This morning I was greeted with this article Long term unemployment (>27 weeks) hit an all time high. 27 weeks is longer than half a year, all time high is never happened before. I then moved on to this article on food bank failures in the next 12 months. Boomers, the wealthiest generation in history continue to retire and the majority of Boomer money is in active funds. I have an old 401K that was in a JP Morgan portfolio during the course of my funding years. The JP Morgan funds, actively managed, had passible returns bur nothing spectacular. That fund was automatically liquidated by the custodian into a Van Guard target portfolio, passively managed according to a simple age based criteria which now allocates me automatically to 65% bonds 35% equities. It’s a tiny part of my money and over time has offered a positive return net expenses so I just let it percolate.
How I got from JPM to VG is important because this portfolio went from active to passive meaning there was a net outflow of active funds and a net inflow of passive funds. This means on the margin the ratio of passive/active funds in the aggregate shifted. My shift caused a small increase in the ratio so the NAV of active went down and the NAV of passive went up. On a one person level no big deal. On a population wide basis big deal. Often the first thing a retiree does is move his 401K into a roll over IRA to loose the management fee. In doing so this causes a demand in passive at the expense of active adding a risk premium to passive and a risk deficit to active. So my demand will on the margin increase the cost of passive my passive purchase and my sale of active will cause a decrease in what I receive for the sale. So if I sell $1 worth of active I may get 99 cents and if I buy $1 worth of passive it may cost me 101 cents. Not a big deal for me but it means the next guy will get 98 cents for his JPM and his VG purchase may cost 102 cents. This causes a further distortion because retirees are mandated to spend their money and money spending from a personal point of view is deflationary. If you have $100 and you spend $4, $96 are left a.k.a. your portfolio is deflated. Boomers also change their spending patterns. 2 years ago travel might have been overseas spending in hotels and on air travel. Today maybe an RV was purchased. This is also deflationary. It represents a kind of “stocking the pantry” move. Instead of spending into the economy renting big hotels on a recurring basis you drive your room around making smaller outlays. The RV represents a pantry of travel experience. All of the demand is pulled forward. None of these ideas are new but when linked to a massive demographic such as the Boomers and now Covid, and Now the highest long term unemployment ever, and now possible food shortages in the face of the rich getting richer….
There is a concept of elasticity which is how one variable changes with another. We use this concept when designing efficient frontier portfolios. We want portfolios with low cross asset class correlation so when one thing crashes the other thing remains unchanged, this is called inelastic or poorly correlated. Traditionally portfolios have been built over the past 40 years on a 60/40 model and that worked because of bonds and interest rates. Now in real terms bonds cost money to own and interest bearing accounts also cost you in real terms. This means in a crash you loose money in the equity and you loose money in the bond in real terms meaning the correlation is now positively correlated. In anesthesia when we would dissect root causes it generally wasn’t one thing that caused the disaster, it was 4 – 6 things, small generally uncorrelated things, that momentarily and dynamically all lined up pointing in the same direction.
And that’s how volatility happens. The volatility of the upper figure is small, the vol of the lower one is massive.
In addition when you loose 10% you need slightly more than a 11% return to break even. If you loose 10 and need more than 11 to get back to zero that means you’re slightly more than 1% underwater when you make 10% back hence 10 + (-10) = -1
These are subtle ideas until they are not. If bonds no longer provide stability what does?