The S&P 500 can be danced like a 3-count waltz: 1 (corporate profits), 2 (price of primary energy), and 3 (interest rates).

Last week, we analyzed the market sensitivity to rising interest rates, all other things being equal. However, rarely are all other things equal.

This week, we integrate the three rhythms, with the conclusion being the cost of primary energy is growing too fast.

You can only purchase two things in the markets: a contract (for example a 10-year bond), or a title of property (like a share). I draw this observation from our trusted source, Charles Gave.

However, you cannot value both in the same way, simply because the first has a finite duration (here 10 years), and the second is a perpetual.

The consequence is of upmost importance when rates are very low – as is the case today – and when they begin to rise (for example from 1.5% to 2.5%), which could be the case for the United States in 2022.

In this scenario – all other things being equal – the contract loses less than 9%, but the title deed loses 40%.

Nobel laureate Harry Markowitz’s Modern Portfolio Theory (MPT) will celebrate its 70th anniversary this year. It has revolutionized the finance industry by formalizing the principle of diversifying an investment portfolio and taken up much of the computing time of the world’s powerful financial computers and the minds of managers for decades. It’s the free lunch of finance.

Today, we tackle this mountain by proposing a new slope in which to climb it: The Intelligence Portfolio Theory (IPT).

The difference between MPT and IPT is ontological. The first focuses on the statistical effects of randomness; the second focuses on the self-organizing intelligence of interacting systems.

Randomness, as we shall see, is a mathematical convenience of ignorance, and this convenience presents many false noses.

Cette lettre est la première d’une série qui prolonge, étape par étape, la Théorie Moderne du Portefeuille. Elle s’adresse aux gérants de portefeuilles financiers et aux risk managers.

Nous commençons par un morceau de choix : la corrélation interne d’un portefeuille. C’est la variable clé qui détermine le risque de crash financier.

Depuis Harry Markowitz, les gérants de portefeuille pensent connaître la solution pour leurs investissements. Choisir des titres les plus diversifiés possibles. En d’autres termes, zéro coopération, zéro corrélation.

Mais comment mesurer la corrélation ? Et surtout, comment la mesurer en temps réel ?

This letter is the first in a series extending step-by-step the Modern Portfolio Theory. It is aimed at financial portfolio managers and risk managers.

We start with a choice piece: the internal correlation of a portfolio. This is the key variable determining the risk of financial crash.

Since Harry Markowitz, portfolio managers think they know the solution to their investments: choose the most diversified assets possible. In other words, zero cooperation, zero correlation.

But how do we measure the correlation? And furthermore, how do we measure it in real time?

With inflation spreading over the world like hot lava and economic growth (especially from China) beginning to show signs of weakness, a risk much forgotten over half a century is resurfacing and fueling conversations between investors: Stagflation!

For once, let us propose a medium-term economic perspective, an attitude quite contrary to the genes of Gavekal-IS which focus on measuring situations rather than forecasting, but paradoxes have never killed anyone.

Is the shadow of stagflation an optical effect or, on the contrary, can it be projected not over a few months, but several years?

Inflation accelerating? Temporary. Supply chain disruptions? A passing moment. Market nervousness? Transitory.

The US suffered from 30 recessions in the last 150 years, and thus, 30 transitory times between recession and expansion. What can we learn from the past?

 As Usain Bolt once said, “All I have to do is work on transition and technique.”

A Minsky moment resembles a snake attack: a sudden and violent destructive move, much like a stock market crash. It originates in a slow psychological process according to economist Hyman Minsky, namely a gradual weakening of the financial system through mounting debts in periods of irrational euphoria.

Can we verify this hypothesis? And is the Minsky moment actually unpredictable?

Like in Sergio Leone’s film, the story of the S&P 500 is played out with three characters:

In March 2021, we warned the Speculator of the likely end of the Price-Earnings ratio expansion cycle. In June, we warned the Moderate investor that the game was no longer worth the candle. Today, we address the Rentier: The S&P 500 earnings yield is now offset by inflation.

For 50 years, when the Rentier expressed dissatisfaction, it was a message for his two fellow investors to take shelter.

Are there laws in economics as well as in physics? We say yes, absolutely. Just like gravitation, classical mechanics, thermodynamics, and even quantum mechanics.

To understand this phenomenon requires a bit of imagination. In particular, a new status of law, which does not find its foundation in an external Platonic world but rather the self-organization of individuals. Here, we state a new scientific law governing a living society: rats in a cage, or «The Law of Diving Rats.”

This example introduces Econophysics.

Does China today play the role of the leaking seal at the origin of the 1986 Challenger Shuttle explosion? Chinese authorities are stiffening up against their own capitalism deemed too “Western,” be they in the tech, food-delivery, real-estate, or tutoring industries.

Here, we focus on the risk of propagation, from Chinese equity markets to world equity markets.

Managing portfolio risks has nothing to do with massaging the average volatility; it is all about not being caught in violent market bifurcations. There are ways not to time bifurcations, but time the risk of bifurcations. Why? Because like nature, financial markets exhibit measurable fractal forms for the better, and for the worse.

This letter introduces fractality for two reasons: