The Three Body Problem of the Markets

  In my thirty years in the financial markets, I had the great fortune of investing across almost every asset class. I was on the ground investing in Asia, Europe and the US. I point this out because one's investment process is, and should be, a function of their experiences. A fully developed investment process is really never complete, because one must be adaptable while still remaining disciplined. However, in an ideal world, we should all look to add the best parts of what we learn along the way to build the most robust process that we can. This is what I have tried to do. 

The process consists of three parts. From my days in equity long/short, one of the key issues we always faced was how to size an investment decision. As I studied this more, I determined the best way to do so was to break the decision into three parts - the fundamentals, the supply & demand and the catalyst. If an investment had all three things in its's favor, it should be a full-sized position. If only two things, then 2/3 of a position. If it had fundamentals working for it, but perhaps the supply & demand was against it and there was no catalyst, the idea would be on the watch list and not be put on. One of the biggest problems for investors is not being able to find ideas, it is knowing how to size them in the portfolio. Too often the best ideas, the ones with the most going for them, end up being small positions. Bigger, more liquid names, that may not have as much going, tend to be bigger. Does this make sense?

As I began to refocus on global macro, I thought to myself that there is no reason I cannot apply a similar approach to the broader markets, as the first and maybe most critical question one must ask in global macro is whether the markets will be risk on or risk off. The types of investments you would choose in either environment depend entirely upon that. For instance, a long volatility position (e.g. VIX calls) might look relatively inexpensive vs. its own history, however, if we are in a risk on environment, you will bleed money on those. Similarly, for an FX carry trade, the interest rate differential might be extremely wide, but if we are in risk off, you will lose more in capital loss than you hoped to make in carry. Thus, determining what type of market environment we are in is critically important. 

My goal each week will be to break down one aspect of this three body problem for the markets. In astrophysics, the three body problem is the problem of determining the motion of three celestial bodies moving under no influence other than that of their mutual gravitation. No general solution of this problem (or the more general problem involving more than three bodies) was thought possible for over 100 years, as the motion of the bodies quickly becomes chaotic. Only recently has a solution been found. 

Similarly, finding a predictable solution to what will happen in the markets each month, other than assuming a positive drift higher for risk, has been thought to be improbable. Efficient markets defenders will tell you as much and point to the statistics of active managers. However, I aim to do so by exploring what will happen using three different pillars of assessment. I will look at the Fundamentals in week 1, the supply and demand in week 2 and the catalysts in week 3. In the final week each month, I will try to pull it together to give an idea of the market environment as we head into the new month. 

I look forward to you joining me on this journey. I especially look forward to any comments and dialogue, as it is that sort of interaction that will improve both of our process. 

Stay Vigilant