.” The Atlantic. Atlantic Media Company, 27 Mar. 2014. Web. 02 June 2017.

Richard Clarida, Andrew Balls, Daniel J. Ivascyn. “Pivot Points.” Pacific Investment Management Company LLC. N.p., n.d. Web. 02 June 2017.

 

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What Keeps You Up at Night?

By Trey Taylor

May 30, 2017

A reoccurring question in the media of late has been what keeps you up at night. To that tune, my favorite response is General Mattis assuring, “Nothing. I keep people up at night.” On the financial front though, particular problems warrant attention. Back in November, I voted for, and continue to believe in the Republican agenda. The tax cuts, fair healthcare reform, and I believe in the quality guidance from the like of Gary Cohn and Steve Mnuchin. Year to date gains have surpassed estimates among overwhelming confidence, but it is only a fallacy to continue to hold an optimistic outlook for this upcoming year. Furthermore, it is foolish to presume that such growth will be sustained base on best-case scenario projections. Although economic action including budget cuts, tax incentives, and government spending are positive for markers, what keeps me up at night is our debt and credit bubble that will become insolvent.

Indeed, if the efficient market hypothesis proves incorrect than markets do not indicate real worth but perceived value and perceived demand rather than true value and demand. While reading “A Random Walk Down Wall Street”, I was reminded the Tulip Bulb Craze in Holland in 1634. Tulipmania is often a reference point to bubbles and insistences where prices were based on pure speculation and not an accurate reflection of the value. The .com bubble in the 1990s notes an example of investors bidding up stock prices without regard to earnings, PE ratios, profits, discounted cash flow or healthy balance sheets. Another thing that I noted was the Price Earnings ratio. Using the CAPE ratio (inflation-adjusted earnings), you can see that whatever “Trump Bump” is already priced in. In fact, today’s CAPE ratio is 182% of the median ratio of the past 137-years. As noted on Graph 1, several other notable events occurred at such speculation. Although an argument can be made against the increase in stock buybacks to raise stock prices and value (Chart 3) such activity is not as relevant. When valuations and sentiment remains in question over hard financial and economic data, the question posed is not if but when will the bubble pop. That is not a question you want to toil over before bed.

The significant use of leverage has continued to increase and only is adding to a huge debt disaster. Currently, margin debt is continuing to grow as upside potential in the market is trumping longer-term logic of risk management and portfolio control. The rise of borrowing to increase buying power and represents eagerness to participate in short-term bull markets. The once simple supply-and-demand theory has been replaced with build now, sell later economics that is developing enormous risk of default. Artemus Capital research argues that we have taken “asset returns from the future and brought them to the present, and they have taken tail risk in the present and shifted it out into the future.” Although many people argue that leverage and debt are votes of confidence, others argue that the market is more overbought than any point in history. Note Table 1 by Bank of America shows stocks are overvalued on 18 of 20 metrics. Such analysis shows overconfidence. Anything is certainly possible. It just is the most probable result that usually occurs. As worded by Kevin Duffy, “Mr. Market Flunks the Marshmellow Test”. Thus, sex, politics, and Ponzi schemes tempt with instant gratification but ever too often fail to look long term and to undermine tail risk.

Debt to GDP numbers has reached the point of no return. With macroeconomic not matching S&P valuations, default only seems further eminent. Concerns of both student loan debt (Chart 7) and impending pension crisis (Chart 8) reason exponential effects upon downturn. Such conditions are gasoline waiting for a match. Pure economics are failing to show through at a time that back to basics valuations are quintessential. Taking a bull approach with hard data including GDP, labor productivity job growth, and no geopolitical factors, the debt crises are unavoidable.

If we can agree that the US markets are fully priced into the future, we must position accordingly. Elect to take capital elsewhere as Chart 2 exhibits significant returns in multiple asset classes outside the S&P 500. While indeed, the risk is not to be eliminated but such gains shed light on the opportunity along with security to shield from uncertainty. Alternatively, significant investments made in patience like the one and only, Warren Buffet, that of idle position. Buffet is currently holding $50 Billion cash waiting to deploy capital. Buffett understands the market conditions and doesn’t want to pay bubble prices for these equities. Speculative value increased margin and tail risk, and impending debt crises prime bearish rational to lose sleep over. Although no one knows when it will happen, the time to prepare is now while at the peak. Once the market corrects, it will be too late to act.

https://www.scribd.com/document/350349888/What-Keeps-You-Up-at-Night

Graph 1 – CAPE Shiller PE

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Table 1 – BOA Overbought

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Table 2 – Cross Asset

Chart 3 – Buyback example

Chart 4 and 5 — Macro Trend Data

Chart 6 — Debt Rising

Chart 7 — Student Loan Crisis

Chart 8 – Pension Crisis

 

 

Works Cited

Beattie, Andrew. “Market Crashes: The Tulip and Bulb Craze.” Investopedia. N.p., 07 Mar. 2017. Web. 30 May 2017.

Duffy, Kevin, and Bearing Asset Management. “MR. MARKET FLUNKS THE MARSHMALLOW TEST.” (n.d.): n. pag. Web.

“Federal Reserve Economic Data | FRED | St. Louis Fed.” FRED. Federal Reserve Bank of St. Louis, n.d. Web. 30 May 2017.

“‘Mad Dog’ Mattis Sleeps Well, Keeps Others Awake.” Inusanews.com. N.p., n.d. Web. 30 May 2017.

“VOLATILITY AND THE ALLEGORY OF THE PRISONER’S DILEMMA.” Artemis. N.p., n.d. Web. 30 May 2017.

“The Hundred Billion Dollar Man – Jeff Nielson.” Sprott Money. N.p., 29 May 2017. Web. 30 May 2017.

 

First Post

My name is Trey Taylor, and I am a rising senior at Southern Methodist University.
I am working to develop my understanding of markets, valuation skills, and writing to foster creative thought and entrepreneurial business ideas.  I am currently a Fellow at Impact Finance Center researching Blended Value investments and social entrepreneurship. Through this experience analyzing various investment vehicles, I have become passionate about measuring different assets and along different hurdle rates. My goal is to be able to articulate my thoughts and analysis. In the past, I have struggled to professionally and effectively argue without direct backing. I hope this exercise will allow me to prepare for the industry and gain as much knowledge as I can in doing so.