I really try to limit and manage my pet peeves. When I say “pet peeve,” I’m not talking about traffic or an empty milk carton in the fridge. I’m talking about behaviors that give you a visceral, physiologically reaction that brings you to a full understanding of why Jeffrey Dahmer kept body parts in his freezer.
One of my pet peeves is the saying “there are no dumb questions” because it implies that all questions are good and right. I whole heartedly reject this assumption. In life, asking the right questions will get you much further, much more quickly than asking the wrong questions.
This is no more true than in the world of investing. Do you want to know the holy grail for juiced returns that look like Barry Bonds? Learn to ask the right questions because most investors, large and small, ask the wrong ones. Speaking of which, everyone is obsessed with knowing “will the Fed raise rates on September 21?”
We live in a world of probabilities. Every day when you walk out into the world, you are faced with a range of possible outcomes, of which only one will occur. If I channel my inner Rumi, I’d define a “smart question” as a question that helps you to further clarify the probability of something occurring or that allows you to reduce the list of possible outcomes that need to be managed.
With that backdrop, the dumb question, is “will the Fed raise rates on September 21?” A smarter question is “no matter what the Fed does on September 21, are there highly probable scenarios that occur either way?” Can you see the difference in the two questions? The first one is the question that a cave man or your local Morgan Stanley guy would ask. The second one is the question that a guy who wants his investment performance to bulge like Mark McGuire’s forearm would ask.
I’m not saying that it doesn’t matter if the Fed raises rates or not, because it absolutely does matter. We can’t know for sure what the Fed will do. However, there are things we know right now that can help us to manage the risk and the profit potential of our portfolios, regardless of what the Fed decides to do or how the markets respond.
I can’t stand it when people say “I give 110%.” No, you don’t actually. Can you drink 110% of a milkshake? If you have $100 in your pocket, can you give a homeless guy $110? No you can’t, because you can’t give more than “all” of something, which is 100% of it. But in the world of investing, there is one asset class that doesn’t share this limitation and when it’s “giving” exceeds 100%, bad things happen to people’s portfolios. That’s right, I’m talking about volatility.
We are currently experiencing record low volatility, that in the case of some markets, like the S&P 500, we only see once every 20 years. The 2 primary drivers of this low volatility regime are seasonal and economic. It’s seasonally driven because trading volume tends to dampen during the Summer months and it’s economic because we’ve also had a relatively stable dose of economic data. The data hasn’t looked good mind you, but it hasn’t deteriorated to the point where investors are overly concerned. This has led the big boys to position themselves in extreme ways. Specifically, commodity traders and guys who run “volatility targeting” or “risk parity” strategies have used this environment to increase their leverage to record levels.
These guys are holding extremely LONG positions in the Dow and the Nasdaq, while they are holding an all-time record SHORT position in volatility. So these professional money managers are betting everything they have, and then some, that this low volatility environment is going to continue. They should heed my pet peeve about giving more than 100%; or in their case, investing more than 100%. We are entering a 6-week stretch that is all but guaranteed to have more volatility than we’ve seen recently.
From a seasonal perspective, volatility normally increases by 30-40% in September and October, each year. Intuitively, this makes sense given what I said earlier about the Summer doldrums of trading. This year, we get the added volatility bonus of a couple of critical central bank meetings. You saw how the markets responded to the ECB last week and we still have the Fed and BOJ on deck. What could possibly go wrong? I’m guessing these money managers are going to wish that my pet peeve limitation of 100% applied to them as well.
I can’t stand it when people order food and use the word “do” as the verb. “I’ll do a bowl of the French onion soup.” Oh really, Mr. 50 Shades of Grey? You’re going to “do” a bowl of French onion soup? What kind of messed up stuff are you into?! How about “try” or “have?” Any of those words will successfully order food without making you sound like you’re auditioning for the next installment of American Pie. Let me tell you, Mr. Grey, what a spike in volatility will do to asset prices.
One of the factors I evaluate as part of the Quantitative Gravity in my 3-G framework, is the relationship between and across various financial markets. I’ve seen a number of interesting developments in those relationships because of the influence of global central bank policy. One of those relationships is the shifting dynamic of how markets relate to volatility. I track the relationship between volatility and asset classes over multiple durations such as the last month, the last 3 months and so forth. Right now, volatility across all durations from 1 month to 1 year, are at extremely negative levels to just about every single asset class I track. This means that if volatility increases, even slightly, then a couple hundred asset classes from US equities to emerging market bonds, are heading lower. The only markets I track that have a positive relationship to volatility are: US Treasuries, US municipal bonds, gold and the US Dollar.
These relationships were on full display this past Friday in the aftermath of the ECB meeting, when volatility exploded 42% higher. All markets, save for a couple, got absolutely destroyed. The S&P lost over 2%, crude oil was down over 4%, emerging market equities lost 3%, Eurozone equities lost 2%, even long-dated US Treasuries lost almost 2%, gold lost just 66 basis points and the US Dollar was up, slightly. This all occurred because the ECB chose not to up the ante. They didn’t downshift their easing policy or change their tune, they just didn’t feel the need to do anymore, right now; and look how investors reacted. I’ve got to imagine that come September 21st, markets will have even more of a response, no matter what the Fed does.
Make no mistake, on a given day, the relationships between assets can do whacky things. When the VIX explodes higher on Fed day, there’s no guarantee that last Friday’s reaction will provide a playbook for side stepping chaos. But there is one market that should hold up well under a broad range of possible outcomes, gold.
All That Glitters
Gold checks several boxes as we enter the Fed’s decision. Fundamentally, gold wins in either Fed scenario. If the Fed raises rates in September, it will increase the divergence between the Fed’s policy and the rest of the world, and it will accelerate the US entering a recession. Both of these outcomes are pro-gold. If the Fed is smart and doesn’t raise rates, it’ll send the market a dovish signal and that, too, is bullish for gold.
The other box gold checks is its relationship to volatility. Gold has been positively correlated to volatility over multiple durations for the last 3 years. If volatility increases, there is a good chance that gold’s price goes with it. If not, you get a replay of last Friday when gold lost just a fraction of what most of the other financial markets loss. Either way, not a bad outcome.
Ok, few things grate my nerves more than when people use the word “journey” incorrectly. Here’s a fun fact, I love the TV show The Bachelor. I have no idea why, but for me it’s must watch TV. Let the judging begin. The women on the Bachelor love to use “journey” to describe their time on the show.
“This journey has changed my life.” I hate to break it to you Sweetheart but you didn’t go on a journey, you never left the mansion. A “journey” is an act of traveling from one place to another. When you left the hot tub to go to the kitchen and take another shot, you were on a journey. Your experience on the show, which showed America just what a train wreck you are, wasn’t a journey.
In a similar way, global investing isn’t a journey, it’s an experience. You can greatly improve your investing experience and your investing returns, if you focus on minimizing your pet peeves. Limit dumb questions. Know your limitations. Don’t “do” your food. Most importantly, embrace the iterative and dynamic experience of global investing.