Global Macro Trading Journal

[Daal]

Dalio implies a similar idea when he talks about how its superior to leverage a liquid investment (say, S&P500 futures) to juice the returns and make it similar (return wise) to private equity. Its better because you always will have the liquidity there, whereas private equity liquidity will completely implode when a tail event hits.

Taleb talks about 'mixtures' in his Barbell paper (which I'm currently dissecting but its difficult, its so full of equations its almost unreadable). Mixtures is a term used in Chemistry but I believe it also applies to Alchemy. Since there is no precision in estimating risks and returns (certaintly, not compared to Chemistry), its more like Alchemy than Chemistry. So that's why I'm calling this "Investment Alchemy"

 

[sle]

Dalio implies a similar idea when he talks about how its superior to leverage a liquid investment (say, S&P500 futures) to juice the returns and make it similar (return wise) to private equity. Its better because you always will have the liquidity there, whereas private equity liquidity will completely implode when a tail event hits.

I would not agree with him there. A key question to this thought process is the source of return on your risk leg. S&P500 is a risk premium product, you are getting paid for taking volatility of [equity investments, economic environment etc]. Private equity, as a rule, is pitched as an alpha product - you invest in a company that is under-priced due to A/B circumstances and you are able to influence the outcome by doing X/Y/Z. If you are harvesting alpha, you should be allocating to it based on the risk/rewards of the alpha strategy. If you are harvesting risk premium (i.e. you playing the general expectations game) you should allocate based on impact of this risk on yourself, a.k.a. your utility function. In short, S&P, even leveraged to the beta of the PE investment, will provide you with a market return while PE (at least in theory) is an investment that has some external value factors and thus should produce excess return over the general market.

 

[Daal]

I would not agree with him there. A key question to this thought process is the source of return on your risk leg. S&P500 is a risk premium product, you are getting paid for taking volatility of [equity investments, economic environment etc]. Private equity, as a rule, is pitched as an alpha product - you invest in a company that is under-priced due to A/B circumstances and you are able to influence the outcome by doing X/Y/Z. If you are harvesting alpha, you should be allocating to it based on the risk/rewards of the alpha strategy. If you are harvesting risk premium (i.e. you playing the general expectations game) you should allocate based on impact of this risk on yourself, a.k.a. your utility function. In short, S&P, even leveraged to the beta of the PE investment, will provide you with a market return while PE (at least in theory) is an investment that has some external value factors and thus should produce excess return over the general market.

I suppose I didn't fully describe his view correctly. He acknowledges that private equity (plus real estate and other illiquids) can be a good source of alpha. He just thinks at this point in the cycle is hard to get much alpha but you do get all the liquidity risk

http://www.ahwilliamsco.com/includes/OurThoughtsaboutRiskParityandAllWeather.pdf

"But the beta exposure that comes with an illiquid investment is generally not additive to what is available from publicly traded, more liquid alternatives, once you adjust for risk."

So presumably he thinks the alpha exposure is additive IF one can find that alpha (either through a manager or by himself).

In my case (and I'm being my own alpha manager), with Brazil USD bonds yielding about 250bps over USTs (vs ~225 of the EM USD bond ETF). I don't think there is much juice left

 

[Daal]

Something I didn't know, Dalio's All Weather strategy uses 2-1 leverage. I thought it was more around 1.25-1.5 to 1

"Second, All Weather doesn’t use very much leverage; the strategy is around 2 times leveraged, which is less than the amount of leverage an average large company in the S&P 500 employs and about 1/10th the leverage the average U.S. bank employs (which we think is too much)."
http://orcamgroup.com/wp-content/uploads/2012/10/pmpt-engineering-targeted-returns-and-risks.pdf

 

[Daal]

Trump impeachment is trending on twitter, of course, that's all nonsense. But if down the line (years in the future), something like that were become a real possibility, I can't help but to think that would be even more bullish for markets. Pence would take over and effectively you would get the pro-business stuff without the volatile game theory stuff that Trump is trying to pull it off. To the extent that the uncertainty is removed from the table, people will feel even more comfortable with stocks

 

[Daal]

My 2300-2400 SPX target range is not looking so crazy anymore. 2400-2500 is an area where things will start to get pricey, but only if stocks go there without policy being announced or if its announced but nobody knows if it will pass

 

[Daal]

Interesting facts from Taleb:

"
Take for example the binomial distribution with B[N, p] probability of success (avoidance of failure), with N=50. When p moves from 96% to 99% the probability quadruples. So small imprecision around the probability of success (error in its computation, uncertainty about how we computed the probability) leads to enormous ranges in the total result. This shows that there is no such thing as "measurable risk" in the tails, no matter what model we use.

Case 2: More scary. Take a Gaussian, with the probability of exceeding a certain number, that is, . 1- Cumulative density function.. Assume mean = 0, STD= 1. Change the STD from 1 to 1.1 (underestimation of 10% of the variance). For the famed "six sigmas", the area in the tails explodes by 2400%. For the areas above 10 sigmas (common in economics), the area explodes by trillions. (More on the calculations in my paper)."

 

[Daal]

Sidney Homer and Richard Silla in their great book 'A History of Interest Rates' have data on old Brazilian government bonds that existed in the last century. I collected that yield data and put it over the inflation data that I have to see how investors might have fared

The book does not say what were the maturity of the bonds so I cannot estimate returns based on changes on yields. I can, however, average out yields and compare to average inflation. I then subtracted the avg yield from the avg inflation (and called it Simple Difference), I also applied the Fisher Equation to see if there was any big difference (and called it Fisher Diference)

Quotations from the bonds stopped after 1959 and the government stared to index bonds and other fixed income instruments to inflation (presumably because the market had enough of inflation and wasn't going to invest in sucker bonds anymore)
Its quite clear the this Brazilian bond market blew up in the 50's and investors were severely eroded by inflation

The book also talks about the Argentina and Chile experience. In Chile, between 1945 and 1960, the currency lost 95% of its dollar value and the cost of living index rose by 50x. The comes out to a 27.7% compounded inflation rate. Chile bond yields averaged 8.48% in the 40's and 8.33% from 1950 to 1953. On 1953 the bond yield data stops. So, another bond market likely blew up

In Argentina, the currency lost 94% of its dollar value in the 50's. The average yield in the 40's was 3.94% and in the 50's (up to 1953 when the series stopped) the avg yield was 3.26%. So, safe to say, another bond market blew up

In Uruguay, Mexico, Pery and Colombia, they provide yield data but provide no inflation so its hard to estimate bond returns, although it appears that Colombia did well.

Still, with 3 countries out 7 delivering huge real losses to bond holders, its safe to say that duration bonds (bonds with significant maturities) in latin america, historically have been quite risky. It looks very likely that they have produced negative real returns and are a value destroying asset classes. This does not apply to the fixed income asset class as a whole. Certain savings accounts, inflation indexed bonds and other products have proven more resilient to inflation in Brazil than longer maturities bonds (but even them had some pretty awful years, plus the price index was manipulated down). But duration quite clearly is a very risky value destroying 'asset class' in Latin America

 

[Daal]

These bond markets weren't necessarly like a developed market bonds markets where the government raises cash every month by selling bonds. Homer and Sylla talk about specific bond issues that are taken an snapshot over the lifetime of their existance. So, it appears that these governments couldn't regularly issue longer duration bonds (those with maturities of more than a few years) but instead, they issued them when global and local conditions were good. Then the bonds continued to exist in a secondary market (although I do not know if their 'quotations' truly reflect market prices as the yields seem too low compared to inflation, regardless a loss will be delivered to bond holders, either through a bond price decline or through low real yields).

Then at some point inflation got out of hand and it appears that these governments had to rely exclusively on short-term financing (central bank money printing, 'overnight' bonds, inflation indexed bonds, super low maturities, USD indexed bonds, etc)

So its important to make this distinction, its non-indexed duration that it's the real problem, not necessarly fixed income in general (although shorter-term or indexed fixed income can be a problem too, its just that its more resilient)

 

[Daal]

Inflation indexed bonds in inflationary countries can also be problematic

In Brazil in the 60's they created an "ORTN bond". ORTN was supposed to be a price index that was going to adjust the bond for the loss of purchasing power. The problem was that this ORTN was consistently bellow one of the main inflation indices (IPC)

The geometric avg as 2.57% higher for the IPC
The difference between the Avgs was 1.76%
The difference between the medians was 2.15%

Looking at the compounded difference I'm seeing a 30% real loss in purchasing power due to this bias.
This wont necessarily happen without the market realizing what is going on and demanding a higher return on the bond (the bond paid the ORTN plus an interest rate) but still, when the government pulls this trick, it takes time for people to notice, all that time the government is effectively raising revenue on the back of bond holders until they realize what is up.

Effectively, the government can always raise more revenue by surprising the market by biasing the index more than what the market is pricing in of bias. If people think the bias will be 2%, the government can manipulate the bias to be 4% and effectively, raise more revenue, and so on