"There are no facts, only interpretations." - Friedrich Nietzsche
For this week's writing, let's address head on some of the market myths out there which are often referenced, but never questioned. I am a deep believer in the idea that one must take an evidence based approach when it comes to long-term wealth generation and preservation of capital, which is precisely why we use a quantitative model and wrote two award winning papers documenting real phenomena that persist in the market.
Fiction: Lower Oil (NYSEARCA:USO) is Bullish. Everyone wants to save money. In my most recent travels, driving to do presentations in various states for advisory groups, CFA and MTA Chapters, I can see how much money is being saved by filling up my rental car before the trip is over. Cheaper oil means more money in the pockets of consumers and corporations, which is a net positive.
Reality: Lower oil is only bullish if it is not a precipitous fall, not a reflection of growth, and not damaging to credit markets. Believe it or not, several states, countries, and corporations need higher Oil prices in order to have enough capital for spending plans. In addition, collapsing Oil results in severe stress in leveraged corporate players in the Oil services industry, something which in turn results in widening credit spreads (happening currently in a significant way). Those widening credit spreads in that industry are beginning to filter through to credit spreads in other industries.
Fiction: There is no point to buying any investment, strategy, or manager when there isn't exceptional performance beforehand. I received an email from a prospect not too long ago regarding our alternative inflation rotation strategy, and our equity sector beta rotation strategy, saying that maybe if we had "exceptional performance," that he would buy into our vehicles.
Reality: By the time exceptional performance comes, you missed that performance. Investing is not about buying the certain past that already happened, but the uncertain future which can look very different. Because people can simply look at their accounts second by second, most fall prey to short termism and the illusion of knowledge. Even if you identified and invested in an exceptional strategy, you'd need to be able to stick with that approach during periods of long dry spells which exceptional strategies tend to have in the small sample, which in turn are forgotten about in the long cycle. As Research Affiliates notes:
"Together, our three mega winning mutual funds would have experienced 17 spells of continuous underperformance, with the median duration of each consecutive stretch being nine quarters. Would an investor be committed to retaining any manager, even a top-notch one, who is targeted for scrutiny quarter after quarter after quarter after quarter (repeat that another five times)?" (click here for full research)
Fiction: The Fed controls rates (NYSEARCA:TLT), and low rates are good. After all, stocks love low interest rates, and that is a tailwind for equities.
Reality: While this is the narrative of the moment, history proves this is simply not true, and this is a MAJOR source of distortion in the small sample we live in. Long duration Treasury yields are NOT low because of the Federal Reserve, but because of inflation expectations which continue to fall. Historically, a flattening yield curve is not interpreted as bullish. A steepening yield curve is. Low rates are a reflection of the demand for money and growth. While this relationship has become distorted in the last year and a half, market history says stocks do NOT love low rates. This flip in the perception of low rates relative to history has been a massive thorn in the side of asset managers relying not just on historical relationships, but logic to guide their asset allocation decisions. Some have said that we are overly bearish. Those that say that have ignored why we have been cautious which is unrelated to opinion, and have everything to do with the historical relationship of interest rates to stock market behavior.
Fiction: The best strategies in the world are the ones where there is a hot streak, every trade is working, and every signal is the right one. Frequency of wins is all that matters.
Reality: Frequency is meaningless. Magnitude is everything. Frequency would only matter if stock returns in the S&P 500 (NYSEARCA:SPY) followed a normal distribution. However, because of kurtosis, the number of wins does not matter except for asset gathering as investors fall for the representative heuristic. The best strategies in the world have a high degree of false positives causing investors to not believe in the approach during those periods of dry spells. What matters is not the frequency of false positives, but the magnitude of the real ones. If there were not false positives, everyone would believe in the strategy, give it assets, and in turn eliminate the anomaly that strategy is attempting to take advantage of.
Phew! Glad I got that off my shoulders. Regarding our two strategies designed to achieve different objectives, we remain close to another risk rotation. Credit spreads are a very real problem, and despite strong jobs numbers, Treasuries remain skeptical. Perhaps a severe decline gets pushed out to the first quarter, perhaps a surprise is coming before year-end. Regardless, widening credit spreads continue to warn of a change in risk perception that stocks can only ignore for so long.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.