Forget Mean Reversion. The Alpha is in Trend Following
February 13, 2016
The regulators, in a blind quest for “stability,” have undone anyone who dares take a risk. They don't even know what stability is.
Most systems comprised of interactions particles are unstable. A system of particles (such as a galaxy) interacting through purely attractive gravitational forces cannot have a "nice" thermodynamic limit, because such a system would collapse in on itself. Contrariwise, a system of particles interacting only through purely repulsive electrical forces cannot have a "nice" limiting thermodynamics, because such a system would explode. David Ruelle demonstrated that a system with even a harmless-looking interaction potential of finite range (compact support), despite wishful thinking to the contrary, does not have an acceptable thermodynamic limit. There are plenty of examples in nature that show a fundamental instability.
Financial systems are among them. There is never “a state of rest”—at least while trading is going on. Financial systems do not necessarily behave in a “nice” statistical way any more than the galaxy itself does. The essential point is that interactions are not independent of other particles’ actions.
This dependence implies the existence of correlation functions and long range dependence. It is difficult to define long range dependence is that one has tried to give a single definition to what is, really, a series of phenomena. Moreover, studying the change in behavior of a system is arguably more important than trying to find a single critical parameter like a correlation.
Global financial markets are locally stable, but globally unstable systems. A financial phase is a set of states for a macroscopic system that exhibit relatively uniform composition and physical properties, such as risk appetite, leverage, liquidity, funding rates, etc. A phase transition is an abrupt transition between states with different physical properties—a big market move and then some.
First-order or discontinuous phase transitions involve a change in the financial state of the market entailing huge transaction volumes. During such a transition, a system either generates big price moves entailing (typically large) gains or losses. First-order transitions involve "mixed-phase regimes" in which some parts of the system have completed the transition and others have not. You can see examples of this when credit market indices move in unexpected way relative to equity indices, or the Main moves weirdly with CDX.NA.IG, or one sector performs differently than another. Mixed-phase systems are extremely difficult to study, because their dynamics are violent and hard to control. Anomalous is the watchword.
Closely related to phase transitions is a concept called “spontaneous symmetry breaking.” During this phase transition process a system typically switches from a given symmetry to a regime of a different symmetry—from a market top to a market bottom. The financial system exhibits an unstable equilibrium phase at the top of the market, and a different phase at a market bottom. The switch from one to the other is a rapid phase transition – similar to the one we think we are currently observing in global financial markets. The breaking of symmetries in the financial world is signaled by anomalies—observed outliers and things uncommonly seen.
Here are a few anomalies we are seeing in the markets in early 2016.
Mean reversion is replaced by trends as the dominant investment factor. Trends in markets are the most obvious symptom of a system heading to a new place. Since it is a mixed-phase system, a number of markets have to simultaneously readjust. In a world of sticky prices, inventories, and a resistance of participants to adapt to new realities, this change takes time. Persistent trends are only way a financial system can resolve from one place of relative stability to another. “From one new normal to another”, as they say.
The random walk assumption of carry and value strategies break down. Instead, momentum strategies get outperforming returns. Price movements and trends are likely to be better predictors of asset class returns than arguments based on relative valuation and fundamentals calibrated to recent generational experience alone. Purely mean-reverting bets become less likely to succeed. Further, the momentum factor is a natural diversifier against fat tails, since it allows for the possibility of markets to overshoot.
Correlations and well-established long-term relationships change. Not just one asset class sells hard, but all classes sell hard. Fluctuations simultaneously occur at all scales and in all markets. An investor exposed to market fluctuations at all scales can improve the odds of success by insulating portfolios against macro and systemic downside risks, or “left tails,” provided they are cheap enough to hedge against. The hallmark of a system near a critical point of transition to a new state is that fluctuations happen on all scales simultaneously.
Thus what might appear as a fluctuation at the firm level is replicated at the sector level and perhaps also at an economy-wide level. This paints a pessimistic picture of the potential for success of short-term regulatory solutions to the problem. Unless the solution is designed to address all scales simultaneously, it is almost certain to fail. Large macro markets become the ultimate shock absorbers of the residual risks. In this environment, trend-following funds and macro investors tend to do well.
Arbitrage bounds cease to hold. The rationale behind arbitrage trading is the relative mispricing of closely related markets, such as the gap between prices for cash corporate bonds and their derivative counterparts. In the current environment, this gap – known as the “basis” – is trading at historically wide levels, with cash bonds approximately 40-50 basis points cheaper than the equivalent credit derivatives (see chart below). This phenomenon is widely observed in other markets (mortgages, treasury futures etc.), and reflects a fundamental repricing of arbitrage bounds.
A fundamental characteristic of the spontaneous symmetry breaking we talked about earlier is that the system at higher temperature has a more symmetric state than at the lower temperature. In fact, Mermin and Wagner theorem is very important because it shows that phase transitions cannot occur in certain systems possessing a great deal of symmetry. At low temperature, the system can get stuck in asymmetric equilibrium. If leverage is the order parameter for the current financial system, it could be a while before the basis reverts and stays in symmetric, bounded ranges.
Leverage and risk are key parameters of the financial system, because they lead to market asymmetry, in this context, crowded trades. generate but the instability itself is caused by In fact, there is a theorem by Mermin and Wagner that shows phase transitions cannot occur in certain systems possessing a great deal of symmetry. This is why an existing matched book is stable. Trying to make a matched book in a crisis is next to impossible.
Brokers and banks are the circuit breakers in a levered economy. By hamstringing their ability to make markets cheaply and withstand asset fire-sales, the regulators, in a blind quest for “stability” have undone anyone who dares take a risk.