Aug

4

Pimco's El-ErianIn several recent essays, Pimco's El-Erian et al claim that reversion-to-the-mean investing will be less compelling in the months/years ahead. Even if one accepts that the US economy will experience slower growth, less leverage, and more regulation, his arguments may be tantamount to endorsing primitive trend-following and saying "this time and every time is different."

He writes; "…, investing based on "mean reversion" will be less compelling. Even though flatter distributions with fatter tails have means, the constituency for mean reversion investing will shrink as those means will be much less often realized in practice. A world where the realized return rarely equals the expected valuation creates a bigger demand for liquid, default-free assets; it also lowers the demand for more volatile asset classes such as equities.

He continues: "… frequent "risk on/risk off" fluctuations in investors' sentiment are here to stay. Investors, based on 25 years of rules of thumb that "worked" during the great moderation, thought they knew more about the distribution of risk than they in fact did. This led to overconfidence during the bubble. The crisis reminded investors that these rules of thumb are less useful, if not dangerous.

He continues: "….With declining confidence in a reliable set of investing rules, markets have become more susceptible to overreactions to daily news and are, therefore, more volatile. Just think of the number of triple-digit days in the Dow. Moreover, because of the complex and broader involvement, real and perceived, of governments in the economy, separating policy signal from noise, and execution vs. intent, has become as important as – but harder than – forecasting the macro data. Third, tail hedging will become more important. An understandable consequence of the crisis is less trust in diversification as the sole mitigator for portfolio risk. We are already seeing increased investor interest in tail hedging, though the phenomenon is still limited to a small set of investors."

My reactions:

1. If the markets experience risk-on/risk-off gyrations, that is the very essence of mean-reversion. (i.e. one should be greedy when others are fearful.) If the constituency for such trades are smaller, it should mean that the surviving participants realize out-sized returns on smaller position sizes. (Exactly the opposite of his conclusion.)

2. If he believes that the systemic tails are larger, "hedging" the tails simply moves the risk from one market participant to another market participant. Absent a directional speculation, if the hedges are correctly priced, there should be no incremental return achieved from hedging which cannot be achieved by sensible asset allocation/position sizing. We've known for years that S&P puts are systematically overpriced relative to calls. Is he claiming that this is no longer the case?

3. Once it's conventional wisdom that we are in a world of everyday fat tails, asset valuations should embed this risk premium, and the phenomenon should self correct. Otherwise, using a slow, primitive trend-following methodology which captures ever bigger fat-tails should produce out-sized returns.

I would be most interested in other's thoughts on his three quotes and my observations. It seems to me that some of his thoughts are contradictory. While the Pimco folks are obviously self-interested, it should be possible to analyze these concepts while ignoring their bias.

Jim Lackey writes:

Mean revert as in 2004 to 07 being levered 14-1 as in no downs greater than 10%… Umm no… so again it's the definition of what "is" is… or forget leverage as that's a function of predictions and max draw downs etc…

How about the fact that we are seeing streaks that have never happened or only happened in 2002, 1933, '34 or all the time in the 19th century. It's been going on since the first shot across the bow Feb 2007. But that's just short term trading… are you talking investing? Then he's dead wrong as the current meme is long term returns are Zero and all I see and hear is "range this adjust for inflation that's a loss" or as usual in any business for a time all rates go to zero…and the get the joke is…that's why so many are tarpitudes and Flexions they need govie contracts rules and regs to profit. So sad.

P.S. I asked the machine tool trader at BMX last night if it's the same trading with Koreans all good vs trading with GE. He said yes but GE is even worse now that it is the government. I said oh come on, you talking bailouts or what. He said no it's like trying to get paper work and all approved to do a trade with the government. Reminded me of in the Army attempting a "lateral transfer" as my tank had an extra M-60 we could use an extra M240 same machine gun one right one left hand feed. It took us forever to get the supply SGT to get the paper work and I found a guy in the Infantry unit that wanted the trade at the mess hall. It took months. But years later the govie got smart and it's all M240's now a days. ha.

Jim Sogi comments:

Mean reversion is too broad a term. The time needs to be specified. The market has multiple time frames and it may be mean reverting in one while trending in another. It is one thing to do mean reversion at 1 hour, and a different trade all together to hold for 4 years in the same vehicle. It is necessary to define the time frame in which there is a claim of reversion or trending, or as Kim notes, positive or negative correlation. 


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