ReSolve Riffs on the Emotional Rollercoaster of Trend Following

In this episode, the ReSolve team delves deep into the challenges and emotional rollercoaster associated with trend following amid an uncertain market environment. They discuss an array of topics, including:

  • The impact of Jerome Powell’s recent statement on interest rates and its implications for market participants
  • The role of central bank policies on systematic investment strategies
  • The lack of clear trends, economic trajectories, and market signals in today’s financial landscape
  • The importance of maintaining small positions and staying prudent in turbulent times
  • Potential shifts in the market and what investors should watch for
  • The role of investor psychology in trend following and how to manage emotions during market turbulence
  • The importance of diversification and its benefits in navigating uncertain markets
  • The effects of market noise on trend following strategies and how to filter relevant information
  • The potential benefits and risks of leveraging systematic signals in the current market environment
  • The role of risk management and position sizing in trend following strategies
  • The impact of behavioral biases on decision-making and portfolio management
  • The team’s thoughts on future trends and potential market opportunities

This episode is a must-listen for anyone interested in trend following, market volatility, and the challenges of investing in today’s uncertain environment, providing valuable insights and strategies to navigate these complex markets.

This is “ReSolve Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day, hosted by Adam Butler, Mike Philbrick and Rodrigo Gordillo of ReSolve Global* and Richard Laterman of ReSolve Asset Management Inc.

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TRANSCRIPT

Rodrigo: 00:37All right. Hello. How’s everybody doing today?

Adam: 00:42Happy Friday.

Mike: 00:44Happy Friday. Another Friday, the dreaded banking crisis day.

Adam: 00:49I know, Jason, one of our partners, said I hate weekends, earlier this morning. Definitely an interesting time.

Mike: 00:58At this particular time. Yeah. And before we dive in, obviously we’ll be discussing lots of things, and none of this is any investment advice of any kind, and you should not seek that here. So, yeah, I guess that’s that.

Adam: 01:12Mike with the very comprehensive compliance declaration.

Mike: 01:20Shall I read it out? I mean, it does say that we believe everything that we say would be somewhat accurate, but are not bound to that – all those good things that would be in any disclaimer. I think there’s a disclaimer at the end, too, that you can read, but just a nice reminder.

Strategy Reversals

That’s right. An interesting few weeks, interesting few weeks for markets, an interesting few weeks for lots of active strategies. Had a major reversal in many of the strategies that have really kind of helped keep portfolios afloat since the start of 2022, during this inflation shock rate rise, liquidity drain environment. We had, obviously a major run in value after a very long drought, and in small versus large after a very large drought, and trend following dominating strategic asset allocations. Obviously, a lot of those dynamics reversed pretty aggressively in the last week or so. At least they’ve corrected. And I think it just highlights how difficult it is to stick with diversifying strategies sometimes, and certain types of environments are especially challenging for all strategies, not just for diversifiers.

But you go through these periods where your kind of traditional portfolios really have the snot knocked out of them. For many months, you’re loving on the diversifiers, and then something happens that is a major overnight shift in the regime and the diversifiers end up getting punched in the face and the strategic allocations end up holding in a little better. So that’s really the story of diversification. I remember Brian Portnoy, I want to credit him with the saying that I will now butcher, but goes something like diversification means always having to say you’re sorry, right? I think this period, this whole, whole period since 2022 has really highlighted the veracity of that assertion.

Before you start, Rod, because I do think we’ve missed a bit of an opportunity here.So. Rodrigo did publish an article called Defying the Bear’s Grasp: The Emotional Journey of Achieving Managed Futures Prosperity. And I want to bring everybody’s attention to that because you can go to investresolve/blog and it’ll be the top blog there. And we’re going to dive into how a strategy like the one Adam is alluding to, the managed futures world. and CTA trend, the index used in it, is really hard to follow, even when it looks like it’s super easy to follow. And I think it’s kind of neat that we’ve got a new sort of channel of thinking and this is entitled Rodrigo’s Reflections. So we’ve got a little bit of…

Rodrigo: 04:35I apologize in advance to all the listeners. You’re going to have to hear my ramblings.
now. I’ve been given full bore now to go and talk about whatever I want to, watch out, in my crass way.

Mike: 04:50So I think if people are on and you’re able to go grab that piece, go and download it because it’ll give you a little bit of insight to what we’re referring to. And I think, as we all know, no strategy is easy to hold all the time. That is just the way it is. But over to you, Rod.

Rod: 05:01Now, the interesting thing, why did I write this? It was actually from listening to myself say over and over again that this is going to be the decade of macro and listening to other macro people talking about how it’s going to be great for macro going into Real Vision TV, which is based out of the Cayman Islands and hearing them say macro is going to be great, and then you start looking at macro, and it’s just been tough. Right? You think, God, it was supposed to be the time of macro. Now it’s over. Let me go back, let me take a look at how easy it was in other bear markets, just to kind of compare. It can’t be this tough, it can’t be this emotiona, and so I went back to another bear market that I’ve always kind of talked about as being a good old fashioned, multifaceted, multi year bear market, which is the tech crisis, right?

We we call it the tech crisis, but in reality, it’s it was multiple crises. It was, it may have started with, it actually started with the LTCM crisis, if you think back because…

Mike: 06:20The Thai baht, Russian ruble, LTCM…

Rodrigo: 06:24And then you get into, like, 911, you get into Enron, you get into recessions and earnings recession in the market, and you find that that bear market is just eight buy the dip opportunities and multiple bear market rallies that are strong., right? 15% to 20%. And we’ve talked about this in the podcast, we just hadn’t talked about it in relation to the other strategies that are generally taking the other side and making money, during that bear market. And the reality is that if you just look at point to point, which is what I’ve just kind of always done, if you’re thinking of trend CTA, global macro, if you look at point to point, it looked great. In fact, I’ve always looked at year over year, right?

So the first thing I do in the pod, in the blog post and I’ll share my screen now, is I just say, okay, look, if I just show you the bar charts and the returns to these strategies no, not slides. And the returns to these strategies year over year for that three year bear market, it looks pretty fantastic, right? So I just grabbed the SocGen Trend Index because it’s easy. And you can see here that in 2000, the MSCI All Country World Index or Global Equities was down 13.5%. SocGen trend up twelve. Next year, down 17.9 versus up 26. Sorry. Next year’s flat. Next year’s flat versus down 17.9 the 2002, 26% positive returns for the SocGen Trend Index versus -22% for Global Equities. Up 12% in 2003, down 9% for Global Equities. And then, you know, the annualized rate of return is around 15% for trend and around  -19% for Global Equities. So upon first blush, it seems so easy, right? This is why people might have been saying it’s the decade of macro.

And I don’t know, you guys probably felt the same way, right? Am I wrong? Until actually digging into this, how easy it seemed from 10,000 ft?

Adam: 08:39Yup.

Mike: 08:41Yes. I’ve been around long enough that I think I’m not really surprised. I may have been hopeful.

Rodrigo: 08:46But even if you look at the equity line, right, that’s the bar chart that’s obviously so good, I can’t get enough of it right? And then you look at the line chart and it’s still pretty good.
It’s a mirror image of global equities for the most part. It’s not terrible. You end up and we’re missing here some labels, but you end up like, up 58% over the full bear market, up until, from 2000 to March 13, 2003, and you’re down, I can’t even remember the…

Richard: 09:1650%, 49 and a bit.

Rodrigo: 09:18Yeah. And so, even the equity line looks great, right? So what I did is, I said, because the issue right now is people that are allocated to these areas, probably allocated at the peak of the cycle, right, when it was doing its best, when they’re like, they had a massive run up in two or three months, maybe February, March. And they’re like, well, I got to get myself some of those non correlated strategies. And then you find yourself having a drawdown, and then a zigzag six to nine month period. And so, the next chart that we show here is just dissecting that trend strategy from periods of zigzagging and consolidation to periods of new highs.

And what you see is just how difficult that decade of, or like three year of macro was, even for macro. Right? It was just one of those, like, you just kind of have to accept that if you’re going to be different, you’re going to have something that’s going to be non correlated and it’s going to be a schizophrenic market, bear market, or bull market, whatever it is, we’re going to spend a lot of time in purgatory and you’re going to spend very little high fiving your friends for having an allocation to something that reaches new highs very rarely. In fact, less than 15% of the time this index is spent in reaching new highs. Now, this varies depending on the strategy, especially when we’re thinking about global macro, the strategies that we put together. There’s a little bit of change here and there, but broadly speaking, that’s the experience. That’s what it is.

In these volatile periods. Right? And I think it behooves us to sort of be honest here and say that we need to remind ourselves of this from time to time. We’re very steeped into all of this. We’re looking under the hood of our strategies. We’re dealing with this day to day, dealing with our clients, with prospective investors. But ultimately, every now and then, when you do go through a drawdown in a volatile period like this, even if you’ve just made a fresh new high recently and your strategies are doing exactly what they’re supposed to do, it does take a bit of stoicism and sort of cool headedness, and doing analytics like this to remind ourselves of just how hard successful investing actually is.

Rodrigo: 11:39Right. Yeah, exactly. Again, this all started with huh, this is tough these days. So what does that all look like since the bull market began, or the bull market in trend, and the bear market in equities? We’re kind of telling the same story, right? It’s the index since the beginning of 2022 was up around 14%, the global equity markets are down around 14-15%. A full offset. But man, oh man, is it difficult, right? Again, same story. You had an abrupt parabolic almost move in the beginning of 2022, and then you give up a lot of it and then you go sideways and you get hit with these exogenous shocks, right?

In the 2000 – 2001 period, it was 911, it was Enron, it was a variety of things. Last week it was the SVB Bank going under and causing a chain reaction. It’s just part of the game. It seems to be. So anyway, that was an interesting, fun little blog post just to remind us that you got to understand what you’re invested in, right? Whether it’s your equities, your credit, your bonds, your private equity, it’s important to understand its place in a strategic holding, as a strategic holding. And you’re going to have rough goes in any one of these mandates at any point, and they might last much longer than you expect. But if you understand why they’re likely to be structurally different, because I think that one of the questions is, well, why do we think this is going to continue to work and continue to be non correlated to equities and bonds? Well, it’s just the way it’s built, right? I mean, we can talk about that. I think we talked about that last week too. It can short things, it has more diversity, it can go long.

Richard: 13:31The investment universe is completely different.

Rodrigo: 13:35Than mill wheat and stuff like that. You know what I mean? It is just structurally different. So we can count on that. And then the data mining aspect of it is, do the humans tend to herd in a trend following strategy, and there’s enough literature out there that probably backs that up, et cetera, et cetera, right? So then if you believe that and understand its structure and its character, then you just kind of have to put it in and then plug your nose and rebalance.

Mike: 13:59Yeah, rebalancing is key. And I think some of the potential challenge for the individual owners or allocators to strategies in this domain is to some degree, a bit of a lack of intuition, to some degree. Because if you have your equity based portfolio and you see generally what’s happening in markets, of a general sense of what’s happening in your portfolios, you may have a value tilt, you may have a growth tilt, and those types of things will be reflected in some differentiated performance. But when you start to think about something like the SocGen Trend index, and correct me if I’m wrong, I think it’s like tracking the ten largest managers or something like that, the index itself, is that kind of correct for the SocGen Trend Index?

Adam: 14:46Yes, it’s reconstituted every year with the ten largest managers.

Mike: 14:51Right. So you have the ten of the largest managers across anywhere from probably 40 to 80 markets, both long and short those markets, trading each individual one of those markets on various trend look-backs and things like that. And that is much more difficult to garner just general intuition as to what to expect on a day to day basis. Right. You could have commodities carrying the day where your equities and bonds are suffering.
Probably the case in sort of that 2021-22 period, you know, as we, as we ended one bull market, sort of started another, and then you go through a transitionary phase where there’s a lot of chop and swap, and so there’s just not a lot of trends to harness in the marketplace and, and so, some of that intuition, the lack of intuition can make it much harder to stick to a strategy. And that’s kind of I think what you’re saying, Rod too, is yeah, you got to kind of know these things, know how they behave, and stepping back and looking at a period like that three year period where it was a multi-year bear market, you can garner some intuition from these things, and we’ve looked back over various time frames over the years and observed the same sorts of things.

And I think ‘08 isn’t too dissimilar. There’s periods in 2008 where it does not look particularly robust for managed futures, but at the end of the year, certainly came out with some robust returns in that period of time, in those indices and strategies and things like that.

Rodrigo: 16:34Interestingly, in reviewing the data and even reviewing some of the other factors like seasonality, mean reversion, what we do put all together, I’m kind of rooting for an inflationary growth environment. That seems to hit all the cylinders, right. You get to be killing it, long only in commodities and some developed nations aren’t doing well and you’re shorting those. That’s the ultimate year if you’re going to be investing systematically. And that’s the ultimate kind of global macro. It works in differentiation because the best things tend to be global equities and developed equities and commodities that most people don’t have. And it’s much more stable. There’s just less crises in a growth environment. All right, so if you actually look at the data, that green part that we were showing earlier is much longer, and there’s much more green and less red in that type of environment.

It’s really, when you’re breaking things that it becomes really hard, even if you’re ultimately making money. So I don’t know what’s going to happen, but let’s root for an inflationary growth environment.

Mike: 17:47

I almost don’t know what to root for. I’m like, I’m actually not sure what to root for, other than those strategies go up.

Richard: 18:00

Another aspect of getting to know the strategy a little bit better and kind of doing these analyses through out different types of regimes, different types of market structures and market dynamics, is to recognize that these periods offer opportunities for entry points.
I mean, typically we live in an industry where people chase returns. Return chasing is one of the most common behaviors that we see out there. But once you go through an analysis like this and you recognize that these drawdowns in the strategy offer great entry points to then reap the rewards, once there is a next phase shift and a leg up in the, call it crisis alpha type of behavior that we see, then you start to understand that not only should you rebalance the strategy using this volatility to your favor, if you already own it, but these are really some of the great entry points for investors that have been on the sidelines, thinking about CTA managed futures, whatever the strategy may be, to complement some of their traditional holdings, as opposed to chasing these strategies next time they pop.

Mike: 19:08

Can we put one of the insights, Richard, on top of that, can we bring back the chart of the actual CTA index line? Just because I think we may have, I don’t know if we covered this one point, but the returns come in a series that is non sort of regular and normal. You have these periods of struggle and potential chop and slot, maybe the longer term one through the period, but you can see there’s this chop and slop, and then there’s these sudden bursts of upward performance that are sort of extreme, and we didn’t quite get the opportunity to get things through the compliance pipeline. I know Rodrigo’s already got his next ruminations ready to go, ruminations and reflections, which is, okay, well, can you time the equity line? So, we can’t share that quite at this point, but will say, stay tuned because that is going to be hot on the heels of this particular article, and the findings of that are, it’s hard. It’s actually really hard to do that type of thing. And you can see through the character of the blue equity line that you go through the chop and slop and then you have these large rewards in very short periods of time.

Adam: 20:29I think it’s worth maybe commenting on Richard’s point about drawdowns being sometimes an opportune time to add to managed future strategies in particular, and we talk about this quite a bit internally, but oftentimes what happens during drawdowns is, why do we have drawdowns? Well, it’s because there’s a mix of signals or the signals are changing fairly rapidly and when you average them all out, you end up with very low exposure. Right. Over time, as you come into kind of a peak in equity, you often have fairly large exposures on because the trends are in fairly extreme, sustained places. All the trends are aligned. Maybe the other signals are also aligned on occasion as well. So you’ve got pretty large exposure on. Oftentimes as you move into drawdowns, especially if they’re more sustained than average, your signals become conflicted, right? Maybe you’ve got short-term trends up, long-term trends down. Carry measured one way is up, carry measured another way is down. Monthly seasonality is positive, weekly seasonality is negative, et cetera, and so you come into these periods with very low exposure, right? So what’s interesting is the ability to enter managed futures or systematic global macro strategies when the strategy itself has already done the hard work of reducing risk for you, right? And so you’re able to come into volatility as low exposure, and you’re able to let the systems then add exposure to markets as those markets begin to generate stronger signals again.

And so if you come in near the peak, you come in when risk often is kind of full on and you’re full exposure to whatever happens next. Whereas, if you come in near, after a sustained drawdown, you’re coming in when often risk is really low in the portfolio, exposure is really low, and you could take advantage of the systems to increase exposure as the opportunity set improves.

Rodrigo: 22:49Yeah. And look, I think obviously one of the reasons that return stacking is an interesting concept is that it helps you keep what you want, right, in whatever ways you want. And you can stack strategies on top that are difficult to hold. So that’s kind of a new innovation that has become a bit easier to, a bit more palatable to invest in things that are non-correlated, right, because it’s just so funny just how short the memories are.
Last week or last month, I was having numerous conversations about how good it felt to have something in the portfolio that was up three, four, 5% when equity markets and bonds were down 3%. Right. And then this month, bonds are up quite significantly, equities are kind of flattish to down, and then you have a negative outcome for the strategy that was short bonds, short some equities, long some I get and getting really hurt.

Now, it has been an outsized event, and we can talk a little bit about that. But the point here is that correlation, you get diversification even when you don’t like it, with these things.

Richard: 24:00And to add some color Rod to that point, I mean, the short exposure to interest rates, short term interest rates, euro-dollar, euro-LIBOR, that sort of instrument, as well as Treasuries and other sovereign bonds internationally, had been one of the key drivers of positive returns for CTAs and global macro strategies throughout 2022 and into the beginning of this year. So it hasn’t fully reversed. Strategies haven’t given all back, but it is not uncommon for you to see some of the price dynamics that managers had been benefiting from, to have some reversal and there to be some widespread pain across an industry. So this is just kind of par for the course. And again, not something we’re unused to, but it still hurts, and it’s still unpleasant, and it just forces us to revisit and have a little bit of a gut check and remind ourselves of what we’re doing and help our clients do the same.

Rodrigo: 25:02Look. That’s a chart of the TLT, which is a long term treasury, right? And the red line is the twelve month moving average. It hasn’t even like crossed…That’s more the higher duration bonds. But you can see that sustained downtrend, and if you’re a trend manager, that’s just beautiful, right? And then you have this pop here in March and then if we go down to kind of the ten year notes. It only is just kind of changing trends, right, and popping out. The scary one really is these short term rates, right? Look at that chart. Beautiful, steady chart. And then, what was it, a ten standard deviation move in some of the rates?

Adam: 25:49Yeah, in rates, yeah. This is more short-term bonds. But short-term bonds, I think the two year had a move that was, if you standardize it for the vol that we were observing coming into the Friday and Monday, the two year still had a pretty, pretty sizable move.

Richard: 26:18Eleven standard deviations.

Adam: 26:21About eleven standard deviations, yeah. The eurodollar and the Canadian Bankers’ Acceptance. And Euribor. All of these, the … so short term German rates, all of these had moves that were, if not the largest one day move in their entire history, the second largest one day move in their entire history. And it happened that they went in the opposite direction of the prevailing trend. So it’s kind of not surprising that all of the macro managers, any sort of systematic macro signal was pointing to a short in rates and bonds, that had been pointing to a short pretty consistently for several months. The long-term trend was very steadily lower. The carry was insanely negative, implying a short, actually happened to be in a negative seasonality period for rates and bonds. There’s a confluence of things that would suggest that you should be short these rates and bonds and you know, I think it’s, it’s reasonable to think that since pretty well all of the major macro systems were pointing in the same direction, systematic macro managers all kind of had the same trade on at the same time.

And so that exacerbated to a small degree, some of the moves that were observed on a few of those days, but then that kind of shook out over the ensuing few days. So this is a pretty rare event, but you have to expect these kinds of events to take place from time to time, and that’s just part of the business.

Mike: 28:07Yeah, they’re very rare in normal distributions, but this isn’t a normal distribution arena of study.

Rodrigo: 28:15The crazy part is looking at the allocations. They weren’t that large from a risk perspective.

Adam: 28:20Yeah. No, it’s cool. When you look at the CTA Index Allocations or some proxy of the CTA Index Allocations, and you go back all the way to 1990 with those allocations, then the worst day with the holdings that CTAs had, or a proxy of them, coming into Monday of last week, the day when most CTAs got hit pretty hard, if you use those weights and you apply the returns on every single day back to 1990, the worst prior returns was around six and a half percent. Six and a half percent loss. And it was at the sort of 12/13 vol that the Trend Index operates at, about one and a half times the worst previous return on that day that you would have observed over the entire history of the index, given those weights. So pretty big shock.

Rodrigo: 29:30Well, yeah, I mean, look, this is from another strategy, but it tells the same story, right, which is, if you look at the exact same weights and go down in history and plot the distribution chart, what happened on Monday had never happened before, right? Which is, again, this is Mike’s favorite saying, right? The future has…

Mike: 29:50The future holds what the past has yet to reveal.

Rodrigo: 29:54And so you have a moderate exposure to whatever it is, and a ten standard deviation event happens, you’re going to get hurt, right? It’s going to be something that you’ve never experienced before. The question is, well, is something broken? Are we going to have a ten sigma event every other week? How often do these happen? And really, what was the carnage? Was the carnage that these systems went under? No, they were diversified enough to sustain a big loss, but not an immeasurably, unrecoverable loss. Right. But it was quite crazy and mind blowing, actually, to see that move in such short order.

These were the standard deviations across eurodollar backs, the two year note, the Euribor. So you’re looking anywhere between nine and twelve standard deviation events.

Mike: 30:46Which are I mean, how often do those happen?

Adam: 30:49In the universe? Yeah. Once in every hundred multiverses. Basically, they don’t happen. This is not an illustration of, so much of, how rare it is as it is that you can’t measure risk properly when there’s a major shock, right?

Richard: 31:16These Minsky Moments, right? Once you cross the Rubicon from low vol to high vol, “methods, used to measure volatility, that stuff goes out the window, and you’re now in Mr. Hyde’s territory. You’re now in Minsky Moment. So it really is a complete change in character.

Rodrigo: 31:42Yeah. And IRImpossible writes here “is the bond price action we saw last two weeks largely due to corporate accounting and treasury departments moving cash in excess of 250,000 to UST and money market sweeps?”  Yeah, I mean, this is a chart from Mike Green’s newsletter that I highly recommend people read to get a different perspective. But what he shows here is the change in bank deposits from peak, right? So if you look back to the 1973 there were a few in the 70s, obviously 1981, October 2001, but this is a pretty big one, and it happens so fast. I mean, when people move money from deposits, they have to put it somewhere. They’re either moving it to one of the big banks, but I think Monday, people were just worried about the whole system. So you’re likely going and buying T bills and money market funds, or buying T bills.

Mike: 32:36What’s interesting about this chart, too is the April 1994 period, which was the bond massacre. That’s when Greenspan came out and unexpectedly, without warning, ratcheted rates up fairly quickly. And we had some of the largest losses in bond portfolios historically, and it would be interesting to go back and look, but I imagine it was sort of some of the same dynamics in that there was a Fed Rate that was increasing at a rapid rate, and the banks could not keep up, potentially with the rates that were competing in the marketplace.

Rodrigo: 33:12Yeah, and the reason for that is because they locked in longer term. That’s how they make money, right? Banks make money by taking deposits and then loaning that out at longer duration, and you’re hoping that you just make it a spread. That’s basically it. And so certain banks have done that better than others. Certain banks have hedged. Certain people decided to mark to market, or not allowed to mark to market. And rates are up at five. You’ve locked in your bank rates at two. You need a spread. You’re offering your depositors 1%. So I do wonder how much of this was yes, okay, there’s a bank run. But once it was solved, people being waking up to the fact like, wait, what am I getting in my deposits? What can I get simply by moving my money to a brokerage account and then buying some T bills or some money market?

I think it was the Minsky moment here was, oh, I can get 4% more a year by doing something relatively simple, right? Even after you quell the fears that there’s going to be a systemic run, if you’re a thoughtful, people are running businesses and the people running the Treasury are just kind of trying to pay their bills, but all of a sudden they’re forced with thinking harder about how to do that. And I think that’s more of a systemic thing that might continue to lead to the changes in how banks interact with businesses.

Adam: 34:40I think, no pun intended, that you didn’t mean to say that the people at the Treasury are wondering how to pay their bills.

Rodrigo: 34:46No. Treasury … companies. I’m talking about, like, small companies. The guy who runs the money being like, being finally like, you got to look at your portfolio. What are we doing with our money? Where can we get more yield? Where can we get more safety? Yeah, I think that’s everyone starts to run out and check US. Treasury CDs.

Mike: 35:10It reminds me of that old meme, that always surfaces at these types of moments, right?

The Monopoly. If the bank runs out of money, the bank never runs out of money. You can just write the numbers of the money on slips of paper. And it’s right in the rules of monopoly. Rule number one, the bank never runs out of money. Just take some slips of paper and write some numbers on them to make more money. I always enjoy that, meme every 15 years or so.

Richard: 35:41And I guess the main concern now is that, what this is actually, like, following through on Rodrigo’s comment and kind of game theorizing, what happens next, you can imagine most of the regional banks of smaller banks continuing to see outflows because now there’s this question, there’s some contradiction between the Fed and the Treasury. What kind of backstop can the non-FDIC insured deposits expect? While there’s a question mark there, we can expect there to be uncertainty and worries about the banks. And even if there is, because there’s so much more yield outside of bank deposits, you’re probably going to see some outflows, so I think ultimately what we’re seeing here is a change in the environment for the banking system in the US, and ultimately just more uncertainty right, that we’re going to see in the markets. I think this comes back to the way they are, our own operating system, which is diversification, risk management and trying to protect one’s portfolio by having different asset classes and different styles and different ways to attacking the problem.

Mike: 36:55And most often it serves best not to try and overthink this. Just do your rebalancing. Whether those rebalances are calendar based or asset weight based within the portfolio, just do your rebalancing and that’ll get you a long way.

Rodrigo: 37:13Yeah, look, to me, the speed of it was mind blowing, but it was just online banking. You can just do things a lot faster. And if you have clout and you’re telling your stakeholders to get the money out of Silicon Valley Bank and do it overnight if you can, you can go at four in the morning in your online banking account and transfer money out, there was just no way that anybody had seen that coming. There’s no guardrails for that, right?

Adam: 37:31Well, this is an interesting point to explore. Right. I mean, what this really demonstrates  is that, in the modern era of social media and instant intra bank transfers via mobile devices from anywhere in the world, there is no reserve ratio less than one, that protects a bank from a bank run, right? It completely obliterates the concept of fractional reserve banking, right? Fractional reserve banking relies on the trust of depositors, and if Kardashian can tweet out that she’s pulling money from Schwab because she thinks that I should probably just use, like, broker or Bank X, from Bank X because she’s hearing that they’re underfunded, then Kim can cause a run on any bank she wants, and all of Kim’s followers on their iPhones, on their glittery iPhones, can use their manicured fingernails to transfer funds from …. I like it. It really is a very different world, and I think we’re exposing a systemic risk in this environment that probably the authorities and most investors and depositors just were not aware of, prior.

Richard: 39:13Yeah. The virality of the dissemination of information. This is the first time that we’ve had this kind of event, post the social media era. I think 2011, 2012, I think, was when the first well, I guess that’s around when the iPhone came out first, and I think the first social media companies came out right after that. So, yeah, this is the very first time that we’ve had this type of event when there’s social media and Reddit and all of these kinds of very viral forums that just, you combine that with 24 hour banking and that sort of thing, the speed at which these things can happen, it’s bound to increase.

Adam: 39:54It’s a good thing that Peter Thiel and Kim Kardashian are not good buddies, because if Peter had reached out to Kim and said, hey, dude, you better be pulling your funds from Bank X…

Rodrigo: 40:02Credit Suisse would have gone under two weeks ago.

Adam: 40:08That’s right. With their bejeweled phones transferring all the money out. It’s just a really strange environment. And I do think it is an interesting question. What is a loss like this in portfolios or in certain types of strategies? What does it say about the risk of these strategies? Is the risk any bigger or smaller than anybody thought before? Right. We’ve had the single largest day loss in the history of many, of many funds in the managed futures and global macro space and in the indices. Does it mean that the funds or the strategies are any more risky than they were before? No. I mean, you had to know going in, any strategy, including, by the way, a strategic investment in 60/40 portfolio is vulnerable to a Black Monday like they had in 1929 or October 19, 1987, or what have you. There’s just no way to avoid these risks, if you diversify your portfolio into a basket of diversified global normal betas, let’s call them, like bonds and equities and commodities, et cetera, and then you diversify across a variety of other sleeves.

Speaker 1 41:36Maybe it’s the value factor, maybe it’s small versus large. Maybe it’s inequalities, whatever. If you’re going to diversify your sleeves, then you just have a lower likelihood of having a cascade of these types of days. It doesn’t mean it’s zero, but you have a much lower likelihood than if you’re concentrating your bets in any single approach.

Rodrigo: 41:58Yeah. Remember, it’s a ten standard deviation event on a single type of security based on an unprecedented run on the bank that we’ve never seen. Now, this has been, now we have all the facilities, and maybe not all of them, but a lot of facilities will be worked out so, that this doesn’t happen to a lot of the banks and regional banks.

So you know what tends to happen in human nature, right? We had a shoe bomber and now we have to take off our shoes for the rest of our lives, because we think that that’s the next thing that’s going to happen. So I wonder how many investors are like, well, we can’t invest in funds that short bonds ever again because we have this issue. No, you know what? You’re never going to see the next ten standard deviation event happening. It is a Black Swan event for a reason.

Adam: 42:42Well, it happened 20 years from now again, right?

Rodrigo: 42:46Somewhere.

Adam: 42:50Exactly. Why didn’t it happen in 2008? Well, in 2008 it happened that when there was a run on the banking system and rates blew higher, the carry and the trend and all of the systematic macro factors were also pointed in that direction. So macro investors benefited from that shock, right?

Richard: 43:03And the setup, right? We were not in a period of actually, the fastest tightening cycle that we had seen, exactly in history. But I think Rodrigo’s point is really good because especially in our industry, we tend to fight the last war. We, there’s this proclivity to keep fighting the last war. After we had COVID, everybody went off and bought Volatility Strategies. And then 2022, the Volatility Strategies did not work. And you can cite so many like countless examples of exactly this sort of dynamic. So, I think Rodrigo’s point is useful for us to sort of make sure that people don’t have the wrong takeaways from this event. I think that that’s key here.

Mike: 43:51The other thing is, if you think about the way the whole financial system has been financialized, and one might argue over-financialized, there are more significant feedback loops that are related to the financial system that directly impact the real economic machine of the development of stuff and things. And this feedback loop is larger and has more opportunities to spin out of control when you have this financialization dominating the system itself, it also creates, lo and behold, inequality of wealth. Are we seeing that genie coefficient, anyone? How about the short term focus of the boards of directors of various companies? Does that happen? I don’t know. Maybe we need better regulation in all this as the financial economy takes over. Did that happen? Did anyone foresee the things coming? Not really. So again, you come back to the prioritization of diversification and something that, if we can alter it from a CTA perspective and just talk about some of the general risk parity strategies out there, they actually weathered this storm pretty darn good.

Adam: 45:11Yeah.

Mike: 45:13So when you think about initial conditions that you guys are referring to and how does everything align together with positioning? It’s just interesting. I can’t help but feel, with all of the financialization that has occurred in everything. You don’t buy jets and then have a jet fleet and then run an airline. You rent every piece of the airplane from the engines to the fuselage. You outsource a lot of the booking, you hedge your fuel costs. This whole world of an OEM type structure, and then hyper financializing everything to try and garner a higher rate of return, has some implications.

And that might be why we’re seeing a lot more of these events, maybe over the last sort of ten to 15 years, than we might have seen, historically?

Adam: 46:20That’s a really good point. I don’t even know. I think what you’re highlighting is also the magnitude of financialization and the amount of debt in the system obviously means that moves are amplified, but also the interconnectivity of, not just banks to other banks, which has also spiraled out of control in terms of the number of nodes and the complexity there. But the shadow banking system or non-bank oriented financialization right, and therefore the opportunity or propensity for shocks within the financial system to propagate out to the actual economy, right, has been exacerbated very dramatically.

And what we’re observing here, too, is that the markets know this. How does that manifest? Well, Jerome Powell came out and spoke two Tuesdays ago and said, we have no reason to believe that inflation is subsiding. We are sticking to our 2% target. We are data dependent, but we will continue to raise rates until we get inflation back to our target. And two year yields and Fed funds futures and the whole rates market went ahead and priced in another 50 basis points worth of hike to the terminal rate, after Powell spoke. Fast forward two weeks and we’re now pricing a deflationary outcome and the Fed is going to, and the market is pricing emergency cuts. So this is the rate at which the market turns because of its understanding of how complex the financial system has become and how connected it is to the real economy.

Rodrigo: 48:13Yeah. And to Mike’s point with, you’ve got to have your area that’s preparation, rather than prediction. You’re going to have your area, that’s prediction rather than preparation. And the preparation part is already fitted with the right things. After you mentioned risk parity, I actually hadn’t taken a close look, but you’re right, it’s kind of like just a boring flat line over the last, the month of March, because as commodities took a bit of a dive and equities did not great, you had bonds offsetting those losses. It was preparation. It was the right balance and the right allocations that kind of handled that. And now the prediction part general only comes in later, right? The prediction part generally gets caught offside and then as things devolve or evolve, it’ll start getting the broader trends that risk parity might not. So, preparation and prediction, you kind of have to have all of them. It’s hubris versus humility at all times, and how much you put one versus the other is what’s going to kind of define how well you get through these moments of extreme duress that nobody saw coming, right?

Mike: 49:25Someone also mentions the All Terrain sort of portfolio, and there’s an article out there. I think you penned that for the CFA Society, right Adam, just talking about the blend of preparation versus prediction if we want to go that route, and how one might think about trying to make a robust All Terrain Portfolio that can handle all seasons in order to navigate these types of situations in hopes that the math of losses versus wins, right? You lose 50%, you got to make back 100. If you can keep those losses a little bit more attenuated through the various avenues of allocation to assets, systems and strategies, then getting back to all time highs is a little easier, and the funding of a portfolio, if it’s in any kind of deacumulation, is more robust. And that is something that, again, I would encourage folks to look up if they’re interested in that kind of approach and sort of go through the research piece there.

Adam: 50:33Yeah, good call. I wanted to highlight, if we can, the IRImpossible who has a quote from Powell from March 7. I just want to read this out because this is, I think, the most incredible juxtaposition, right?

So on March 7, Powell said, “the latest economic data have come in stronger than expected”, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated. That was the 7th. The 9th, we had a major interest rate shock event, and then the 10th was the interest rate shock event of the last 30 years, in the opposite direction of Powell’s statement, right? So this is the ultimate flip flop in market positioning and any kind of systematic manager is just going to be expected to be unable to flip the switch on a complete change in regime over a three day period, right? It really is a remarkable time.

Mike: 51:39There is an adjustment that occurs fairly rapidly and we’ve seen the adjustment…

Adam: 51:43Yeah, definitely.

Mike: 51:45… in indexes and whatnot in portfolios. I think that’s the key in that, and I think we’ve talked about this before, letting the maniacs run the asylum, right? There is setting a strategic asset allocation and closing your eyes and sort of letting the wildness of certain assets sort of dominate the volatility of the portfolio, or there’s the idea of, well, let’s set a reasonable risk target and adjust the exposures to keep the risk experience a little bit more consistent. And we’ve talked about this in just the basic stock/bond context previously, last year when we had a lot of stock/bond correlation and the fact that with the lack of correlation and increase in volatility, your experience as an investor is going to be unlike anything you’ve experienced over the previous, whatever it was, ten years.
You can think about addressing that problem in a couple of different ways.

Richard: 52:42Adam, just to push back a little bit on your earlier point about what the market is now signaling, I wonder how much signal can be actually gleaned from the price dynamics, especially the short term end of the treasury curve when you have a move that is call it fear based? Let’s say everybody, or a large amount of investors and depositors have flocked away from the smaller banks and deposited their money in Treasuries, just because it’s similar to the … dynamics.

You don’t know what the next domino is that’s going to fall, so you might as well lend it to the ultimate too big to fail institution, right, the US Treasury. So I wonder if that sort of knee jerk portfolio move, it doesn’t really offer that much signaling mechanism. Surely we can expect that if credit markets freeze and if you do have a number of banking failures, that in fact we are going to be coming into a deflationary shock that would then call for a 180 from the Fed, and you will see those interest rate cuts. And then the Fed would cut, a catch up to the curve, if you will. But I wonder if in this first kind of few steps, the first few weeks following this event, that there isn’t that much signal there, and this really is, it’s less about where the smart money thinks the curve is headed, and more about where depositors feel they have the least to lose.

Adam: 54:09Yeah, I would say it weakens the prior view that we’re going to continue to go higher, the Fed is going to continue to push rates higher, right? It weakens that view substantially. It doesn’t necessarily suggest a pivot or a major regime change is on the horizon. And how do we know that? Well, because the signals across different strategy sleeves are all dramatically shrinking, right? So there was a very strong view represented in the market, captured by the macro signals in the week of March 7th, suggesting that rates were going to continue to march higher on Powell’s initiative. And that view by market participants is now a lot more confused, and while we shouldn’t take, you know, there’s obviously not a strong signal that rates are going to now march lower. The the view that rates are going to continue to march higher, that has come in very dramatically now, right?  And so if we just sort of look at the positioning in our systems flipping long non-US dollars, right, long the dollar before, now we’re short the dollar in general, right? We were extremely short rates before, now we are a little tiny bit short rates, right? We were very short bonds before. Now, a little tiny bit short bonds. But the point is that the positioning in aggregate across financials is very, very low in aggregate, just because the market is expressing that they don’t have a strong view.

How do we know? Because we’re viewing the market and it’s positioning from a variety of different angles and all of those angles are sort of expressing confusion, right? So, when the market begins to express a stronger conviction in one direction or another, in whatever dimension that you’re observing, then we would expect the exposures to expand to express that conviction in portfolios.

Rodrigo: 56:12And you see in that right now, right, like just the systematic global macro, the managed futures have reduced exposures, have trimmed down positions, are kind of in very low exposure territory, and that tends to be the case whenever there’s a shock, right? It’s kind of like you see it all the time. Just all the systems go a bit haywire and there’s more noise than signal, and you kind of flatline for a bit. And I’m just looking at the trend the SocGen Trend Index and how flatlined it’s been compared to other asset classes.

It’s that mix that makes it difficult and you’re still looking at, like nothing really from the macro perspective has changed, right? If you think of 1998 when the LTCM crisis happened, that was attacked as if it was a broad economic event, but it was, I think in retrospect, it’s seen as an acute problem, liquidity problem that that was plugged and it wasn’t necessary to …

Richard: 57:12It wasn’t solvency. It wasn’t a solvency thing. It wasn’t liquidity.

Rodrigo: 57:18Yeah. And I think the Fed overreacts and you have this massive run up in tech that leads into the crisis, right? In 2000, similarly, the market’s up 3% for the year. Global MSCI AQUI is up 4%, right? And so you have a situation where a crisis has happened and everybody’s clamoring for the Fed to change direction. I feel like they look at that in the same way that the Central Bank of the UK dealt with their pension issue, which is, let’s plug that issue. That’s a liquidity issue. Let’s go ahead and continue with our global macro reality, which is, inflation is still sticky. And I’m not one to say whether the Fed’s got the right indicators or not, but when they’re looking at those markers and saying, nothing’s changed, right?

There’s an interesting aspect in Europe. Nothing’s changed from a global macro perspective. And Bob Elliott was saying how micro events like this happen quickly, but the macro story changes very slowly and it’s going to take a while to figure out how all this plays out. But the macro story hasn’t changed. The macro indicators that the Fed responds to haven’t changed that much.

Adam: 58:42Well, I think the qualitative aspect, it’s unlikely. Yeah. There has been a major shift in that there was extremely high conviction priced in the market as of March 7th and 8th, that we were going to continue on a steady trajectory of higher rates, right? That has very clearly shifted to we are not clear. The market is expressing that they are not clear. They have very low conviction in the direction of Fed policy, right? We’ve also seen long rates decline pretty aggressively, right, suggesting that the market is pricing a larger potential for an economic shock and potential deflation, right? Whereas before all signals were pointing to, the Fed was going to continue to push liquidity out of the system and raise rates. Now it’s very uncertain. And that’s kind of where we are. And so in general, people should have low exposure from a tactical standpoint because the picture is very uncertain.

Richard: 01:00:00What might make this event, I think, slightly different than other similar historical analogies is the fact that we’re dealing, like to look at our qualitative analysis real quick, is, we’re dealing with a Fed chairman that appears to be quite focused, some might say obsessed with legacy and with the analogy of the 70s and 80s, this Arthur Burns, Paul Volcker dichotomy, right? And so because he is so focused on the legacy and how he will go down in history, and this has been a topic that has come up time and time again, it may require something bigger to break to convince him that a pivot is required. So it seems like he continues to try and win over the market with speech and not so much with actions. I forget who said that, the central banking is two thirds theatrics and one third the numbers. or I forget what the breakdown really is.

But it does seem like there is this preoccupation with not going down in history as, the inflation is not coming back on my watch. And if that’s the case, then whatever the other signals might be, the laser focus on that single variable, which by the way, lagging, and the effect of monetary policy is quite lagging, as we all know. Twelve to 18 months on average is typically how long it takes for any effect to take place. So we are coming into a period where the historical analogies might not bear too much information right now.

Rodrigo: 01:01:34Look, it just speaks to going back all the way to the beginning of this podcast, which is you have these moments in these types of multifaceted bear markets. We kind of are in the land of the blind, right? Most of the time it is unclear what is going to be the dominant trend. Who is going to win? Is it the market that’s going to force the Fed’s hand or is it the Fed that’s going to break the market or make it come its way? It’s really tough.

And then you have these moments of clarity, weeks, if not months of clarity, where there’s a dominant theme that we like, all of a sudden the market prices in a narrative. And it just goes, and you make new highs in these types of strategies, and then you go into obscurity again because… Everybody here kind of just blabbed on about different people’s perspectives, lives. Nobody can take a signal out of that. That’s exactly what we’re seeing in the systematic signals and it’s exactly what we saw for three years in the tech crisis. And we’ve just got to wait for those moments of clarity.

Like, look, the February, March period of last year was a moment of clarity. Global war. There was an issue with grains and commodities. There was an inflation story that finally bled in. Everybody got into that trend. You were able to get that moment of clarity, and then it became all jumbled up in the other half of the year. Right. So, again, it’s just taking it back to basics. Nobody knows right now. The signals we’re watching are very low exposure. They’re kind of in and out. A lot of these are…

Richard: 01:03:08The marginal dollar is confused. The marginal dollar doesn’t really know what to do. I like Mike Harris’ point, which is the stock market is moving sideways for 224 days. They do not believe any of the narratives, right? It really is unclear. The signals are confusing, depending on the look back that you use.

Adam: 01:03:38The stock market is a ferret on crack, dude. The fact that the stock market has gone sideways, that’s basically just because all the DGENs are just getting tired. Like, don’t worry that the stock market is going to do what the stock market does. I think that’s definitely not the canary in the coal mine. It’s the lowest signal market that there is. So, I’m kind of not that worried about what the stock market does. The stock market is going to be the stock market. But I’ll certainly agree that at the moment, there are no clear trends. There are no clear economic trajectories. There are no clear Fed trajectories that the market can point to, and so having small positions on is probably the prudent way to play this for the time.

Rodrigo: 01:04:22And just like that, it could all change, and they could become abundantly clear. Yeah, you just kind of have to keep on playing that game and keeping your allocations in there.

Rodrigo: 01:04:36Anyway, I think we brought it full circle. Anything else anybody wants to add?

Mike: 01:04:44The only thing I would add is that next week’s guests are going to be kind of cool. We’ve got Brian Moriarty from …

Richard: 01:04:50Portnoy?

Mike: 01:04:51…Morningstar and not Portnoy, Moriarty. And Dave Natig is going to join us. And it turns out Brian has a particular set of expertise in Credit Suisse bonds and … and CoCos and all kinds of fun stuff. So, interesting. That’s going to be an interesting discussion, I would say so, we’ll be back to having some guests next week. It won’t be us. And in chatting with Brian, there’s some really interesting stuff that occurred in the capital stack and some bond portfolios around the Credit Suisse restructuring. Very cool stuff. So can’t wait to dig into that next week. So, I’ll give a plug for next week, I guess.

Rodrigo: 01:05:39What’s the next bank to fall?

Mike: 01:05:32Deutsche bank? Maybe. Deutsche bank. Maybe I know something. Deutsche bank.

Adam 01:05:47Michael?

Mike: 01:05:49Not advice. Not advice. Not advice. Deutsche bank is not, I don’t know. There’s nothing there nothing there. I don’t know what he knows about.

Adam: 01:05:55And if you guys like the episode, don’t tweet it.

Richard: 01:05:58Yeah, if you guys like the episode, hit that like button, share it, subscribe to the channel, and have a great weekend, everyone.

Mike: 01:06:03Yeah. Here we go.

Rodrigo: 01:06:05Thanks, all.

Adam: 01:06:08Thanks to everyone’s contribution and questions. To, Michael, appreciate your comments, as always. And you and I are always going to disagree about the relevancy to the stock market, so with love.

Rodrigo: 01:06:26Thanks all.

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