by Franklin J. Parker, CFA
The Summary
- Last week was the FOMC meeting. No surprise, the Fed left interest rates unchanged and began tapering. Rather than print $120 billion in November, they plan to print $100 billion, and then print a little less each month until they are at $0 by next June. This is more-or-less in-line with market expectations. Markets popped, but more on the much more dovish tone of the Fed—rather than feel pushed by recent inflation figures, Chairman Powell said that they will be patient and let many of the factors in the supply chain work themselves out. In essence, anything that is a temporary price hike will be viewed as “transitory” by the Fed.
- Jobs posted on Friday of last week considerably stronger than expected (531,000 jobs added vs 450,000 expected, plus some upward revisions of previous data). Normally, I would have expected this to trigger a “good-news-is-bad-news” move in markets, but because central banks indicated they are willing to be very patient, markets rallied. It makes sense: with the Fed in play and the economy gaining steam, markets are pricing both growth and easy cash.
- Earnings season is mostly now behind us with 89% of S&P 500 companies having reported earnings for Q3. The S&P 500 companies are reporting earnings growth of around 39% year-over-year. This week, then, investors will be watching some key data on the fundamentals of the economy. Producer prices (a common measure of inflation) are due on Tuesday, and core CPI (the headline measure of inflation) is due out Wednesday. While most analysts expect these figures to be high, the report on why they are high will be important (i.e. is the effect “transitory” or permanent?) because that will help inform the Fed’s response.
- Just to reiterate, my view is that markets will trade higher up to late spring of next year, fueled by ongoing central bank activity and economic reopening. By summer of 2022, however, the Fed will be done printing money and markets will begin pricing rate hikes, plus the reopening trade will have subsided. It seems likely to me that the summer of next year will be rocky, given those forces, and investors may do well to be prepared. Of course, there are risks to this view, not the least of which is how inflation evolves over coming months. As I have said many times before, flexibility is among the most important skills in this environment.
The Details
I spent some time analyzing the price returns of bitcoin late last week. Partly because I field lots of questions on the topic, but also because the nature of a financial asset’s return distribution is a major contributor to the role it plays in an overall portfolio.
Now, I don’t want to get too technical here. Suffice it to say, in portfolio construction, returns are assumed to be statistically normal (remember that bell curve from college? That is the “normal” curve). This assumption, while not true in practice, is close enough to allow us to use some tools to mix and match investments in a reasonable way.
However, when we look at the daily returns of bitcoin, what we find is that returns are not even close to the normal distribution (in the chart below, blue is statically normal, and red is bitcoin’s actual distribution).
What we find is that not much happens considerably more often than we would expect, and huge moves—both up and down—happen much more often than we would expect. The problem with this is that it evades our intuition of how financial assets behave. In short, our experience investing in other assets does not well inform our experience in bitcoin.
There are, of course, models which do closely match bitcoin’s actual return distribution, but those models are not well behaved. In fact, we currently have almost no tools for building portfolios of assets with distributions like that! That said, we can use the model to generate some future expectations for the asset, namely its risk profile. Given the parameters of the observed data, we should expect a 1-day loss of:
- 10% about 7 days in every year.
- 20% about 3 days in every year.
- 30% about 1 day every year, and
- 50% or more about 1 day every other year!
In short, bitcoin is a tough asset to place in a portfolio—we don’t really have tools to know how much to buy, when to buy, etc. Moreover, it has the potential to realize considerable losses—the worst of which have yet to be seen! Given that the worst 1-day return of bitcoin has been 37% since 2014, there are some really bad days not seen in the historical data, but which are predicted by the distribution model.
Of course, good days can happen, too (about the same metrics apply to the upside of the distribution), and that is the exciting part.
My advice is what it has always been: bitcoin is a bit of a gamble, so you should only invest what you can afford to lose!
Chart of the Week
One interesting outcome of the Covid recession has been that incomes have jumped for lower-income workers. The bottom and penultimate quartile of incomes saw higher gains over the past year while the highest and second-highest quartile of incomes saw smaller gains over the past year. While a stark increase, this has been part of a larger trend—lower-income-earners have seen their wages rise faster than higher-income-earners since about 2016. This is the first time that has happened since the 1990s.
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