Inflation as a Target

Currently the markets are deeply focused on inflation. More specifically…the lack of it as wages have risen, growth has picked up and the labor market has tightened. Core PCE has dropped to 1.55% recently. Is this a sign of underlying weakness in the economy that the Fed should respond to?

In our view, no. This San Francisco Fed Economic Letter from a couple of years ago should be the guidepost.

They split inflation into procyclical and acyclical components. Procyclical components generally have moved in tandem with the economic cycles, prices rising as the economy booms and falling when it weakens. The acyclical components dance to their own tune. They concluded that procyclical inflation had returned to its pre-recession level, while acyclical inflation had remained low, driven by idiosyncratic factors. The data are updated through March 2019 in the chart below. The white line is procyclical, orange line is acyclical.


Source: Bloomberg

Procyclical inflation is running at 2.5%, up a little over the past 6 months. Acyclical inflation is where the drops are. It has fallen from 1.8% to 0.9% over the past 6 months. As the San Fran Fed says, it is still being driven by drops in health care costs. There is no economic signal for the Fed to worry about here, and easing policy to remedy makes little sense. More broadly, commentators hoping for health care inflation to go back to the levels of a decade ago in order for the Fed to hit a policy goal are out to lunch. The Fed has the granularity of data to see more clearly what is going on, it seems a shame this doesn’t get more air time. Mary Daly, the San Francisco Fed Chair, presented the case in New York recently – it would be good to see the issue at the forefront.

The Wisdom of Crowds and the Anatomy of a Panic

Major asset markets are generally too large to be overly influenced or pushed around by any one participant, and so are characterized as reflecting the wisdom of the crowd. This is thought of as a positive, as individual participants value different things, have different utility functions and approach and weigh the same incoming information in different ways. The net result, through different individual buys, sells and portfolio shifts gives the ‘best’ value at any one point.

We read an interesting exchange from polymath Sam Harris on the wisdom of crowds the other day that got us thinking about how this works in reality over fairly short, but significant, periods in markets. While the wisdom of crowds notion is true over the medium term, over shorter periods, some participants do cause flows that overwhelm. The events of early 2018 are a good example. The exchange is below; Harris had spoken at an event the previous night in New York with psychologist and economist Daniel Kahneman.

Frank Villavicencio: Sam. I attended & enjoyed it but didn’t get to ask my question: your take on collective decision making. Given the many identified flaws in our individual cognitive abilities, should we consider humans as more optimized for collective, swarm-like decisioning?

Sam Harris: The crowd is only wise when individual errors are uncorrelated. When correlated—as is the case when specific biases are widely shared—there’s no safety in numbers.

Hits the nail on the head. When the errors are correlated, you don’t have a crowd, you have a mob.

Continue reading

Trend Follower Agonistes

A recent Bloomberg News article ( mourned the passing of a venerable quantitative trading strategy – Trend Following.  The central claim of the article is that the strategy is antiquated relative to the speed and variability of modern markets.  We have been doing this for 40 years – it’s not the first time we have heard this. There is no denying that trend following has struggled, but we think the article has the reason exactly backwards.

The investment world’s conception of trend following has changed over the years.  Practitioners of the craft were, in the 70’s and 80’s, viewed as highly skilled magicians, teasing returns out of the tangled chains of futures markets, worthy of fees supporting retirement owning Major League Baseball teams or living in mansions in Mayfair.  Starting in the late 1980s, investors began to think about trend following in risk premia terms, reproducible factor returns – more science less magic.  Like other risk premia, trend results are highly variable (see our view on risk premia here –, with recent trend returns on the downside of that variability curve.  We thought we would take a closer look at what is driving those lower returns, and why and when they may change.
Continue reading

Looking Beneath The Hood Of Factor Investing

Factor investing, particularly within the scope of risk premia strategies, has been a popular topic. Vanguard has convinced the investing community that beta can be achieved by buying passive indices and the cost of owning beta should be very low. Investors use risk premia strategies as a source of generating alpha.   But …. are people looking carefully enough when evaluating these strategies? Much gets hidden in broad risk and return statistics. We thought we would take a deeper dive into how factors behave over market cycles. Continue reading

Parallels on Trade and an End Game Question

As the trade impasse with China continues, it is worth trying to think about some paths for what comes next. The US administration has a raft of complaints around issues of the bilateral trade deficit, export penetration, tighter intellectual property protections for US innovation and state support for business.

First thing to note, for all the partisan rancor in the US, and the Trump hating in Europe, it feels like this is one issue that has rapidly become consensus – China finds few friends on these issues in DC, Europe, Wall St or the corridors of power in American business. By way of example, in late March 2018 the US, through the WTO, filed a Request for Consultations with China concerning tech IP rights. In early April, the EU and Japan amongst others formally requested to join the Consultations. By June, the EU had filed an expanded Request. Continue reading

Recessions Everywhere

It is likely the depth and severity of the 2008/09 crisis are contributing, through something akin to PTSD, to the deafening drumbeat of recession calls. The interviews out of the WEF in Davos are almost unanimous that a recession is coming in the next 18 months or so. David Solomon, the new Chairman and CEO of Goldman Sachs put the odds at 50% for 2020. It is by now certainly the consensus view, and judging by the interest rates curve, it is in market prices. We think this has gone a ways too far. Sure, there are paths that lead to that outcome, it is perfectly possible. But 50%? Or a base case from here? We think that’s a stretch.


Continue reading

Equity Bull Bias in Volatility Targeting

Frustrating. A sharp break in the market for stocks, diversifying assets (hedge funds, risk premia, risk parity, trend following, equity l/s) all down. What gives? In a word- Vol. In the hedge fund space, or more specifically the quant hedge fund space (which is responsible for bulk of trading flow today), trading in the short run is being dominated by reactions to changing vol. Whether you are risk parity, risk premia, trend following, equity l/s, momentum, value, carry, etc., the common theme is sizing positions based on vol. When vol is low, take bigger positions, when vol is high take smaller positions. So, what happens when equity markets break and vol spikes? Hedge funds “de-risk”, “de-lever”, “gross-down”, “vol-adjust”, “risk manage”- lots of names, all mean the same thing.

Think about it.  You invested in all those factors, methods, markets, using all manner of sophisticated quantitative methods, but they all get unwound at the same time. Irony is, it is the manager’s risk management that is creating systemic risk in your balanced portfolio. Continue reading

Can News Flow Create Value?

Searching Google for “Retail Apocalypse” returns 8.8 million results (in .45 seconds!). For the better part of a decade the sector has been beaten up in the press. The headlines are not unfounded. Former staples of American consumerism such as Toys-R-Us, Radio Shack, and Payless ShoeSource are no longer, while many others struggle to find stable ground. The negative hype surrounding the Retail Apocalypse has created a fog around the whole sector and retail stocks have not been a popular pick amongst active money managers in recent memory.

Behind the retail apocalypse headlines are companies who have adapted to new market conditions, have strong balance sheets, and forward-thinking management. Looking into the fog, we see a shunned sector, overly beaten down valuations, and good potential to seek out value. Our Mount Lucas Focused Large Cap Value currently holds 4 retail names amongst its 36 total holdings. Some may view this as a high concentration of an unpopular sector for a focused strategy which holds no more than 40 stocks. However, our quantitative stock picking algorithms have no such opinions, they are programmed to seek value.

Below are the 4 retail names currently being held in the strategy, each picked for the portfolio on Sept. 22, 2017. Presented are price charts with selection date indicated and resulting price move, as well as headlines from the time preceding selection. Even positive news is tinged with negatively worded headlines. We believe this illustrates the headline fear and peer pressures that all human stock pickers face, as well as the benefit of a non-biased quantitative approach to value investing.

Mount Lucas Focused Large Cap Value Strategy Information

Continue reading

Stress Testing CTA Portfolios – Impact of Volatility Adjusting Positions

In light of recent market performance, and the corresponding effect on changes in volatility on CTA returns we thought it important to give our views on the topic. Late last year, we were asked by a prospective client to see how one of our trend following models performed over several different stress environments. We highlight one particular stress that was given- a 20% stock market drop over 3 months, with 40% of move in month 1, 35% in month 2, and the last 25% of the move in month 3. A relatively straightforward exercise, but to really understand the nuances of different CTAs relative to our approach, you must look past just the change in level, but consider the potential price paths and volatility over that stress period. The difference boils down to whether one is viewing CTAs as a standalone investment, or as a piece of a larger portfolio, and the role of volatility targeting in position sizing.
Continue reading