Investors Positioned For A Correction Are Positioned For Failure

"The assumptions of orthodox financial theory are at least as absurd."

-Benoit Mandelbrot

It doesn't take me long in an Institutional Investor meeting to start pulling out "The Brot." I'm in San Francisco, California this morning and I'm fully expecting to be taken to task on all of the growth and inflation accelerating assumptions that are currently in our model.

The thing about our model vs. others that compete with ours is that:

1. Ours has a Bayesian overlay (it changes as the data does) and
2. We realize that markets are subject to behavioral realities that are non-linear relative to our rate of change forecasts.

On models, as "The Brot" (Benoit Mandelbrot) taught me:

"All models by necessity distort reality in one way or another… there is a rich vein of jokes about economists. Take the old one about the engineer, the physicist, and the economist… They find themselves shipwrecked on a desert island with nothing to eat but a sealed can of beans. How to get at them? The engineer proposes breaking the can open with a rock. The physicist suggests heating the can in the sun until it bursts. The economist's approach: First let's assume we have a can opener… (The (mis)Behavior of Markets, pg 83)"

One of the weakest assumptions in orthodox financial theory (i.e. the one that the "Old Wall" and its media cling to for clicks) is that investors are "rational" when it comes to making portfolio decisions.

In the immediate-to-intermediate-term, they may often be predictably emotional or political, but they certainly aren't "rational."

That's why some of my favorite one-liners about macro markets and asset allocations relative to prevailing growth and inflation conditions are "cheap gets cheaper" and "expensive gets more expensive"…

They seem like "irrational" comments. But that's the point. If markets aren't "rational", why not be irrational?

"Growth" guys and gals have a tendency to agree with me more on this than bottom-up "Value" guys and gals do. I get why. And when I explain my perspective, plenty of "Value" investors do too. It's usually easier to communicate my framework using stocks:

1. What happens when an "expensive" stock crushes the quarter on accelerating revenues and big "beats"?
2. What happens to an "expensive" stock when they miss the quarter on decelerating revenues and guide down?
3. What happens to a "cheap" stock when they miss, guide down, and announce an SEC investigation?

I can go on and on with these questions. What's most interesting to me is that the answers end up being "rational," even though my premise on expensive getting more expensive and cheap, cheaper, is considered irrational by the orthodoxy.

"Cheap" stocks that show an acceleration (after years of deceleration) are typically called "value with a catalyst." And "expensive" stocks that show a big deceleration (after years of acceleration) are typically called "epic shorts."

I'd love to engage in a debate about this with any of you. Like all of us, I have plenty to learn. My mind is always wide open to why I'm so wrong. In the meantime, I'm going to keep pushing the envelope on what we spend a lot of time debating internally:

How does the rate of change of volatility (VIX) affect what's getting "expensive" and "cheap"?

I think about that in terms of the volatility of volatility. It's something you can readily measure and map with futures and options data. We're going to do a conference call on where we're at on this internally. Some of the questions we're solving for already are:

1. Where's realized volatility vs. implied volatility, across multiple macro exposures and durations?
2. What are the implied volatility premiums and/or discounts, across durations? Where is realized and implied at relative to itself using z-scores?

And, obviously, how do we use these learnings to help us time when something is not only really "expensive" or "cheap", but the market finally expects it to remain perpetually expensive or cheap?

Looking at the S&P 500's (SPY) realized volatility, for example:

1. 30-day realized volatility has been smashed to 6.6%
2. But, at 8.7%, implied volatility is trading at +29.2% premium
3. On a TTM z-score that implied volatility premium is +0.44x

All the while, my front-runner on probability weighing the upside/downside in front-month volatility (i.e. my immediate-term risk range) is 10.44-12.91 for the VIX. So that keeps telling me that the highest probability outcome remains for lower-highs and lower-lows in VIX.

And that keeps happening in a US Equity market that is often called "expensive" (it is), but doesn't get cheaper. Maybe someone from the orthodoxy of macro "valuation" experts can chime in on why this is happening.

I think it's because consensus continues to position for a correction that would be deemed "rational", as opposed to buying all dips in an irrationally profitable position that's been complimented by prevailing growth and inflation conditions.

Can the U.S. stock market get more expensive? Absolutely.

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