Risk Parity is allocating a portfolio based on risk using leverage to make the less risky assets equal in portfolio risk. The issue has been that when they underestimate risk, and usually you may substitute volatility for risk, they have to unlever the portfolio to reduce risk. To me it is the same thing Van Tharp has been teaching all us retail types for years on position sizing based on R multiples of each stock, only instead of limiting the number of shares based on your total dollars the funds, with essentially unlimited credit go the opposite way.
So those very leveraged funds are blamed for every significant market drop. So is the team at Bridgewater superior to the rest of us or do they just have a higher credit limit allowing them to capture more returns from the central bank put propping up the markets? Well Uncle Warren says we will find out who was swimming naked when the tide goes out.
Mid week I saw a chart showing that 52% of the S & P gains year to date were due to 10 mega cap stocks. End of the week I read about how puts and different flavors of VIX were skewed because of the very large levels of drop insurance on the S & P. I would ask what about the effects of buybacks on these mega caps. Hasn't that damped volatility? Doesn't reduced volatility mean even more leverage from the risk parity funds?. So the obvious conclusion has to be that it is all about unlimited cheap debt where the funds and management are in some sort of bidding war and the best part is that it is all other peoples money. Our management proxy Tim Cook wins short term for himself and our Ray Dalio proxy the 28 year old Ivy League history major collects his 2 and 20 with money pouring into his fund.
But as Nassim Taleb has said somewhere in his books these sort of arrangements continue to work until they don't. Then the big problem becomes that the people who looked like financial wizards are proven to be one trick ponies. But when will volatility return? Clearly the crowd has decided that the Fed is lying about rate hikes just as they have been for several years now. So party on! Or maybe not. First quarter saw a huge shot of liquidity from ECB and BoJ. US Treasury dumped money into the US market by paying off debt rather than rolling it over. It looked like a credit surge from PBoC ending on some charts but many do not include PBoC so I am not sure. And they are the biggest expander in the world. Current media chatter is that Super Mario is running out of time and those cautious Germans have had enough of the printing. Also something about PBoC trying to deflate the stock market bubble. But how much public outcry can the central bankers stand before they relent and once again turn on the presses? We know there really is a limit as Zimbabwe, Argentina and now Venezuela have added their names to that long historical list of governments that have destroyed the value of fiat currency, or in the Roman tradition shaved their coins.
This Time Is Different: Eight Centuries of Financial Folly: Carmen M. Reinhart, Kenneth S. Rogoff, was a whole lot of tables that I admit I didn't read. What I did read is you just never know when the house of cards will come down. They called it the Aha moment. I like the story of the little boy crying out the truth in "The Emperor's New Cloths". It is all the same, at an unpredictable time an unpredictable event will change public opinion and overnight what was acceptable becomes unacceptable. Financial systems or maybe a better term would be arrangements, happen and then stay in place as long as they work well enough to not take the risk of change. But the issues slowly build up, the inefficiencies and the dead wood and the parasites untill the whats wrong overwhelms the whats right and it blows up. Most of the historical markers are pointing to the end of the cycle. With all the extra stuff that has been put in place by the central bankers and all the interference in the markets to keep risk from getting out of hand, well I just wonder how deep are the pockets of those central bankers when the Risk Parity funds decide to get out of the market. And I wonder what will be the trigger for that test?
As we wait I can't help but imagining the great wizard up on stage announcing what is about to happen while glancing at the central banker behind the curtain. There are clearly several wizards of Oz around the planet right now and I am guessing that the one in Europe runs the best chance of being booed off the stage as a fraud but maybe that's because I just watch too much news.