ET Note: Hyakujo’s Fox

hyakujo-fox

(Disclosure: This is another one of those philosophical posts that (optically, at least) has nothing to do with finance or investing. If you’re just here for the finance stuff you’ll probably be happier skipping it)

I’ve been slow to post on the blog lately. Partly because I moved houses recently, and partly because any remaining creative bandwidth had been eaten up by the idea for my most recent Epsilon Theory note.

Teaser:

Recently, a friend and I were texting about the meaning of life. (what? you and your friends don’t text regularly about the meaning of life?) My friend wrote that in the end, all you can really do is carry your cross to the finish line. I quite like this. It cuts right to the heart of the issue. There are no Answers. There is only Process. I did suggest adding an inscrutable Zen twist, however. My version:

In the end, all you can really do is carry your cross to the finish line. Except there is no finish line, there is no cross, and there is no you.  

Read the whole thing at Epsilon Theory.

Must be something in the water lately as I discovered (only after my ET note was written) this Ribbonfarm post by Jacob Falkovich dealing with the “self” and cognition. The money shot:

When the part of your brain that monitors itself notices repeated patterns of thought it creates a high-level model called “self” that it can use for prediction. “I” am interpreting the sound as a stick hitting a woodblock. “I” suffer when in pain. “I” think of everything in terms of predictive processing. And “I” will likely continue to do so in the future.

But when a thought or interpretation arises that can’t be predicted from the habits of my mind, there is no reason to assign it to a consistent thinking “self”. The thoughts I’m used to thinking are mine, but the novel ones could be anyone’s or no one’s.

Have you ever had a random transgressive thought (or even a transgressive dream) that disturbed you? I certainly have. What’s disturbing about the experience is that some horrible idea originated within you. Some horrible idea that’s destabilizing to your conception of self. A “residual” in the predictive model for thought patterns.

Every religious tradition acknowledges the existence of these residuals. Broadly speaking, they’re sins. What differs across religions is how you treat them. In the Catholic tradition I was raised in, there is a whole guilt complex built up around our inherently sinful nature (it’s a bit less apparent in the kinder, gentler, post-Vatican II Catholicism I was raised with than the hellfire and brimstone Catholicism of my parents’ generation). Residuals represent corruption. To cleanse yourself of their taint, you seek absolution through confession and penance.

Zen takes a different view of the residuals. Among other things, it teaches you to see them for what they really are: random noise in your thought patterns. The Zen response to transgressive thought is simply to acknowledge it. Observe it the way you might observe a passing cloud. It will pass.

This is not at all to argue that the Zen tradition is “superior” to the Catholic tradition. It is, however, why I think Zen philosophy resonates more with me than the Catholic doctrine of my youth.

What I’ve found to be most challenging about Zen is squaring it with morality. Indeed, one of the most common reactions to my ET note was: I liked this but isn’t the message still that ‘nothing really matters’?

A true Zen master (which I am most definitely not) would whack us over the head with a stick for asking that question. Not only is it the wrong question, it is an irrelevant question. It is a question only a “deluded” mind stuck in a dualistic thought pattern would ask.

There is no good. There is no evil. The enlightened mind is beyond good and evil.

But doesn’t that mean you can justify anything?

Again, it’s the wrong question. Only a deluded mind requires an intellectual basis for moral action. Likewise, only a deluded mind would interpret “beyond good and evil” as “license to burn, rape and pillage.”

Put another way: even in religious traditions where a framework for determining “right” from “wrong” is made explicit, people still sin. Literally all the time. Hell, the Catholic Church I was raised in pretty much institutionalized the protection of child rapists. That fact doesn’t invalidate Catholic religious doctrine by any means. All religious institutions are flawed and corrupt to one degree or another, precisely because they are run by fallible humans. But it goes to show that a clear framework for moral behavior isn’t The Answer. To my eye, it’s not even half The Answer.

I conclude with a Zen story that addresses these “substance versus form” issues related to morality and moral action. It is one of my favorites.

Tanzan and Ekido were once traveling together down a muddy road. A heavy rain was still falling.

Coming around a bend, they met a lovely girl in a silk kimono and sash, unable to cross the intersection.

“Come on, girl” said Tanzan at once. Lifting her in his arms, he carried her over the mud.

Ekido did not speak again until that night when they reached a lodging temple. Then he no longer could restrain himself. “We monks don’t go near females,” he told Tanzan, “especially not young and lovely ones. It is dangerous. Why did you do that?”

“I left the girl there,” said Tanzan. “Are you still carrying her?”

10/19 Permanent Portfolio Rebalance

This post marks the second rebalance check for my leveraged permanent portfolio. Based on some feedback from Twitter, I am making a small tweak to the volatility targeting overlay, and increasing the lookback period from 1 month to 1 year. The intention here is to make the portfolio less sensitive to sharp, short drawdowns in the underlying assets. The purpose of the volatility and trend overlays is not to avoid these types of drawdowns, but rather to adapt to regime changes.

Here is the current portfolio:

201910_pp_rebalance

On a 1-year lookback this gives us a 9.2% return and 10.33% volatility.* Below the 12% target for the portfolio, despite being fully invested. You can nerd out on the lookback data versus a global 60/40 portfolio and SPY here. In an ideal world, if I had access to the full investment toolbox, I would actually leverage the portfolio to reach the risk target. But, as a small investor, being fully invested will have to suffice.

So, no changes this month.

Below is net performance since inception versus the S&P 500 (my actual allocation differs from target slightly due to transactional frictions, but not in a material way). Again, I wouldn’t normally expect the portfolio to perform this well against a 100% equity allocation over any arbitrary time period. But I think this time period offers an excellent out of sample test of the strategy’s efficacy and in particular its ability to tamp down risk.

201910_pp_performance

* Fun Fact: 10.33% volatility for the portfolio in spite of the fact that individually, each asset in the allocation had a volatility above 12%. This is the magic of true diversification.

 

ET Note: On The Great Jihad And Other Possible Futures

dune_pic

My latest note for Epsilon Theory is about possible futures. And Dune.

One of the recurring images in the book is what we in finance know as a probability tree. In the world of Dune, if you are at least a little bit psychic, and you amplify that psychic ability with a generous helping of hallucinogenic “spice,” you can catch a glimpse of the branching probability tree that is the as-yet-unrealized future.

Here in the investment and financial advice businesses, we, too, seem to have reached an evolutionary crossroads. I don’t claim to know exactly what the industry will look like in ten or twenty years. But like Dune‘s protagonist, Paul Atreides, I think I can peer through the haze of a spice trance to glimpse some of the branching possibilities.

Click through to Epsilon Theory to read the whole thing.

I got a lot of great feedback on this note. In reflecting on it, there are a couple points I wish I’d articulated or emphasized more explicitly.

 

Non-Linearity In Causal Relationships

The imagery of a probability tree used in the note is oversimplified. In reality, discrete paths do not lead inevitably to particular futures with such-and-such probabilities. Rather, events exert a kind of gravity on one another. (See: The Three Body Problem) For example, if MMT were to become the fiscal policy paradigm adopted by our fiscal policymakers, it wouldn’t “automatically” mean that X, Y, and Z would follow as consequences. Rather, the “gravity” of this event would shift the positioning of events in probability space.

A “better,” but more conceptually challenging way of thinking about this is in terms of the light cone used in special and general relativity.

lightcone

A detailed exploration of the light cone concept is beyond the scope of this post (A Brief History of Time by Stephen Hawking offers a good, in-depth introduction if this topic piques your interest). For simplicity’s sake I’ll rip the relevant principles regarding causality straight from the light cone Wiki:

Because signals and other causal influences cannot travel faster than light (see special relativity), the light cone plays an essential role in defining the concept of causality: for a given event E, the set of events that lie on or inside the past light cone of E would also be the set of all events that could send a signal that would have time to reach E and influence it in some way. For example, at a time ten years before E, if we consider the set of all events in the past light cone of E which occur at that time, the result would be a sphere (2D: disk) with a radius of ten light-years centered on the position where E will occur. So, any point on or inside the sphere could send a signal moving at the speed of light or slower that would have time to influence the event E, while points outside the sphere at that moment would not be able to have any causal influence on E. Likewise, the set of events that lie on or inside the future light cone of E would also be the set of events that could receive a signal sent out from the position and time of E, so the future light cone contains all the events that could potentially be causally influenced by E. Events which lie neither in the past or future light cone of E cannot influence or be influenced by E in relativity.

As events “fire” in space-time, they dynamically shape the geometry of possible futures. Of course, when we think about this in the context of politics, geopolitics, or economics, it is important to acknowledge that events/signals “fire” with different levels of intensity–they create proportionally greater or lesser perturbations in probability space.

If someone were to shoot me dead tomorrow it would not even cause a ripple in global probability space. The event would really only impact probability space in a way that is localized to me and my immediate personal connections. Maybe my local community.

If the President of the United States were to be shot dead, however, the event would “shock” global probability space. A much wider range of possible futures are impacted, distorted, and/or brought into play, and on a much larger scale.

The concept of “blowback” is interesting to consider in this context. The term is used in the intelligence community to describe unintended consequences resulting from covert ops. For example, you arm and train some Islamic fundamentalist religious groups to fight communism during the Cold War. Decades later, the same fundamentalists are using their arms and training to commit terrorist attacks against you. Blowback results from our inability to precisely forecast changes in the geometry of probability space.

We are not Paul Atreides.

And for what it’s worth, if you’ve read Dune: Messiah, you know that even Paul’s prescient vision lets him down in the end.

 

Some Thoughts On Permabearishness

On a completely unrelated note, I think it’s worth making a few comments on bearishness and permabearishness in particular. If you are not familiar with the term “permabear,” it refers to someone who is constantly calling for the end of the world and therefore refuses to put capital at risk in the equity markets, or is chronically short equities. Sometimes people mistake me for a permabear because I spend a lot of time thinking and writing about economic and investment risks.

There is an important difference between spending a lot of time and energy thinking about risk and refusing to put capital at risk, or being chronically short equities.

Why do permabears exist? Some are cynical charlatans who are permabears because they make a living as permabears. Other permabears get one bearish call right and it leads them down a path of perpetual bearishness as a result of overconfidence in their own prescient vision (there is a Dune reference for everything).

In my view, the core failing of permabears is confirmation bias. They become so myopically focused on justifying their perpetually bearish stance that they lose sight of the fact that you don’t actually make much money (any money?) as a permabear.

The core tenets of my personal investment philosophy these days are the following:

  1. Minimax Regret > Utility Maximization
  2. Create Convexity

My affinity for barbell-type portfolios is the result. Rather than create “muddy” blends of fixed income and equity, strive for a convex risk/return profile. Use some method (simple annuity, permanent portfolio, T-bills) to create a kind of “floor” for a portfolio. Then take the remainder of your capital and place your high risk, high reward, high convexity bets. The goal is to create and maintain an asymmetrical risk/reward profile. Skewed to the upside, obviously.

To summarize:

  • It is not okay to be a permabear. In fact it is dumb to be a permabear.
  • It is okay to be a nervous bull.
  • It is okay to view the world through the lens of minimax regret instead of utility maximization (though you must acknowledge potential opportunity costs).

It’s Worse Than I Thought

Over the last couple days I’ve had the pleasure of corresponding with David Merkel of The Aleph Blog over differences in our S&P 500 expected returns modes. (Mine was much higher than his). Upon comparing models, I discovered I’d made a huge mistake. I’d essentially included only corporate debt in my calculation, excluding a huge swath of government liabilities from the total figure.

After adjusting my numbers to correct for this, and updating the model, I get a 3.74% expected return for the next 10 years. This is consistent with David’s 3.61% estimate. The small difference that remains is likely down to some minor differences in the time periods we used to estimate our models, as well as the type of S&P 500 return we use in the calculation (I believe David uses the price return and then adjusts for dividends, whereas I simply regress the S&P 500 total return against the “allocation” data).

SP500190630ERREV
Source: Federal Reserve Z.1 Data / Demonetized calculations / Corrections from David Merkel

Previously I’d been referring to my results as “A World of Meh.” I think I’m now comfortable revising that down to “A World of Bleh.” (“Meh” is kind of like an indifferent shrug, while with a “bleh” you are maybe throwing up in your mouth a bit)

I’ll give David the last word here, since I think his take on all this is a nice summary of the quandary investors face these days:

Not knowing what inflation or deflation will be like, it would be difficult to tell whether the bond or stock would be riskier, even if I expected 3.39% from each on average. Given the large debts of our world, I lean to deflation, favoring the bond in this case.

Still, it’s a tough call because with forecast returns being so low, many entities will perversely go for the stocks because it gives them some chance of hitting their overly high return targets. If this is the case, there could be some more room to run for now, but with nasty falls after that. The stock market is a weighing machine ultimately, and it is impossible to change the total returns of the economy. Even if an entity takes more risk, the economy as a whole’s risk profile doesn’t change in the long run.

In the short run it can be different if strongly capitalized entities are taking less risk and and weakly capitalized entities are taking more risk — that’s usually bearish. Vice-versa is usually bullish.

Anyway, give this some thought. Maybe things have to be crazier to put in the top. At least in this situation, bonds and stocks are telling the same story, unlike 1987 or 2000, where bonds were more attractive. Now, alternatives are few.

2Q19 Expected Returns Update

2Q19 Fed Z1 data is out so I have updated my little S&P 500 expected returns model. The model and its origins have been discussed rather extensively here on the blog so I am not going to belabor its strengths and weaknesses going forward. From a long-term forward return perspective, the message remains: “meh.” As of June 30 it was predicting a 7.81% annualized return for the next decade.

2Q19SP500ER
Source: Fed Z.1 Data; Demonetized Calculations

It is interesting to note that the model disagrees with the dire prognostications of much of the investment world regarding forward-looking S&P 500 returns. Many shops out there are predicting low single digit or even negative returns over the next 7-10 years. These folks correctly called the tech bubble in the late 1990s but missed the post-crisis rebound. The model, meanwhile, caught both.

Given the output from the model, and the investment opportunity set more broadly, I’d bet with the model when setting expectations for the next 10 years.

What I think those shops are missing, and what the model captures, is the TINA Effect.

For many investors There Is No Alternative to owning equities.

Given that global interest rates remain very low, investors need to maintain high levels of equity exposure to hit their return hurdles. In the US, for whatever reason, the aggregate equity allocation typically bounces around in the 30% – 40% range. Unless something occurs to dramatically and permanently shift that range lower, I suspect forward returns will end up being a bit better than many people are predicting these days.

Not great. But not dire, either.

Meh.

Hope Is Not A Strategy

Here is a question I get all the time, either directly or from colleagues on behalf of clients:

“I bought [INSERT RANDOM STOCK]. It is down 50%. Should I sell it or hold it?”

The answer should be obvious and it is that you sell ASAP. I kind of hate to say it (okay, not really), but if you need to ask someone like me this question, you had no business buying the damn thing in the first place. Note that the fact the stock is down 50% is basically irrelevant here. You should not take a position in a security if you have no framework in place for updating your views on the basis of new information.

There are lots of different ways to play the game. You can immerse yourself in 10-Ks and 10-Qs and try to find great businesses selling at reasonable prices. You can take the view that “price is all that matters” and trend follow or whatever. There are all kinds of sensible strategies for making money.

Hope is not one of them.

If you own something that has halved and the only reason you have for holding it is “gee, I really hate the idea of locking in a loss” then you are in trouble. No one will be able to begin helping you until you first help yourself by exiting the position. Hopefully it is at least in a taxable account and you can write it off. You can think of the slightly milder after-tax loss as discounted tuition.

When people talk about “dumb money” or “the suckers at the poker table” they are talking about hope-based investing.