What is happening on the battlefield in Ukraine left aside a second war (not military this time) in the monetary sphere. Roles are reversed. The Western world pushes hard to collapse the ruble, and thus destroy the Russian economy, and so, Russia retaliates. In both wars, resistance seems to be much stronger than expected. In three weeks’ time, we’ll see if Europe yields to President Putin’s requirement to pay Russian gas in rubles, or not.

The outcome could be a monetary game-changer.

US CPI at 7.5% YoY and 5% in Europe, oil at more than $100 a barrel, Ukrainian refugees by the millions, wheat prices up 30% this year revealing possible food shortages to come in the Maghreb, European governments over-indebted by the management of the Covid crisis which, therefore, can only mean minimalist support measures in the face of the energy shock – a shock that will lead to stagnation in the next six months (likely recession), and FED raising rates by 0.25% this month – the first in an expected series of ten successive hikes – which cannot contain inflation as real interest rates will remain deeply negative… Despite the warlike rhetoric of Mr. Powell, central banks have lost the upper hand.

We are back to the real world.

For 150 years, investment cycles have been mostly controlled by the balance between efficiency and scarcity. Efficiency when primary energy is abundant and cheap; Scarcity when primary energy is scarce and expensive. In efficient times, the stock market thrives; In times of scarcity, it trembles.

Historically, expensive energy cycles tend to last a full decade. What if history repeated itself?

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.

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?

Last Friday, the COVID-19 omicron variant from southern Africa awoken loudly under the horns of the media, and European stocks lost nearly 5% in the day. Bad surprise!

The financial market seems to have been invented to surprise managers, more specifically to dispel the surprise, and managers generally do not like this too much.

What are the market consequences of surprises?

In a stable regime where finance and economy grow in parallel, cash and oil are two forms of free energy which, in theory, should be fungible. Since early 2020, however, the central banks from the US, Europe, and Japan, issued 40% excess cash on average out of the blue to fight the deflationary consequences of the pandemic.

Cash and oil are unlikely to remain fungible: you can print cash, but you can’t print oil.

One year ago, facing the largest bond bubble in history, Gavekal-IS published “Bonds. Which Bonds?” focusing on four investment alternatives to US fixed-rate treasury bonds to protect income portfolios:

The four positions generated more than 20% alpha against US bonds, on average, which now raises the question of a possible over-extension of their outperformance.

Keep? Sell? Who knows?!

Unlike most physicists, value investors should welcome negative mass.

Financial assets carry a mass, just like objects in physics. Some are heavy, others are light, and a few carry a negative mass, a key property for efficient portfolio construction.

Today, the energetic approach tells us more: the expected return of value stock indices outpaces growth indices for the first time in ten years.

« All the things I could do, if I had a little money » chantait ABBA en 1976.

Aujourd’hui, ce n’est plus l’argent qui manque. Les grandes banques centrales des EtatsUnis, de l’Europe et du Japon, en ont imprimé entre 6 et 7 billions de dollar américains depuis le début de l’année 2020. Comment comprendre cette monnaie ? Est-elle surévaluée, sous-évaluée ?

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