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?

«Yes, is like credit, no is like cash,» said Cornelius Jacobus Langenhoven a century ago, the writer who composed the South African national anthem.

On one hand, inflation is back this year, globally. That is a fact. Whether it’s temporary or not, no one can say. On the other hand, global liquidity in USD for the first time in eight months is tightening. This is a major macroeconomic event of the month.

A contraction in liquidity in an inflationary context is a harmful configuration for equities, but also for bonds, be they long-term ones with a fixed coupon, or short-term ones with an inflation-indexed coupon.

It is no longer unreasonable to say “no.” And no, is like cash.

US Investors worried about equity valuations safely reallocating to fixed income. Safely?

With 10Y US government bonds providing negative real rates, losing more than 5% in the last 12 months (same for gold), cash yielding zero, and expensive TIPS reaching a 2 standard deviations’ outperformance vs. fixed-coupon bonds year-on-year, what exactly does safely mean?

Here, we propose a simple rule to dynamically select the best US fixed income asset.

The simplest rule ever.

As for any economic indicator, monetary polices can be viewed from two interdependent yet different angles:

A major “price” signal took place two years ago, announcing the debasement of major fiat currencies and the awakening of gold. Since then, gold has spiked 40%. A “volume” signal took place just one week ago, announcing a second wave of world liquidity in USD intimately correlated with the second wave of the COVID pandemic.

The consequences of the “volume” signal on asset allocation (if it lasts) could be as significant as the one on “price” some two years ago.

Gavekal-IS is excited to announce the launch of its new TrackMacro 3.0 application! The app is downloadable on the website with free access for one month. TrackMacro 3.0 is a major technical step concentrating years of financial research in portfolio construction.

So, how does it work?

Gavekal-IS proposes a 3-dimensional perspective on portfolio construction: macroeconomic, monetary, and behavioral. In each dimension, we straightforwardly consider which of two opposing economic theories is in the ascendancy:

Today, the world votes for Smith, Keynes, and Markowitz.

Roulette players place bets on a number, from 0 to 36. They are deemed winners when the ball lands on the said number. A fair gamble? Not really. Roulette has a trick.

In the Covid-19 crisis, Charles’s “Jeep” portfolio, introduced at the end of 2017 and expounded on in mid-2019, has amply demonstrated its worth, outperforming a pure equity portfolio, but with much lower volatility. In this paper, Charles reviews the Jeep portfolio once again, upgrading its components to navigate a post-Covid world.

One of the notable financial events of 2019 was the switch by major central banks to a ‘Keynesian-type’ global monetary policy. Keynesian polices target the ‘euthanasia of the rentier’, so we know quite well who is likely to suffer from them. The question is, however: who benefits from the crime?

This letter presents visual analogies between quantum physics and market behaviour with regards to risk memory. As shown in the previous publication, market risk memory exists, which is inconsistent with the theoretical picture proposed by traditional financial mathematics. Such an inconsistency, between theory and reality, is at the heart of quantum physics, known as the wave-particle duality. As for particles, represented by wave functions, market distribution of returns are distorted by intercations, i.e. transactions. Such distortions can be measured, and affect all common financial risk measures, such as Value-at-Risk.