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I ran into a good friend who is a hedge fund analyst in the lobby of my building. “Cannot talk, have to run to call some managers and get their updates. Let’s do lunch next week. See you.” Coming from a quant background, I am always interested how other analysts question managers. I get nervous that I am going to fall in love with the manager’s narrative if he is a good talker, that I am not going to ask the right question to extract their secret value, or that I am going to be turned-off by the poor speaker without truly hearing his message.

“Charlie Chaplin once entered a Charlie Chaplin look-alike contest in Monte Carlo and came in third; that’s a story.” – Movie line from “Lucky Number Slevin”

This myth has been out in the public since the before the 1920’s. It has never been verified or reported as being true in any Chaplin biography, yet it continues to hold the attention of many when it is heard. It provides a cautionary warning about how we perceive in competitive group dynamics. Call this a variation of the Keynes beauty pageant story. 

I have been a close follower of behavioral economics research. This broad research is insightful and has caused me to think deeper about how to make better decisions. It has certainly reinforced my belief that using algorithms to make decisions is better than discretionary judgment. However, I have read a series of recent papers that have caused me to take a closer look at some of the core behavioral beliefs that have been established in this area. See the work of Dan Gal and Derek Rucker in the Journal of Consumer Psychology and the recent article in the Observation Section of https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3049660

Reading the Bank of International Settlements (BIS) annual reports and the speeches of Jaime Caruana, the BIS General Manager, who finished his term at the end of last year, I formed a simple checklist of the recurring themes he has focused on in his work. For the last few years, he has emphasized four factors which he closely watches to determine whether there will be a financial downturn:

There has been a bubbling up of new ideas on fees for money managers. These discussions are focusing on the conceptual framework for fees in order to change the thinking of both managers and investors. A battle to just lower fees between large investors and managers is a lose-lose situation. Managers who do their job well are frustrated with these discussions and investors feel they are disadvantaged when managers underpeform. See the latest piece from my friend Angelo Calvello, Your Fees Are Bull%$&. The capital rental concept should be explored further.

You might think some research is obvious after the fact, but in reality, good research can allow us to deepen our understanding on a topic and may provide subtle insights that were unexpected. One topic of interest is competition and rivalry.

The returns of alternative risk premium strategies and products developed by banks and investment managers will have close links with the underlying macro relationships that are modeled. In the case of credit carry risk premiums, investors will gain from the difference between high yield and investment grade spreads. In the case of rate carry risk premiums, returns will be tied to the term premium in the yield curve.

Volatility has fallen since the February vol-shock, but the vol-of-vol shock paints a deeper picture of the calm that has overtaken the equity markets. This same behavior is seen in other asset classes. Given the combination of geopolitical risks, economic uncertainty, and policy changes, should we expect this level of calm? It seems unlikely.

Investors want diversification from their equity exposure. This desire for diversification increases with uncertainty and with expectations of an equity decline. The big question is how or where are you going to get this diversification. The diversification winner for the post Financial Crisis period has been simple, US bonds. Bonds have been an asset that generated a good rate of return with lower volatility and a negative correlation with equities.  You could not ask for a better diversifier. Unfortunately, the investment environment is changing and the benefits from bonds may no longer be available, so there is an increased desire to find new diversifiers.

Ben Bernanke, former chair of the Federal Reserve. “In 2020, Wile E. Coyote is going to go off the cliff and look down.”
Alan Greenspan, also former head of the Fed. “There are two bubbles: a stock market bubble and a bond market bubble.”
Scott Minerd, Guggenheim Partners chief investment officer. The market “is on a collision course with disaster” and the catastrophe will hit in late 2019, with stocks losing 40%.
Jim Rogers, founder of the Quantum Fund. “When we have a bear market, and we are going to have a bear market, it will be the worst in our lifetime.”
From Forbes 4 Financial Savants Warn About The Great Crash Of 2020 Larry Light

These four experts are telling us doom is ahead. Call it Wile E. Coyote moments, double bubbles, bear of bears or a collision course with disaster, the prediction is the same – wealth destruction is coming. These are the usual doomsday stories. They may be right but there seems to be a natural bias to the dark side. We seem to like it and pundits keep feeding us these narratives.