How to grow GDP

It's not rocket science. This is the only country in the world, as far as I know (I've only visited 20 or so), where, at least for 5-10 major ethnicities, you can find a group of people with a similar background, and feel somewhat at home. Yes, sure, there will be plenty of little tit-for-tats based on some silly difference you have with others, but at least you can find a place and very likely do something productive for the little society you live in. So, all we have to do to grow GDP is to allow more immigrants into the country. If you've taken a serious roadtrip around the country, you'll notice we have lots of space. Some cities, I believe Dayton, Ohio is one, is making it easier for immigrants to move in and start businesses. New businesses will have new employees, with incomes to spend. Leaving your home country and starting fresh is a very motivating experience, and people will work very hard to make that work. After all, didn't your ancestors do that?

http://www.nytimes.com/2013/10/07/us/ailing-cities-extend-hand-to-immigrants.html

Market Outlook

Now that the June Fed meeting is done, focus will turn to geopolitical events and earnings. I see a choppy summer market, sp could drift up to 2k, or down to 1895; should be in that range unless a clear catalyst emerges. note that a 100 point range is only 5% now, vs 10% when the sp was at 1k. Interesting magazine covers this week - the economist has amazon.com going to mars, and time magazine has "the end of iraq."

How to measure risk?

Risk vs reward measures are typically used for performance evaluation of a strategy or portfolio. But what does risk really mean? Presumably we're talking about risk of loss. But risk of loss means that you actually exit a position at a loss. So really, then, we're talking about the risk of making a decision to take a loss. That means to measure risk using a statistical measure of past prices, like standard deviation (used in sharpe ratio) or negative semi-deviation (used in sortino ratio), you're ignoring any behavioral economic aspects in making that decision.

The implicit assumptions in using a price-derived statistical measure of volatility in a performance evaluation are (1) that we make decisions at fixed-width intervals (because the mathematical definitions of those measures use such intervals), (2) that measure is the same in the past as it will be in the future, and (3) average return compensates for having to tolerate the volatility in real time.

Assumption (1) depends on the freedom of investors (or portfolio manager) to withdraw funds or exit positions. (2) is definitely false, and generally just used for convenience. My main focus for a new measure of risk is on (3). The average return is the best estimate of future return, given that the future is unknown. But surely risk tolerance is path dependent. It's one thing for a portfolio to be up one day, down the next, for e.g. 30 straight days. And it's another for a portfolio to be down for 15 consecutive days, then up for 15 consecutive days; that may incur different behavioral economic aspects for investors. Many risk models assume that prices have no memory, but investors surely do have memory. And no matter what the average or expected return is, I would argue that it's the Probability(return will be x% greater than a volatility-free portfolio) that matters most. And that probability may depend on factors other than the statistics of past prices. Surely neuroeconomics will bring us to a new definition of risk, which does a better job of measuring how we anticipate future outcomes.

The managed macro portfolio is +5.4%, with its worst drawdown at -2.56% on May 15. The drawdown was 1 day after I moved to full leverage, so clearly I was not worried about the possible volatility. If I had outside investors, I would have told them that the probability of having a good return within 1-3 months was 100%. I said over a month ago that the russell will rally back to 1200, that the dax will get to 10k, and they are on their way. The stock market will continue higher this year, with a few bumps and detours along the way, to be sure. As Laszlo Birinyi says, it's like driving from NY to LA. You're sure to get there, and don't sweat the possible traffic or flat tire along the way.

1987 vs 2014

The market has moved roughly sideways, the PL in the model portfolio for the first 3 days has been (+63K, +15K, -20K). Most of the gain was due to entering mid-day before the FOMC announcement. I have no special knowledge about the Fed or any geopolitical events. I use my best judgement based on the aggregate experiences I have accumulated over the past 20 years.

Some market analysts / portfolio managers are looking for some sort of big market crash in the near future. It's possible, it's always possible, that's the nature of financial markets. I've listed all the known unknowns I can think of in a previous post. Today I will make some comments about 1987 vs today.

This is not 1987, this is not 2000, this is not 2008. This is 2014, and as far as I can see today, we are in a stable uptrend / bull market. There are selloffs in a bull market, and every one is an opportunity right now. Leverage must be managed, of course. Any incidence of over-leverage can destroy any strategy based on a correct analysis of the markets. Now, 1987 was the fifth year after a very strong rebound from the 1981-82 recession. The US economy was moving from fast growth and high inflation to slower growth and low inflation. This year, 2014, is the fifth year after a very weak rebound from the 2008 "Great Recession." We have had low inflation for some time, and obviously interest rates are much lower than in 1987. The Dow Jones moved from 1895 to 2722 in a matter of 7 months in 1987, peaking in August. The 10-yr Treasury rate moved from 7% to 10% between April and October 1987, after having moved down over a long stretch in the early and mid-1980s. It's interesting that the SP500 this year has pushed up near 1895 twice, with yet to break and stay above that level. It may soon, unless events unfold to derail the trend.

Additional events from 1987 were some geopolitical events in the middle east, with Iran firing a missile at a US built ship called Sungari. There were no casualties, and the ship did not carry a US flag. Therefore the US made no retaliation, only saying something to the effect that it was an attack on Kuwait. Of course, 3 years later, Gulf War I unfolded. Portfolio Insurance was a new fad back in 1987, which is said to have contributed to the size of the selloffs in October of that year. There was "program trading," which of course is always out there now, with the added uncertainty of "high frequency" and a "flash crash" as in May 2010.

Everyone knows the geopolitical events going on now, and as I've said in previous posts, there are lots of strategies and groups that will add to volatility on that score. Sometimes that allows the markets to climb a "wall of worry" and march higher. I stand firmly in that camp at present.

Macro Trading Experiment

So, let's do a little macro trading / money management experiment. None of this constitutes investment advice. But from my previous posts, you should be able to see that I think the US stock markets are headed higher this year. I had a feeling a few weeks ago, that those were the lows of the year for Nasdaq and Russell. The Russell is now re-testing that level, and the Nasdaq (NDX) is about 100 points higher. SPX likely had its lows in early February. There is always some volatility around a FOMC announcement, and the best case scenario is to get a move against your thesis, so that you can enter a trade at the best possible price. In general, trusting a feeling in any profession should be used cautiously, unless it has been kicked and slapped by feedback so many times that it has become a disciplined personal signal. Anyway, this is an experiment to give my analysis and feelings about the market some further discipline by putting them in a public space. I do manage some capital with a Chicago trading firm, so you can say that I have "skin in the game." In my mind, I've worked on this for so long that I have skin, bones, heart, and soul in the game. Paper trading with no risk at all is fairly useless, and more than likely an incentive to risk real money, which often results in losses. With some risk in reputation, I expect this will be a further benefit.

So suppose a hedge fund hired me to manage $10M. Here is what I'm going to do today. I'm going to commit to staying between a leverage ratio of 0 and 2. That's important to manage the drawdowns. Any major event that causes a market selloff could easily be 10%, or more, so what I'm saying is that if I can't anticipate it at all, then I'll have to live through a 20% or more drop in capital. I can live with that because I believe that I have a US macro model that predicts well at a 3-6 month timeframe. The out-of-sample Sharpe ratio for 2001-present historical testing is 2.7. And when I say drawdown, that could mean a market upswing, if the model is predicting lower market values. In that case I would hold a short position. I call my strategy a "Managed Macro Fund." Any portfolio drawdown is temporary on this 3-6 month timeframe, in my mind. Sometimes you have to just not watch the market in order to "sit on your hands," and avoid exiting a position out of fear. As Warren Buffett has said, "If you enjoy the weekends not watching the market, you should try it on weekdays." Admittedly, his timeframe is likely much longer than mine, but the message is still relevant. There are times you have to go do something else, because in this age of constant information flow, watching the markets can draw you in to make a poor decision. For this paper portfolio, I will use futures because they are the most cost effective tool to manage leverage. So I need to setup a portfolio based on my US macro model, with a notional value between 0 and $20M. I will use 3 index futures, ES and NQ traded on CME, and TF traded on ICE. My leverage is so low compared to margin requirements, that there should be no issue with the exchanges. The current range (as of 1:30pm on Wed Apr 30) of the futures in the order (ES, NQ, TF) is (1870-1875, 3560-3570, 1105-1115). The contract multiplier for (ES,NQ,TF) is (50,20,100). I will take the high of the price ranges, buying 32 ES contracts for $3M (32*50*1875), 84 NQ contracts for $6M (84*20*3570), 54 TF contracts for $6M (54*100*1115). The notional portfolio value is $15,018,600. Ignore transaction costs, but roughly they would be (depending on your membership at the exchanges) a few hundred dollars. Also ignore the possibility of holding T-bills as collateral in a futures account. My initial leverage ratio is just over 1.5. If the market sells off 10% from here, then the portfolio value will drop by 15%, and with only $10M in capital, that means the cash value of the account is $8.5M. I can live with that right now. If geopolitical risk picks up, or there is some unknown event that changes my views, I will make adjustments as best I can. If I can anticipate the fear, I will scale back a bit on the leverage. If things happen that I cannot anticipate, and my view is still bullish, I have some capacity to add when everyone else is selling. So to sum up, initial portfolio of (ES,NQ,TF) = (32,84,54) and initial account value = $10M.

Income Inequality and the Cooper Model

There is a lot of press lately about income inequality, economic growth, and how they are related. Some argue that we need more progressive taxation to get better growth. That may be true, I don't know enough about it. They point to a very long correlation between high marginal tax rates on the wealthy, and economic growth. Referring to this graph: Top Tax Bracket, the argument goes, the golden age of solid growth and a large middle class occurred in the years 1935-1980 or so. The years outside that range, with lower top tax rates, had larger income inequality, and presumably less stable economics. Notably, the 1929 market crash, as well as the 2000 tech bubble bursting and the 2008 financial crisis, all occurred when the top tax rate was below 45%.

I only have two thoughts about this. 1) Correlation is not causation, and 2) it may not be as big a problem now as it was in the past. The reason for point 2) is that, with each recession, or worse, even though the myriad of news sources will make it to look like the worst thing ever (after all, they are selling advertising, and competing for advertiser dollars, and hence readers or viewers), we have still had much technological progress in the intervening years. And people seem to like that. After all, they are buying cable TV broadcasts, smart phones, automobiles, refrigerators, washing machines, etc. As I've read somewhere, we are all living better than John D. Rockefeller ever did. So, at least as far as US culture (and of course Europeans like to say we have none), technology carries us along and apparently makes being in a low income level quite satisfactory. The only reason one might not be satisfied, is that we are constantly comparing ourselves to our peers or nearby social groups, and hence we are motivated to have a newer smart phone, a bigger or better car, more travel stories, etc., etc.

And that is the link to the Cooper Model (it's a lot easier to call it this, than the Darwinian competitive circulatory flow economic model). Any good economic model has to start with a competitive individual who has more than just a marginal utility function of financial gain. Quite probably, this basic competitive individual has a set of values, known or unknown, and is competing to achieve the highest rank in all categories. Sure, there might be some down time, taking a rest from all that, but even holidays and vacations are a point of competition among those who can afford to take them. (I expect several calls from friends about their great trips, just because I've written that;) It may be eventually shown, that we all have a multi-strategy game going on in our heads, and we continually assess potential behaviors in terms of how we can win that game (quite probably winning will involve a combination of serotonin and dopamine, and other feel-good brain activity).

All that micro-behavior adds up to a social / economic model as shown in Ch. 9 of Dr. Cooper's latest book. I think that picture should include lending / borrowing in addition to taxation as a way to keep the flow from the top to the bottom of the pyramid, but that is more about money flow than wealth flow. In any case, the analysis starting on p. 161 explains that part of the process very clearly. The recent press mentioned above is all about modifying taxation as a way to increase the circulatory flow of wealth in the economy. And that might work, it's true. I'm all for better circulation, no matter where in the pyramid I fall. Cooper's description of Quantitative Easing, as a way to increase the borrowing and lending portion of the flow, sounds accurate. QE probably is just short term help and a longer term hurt as far as economic growth. But I remember reading Paul Krugman's "Depression Economics", which I believe had the story of the Washington D.C. babysitting coop, where simply printing more coupons and distributing them to people who would use them, led to a re-start of the tiny model economy. So I cannot help but ask the question, why aren't we trying that? If the Fed is going to print money through QE, why give it to the banks to lend to people at low rates? Especially after the borrowers have all been hit with a "debt sucks" brick in the last 5 years.. Why not just print the money, and give it to those people directly, and let them spend it? I would call that QF, Quantitative Flowing. Let's see if it creates inflation; after all, it appears that we need some of that. It would almost certainly be a good test of the Cooper Model. Maybe it will be tried after the next banking crisis, which according to Hank Paulson's documentary on the last crisis, is certain to occur.

It's more than just bulls and bears out there..

Wayne Gretzky's Dad told him at a young age, "you can learn to anticipate. Go to where the puck will be." Good advice if you can do it. In terms of finance, and the larger stock market moves, that means you have to think about the question, who are the major competing groups with capital at risk? There are market participants at all different time frames, with fundamental, technical, quantitative, or other reasons for having their capital at risk. Many are very long term and passive, eg. mutual fund buy / hold participants. There are long term individual investors buying or selling their favorite stocks. There are hedge funds and traders of all sizes: macro, event-driven, long/short, intra-day, market neutral, dedicated shorts, emerging markets, the list goes on. There are new strategies entering the market, transitioning between asset classes or investor segments, funds closing down, and new funds opening up. It's obviously complex, but that doesn't mean a seemingly simple model cannot capture some of the behavior. The question is, are there times when most of these competitive participants are doing nothing, and one or two groups dominate. Geopolitical risk falls in that category. So the current question is, now that we've had one or two selloffs this year already, has the situation in Ukraine stabilized sufficiently such that event-driven hedge funds are not looking to put on massive short positions? No one knows the answer to that. I suppose at various times, you could get people leaking important information about the situation, and if there is the possibility that any event might scare some market participants, then you can bet that a large event-driven fund would look to put on a position in anticipation of that, and then exit once everyone knows about it, and the fear hits its peak. "Buy the rumor, sell the news" is the cliche there. But you really have to be on top of things, and have good informational connections to do that sort of thing. From an informational outsider's view, the market may push sideways for a week or two, while it becomes more clear what might happen in central europe. In recent past military scenarios, which were probably much more clear than this one (and everything is more clear looking backwards, of course), once the apprehension stopped, and the fighting started, the market generally rallied.