Ahistorical Covariance

As anyone who’s studied finance even casually knows, the most celebrated principle of investing is diversification. In particular, purchasing multiple securities with low or negative covariance diminishes the risk an investor faces in owning a portfolio. Risk, in financial parlance, is operationalized as volatility, the variability of a security’s value. Covariance means the tendency for two securities to move simultaneously. Holding multiple securities of low covariance reduces risk, because if one security drops in value, low or negative covariance implies that it’s unlikely that all will drop in value simultaneously. The the risk — the variability in value — associated with a particular security is diluted in the portfolio by the likelihood that when one security falls, others are will rise or at least hold their value, damping any change in value of the portfolio as a whole. This is the principal of diversification.

In practice, investment managers construct portfolios by estimating the return prospects, the risk (volatility), and the covariances of various securities, and computing the portfolio that, based on these estimates, maximizes the ratio of risk to return. If managers were able to forecast expected return, variance, and covariances with 100% accuracy, rational investment would be a science, and there would be a clear “best” portfolio. To the degree that within a universe of securites, there are ample choices with low or negative covariances, investors would see great benefits to diversification. But unfortunately, future return, risk, and covariance can be forecast imperfectly at best. Portfolio managers understand this, especially with respect to return. Few professionals would rely on the naive forecasting strategy of guessing that this year’s return on some stock will simply be the same as last year’s. But variance and covariance are different. Historical values for the volatility and comovement of securities are in fact very frequently used as “best guesses” of future covariance. Investors are urged to hold portfolios that include stocks, bonds, commmodities, precious metals, currencies, and real estate, because historically these asset classes don’t typically move together.

But guessing future covariance from past covariance can be as hazardous as expecting a stock to do great this year because it did last year. Over the past while, there has been an odd spate of covariances. US stocks, real estate, precious metals, and oil have all done well. The US dollar has also done well, despite the historical negative covariance between USD and precious metal. Bonds have, until very recently, been flat. US wage perpetuities, the stream of future wages that represents most Americans’ core asset, are not directly priced. But wage growth, the value driver of this asset, has been flat, unusual in the face of rising stocks, commodities, and real estate.

In other words, covariances over the last year, viewed in terms of annual return, have been weird. There’s been a lot of simultaneous zigging where ordinarily a bit of zig and a bit of zag would have been expected. These are ahistorical covariances. Most investors haven’t minded, because nearly everything in their diverse portfolios stayed put or went up, rather than the usual won-some-lose-some scenario. It’s almost as if there’s some magnet or wind pulling normally independent spirits in the same general direction. Covariance is nice when it’s a general updraft.

But beware ahistorical covariance if the wind changes direction. The most professionally crafted portfolio won’t protect an investor from wild swings in value, if its holdings were based on historical covariance assumptions that suddenly fail to hold.

Update History:
  • 23-Apr-2006, 12:45 a.m. EET: Changed “vaunted” to “celebrated”.


Glenn Reynolds writes

ARNOLD KLING ON fear of confrontation: “Unfortunately, large segments of American society no longer have the ability to confront real evil. People lack the confidence and moral clarity to stand up to intimidation. . . . One can view Islamic militants as armed versions of unruly teenagers. We should not feel guilty toward them. We should demand reasonable and decent behavior from them, rather than excuse their tantrums or their crimes.”

That would require thinking of ourselves as adults, which is unacceptable to many.

I want to think of “us” as the adults. In fact, in the run-up to the Iraq war, which I supported despite the clear disingenuity of the war’s justification, I took a similar, explicitly paternalistic view of the world. The Europeans in particular were behaving like petulant teenagers, protesting “the system” while enjoying a vast subsidy, in financial terms and as “moral comfort”, by letting America do the dirty work ensuring their security. And I viewed much of the Middle East as locked in a kind of post-Marxist, post-colonial, Che-T-shirt-style adolescent radicalism, which mixed with Islamism and pan-Arab nationalism, and unfortunately real explosives. My view at that time was that the United States was an arbiter of reason and civilation, imperfect but sufficient to enforce certain standards and keep the peace.

But, owing partly to the incompetence which with Iraq’s reconstruction has been managed, but primarly to the fact the United States has allowed the soundness of its own economy to become badly undermined, I no longer believe we are credible adults. My estimation of the Europeans and the Islamic world have not changed. I’ve little flattering to say about either. But now the United States reminds me of an alcoholic parent trying to keep its delinquent kids in check. Tipsy, blustering America might be well-intentioned, it might in fact know better what’s right and what’s wrong, but its constant bumbling, its ability to throw tantrums but incapacity to lead or to guide, and its self-destructive partying on cheap capital render it an ineffective role model. The US is in for a bad financial hangover from its subsidized home-equity binging. While I have complete faith in America’s ability to take a cold shower and figure out how to right itself economically, that will take several years, and those will be years in which the US will be weakened, and manifestly in crisis. America’s security burdens will weigh heavily in an era of financial pain at home and escalating US dollar prices for anything and everything in foreign lands. I’m afraid we may not have the wherewithal to carry the load.

And then I am haunted by Osama Bin Laden’s tale of the weak horse and the strong horse. In a world where America is weakened and Europe is senescent, let’s hope that it is India, or the Pacific Rim, or even Red China itself that rides tall for a while, and not some destructive amalgam of religion, nationalism, and fascism.

Enormously wealthy country?

Stephen Den Beste once wrote about electrical power:

…electric power has unique properties, and one of the most important is that at any given instant the amount of electric power being generated will always exactly match the amount of power being consumed. If you don’t deliberately balance the system, the laws of physics will do the balancing for you in ways you won’t like.

Electric power has to be generated at the time it is needed, and the electric power grid overall has to have the ability to add generation capacity as demand rises, and to reduce generation when demand falls again.

But this property is not unique to electrical power. Wealth in general must also be generated at or very near the time at which it will be consumed. Just as electrical power can be stored in batteries, but it’s inefficient, wealth can be stored (durable goods, commodities like gold or oil), but only very imperfectly. Here’s a thought experiment: Imagine you have a million dollars today, and a reliable single-use time-machine. You buy a million dollars worth of gold, cart it into the device, and set the dial to Y3K. When you step out, you find that some apocalypse has occurred. Fortunately, humans are not extinct. The locals still like gold, and they respect your property. You live out your life, but as a very rich man would have in Neanderthal times. Your gold was perfectly storable. But your wealth was not. You are much poorer now than then. The same story would hold with any commodity, or with any practical mix of commodities, by which a person might try to store wealth. An individual’s real wealth is a function of the claims he can muster on the products and services provided by a diverse current economy. Without such an economy, whatever one has, whether financial assets or real stuff, will have only very temporary and limited value.

Americans perceive themselves as very wealthy, and as Alan Greenspan used to say Americans’ balance sheets have never been healthier. But “health”, in this sense, means equity, stored wealth. But this is only the illusion of wealth, truckfulls of gold in a time machine.

The US economy is not producing a sufficiently diverse range of goods and services to support its apparent stock of stored wealth. Foreigners who produce what Americans need have progressively diminishing incentives to exchange their current products for claims on US wealth, as what the US economy produces is increasingly useless to foreigners. There may be all kinds of political reasons, domestic and international, for foreign countries to treat US money as valuable, but there are precious few economic reasons. Thus it is not private citizens in foreign countries who value US claims, but their governments.

Fundamentally, whether a country is wealthy or poor has little to do with what it “has in the bank”. A country’s real wealth is nothing more than its capacity to produce goods and services that make its citizens feel wealthy, or that can be exchanged outside the country for what its citizens want. The US economy is dynamic and productive in the broad range of goods and services. But for the moment, the US is neither producing all that it wants, nor producing what others want in exchange for what it fails to produce. Whether the US is rich or poor is unknowable at the moment. That will be put to the test, when other nations stop providing free goods and services and Americans are asked to actually produce or trade for all that they wish to consume.

There’s a difference between being on an expenses-paid vacation and being rich. And the longer the vacation, the harder it may be to get back to work. Or not. We’ll see.

Bubbles and the bias against shorts

Keynes’ words have become one of the most tired clichés in finance. “The market can remain irrational for longer than you can remain solvent.” I can’t find date attached to the quotation, but since Keynes died in 1946, it’s a fair guess that he uttered those words at least 60 years ago. Yet, his words are just as true today as they were then. That, I claim, is a blot and a shame on the profession of finance.

Markets are human institutions, evolved and invented to serve an incredible social purpose. They collectively are tasked with deciding how we make use of all that is precious, so that we productively employ rather than squander our providence. The financial press often treats markets like sporting events, like a kind of casino, or a thermometer for the “economy”, like all kinds of things. But markets are not weather, nor idle wagers. They guide what people do and do not do. They determine what is built and created, and what is left merely imagined. Markets guide us in deciding whether to learn computer skills or carpentry skills, whether to drive or to walk to work, where we will live and whether or not to have children. Markets are mind, we are all neurons. We are also the fingers and toes that do their bidding, individually rebellious but statistically obedient.

Update History:
  • 31-Mar-2006, 5:08 a.m. EET: Miscellaneous small clean-ups, added sentence about how no means of profiting from identification of bubbles implies that bubbles can grow unrestrained.
  • 21-Apr-2006, 10:53 a.m. EET: Some small clean-ups, removed phrase “with very diverse portfolios shorting low-cash-flow instruments” in description of investors who can take advantage of positive asymmetries in shorting, because the sentence was too long and wordy.

Confessions of an underwater short

For the last year or so, my personal investment portfolio has been heavily, aggressively short US equities and the US dollar. It’s not working out for me so far. Both the dollar and US stocks have done fairly well, and I have significant unrealized losses, and am struggling a bit to cover my positions. I find that being short is an ethically interesting and challenging position. I find troubling my awareness that to some degree, I have a financial interest in bad things happening. A terrorist attack in Saudi Arabia leads to a spike in oil prices? Ka-ching. A hurricane in the Gulf? GM declares bankruptct? Ka-ching, ka-ching, ka-ching.

That makes me feel nasty, like some evil Gargamel plotting misery and mayhem from his castle keep. Really, I’m not. Like most people, I’d like for everything to work out for everybody. So how is it that I’ve put myself in a position I stand to profit from other peoples’ loss and misfortune? (And perhaps there is justice, the hand of God even, in the losses, rather than profits, I’ve made from the strategy.)

The idiocy of crowds and “contained inflation”

We live in an infinite-dimensional economy that is forever summarized by a one-dimensional statistics. Monetary policy is summed up in terms of a few numbers: short interest rates, long rates, CPI and its variations. It’s very easy to miss the obvious if one just looks at these numbers.

New York Fed President Tim Geithner, in a recent speech, pointed out the obvious: “Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.” In other words, the “federal funds rate” may be at historical neutral, but monetary policy is very loose, owing to the activity of (especially) foreign central banks.

If you look deeper than one-dimensional summaries, you can find the evidence: Despite high short rates, we have low long rates, the famous “conundrum”. Despite low-ish headline and “core” CPI, check out the detailed CPI report.

Choose any category that is heavy on untradable services, and compare. Over 12 months, food at home is up 2.4%, food away from home (more service intensive) is up 3.0%. Alcohol at home, up 1.5%; alcohol at bars and restaurants, up 3.5%. Housing is up 4.0% overall. “Household furnishings and operations” are up only 0.6%, but most of that category is tradable goods. Look at the domestic “household operations” part (maids, gardeners, movers), you’ll see it’s up fully 5%! Medical care? Up 4% over 12 months. Recreation? Only up 1.1% But recreation includes TVs, bicycles, etc. — tradable goods. Drill down to the domestic-service-intensive components: Pet services are up 4.5%, recreation services up 3.2%. Education is up 6.2%. Personal care services (hairdressers, etc.) are an outlier on the low-side of the service universe, up only 2.5%. But “Miscellaneous personal services” are up 3.2% overall, and more for most subcategories. (Don’t die! Funeral services are up 4.5%! If incentives really do matter, we’ll all be immortal soon.)

The pattern is quite clear. Whatever is exposed to global competition is cheap, with low or even negative price growth. (Apparel, television, appliances, etc.) Pull this stuff out of the equation, and you’ll see the traditional mark of an overloose monetary policy — inflation. Put it all together with Geithner’s and Brad Setser’s insights, and it is not so complicated a picture. Thanks to the behavior of foreign central banks, monetary policy is very loose, even with a historically “neutral-ish” US Fed Funds rate. The market-priced long-end of the yield curve is a more accurate gauge of effective liquidity than the controlled short end, which at best represents an intention. A loose monetary policy is creating inflation whenever dollar-paid Americans are producing the goods. But our “sophisticated capital markets” are mollified by “central tendencies” of CPI, PCE, in which the inflation is masked by low-priced imports. The same central bank behavior that creates the dollar liquidity creates artificially low prices (in the form of undervalued exchange rates) to help hide the inflation. The idiocy of crowds.

Adapted from a comment to a post of Brad Setser’s.

Debt Sequestration: Why Debt-to-GDP is not a reliable constraint

In a comment to a post of Brad Setser’s, DF challenges (perhaps rhetorically), “What is ‘too high’? [Debt-to-GDP is] now ‘higher’ than in 1929… Let us know, if you have a solution to keep the debt level in a permanent high plateau, or have the debt rise forever, or reduce debt level without any harm for the economy.”

I’m glad to oblige:

Sequester the debt. Let it be purchased by entities that are willing to roll it over forever, that will absolutely never sell or demand cash for the debt that they hold, and that will accept further debt in lieu of interest payments. Private actors seem unlikely candidates for permanent debt sequestration, they do want eventual cash flow from the assets they hold.

The quadruple whammy of a petrostate crisis

There are at least four very bad and mutually reinforcing effects an “event” in Saudi Arabia, any of the Gulf states, or even Iran, would have on the United States’ macroeconomy:

  1. The price of oil would jump, because of both the immediate supply disruption and an upping of the risk-premium owing to the fear that turmoil may spread to other oil producers.
  2. The United States’ trade deficit would sharply increase, driven by the cost of oil.
  3. Financing of the United States’ trade deficit would be reduced, as the recycling of oil funds into “petrodollars” is interrupted in the affected state or states. Increased petrodollar flow from other oil states due to high oil prices might or might not take up some of the slack.
  4. The US would face immediate, expensive security options, likely requiring the Administration to request large emergency funding packages, as for Hurricane Katrina and Iraq War. These would worsen both the Unied States fiscal and trade deficits.

In short, aside from the ugly politics and warfare, the nationalism and unrest that any Gulf state crisis would provoke, it’s hard to imagine anything more perfectly tuned to turn America’s worrisome but so far benign deficits into a debt-financing and balance-of-payments crisis. If such a scenario were to occur, a lot would depend upon the willingness of other states to underwrite some of the security costs and to step up to the plate in replacing lost petrodollar purchases of US assets. If China, Russia, Japan, Western Europe, and other Gulf states support the US position, and want the US to take its traditional lead role in security interventions, they could collectively ease much of the financial pain. If there is not strong support for America’s position during the crisis, surplus countries could worsen the pain by slowing purchases of US securities. (That the economies of these other countries would also be rocked by any American financing shortfall might not matter in the context of a “hot” geopolitical event.)

Note that the above scenario would largely hold for an Iran-related crisis. Iran is not a “petrodollar” country — they don’t peg their currency to the dollar or spend their oil wealth directly on US securities. But it is likely that much of Iran’s current account surplus indirectly finds its way to purchasing US debt. In the end, money from countries that save more than they consume or invest flows to the countries that consume and invest more than they save, even if that flow is indirect and intermediated. An interruption in flows from any major surplus country would affect the ease with which United States meets its huge need for external finance.

Update History:
  • 17-Mar-2006, 2:52 a.m. EET: Changed title from “The quadruple whammy of petrostate insecurity”.

China and the folly of positive real interest rates

Let’s start with the conclusion:

Claims that China is still a communist country are often dismissed as nothing more than a historical conceit of capitalism’s new Wild East. But maybe China really does represent a new and interesting take on communism. Using the old words, one might describe China as allowing the development of a small bourgeoisie, with its constant revolutions in production, while harnessing the arcane machinery of bourgeois financial institutions to nationalize much of the wealth produced by the proletariat. Expropriation via high finance is superior to taxation or outright nationalization, because it masks itself as a fact of nature, as something implicit to markets and currencies and banks. It also has the advantage of turning the bourgeoisie into an ally rather than an adversary of the confiscatory state. Since the bourgeoisie are financially sophisticated, they can avoid expropriation of returns by working outside the state-regulated money and banking system. Plus, the state uses part of the excess returns extracted from the proletariat to buy the support of the bourgeoisie, while the rest can be used to pursue national goals. At the moment, China’s currency policy captures much of the action: By subsidizing exports, it buys off the capitalists; by preventing Renminbi appreciation or deflation, it robs real returns from ordinary savers; and by encouraging development and increasing China’s economic and industrial power, it serves state interests and arguably the public good.

To see how I got here, read below the fold. I seem to recall it had something to do with ice cream.

Update History:
  • 17-Mar-2006, 4:26 a.m. EET: Changed “Wild West” to “Wild East”.

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