When does 10 + (-10) = -1?

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.

This

Became

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?

4 Replies to “When does 10 + (-10) = -1?”

    1. Thanks Al It’s a small but extremely important point. Like poker the game is rigged to the downside. It’s natural rhythm is asymmetric because to cover a loss requires a gain greater than your loss. The oscillation is a function of time as well. It takes longer to make back 11% than it does 10% and since a persons time is finite that extra time required is realized as a loss you will never recover. The 2 graphs of the vectors is also important. The coefficients between vectors is dynamic. You may get a 1 day alignment pointing into the ground and the next a 1 day alignment pointing away from the ground and that’s called Brownian. 3 days less Brownian 3 weeks extremely less Brownian. The machine now trades the market, and the machine trades momentum (first derivative), not price, based on 1 month flows to “smooth out” Brownian volatility, so a 3 week trend in the arrows pointing into the ground or pointing into the sky is what dominates the relative risks. That traditionally has dominated 90% of market action since the machine took over in the late 80’s. Now with the advent of Robin Hoodie and Portnoy traders, the machine is 70% of the momentum and the Hoodies are 20% and the Hoodies don’t have a clue. They buy shit like Hertz which is bankrupt and Nikola which is a fraud.

      I once wrote a Star Trek game back in the 70’s on an IBM mainframe using PL language when I was a grad student in biophysics and one sprite was a Romulan who appeared out of nowhere and shot at the closest entity be it a planet, a sun, a ship, or me. It’s appearance randomly and immediately set all vectors into alignment because the death of something on the screen was immanent. That’s what the market is like today. Hoodies are like Romulans. Long side buy and hold used to work because the market was driven by mean reversion to an ever increasing long term mean. The mean was “always” up and to the right. On the average the market always went up so volatility was contained as long as you held. In those days value had meaning. Buffet made his nut by understanding the meaning of value. Today value has no meaning. It’s all a levered mirage. Passive funds ae insensitive to value. Passive funds are automatic and binary. You place a buy order and a purchase happens at some instant in time, you place a sell order and the same thing happens and so the price you pay is dependent only on price momentum. This means you are fighting 2 things. It’s Buffet vs The machine. It’s mean reversion vs momentum and mean reversion will save you only if it can overpower momentum and that will only happen in a strongly growing economy. If mean reversion fails then the economy deflates and momentum will add to deflation because the machine doesn’t care. It makes money going short or long and will happily ride the mean strait into the ground. It’s unclear to me a real up and to the right economy strong enough to counteract downward momentum on a sustained basis i.e. on a basis that creates real gains, will ever exist during the rest of my lifetime. Sounds pessimistic but it’s not. It’s only pessimistic only if you your future is levered and is strongly attached to a presumed up and to the right future.

  1. Interesting analysis and prognosis.
    You clearly have spent some time considering this, and I have to say , the recent changes to your AA and approach seem to be totally in-line with the views you expressed above.
    My favourite real-world example of people failing to understand the maths of loss is at first reading much less far reaching but on reflection explains a lot of stuff that goes on in the world today.
    The example is as follows. Throughout my working life I had to spend a surprisingly large amount of my time explaining to (allegedly numerate) and often rather senior folks that there are only three possible ways to recover slippage to a critical path activity on a schedule, namely:
    1 – a miracle;
    2 an instantaneous, sustained, and significant efficiency improvement; or
    3) more resource

    and that as 2) is really just an example of 1) and as far as I know type 1) events are pretty rare, then practically there is only one way to recover and yes that means costs will probably increase too.

    Ho hum, some people live and learn!

Leave a Reply

Your email address will not be published. Required fields are marked *