Tuesday, July 31, 2018

"Playing For A Potential Yield Curve Inversion"

Also trying to ascertain the timing for a very high leverage, highly concentrated short-term equity long. Not yet but maybe more later today.

Here's the curve from The Integrating Investor:
If you’ve consumed any financial media lately, you’re likely well aware that the yield curve has been flattening. Since roughly 2014, the yield differential between the 10 year U.S. Treasury bond and any number of short-maturity ones has been compressing (the 2 year is most commonly used). Why this has much of the investment community in a tizzy is due to the measure’s reliability as a recession predictor. But given all of this press and – most importantly – the lack of a causal link, should we Integrating Investors take note and make preparations for a Keynesian Beauty Contest; or does the immense scrutiny make it subject to Goodhart’s Law and hence the entire spectacle may be ignored?

Investing is a funny business where expectations and sentiment can trump reality, at least over the short term; and let’s face it, the short term is actually what constitutes even the most patient of all professional investors’ timeframes. Economic and market cycles oscillate over the course of years, so trying to precisely pin down price movements in any given 3-12 month period is difficult to say the least. Thus, a large part of these day-to-day investment gains (in general) can result from trading range noise rather than reflect fundamental price movement.

Dr. Ben Hunt over at Epsilon Theory characterizes the way in which most of us invest as “playing the player.” Stealing an analogy from poker, Dr. Hunt contends that what most investors are engaged in is a giant, zero-sum game whereby each is trying to outmaneuver opponents (i.e. other market participants) as much as they are playing their best hand (my apologies to Dr. Hunt for butchering his eloquent analogy). Now over the long run investing is most certainly not zero-sum activity, but in the competitive field of professional money management where one is ranked versus his/her peers, it certainly can be.

Dr. Hunt is not the first to take note of this behavior. The infamous John Maynard Keynes described such a phenomenon using a beauty contest analogy. In Chapter 12 of his seminal work, The General Theory of Employment, Interest and Money, Keynes wrote:
“… professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”
And so was birthed the concept of the Keynesian Beauty Contest (though I find “playing the player” to have a nicer ring to it). While approaching investing as a poker game or gimmicky beauty contest may seem “low brow” for the “Harvard types”, it is precisely this mispricing of future expectations that lubricates “buy low, sell high” activities....MUCH MORE