Posted on 19th Jun 2020
As I sit out here in Asia watching my Bloomberg screens on a late Friday night / early Saturday morning I thought to share a few quick thoughts on the markets with you all. On my screen I see predictable headlines passing by about Ray Dalio warning that we may be looking at a "zero decade" for US stocks as profit margins reverse, JPMorgan discussing the highest ever levels in cross-asset correlation and another warning to add to the pile of endless screaming about how Robinhood traders are going to be the sole cause of the biggest bubble ever. Something something US-China trade talks and COVID-19. Nothing new under the sun today.
Taking more of a macro view though, what's funny to me thinking back to the last few months is how one can spend the better part of the previous decade wondering about and preparing for the "next big crisis", the mother of all crises that will surely make GFC seem like a blip, but when it comes and goes in a matter of weeks you find yourself staring at the V-shaped charts in denial even months later. Was that really it? Surely we will get a bounce back down at some point right? Global central banks and policy makers (EM and DM alike) brought out the bazookas and I am slowly coming to terms with the fact that that may have been the most volatility we will see for quite some time to come.
Throughout it all, our models kept a cool head. February 25th till March 12th was a busy time with six subsequent SHORT calls on first the S&P500, then EuroStoxx 50, then Bitcoin, Emerging Markets Equity, Gold and IG Credit. Five out of these calls were hugely profitable (with three of them generating +11%, +19% and +32%). The sole negative return? Gold with -0.07%. In the weeks that followed, most models flipped around again as they caught onto the changing nature of markets and the V-shape well before I ever did. Our model portfolio has delivered a return of 49% with a 1.6 Sharpe ratio, outperforming the S&P500 by 52% year-to-date.
So what do I think lies ahead and how can an investor position themselves for the future? Here's my take:
Diversification is dead. Throw away any correlation analysis you use in your portfolio construction or risk analysis. None of that will work anymore going forward. As people used to joke about banks' Value at Risk models post GFC: "it's like a seatbelt that always works, except when in a car crash". During recent sell-offs correlations spiked again, and this time even higher than in crises of the past as everything becomes liquidity driven. Think gold or bonds diversify? That's nice, but they were still down 10% during the worst of the sell-off in 2020. Every single asset did the same thing.
Fixed income is dead. Strongly related to this is the idea that traditional fixed income is dead. We're in a global debt bubble and yields are now only being backstopped by central banks (by some estimates US yields should be at 5-6% today without Fed involvement). Sure, you can try to get your 50 basis points in juicy treasury yields if you so desire, but if inflation starts moving at some point do you really want to get whacked around the head with -20% duration returns? There's probably a last bit of positive return left in the tube, but risk/reward seems hugely skewed to me at this point. Don't be an asset allocation dummy.
The solution? Investors need a modern twist to their portfolios. There are two things I have done in my own investments which so far have worked out rather nicely. Number one is investing in crypto. You wanted assets in your portfolio that are totally uncorrelated to anything else and have potential for massive returns (or losses), here you go. Number two is the incorporation of quantitative signals much like what we produce here at LSS. The way forward for investing is not to be passively and perpetually long stocks or risky assets. The way forward is probably also not outsourcing your money to "active" managers who just do some stock picking and strike up huge fees to deliver market-2%.
Instead I think the way forward is to dynamically bounce along with the ebb and flow of the market and every few weeks step in or out of specific assets as opportunities arise. Yes you can sit through the -30% drop of stock markets this year and hope we recover with 35% so you can make your pretty 5% return. But what about capturing say 20% of the ride down and say 20% of the ride on the way back up for a total return of 40% instead? And all of this without doing any day or even excessive amount of trading.
Don't fight the new financial market structure which is largely driven by algos, but join us in the quantitative revolution.
Have a nice weekend all!