You can't stop the mean reversion

Firstly, Merry Christmas and happy New Year to all. I thank you for your support during the year and look forward to helping you out in 2013.

Now, to the post:

PART 1

In Who cares about the budget? I pointed out that we, as a nation, were rather silly get worked up about the budget when the actual financial results were likely to be out by billions. Why not just wait until the 'actuals' were in?

Well, reality is coming soon and Wayne Swan has waved the white flag. After brilliant feats of accounting gymnastics at Mid Year Outlook time, Mr Swan has finally acknowledged the promised budget surplus isn't going to happen. There's only so many $4 billion revenue holes that can be plugged with a shift from a long forgotten reserve account.

One of the factors he blamed was the high Aussie dollar. This was rather odd since, in the first four months of the year the AUD/USD ranged from $1.02 to $1.08 and now it's just under $1.05. The Aussie dollar might be one of the few things that hasn't moved!

The problem for Mr Swan is that he's fighting 'mean reversion'. The Federal Government revenue base is heading back towards it's long term average and he's been desperately trying to cling to boom time forecasting.

This wasn't a partisan comment. Joe Hockey would be having exactly the same problem. I doubt Joe has it in him to say 'you know what, we had a great year last year but I doubt it's going to be repeated.  I'm going to build a buffer against being wrong on the revenue forecasts'.

Politicians have a need to believe whichever is more rosy of the 'here and now' and the 'theoretical tomorrow'. If they were picking from a selection of forecasts, they would always choose the most optimistic one, so long as it carried some basic credibility.

Unfortunately they tend to forget about the possibility of reality intervening and upsetting their plans. The Australian federal budget now appears to be meeting the 'real' long term.

PART 2

Some investments are also defying mean reversion (bonds being a stand out).

A recent article (extract below) attempts to identify them by reference to volatility. The basic premise of the article is that investors should be buying assets with volatile prices, since low-volatility assets have had their prices manipulated (making them more risky). It also wonders where the current price manipulation will lead us?

The article has an equities bias but the point is an interesting one, especially when one considers that traditional portfolio (asset allocation) theory says that high volatility = high risk, low volatility = low risk.

I suspect the author's contention goes contrary to the strategies of most retail investors, but it's worth a read if only as 'food for thought'.

The Control Engineers and the Notion of Risk
Charles Gave, GaveKal

There is a great movie scene where Harpo and Groucho Marx meet in the “socialist restaurant.” Groucho says, “this food is disgusting and inedible!” To which Harpo replies, “and on top of that, the portions are far too small!” So by the late 1930s and the golden era of the Marx Brothers, it was already obvious that socialism was bad fare in high demand. Yet it took another half century for “scientific socialism” to be finally discredited in rivers of blood, murder and poverty. With the economic disasters wrought by socialism, one might have assumed that policymakers would accept that the future cannot be forecasted. The role of economists, governments and central banks is to promote a stable monetary and legal framework for the risk‐takers (entrepreneurs, money managers etc.) to make their decisions as rationally as they could.

Unfortunately this has not happened. Instead, in a new and improved declination of Friedrich Hayek's "fatal conceit," we seem to be moving away from “scientific socialism” to "scientific capitalism" – where the overconfident and overeducated control‐engineers are no longer members of the avant garde of the proletariat, but plain, boring and well‐meaning economists working in the entrails of the world central banks. My intent is not to show why these economists will fail (bigger and brighter minds such as Hayek, Mises, Friedman, etc. have already done this) – but rather to review the impact that the misguided manipulation of the price of money (exchange and interest rates) is having on the notion of risk.

In standard financial theory, most practitioners use the volatility of underlying assets as a measure of risk. To some extent, quantitative easing policies have had their biggest impact on this measure. Not only are prices totally artificial for a number of assets (government debt chief amongst them), but the volatility of these prices is also completely meaningless. Volatility no longer indicates the risks involved in holding certain assets, but instead measures the amount of the manipulation that the poor prices are enduring. For example, no‐one today could say with a straight face that there is any information in the volatility of the euro‐swiss exchange rate, or that this zero volatility adequately measures the risks that a Swiss based investor takes in buying eurodenominated assets. So as a direct consequence of the manipulations of our well‐meaning "control engineers" of market prices , today's volatility readings have absolutely nothing to do with the underlying risks. From here, it is hard to escape the following conclusions:

This will lead to the next disaster, for major financial accidents typically find their source in a misconception of risks, rather than a misconception of returns (e.g., Greek bonds are just as risky as German bonds, levered US mortgage bonds are as safe as houses, etc).

Building a rational portfolio, where risks can be properly hedged, is almost impossible when market signals have disappeared (explaining the recent difficulties of so many macro and CTA hedge funds?).

Staying with the above ideas, consider that all the quantitative models and statistical techniques like “value at risk” will prove to be hopelessly wrong when true volatilities re‐emerge (as they always do!). And when that occurs, who doubts that many financial institutions will, once again, find themselves in the line of fire. After all, as Karl Popper explained: "In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable". The sum of the risks in an economic system over time is a constant and the only question confronting economists is whether we should prefer to take our risk in small doses, or in a massive injection (as occurs when a fixed exchange rate system breaksdown, or when a debt restructuring happens etc...)?

So in a world of “suppressed volatility,” the only smart thing a long‐term investor can do is to buy the assets which have been sold because of their higher volatilities. This obviously is equities, and in particular, the very long duration equities of companies in technology, healthcare, energy, etc. A well‐diversified portfolio of such shares will be volatile, but investors will likely see their money back over time and then some.

In fact, strange as it may seem, the only way to reduce the risk today is to own assets that still sport a "market price" – which will thus automatically have a very high volatility compared to the other assets exhibiting a very low, but artificial volatility. To reduce risk today, one has to build a very volatile portfolio! This is partly because a lot of non‐volatile assets are extraordinarily risky. For example, I cannot think of more dangerous assets to own today than French or Japanese government bonds. I could easily imagine Groucho looking at a menu of JGBs and OATs and exclaiming, “these assets are terrible and have no yield”, only for Harpo to reply, “and their aren't enough for everybody.” This last line will change rapidly when reality hits. Because economic history teaches us that no policymaker can control volatility for ever. The real hedge for portfolios today no longer is government fixed income, or even gold, but is instead volatility strategies.