returns, volatility of returns, correlation of returns

If all investment occurred via a single product, with a single pattern of returns, and no choice, and if this happened over a sufficiently long period that the short term swings of volatility become secondary when measured against the timeline of a typical investor's expected life, then the only one fact you can survive with is the (long term) expected return of that product.  I refer to it as a product and not an asset because I imagine it to be the offering of a company or set of companies which may have the freedom to manufacture this product.  

But reality isn't like that.  And as soon as a second product emerges as a choice (or even if you examine how the company manufactures this product), then correlation and (therefore volatility) enter into the frame.  

In the history of major assets, cash was invented first.  (Of course, loans existed before all that, and were a huge part of early human culture - the loans being loans of non-cash valuables for non-cash rewards e.g. slaves, food; these goods, like cash, may also have been understood to be fungible and tradeable).  Not surprisingly, the place which brought us writing also brought us the first bond.  The city state of Nippur in Sumeria offered one.  Italian city states pioneered state bonds as far back as the twelfth century, quite a while before the official story that Amsterdam and then the Bank of England invented them.  Certainly they set the modern pattern.   Shares were known certainly in Roman times, as was property, which had deep underpinnings as the earliest Greek and Roman religions were domestic hearth ancestor religions.  This simultaneously raised the cultural value of property but also introduced a whole bunch of restrictions, rules, taboos around selling property.  As the Roman republic evolved, and as class war between patricians and plebs loosened the grip of the old domestic gods, property as an asset class began to evolve too.

Inflation, of course, is not an asset.  But it is the force which makes cash experience volatility in real terms.  So these are the primary financial assets:  Cash (and loans), Property, Equities, Bonds.  And inflationary pressures contribute to the volatility of all four of these assets.  The primordial question is to work out how much each one will return to you, and how uncertain that return could be, and finally, to design of set of weightings which might exploit their time-evolving correlations.

By the time Markowitz came to develop the standard maths of modern portfolio theory, he addressed just two assets, equities and bonds.  Why?

Credit spread is probability through a sausage machine. Volatility is probability through a juicer

Just as statistics is really an elaborate form of a particular kind of probability activity over sufficiently large numbers, then so too am I beginning to see the volatility of equity derivatives and the credit spread of the fixed income world as two other distinct kinds of mathematical context within which you can find probability theory applied.  And of course, probability is useful to us insofar as it can place a number on something ultimately unknowable.  Albeit a known unknown ('risk' or measurable uncertainty, in the Knightian sense).  My main point here is that credit spread and volatility, the two great inputs into fixed income and volatility modelling, are brothers.

All quiet on the western front

Tuesday evenings these days for me is economics night.  At the moment, I'm reading a macroeconomics populist book, "Endgame".   I'm on chapter four, which I'll summarise as succinctly as possible here.  First, I notice that when I search for an Amazon book called Endgame, that this one comes up first, well ahead of Samuel Beckett's great play.  Beckett's should come first.

Also, as I write the current posting, I'm listening to the following artists from my colelction: Banshori Baaje, by Aajo Madhuro.  La Femme D'Argent by Air.  The moon is full by Albert Collins.  International by Laidback.  Long Haired Doney by R.L. Burnside.  Riddle I This by Scotty.  Cowboys by Portishead.  Mis Pensamientos by Las Hermanas Mendoza.

Finally, I'm reading this 2011 published book in February 2013 so I get to see how the immediate future panned out for the authors' predictions.  On p42 the authors state that they wrote that section in November 2010.

The authors in chapter four propose a macroeconomic thesis.  Many countries, primarily America, are so indebted that it will be practicably impossible to innovate and grow out of their current economic endgame.  Phenomena of the endgame include generally slower real GDP growth, more frequent recessions, higher real GDP growth volatility, higher equity and bond market volatility, higher structural unemployment, particularly at the low skilled, who have been undercut by a cheaper globalised workforce and who are receiving compensatory governmental transfer payments which merely extends the pain.  Looking back from proximal to distal causes he draws on elements of Minsky the so-called post-Keynesian.  This is a story of complacency and low volatility leading to credit booms.  This is itself an elaboration of the 'animal spirits' of Keynes.  In a way Minsky seems to have taken the idea out of the realm of personal psychology and embedded it in financial institutions.  He also identifies the effects of lengthening global supply chains as a significant cause of global volatilities of the kinds mentioned above.  Central bank responses will lead to continued quantitative easings, which in turn makes the debt burden worse.

Next they spell out advice to readers as investors.  Reduce the average holding period of your investments.  Invest tactically.  This isn't too surprising, coming from money managers.  Readers as ageing citizens should count on receiving a much reduced safety net in their retirement. 

How's he done in February 2013?  Well, we have just had surprising negative Q4 GDP read for the US, and for the UK and Europe too.  But Equity market volatility is at 5 and 6 year lows as measured by the daily S&P500 realised volatility and the VIX.

Two intriguing charts plot a relationship between the credit cycle and equity volatility.  First, he gets a chart of annual change in commercial and industrial loans over time.  He plots a point against a time two years into the future.  That is, the C&I growth obervation point for October 2010 gets plotted on the October 2013 x-axis. On this same diagram he plots the VIX, which exhibits a very strong correlation.  He does likewise with the MOVE Index 3 years forward, against the Fed funds rate.  

Both of these curves exhibit impressive correlation, especially given the seeming predictive power of the two proxies for the credit cycle - commercial and industrial loan growth and fed funds rate. However, the leading indicators are actually predicting incredibly low volatility for 2013, which is exactly what we've been seeing.  This appears to be, short term, exactly the opposite of his stated macroeconomic thesis of increased volatility.  Certainly the Fed funds rate now is still flat on the floor, leading me to wonder if volatility is in for several more years of flatness (VIX below 18)?  In any case, it doesn't support, in the short term, Maudlin and Tepper's claim.

This is my whole experience with the book so far.  They look like they're reading a lot of other peoples' research but not quite connecting some dots which are there right in front of their eyes.