The False Precision Black Hole

When I started at Commodities Corporation in 1979, we managed $100MM dollars. We had computers that sat on raised floors in climate controlled rooms. We were state of the art….and we still had 100 employees. Alas, fees were higher, but my point is that advancing data availability and data processing has been a boon to the investment industry.

But there has been an unmistakable downside to all this power and information, what my partner Roger has christened “false precision”. Everyone has lots of data and the power to manipulate it with ease. All questions can be answered with “hard numbers”. Risks can be fully calibrated (see previous post, A Note on Risk). Nowhere has this thinking reached more heroic levels of absurdity than at your Federal Reserve. From a Chairman Yellen speech, circa 2012:

Although simple rules provide a useful starting point in determining appropriate policy, they by no means deserve the “last word”–especially in current circumstances. An alternative approach, also illustrated in figure 10, is to compute an “optimal control” path for the federal funds rate using an economic model–FRB/US, in this case. Such a path is chosen to minimize the value of a specific “loss function” conditional on a baseline forecast of economic conditions. The loss function attempts to quantify the social costs resulting from deviations of inflation from the Committee’s longer-run goal and from deviations of unemployment from its longer-run normal rate. The solid green line with dots in figure 10 shows the “optimal control” path for the federal funds rate, again conditioned on the illustrative baseline outlook. This policy involves keeping the federal funds rate close to zero until late 2015, four quarters longer than the balanced-approach rule prescription and several years longer than the Taylor rule. Importantly, optimal control calls for a later lift-off date even though this benchmark–unlike the simple policy rules–implicitly takes full account of the additional stimulus to real activity and inflation being provided over time by the Federal Reserve’s other policy tool, the past and projected changes to the size and maturity of its securities holdings.

Lord have mercy! Can she really think this can work? Is there any Fed model that caught 2008, 1998, 1987, or any other market moving event? This is the event horizon of the false precision black hole. But don’t worry, just throw a bunch of junk mortgages in a bucket, stir, and voila – AAA. It’s all right here in this spreadsheet.

Commodities are not Stocks

Apples vs OrangesThe Bloomberg Commodity Index finished July down 12% YTD and 28% over the last 12 months. It is currently 60% off its highs in June 2008 (remember $150 oil?). Several large commodity funds closed in July. Does this asset class make sense? Our answer – absolutely YES – but commodities aren’t stocks so let’s stop benchmarking and investing in them the same way.

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“Simple Enough To Be Good”

picassoI just read a great book – The Simplicity Cycle by Dan Ward. It articulates wonderfully a philosophy that underpins everything we do here at Mount Lucas, something that we feel is incredibly important for investors to understand, and that investors in general are moving away from. The book isn’t finance based at all, a quick and easy read. The basic premise is summed up with the quote below:

“…humans gravitate towards complexity, in our technologies and religions, our laws and relationships, because simplicity is so often inadequate to our needs. We require a certain degree of complexity in our lives, just as we require a certain number of calories each day. Accordingly, we add layers, gizmos, features, functions, connections and rules to the things we create in an attempt to make them more exciting, more effective, or otherwise better. This preference, too, becomes a problem when it spirals out of control and produces industrial-strength concentrations of complexity that surpass our needs by multiple orders of magnitude….Simplicity is great and important, to be sure, but let me say it again: simplicity is not the point. What is the point? In a word, goodness…Simplicity matters because it affects goodness, but it turns out the relationship between simplicity and goodness does not follow a straight line. This means an increase in one does not always correspond with an increase in the other. Sometimes making things simpler is indeed an improvement. Sometimes not. Life is tricky that way”

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July Press Conference?

fedGenerally we aren’t ones to criticize the Fed – post crisis they have done an excellent job supporting a recovery through zero rates and unconventional measures, and have begun to step back without causing the panic and damage that was predicted. It’s an incredibly difficult job, with huge importance.

That said, our view is that the Fed has pretty much hit the mandate, the data supports that, and an end to zero rates is warranted soon. The drop in Q1 GDP looks increasingly like a quirk. In reading the dueling Fed blogs as to the cause of this drop (New York FED says winter and San Francisco FED says residual seasonality), we can’t help but think that either way, Q1 is not a true reflection of the economy now or going forward. Do you think productivity fell 3% in the first quarter? Although the Fed has consistently been too optimistic with GDP projections, it has also been too pessimistic on jobs. Only one of these is in their mandate. Put simply, the economy doesn’t feel like it needs the same rates as the depths of the crisis, particularly at a time when expansionary policies are starting to take hold elsewhere.

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Retail Prices and China

Regarding the price of retail products. Where are most of them made? China.
Import prices from China FELL 0.3% month over month and are down 1.3% YOY.
See below:
image001

This speaks to the failure of the Philips curve framework to explain U.S. inflation swings. Inflation rose, 2010, with unemployment at 9%, as the China infrastructure boost lifted Chinese activity. Inflation is now quiescent with 5.5% unemployment, as China is in a bust.

A Note on Risk

mousetrapI heard a quote from Howard Marks at Oaktree, who was explaining that managing risk should not be left to designated risk managers: “The bottom line for me is that risk management should be the responsibility of every participant in the investment process, applying experience, judgment and knowledge of the underlying investments.” We love our risk guy – he is a critical part of our team, but I like to think that this diverse approach applies to our firm as well. Everyone in the firm, and clients who want to, have access to our risk analytics. We are all thinking about the elements of the portfolio, how they interact and the relationships we may have overlooked. We also look for trends about how others think about risk. What follows are a few observations:

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Convergence of Consensus

potd-horses_3003379kSince we have been in the business, and well before, sentiment measures have been used to gauge the popularity of trades –everyone of age remembers the MarketVane sheets. It is our sense that there is a more rapid convergence to consensus than ever before – that is, investors, in response to changing data, coalesce around a forward view very quickly. We hope to add some statistical meat to this idea over the next few months, but for the time being let’s begin with an anecdotal example. Continue reading

Know Your Roll – Commodity ETF Edition

The biggest macro-economic event in the past year has been the collapse in crude oil prices.  Since mid-July, WTI crude oil spot prices are down over 50%.

KYR1

Source: Bloomberg

Crude is the most liquid (no pun intended) and most analyzed commodity on the planet.  Its covered exhaustively by a wide array of shareholders and stakeholders; public and private oil producers and consumers, physical traders, banks, and geopolitical think tanks just to name a few.  This is why the most interesting aspect about this huge move in crude is that no one foresaw the magnitude or velocity of this decline.  Bloomberg had an article back in December on the hedging strategy of some U.S. shale drillers which showed that those companies certainly did not anticipate a decline in crude prices like what we’ve seen.

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The U.S. as a Small Open Economy?

Back in the day, macroeconomists used one of two models to think about how central banks steer economies. For a big economy, with modest international trade and capital flows, the model ignored the rest of the world. The central bank, by changing liquidity conditions, raised and lowered interest rates. Changing interest rate levels drove interest sensitive sectors up and down, thereby tightening or loosening slack in the economy. Inflation rose or fell, depending upon the tightness or slack in domestic markets. For a small economy, with large international trade and capital flows, the model highlighted rest of the world dynamics. In this model, global capital markets set the interest rate. The central bank, by changing liquidity conditions, raised or lowered the value of the currency. A rising currency would restrain growth and weigh on inflation. A currency in retreat would do the opposite. The U.S. was the poster child for the large closed economy. Canada was the prototypical small open economy. Continue reading

Everyone is in a lather about…

…the disconnect between retail sales and jobs.  But check out this chart:

retail sales

The same thing happened in the mid 90’s, an absolute boom period.  What was going on….? Gas prices collapsed, just like now. Gas as a percentage of total sales has dropped by a third. Even stripping out gasoline isn’t totally clean either – the likes of Costco, Walmart and WaWa all sell gas as well.

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