How should I be positioned? with Cliff Asness (AQR) and Jason Draho (UBS CIO)
The desk sees the current macroeconomic landscape undergoing a profound transformation due to the integration of electronic trading, machine learning, and artificial intelligence in financial markets. Per the full note from the 1285 podcast featuring Cliff Asness and Jason Draho, there is a notable shift in how traditional portfolio strategies are assessed in light of these advancements. Given the current state of equities and fixed income influenced by upward inflation pressures, traders are advised to consider new positioning strategies that leverage these technological changes as well as monitor the evolving landscape closely. The sentiment in macro trading segments could precipitate movement in currency pairs amid these technological considerations.
What the desk is arguing
The desk argues that the integration of electronic trading and AI is redefining investment strategies and market dynamics. This shift suggests a fresh perspective on traditional asset allocations, as highlighted by Asness and Draho in their recent discussion. The consideration of these factors is paramount as traders navigate these turbulent macroeconomic waters with heightened inflation and geopolitical tensions.
The supporting evidence rests on the premise that financial markets are not merely reactive but are evolving through technology, leading to more efficient price discovery. Asness noted that this could fundamentally alter how both institutional and retail investors strategize moving forward, especially in a diversified portfolio context.
Where it sits in our coverage
Our consensus target for the EUR/USD currently sits at 1.075, with a range from 1.04 to 1.12 according to various firms analyzing this pair: - jpmorgan: 1.10 for Mar26 - bofa: 1.04 for Mar26
The desk's positioning aligns with jpmorgan's target, which is at the higher end of the spectrum, reflecting a bullish bias in the short-to-medium term outlook compared to bofa's more conservative stance.
How other firms see it
Firms such as jpmorgan align with the desk's view, advocating for an increasing allocation to currencies influenced by technology-driven trading strategies. Conversely, bofa maintains a more cautious approach, indicating potential downside risks amid ongoing uncertainty.
Key related factors include the anticipated responses from central banks regarding interest rates, particularly the ECB's upcoming monetary policy adjustments which could influence EUR/USD dynamics significantly. Additionally, the ongoing technological advancements should be watched closely as they could catalyze broader changes in trading behavior.
01Integration of AI and electronic trading reshapes investment strategies.
02Heightened inflation pressures could lead to new positioning requirements.
03The evolving macroeconomic environment is critical for currency traders.
04Institutional perspectives are shifting in response to technological change.
Market implications
Traders should closely monitor the EUR/USD pair, particularly around the 1.075 mark as a psychological level. Any significant fluctuations in inflation data or monetary policy signals from the ECB could influence positioning ahead of any future trading strategies.
Risks to this view
Potential risks to this outlook include a significant deviation in inflation outcomes or an unexpected dovish monetary policy stance from central banks that may trigger a reassessment of currency valuations. Furthermore, a sudden shift in geopolitical stability could impact market sentiment drastically.
ubs
Hi everyone, Dan Cassidy here. Welcome back to How Should I Be Positioned on the UBS Market Moves podcast channel. On this podcast, we like to catch up with our industry colleagues and partners to talk about the market and macro environment along with thinking when it comes to asset allocation.
Joining me here today from the UBS Chief Investment Office, glad to welcome back Jason Draho, Head of Asset Allocation for the Americas. We're also very excited to have with us today here at our 1285 podcast studio in New York, Cliff Asness, Founder, Managing Principal and Chief Investment Officer of AQR Capital Management, his first appearance with us. So with that, Cliff, thank you for making the trip down here to the studio.
Jason, it's great to be with you as well and looking forward to what will be a very insightful conversation. Great to be with you both. Thank you.
I'm very excited about it. Yeah, thanks for joining us today. I think it's going to be a good conversation.
So with that, I know there's a lot we want to cover with our listeners today. So Jason, let me now pass it over to you to lead the conversation with Cliff. Thanks Dan.
So as we're recording this, the S&P last week continued to kind of grind high, all-time new highs. We've lost a lot of concern in the markets, you know, by talking about bubbles, kind of deja vu to the late 90s. There's also been a lot of change in financial markets in recent decades in terms of like electronic trading, ETFs, things of that sort.
So in this context of bubbles, sort of the flip side is that kind of a question, are markets efficient or not? Are they kind of somewhat inefficient? How would you say, maybe from looking going back, you know, to the dot-com era to now how markets have evolved, do you think they've become more efficient, less efficient, more prone to bubbles?
And if so, why? Yeah. I have recently written a piece, the Journal of Portfolio Management had a 50th anniversary and they invited some of us to write a piece and an invited paper is great because there's no referee.
There's no standard. I shouldn't say that. Frank Fabozzi hopefully would stop me if I was doing something insane, but it was encouraged to be opinion and forward-looking and the whole theme of the piece.
So you'll see I do have a very staked out position on this, is in my career, I think in one particular important sense, markets have gotten actually less efficient. And I say one particular sense because you named a few of the things that a lot of them are technological advancements. I can't say markets have gotten less efficient in terms of their speed of reacting to new information.
You know, we used to trade in minutes and now we trade in nanoseconds. I will say I'm not sure minutes versus nanoseconds is that important to whether the price is actually a reasonable one, but in an informational short-term sense, which I think is what a lot of people think of, yeah, markets have gotten more efficient. But in a, as you put it, are we prone to bubbles?
Are there times, not always necessarily, when there are giant disparities between very broad portfolios of stocks where some look silly expensive and some look silly cheap? Yeah, I do think we've gotten more prone to those. Part of it is admittedly ex-post and empirical.
AQR started in late 1998, which means a fair amount of our first two years was the crescendo of the dot-com bubble. At the time, we said we think the disparity between cheap and expensive, you can measure that very simply like the quant academic factors do. You could be a Graham and Dodd person.
They agreed. Also, you could be much subtler. We thought the disparity between expensive and cheap was the largest we had ever seen by far.
Survived that, thrived from it, actually, when it came back down, round trip. And then 20 years later, it happened again, bigger. By the end of COVID, we saw that disparity, and we've written a lot on this.
Others have picked up the ball, too, on measuring this and all kind of agree that disparity got to larger. And if you had asked me after the dot-com bubble, you ever going to see something this crazy again? Because I did think it was crazy.
I'm an ex, I guess I'll never be ex, but I was a Gene Fama PhD student. He was the chair of my dissertation. I grew up with the efficient market theory, but even Gene says they're not perfectly efficient.
He just thinks they're probably more efficient than anyone in this room does. So this was a little hard for me to move on this, and I haven't gotten to the point of chaos. I haven't said markets are terrible.
I have no better alternative to them. Eight guys in a room deciding on prices, not as good as a market. But I had to sit there and I go, gee, in my career, two episodes both bigger than anything we saw in the last 50 years.
It's a hell of a coincidence unless something's changed. So I list in the paper a lot of candidates, and again, it's an opinion and a paper with nothing I can prove, which is wonderful because no one can disprove it either. But my two favorites are an obvious one that I'm sure you've thought about a ton, the rise of passive indexing.
I'm not a screaming, sky is falling person on this. There are a fair amount of people who think the end of the world is coming from passive. But we all know 100% passive is impossible and stupid.
Jack Bogle, we had a podcast for a while, and we had Jack Bogle on it, who I knew well, and he absolutely agreed with that. I asked him at one point, so how much of the market can be passive and we still have a well-functioning market? And he said, 75%.
And I said, that's fascinating, Jack. What model are you using? Where do you come up with that?
And he said, I made it up. And when you're late 80s and Jack Bogle, you can get away with that. But we all know at 100, nobody's thinking about prices.
What is Nvidia worth versus the corner drugstore? No one knows. Where it starts to get crazy, where that starts to impact, where we don't have enough people thinking about prices and willing to take positions, nobody really knows.
Actually people are working on this now, but it's brand new stuff. But I can't imagine all the crazy happens between 99% and 100% passive. So is that a contributor?
I think probably, yeah. My favorite one, though, is a very old man curmudgeonly, those kids and their social media and their phones. I think the dot-com bubble, and I'm judging you guys, I think you probably were both around for this.
As I get older, I look at people and I go, do I have similar experiences to you? But in the dot-com bubble was the first time proto-social media, message boards were the big thing back then, where a lot of the more bubbly people spent their time on text message boards that are fairly low tech compared to today, hyping each other up. Well, we've taken that to an extreme.
I don't think you'll find many people, you'll find some, but I don't think you'll find many people who think social media has made our politics better and more rational and more adult and more discriminant. I think it's made it more mob-oriented, more false information, as Winston Churchill used to say, a lie can get around the world before the truth gets its pants on. Social media has made that a reality.
It's made groupthink and being in a bubble worse. Politics are very analogous to markets. Markets are voting mechanisms.
It's weighted by dollars. I may get more vote than the average guy running AQR, but Warren Buffett gets more votes than me, but it's still a weighted average vote. If that kind of thing can make our politics nuts, why would we not have mob psychology and bubbles and self-reinforcing activities?
I could be cheap and just point to the meme stocks and say I've proven it. I don't think it's fair to point to the most extreme example on the other side, but I do think that as a point on a spectrum, as the extreme, just to think about what's going on. I think we've gamified and meme-ified a fair amount of the markets, making bubbles and extreme mispricings still better than any alternative to markets.
I don't have an easy fix to this, but I think it's made it more possible, and we've seen it at least twice. I have two follow-up questions on this. I'm not a disciple of Gene Follik.
I wasn't a student. I went to Yale. I did take a class with Robert Shiller.
Well, you're the opposite of a FOMA disciple then. Well, so there was something like Shiller started probably as a very traditional but involved. I know.
But there's something I think he wrote. I think it was after his book, Irrational Exuberance, that he gets to market efficiency and that there's almost like maybe two levels of efficiency. There's the micro level and the so-called macro.
So the micro level, like stock by stock, that efficiency, that's the conjecture, has probably improved over the last 30 or so years, like the arbitrage and mispricings. Macro level efficiency has maybe gotten worse, and the argument a little bit from a theoretical perspective is that it's really hard to arbitrage the U.S. equity market because what are you short? If you go along with that, what are you short?
And so it's just harder to arbitrage mispricings. And there's other reasons that you alluded to that would suggest that. And so I'm curious, when you think about efficiency, if you would think like it's harder maybe for individuals picking securities like active fund, discretionary fund management, it's gotten harder.
So the efficiency in that regard has gotten better, but a macro efficiency where markets can get into bubbles and that actually has not gotten better. Maybe it has gotten worse. Do you kind of agree with that framing?
I'm, believe it or not, on the inefficiency side, going to be a little more radical than Bob Shiller. Bob Shiller split a Nobel Prize with Gene Fama. There was also a guy named Lars Hansen who absolutely deserved it, but no one talks about him because he wasn't fighting with the other person.
Fama and Shiller get along, but it's an intellectual fight. The example I was giving was stock picking, was if you sorted stocks on your favorite valuation ratio, you can use the simple ones from academia, you can build a very complex model that accounts for every, you know, growth differences, risk differences, intangibles, anything you want to do. The difference in cheap and expensive did explode.
I do agree with the general notion that the arbitrage mechanism is, should be, and probably still is stronger for individual stocks than it is for markets. Yeah, saying that you think the S&P is expensive and shorting it. We always overuse the word arbitrage.
The technical definition is riskless profit, and I've often joked that Wall Street writ large uses it to mean a trade we kind of like, which is not quite the same thing. But with that weakening of the definition, I think it is harder to generate a high-risk adjusted return trade. But I also think it has gotten harder.
But he's probably right. So we probably do agree in order, but I think both have gotten harder to do. Now the interesting question to me, and implied in your question, is if inefficiencies or bubbles within stocks, these kind of stocks are wildly expensive or cheap to these kind of stocks, are more extreme.
Should it make active management harder or easier? And again, I started this saying there's a lot of conjecture going on here. But if I'm right that these disparities are bigger and are coming more often, I think it makes an active manager, and here I can mean part of what we do.
Part of what we do is much more quantity, but part of it looks like a quant version of I think just good active management. But think about a Graham and Dodd stock picker. If I'm right, it makes at those times of extremes what to do easier to identify.
When to do it and surviving it considerably harder. Because when you say markets, if you think they get less efficient, meaning they can go to bigger differences away from reality, and it can last for longer, that's wonderful if you have infinite patience and an infinite bankroll. You just say, oh, thank you for the money.
This is stuff that's mispriced. But in the real world, that makes sticking with a position, a trade, a portfolio, a strategy harder. You put it on here and you end up being right one day, but it got doubly as extreme.
It can be hard to live with. All the old saws, the market can stay irrational longer than you can stay solvent, are true. This is not all we do.
We do a fair amount of things that aren't just this kind of valuation work. But we've managed to size things. So while we've not enjoyed the bubble times, we've survived them and thrived round trip.
But that ain't easy. And I will say it does kind of suit my sense of how markets work, and even a sense of fairness, that the job, if I'm right, the job of picking stocks has gotten easier to do, but harder to survive. And that's fair, right?
You don't get paid for nothing. If it was harder to do, if it was easier to pick stocks and easier to survive, it would get arbitraged away very quickly. This always has to be some difficulty.
It could be an informational problem. It could be lasting with the trade. But to have something, if you believe it is mispriced, not arbitraged away, there has to be difficulty to it.
So I don't necessarily see this as a bad thing, but I think people investing in these strategies should realize we are susceptible to these periods. And don't do particularly anything that's closer to a pure value-based strategy. Don't do that if when it looks really, really cheap, you're not going to be able to stick with it.
And figuring that out is an art form. We've all tried to come up with ways to say, how much could you tolerate? And people are notoriously bad about answering.
But you try real hard to come up with that number because it's not going to work for you if you don't stick with it. The second question, and I may preface it by saying, look, I do asset allocation. I'm not doing single security.
So to me, inefficiencies at a macro market asset class level creates opportunities for active management. But it's also not easy, as you kind of were just alluding to. So a conjecture that I would have, I haven't tested, I'm not sure it's easy to test, but I kind of like the idea.
And it's sort of like, you propose that idea that can't be refuted, that's always good. It's not only maybe if markets become a little bit less efficient, but in some ways they feel like they move faster. I think of what happened obviously back around Liberation Day when the market sold off very quickly and very quickly they bounced back.
Last summer is even maybe a cleaner example because it wasn't a policy news per se, but we had some economic data that suddenly the markets got worried about growth rolling over. In about two and a half weeks, there was a 10% drawdown in the S&P, two and a half weeks later it almost fully recovered. So you get these really kind of sharp fees, which even for the most skilled, best traders who can manage their books, that's really hard to time that.
As a long-only asset allocator thinking for our clients, wealth clients, we want to stick long-term. My conjecture is that markets have these kind of dynamics much faster. So we say buy the dips, but the dip can last an afternoon versus 20 years ago, 10 years ago, 30 years ago, there would be kind of slower, maybe more slightly genteel pace and now it's just faster.
And therefore, how you think about managing this, how you want to take the risk, how long your positions has changed, that's again, it's a conjecture, but I'm curious, how would you think that you sort of seen these things moving faster and faster than ever? Probably a little bit. I think what we've seen more is big crazy things happening more often.
I do think if you went back 20 years and take Liberation Day, I forget the actual numbers, but if suddenly we went from a fairly low tariff environment to announcing fairly gigantic tariffs, I think it would have taken a little longer and probably, yes, I would agree with you, it would move a little slower, but I think we would have seen a hell of a reaction to that. And then I think as we backed off the most extreme, I think we would have seen a recovery. So I do think things are somewhat faster.
I know simple price trends, which we've actually, it's still a part of what we do, but we've diversified quite nicely away from it, which has been a good call in the last few years because things like where are economic trends going has been more effective for us. Simple price trends, famously CTAs and managed futures, a lot of names for the same thing, have had a fairly rough period recently. And that might be some evidence behind what you're saying.
They try to trade markets based on prices acting like they normally act. And again, though that speed, I do agree with you on, there are two enemies to a trend following strategy. And somehow I've switched this to trend following strategies.
One is not seeing, this is the most obvious thing on earth, not seeing a lot of volatility or trends over long periods. Long boring periods where nothing moves is a slow problem. The fast problem for trend following, by the way, we believe in trend following, you can overcome problems.
Problems can be worth taking on for the payoff. But the fast problem for trend following, the simple Wall Street term is whipsaw. And a trend following strategy gets it naturally because if something falls, the trend is weaker and it sells, possibly exacerbating.
I think the world blames us for this all the time. I think they exaggerate how much trend following exacerbates it. But it has to be some if you sell into a fall.
And then if it comes back really quickly, a great time for trend following, I'll give you two examples, it's 2022. Really bad year plus that didn't all happen in a day. Really terrible time for trend following, March of 2020.
Everything is wonderful going along and a global pandemic hits. There's no price trend that's going to get that right. It actually wasn't disastrous, but you like to make money in trend following when the market falls.
It's just kind of flattish and disappointing. Again, fundamental trends, some other things we've done has made our life pretty good in this world. But price trends have been quite weak versus history.
And I think that backs up what you're saying. I think it's particularly probably coming from the whipsaw side. That's again trying to like navigate us.
We're not going to be as fast as momentum strategies like what's the right way to kind of navigate? I think we'll come to that a little bit later. Pivoting from market efficiency, the way the markets of trade and trend have evolved.
You mentioned AQR founded in 98, so factor investing back then not nearly as known. Even on Wall Street now, everyone sort of knows the terms, the ideas, value investing, things of that sort. How do you see at this point in time, do you still have faith in those strategies?
How do you see things going to be evolving in terms of new things coming online, especially with artificial intelligence, machine learning, sort of new? What's the frontier, I guess, in this approach? Well, I always, and this is, you know, anytime you split things in two, you're missing the whole spectrum in between, you're oversimplifying.
But I tend to think of the things in our process as old school factors that have been around a while. Obviously, we've been working on how to measure them, how to measure valuation. A number of years, actually before it became a very popular thing, we incorporated some ways to handle intangibles into values, value measures, value measures famously.
Some value measures are very susceptible to not measuring them correctly, but it's still old school value, old school momentum, old school profitability, low risk investing. These are known things that we and others have published a million things on. And then there's new or brand new, ML being applied sometimes to better versions of these same factors.
So maybe it's halfway on the spectrum. Sometimes the things we just had no ability to do before, alternative data. That's something we and other quants are deep into, ferreting out wonderful new databases that have been built with sweat equity that didn't exist before.
The way we all used to do it is we all bought the same data. It's not how I would market it necessarily. We all buy the same data, but it was true.
From the same five companies, and then there was true skill or lack of skill and who processed that data better, who came to a better conclusion. The new world of alternative data, which is really technologically driven, I don't think a lot of these could have been built before that, is someone's created a new data source by rolling up their sleeves. They have it for six years going back.
They're going to charge you a ton more than the generic databases do because they essentially have built at least a temporary monopoly on that data, and you have to decide if you want to buy it. Part of this, the alpha here, part of it is the bespoke negotiation that goes on. We're like, should we buy it?
Well, let me see the data. I'm not going to show you all the data. Then you'll have all the data.
All right. Give me three years. I'll give you a year.
All right. We think we should take a flyer on this and do it. I'm going to the tip of the spear.
There are things all along that we're using ML to do value now that can vary a lot more between industries, between the shape. It's not so linear. It can have nonlinear things.
So new technologies and new data are there. The big difference between these two is the old stuff is, I would call it, a medium decent sharp ratio, but it's not a super high one. Very hard to arbitrage away.
You take something like valuation. I think it works because of a deep seated, we think whatever's happened in the last three to five years is going to continue forever bias of extrapolation. It's very hard to get out of the market.
You need a lot of money if you ever wanted to arbitrage this away. And spreads between cheap and expensive are still, they hit their record in late 2020, but they're still wide versus history. So the evidence it's arbitrage away is not there, but it can be a very hard strategy to stick with.
And the short term is not very high risk adjusted return. The newer stuff for now, I think is a decently higher, considerably higher risk adjusted return, though much more subject to rapidly going away. If you take alternative data, there are ready things in that area that we've used a few years ago and we've thrown out.
That tends not to happen. When you write papers and introduce a new academic factor in 2003, you tend not to get rid of it in 2005. For one thing, that would be mildly embarrassing.
With alternative data, you expect it to have a fairly high Sharpe ratio. And if it doesn't, or if there's evidence others are marketing a similar database that maybe you bought the first one, but someone, you have to be much more dynamic, it's much more of an ongoing arms race. I like to think of what we're doing as a portfolio of the two.
I think both can still work. I think both can still work at scale, but they are somewhat different. And again, I'm oversimplifying.
There are plenty of things that probably fall somewhere in the middle between old school and using some new technology to do old school. Sorry, go on. So on this alternative data, to work for a period of time, you mentioned that maybe five years later, you realize we don't use it anymore.
There's different reasons why that could be the case. It could be like there was some data provider, had an edge, they used satellites before anyone else. So now everyone has the data.
There's also a possibility that what they find is Hayden seemed to have sort of predictability or you find that based on the state, it has predictability returns, but it's a very specific kind of regime period. It's not a fundamental factor that would persist. And so it's a little bit like the factor zoo idea, like you can always perhaps find something that explains it for a period of time, but it's not structurally like value.
When you look at this data, how do you sort of decide whether you think that is a case of like, you know, everyone else has the same information, therefore it's no longer valuable versus you kind of work for this time period, but it's not actual structural thing that could be persistent. That's a hard one. Most of what we're going on, I think, we think is going on as your first example, that just a database that's new is essentially a speed advantage.
Valuation is not a speed advantage. You can wait. You can come up with all your analysis, say these stocks are cheap, then you can wait a month and it's fine.
Maybe you missed one. Alternative data is about acting faster. It's about knowing, hey, those receivables are going up and we know that a little.
By the way, this is the only one I'm allowed to talk about because it's in the public domain. Let me tell you a quick story because I love it. I'm being interviewed by the Australian Financial Review, kind of their Wall Street Journal.
The reporter's really on his game because he's asking me about alternative data and a lot of reporters won't even know to ask about that, but he wants an example. I tell him, our head of stock selection, Andrea Frazzini, has asked me not to speak about the specifics because they are more arbitrageable away. I can talk about value because it's pretty hard for you to arbitrage that away.
He says, fine. He writes the piece and instead of saying Andrea Frazzini has asked me not to speak about it, he says, Andrea Frazzini won't tell me what we're doing in alternative data, which has a very different connotation to it. It's like, oh, man, don't worry about it.
We got you covered. The second one, is it a regime? That you worry about a lot because what I just described was you have three years of data to decide on if this is good.
Fortunately, the cure for both of these is something that I would not have been a big fan of 10, 15 years ago when it was more traditional factor investing. You don't put up with bad returns for very long. I would have been the guy 10 years ago, and I'd still say this for some of the traditional factors saying they go through some pretty bad periods, these bubble periods.
Some other factors have their different periods they don't like, but we've seen that we have 100 years of data and we've seen that before and that's just something you live with. We don't have that with these and they're supposed to be a decently higher risk-adjusted return. Nice and bad things.
If you have a 0.3 sharp ratio strategy, I'm geeking it up for your people, that's a measure people use for risk-adjusted return, 0.3 is a little below the stock market, so it's not bad at all. Stock market's been about a 0.4 to 0.5 historically in the US, and the US is like the best in the world. So, 0.3 is nothing to sneeze at, but active managers are typically looking for more. 0.3 sharp ratios have bad years all the time.
If you throw out your strategy because they had a bad year and you actually think it's a 0.3, you're throwing out a lot of good stuff all the time, missing, adding them back after the good year, not a good plan. If you think your strategy, you have a unique edge and it's a 1.5 sharp ratio, but you know it's not going to last that long. Bad year's still possible at 1.5, doesn't take a Nassim Taleb black swan, but it takes a more extreme event.
And if you have two down years, that's getting a little weird, not weird for value. So you apply a different standard. If something stops working, we'll pull the plug faster.
You do try to figure out other things. Like I said, if you see the regime did change and it stopped working, maybe you're more suspicious. If other people are starting to get closer to the database, maybe you're more suspicious.
So by the way, you're talking to a quant who's now talking about some judgmental things and how to include these, right? It's still fundamentally quantitative, but there is some judgment in what factors to buy and how long to use them. But your example is a great one.
Both of those can occur. There are probably more reasons I'm not thinking of that can make it stop working. But we've had some pretty good success with it, but it's a lot more work.
It's a constant battle to keep it good, to make it better. There's one. You never know if you're making it better or just keeping it the same as it was.
Sometimes edges are hard. The world's trying to take away your edge. They want some of your edge, and if you're first to something, they do it too, and that reduces your edge.
So one of the sadder parts of my business is you never know if you're improving a model to stay in place or to actually make it better. If you think you have a pretty good model that's worked for you for 30 years, staying in place is not a disaster. And the alternative was to get worse because the world ate your alpha.
So I don't want to exaggerate and say we're always making it better. Sometimes we're fighting just to stay where we are. Yeah, like staying in the race is important as well.
And we're coming up close to the end of our time. I guess where I want to end is we talked about the markets, how they evolved, efficient, less efficient, some of the new ideas. The macro environment is certainly different today in ways that we haven't experienced.
The political environment, the geopolitics, driving markets, Liberation Day wasn't a data point. It was a decision by policymakers. So when you think about conversations you'll have with different types of clients, and it may be easier to sometimes start with an institution who doesn't pay taxes because every client who is taxable, they usually have a unique tax situation.
So you start with an ideal, then you customize it. So given these economic challenges, political uncertainty, how do you think then from a portfolio construction, like whether it's 60-40 or adding sort of factors, other things to like, you know, what do you think is kind of the right way to at least conceptually kind of start thinking about things and making adjustments? Sure.
First, we agree uncertainty is higher than normal. If I did it just anecdotally, non-quant, I would certainly agree. But there are measures that look at this.
You can measure it with things like what's the average dispersion in forecasts. They could be earnings forecasts for individual stocks, macro forecasts. You can look at the average miss rate, not bullish or bearish, just the absolute value, how far off are these various prognosticators.
And when they're more far off, I don't think it's a big leap to say uncertainty is higher. And if you look through time, you know, peaks around COVID, peaks around the GFC, we're probably well off the highs, but it's been higher for a while than normal. So we have some numbers that confirm, I think, our basic intuition.
The next question is, what do you do about that? Which is kind of the most important question. First, there may be people who can do this, and I wouldn't want to be disparaging.
AQR is not the place that's going to try to predict the results of that uncertainty, get it right, and say, you know, we think the war in Ukraine is going to settle within the next three months, and therefore we're taking this position in oil. I am personally a little skeptical that that's an easy thing for anyone to do, but it's certainly not what we do. We just ask ourselves, in a more uncertain world, how would you design a portfolio very differently?
And I said very, I shouldn't have said that, because first, the answer is not very. You start out and you guys do this with a strategic asset allocation that by definition means something, maybe you could do better then, but that you're comfortable with owning for the long term, and you know it's going to go through some crazy periods. But I do think some of the classic things that are designed to moderate those periods are at least a little bit relatively more important.
One is basic diversification. I've been a defender of diversification as the U.S. market keeps making me look stupid year after year after year, but as I'm fond of pointing out, diversification always works. It just doesn't always work for everyone at the same time.
For a pure U.S. S&P investor, not been a good time for a while now to say, I'm going to go do these other things. For a non-U.S. investor investing into the S&P, it's been a wonderful time.
So to say diversification doesn't work, it always works. The U.S. is victory, and I love the U.S. I think we have some structural advantages, I think we probably deserve a higher valuation than other countries, but over the last quarter century, the U.S. has beaten other stock markets by a healthy margin after losing for a while up through about 1990, it lost quite badly, but has won.
But the way we measure it, and depending on your favorite valuation measures, you can have slightly different figures, but 80-85% of the U.S.'s victory has come from getting more expensive. Pick your favorite valuation measure. Maybe you mentioned Bob Shiller before, maybe you're a Shiller Cape guy.
The U.S. Shiller Cape, I believe, used to be lower than the world's and is now considerably higher. Obviously, that's a capital gain to a U.S. investor.
That's for the same earnings as I would have, forget better earnings growth. If it just matched it, I'm going to outperform if the valuation ratio goes up. Now, that leaves 20% of it true kind of structural outperformance, the U.S. outgrowing the world.
But I think sometimes people think that 100% of our victory comes from just being superior in terms of our companies, and I would say it's been 20% of our victory coming from that. And that might repeat. It might not.
I'm not the guy to forecast that, so I think people extrapolating what's happened to the U.S. going forward are way overdoing it. There are people much more cynical than I am who predict massive mean reversion for the U.S. where you don't want the U.S. because it's so expensive. We don't go that far.
We trade on many things, including quality, which tends to favor the U.S., momentum, which is often not always favored the U.S., short-term, and long-term, we only make forecasts because 10-year forecasts are terrible things to trade on. So I wouldn't be one of the people who says get out now, but I would say be your normal level of diversification. And we've seen it this year.
It's been one of the first years we're diversifying out of the U.S. I mean, the U.S. has been fine, but a global portfolio has been somewhat better. So we love diversification.
And then if I can give one final plug to just simple one of the things we do, I've already plugged this. So we do tons of investment products, and I've plugged one twice, but trend following. Trend following, again, doesn't really help you in the bolt from the blue in the March of 2020 in a flash crash because there's nothing to follow.
There's no economic trend. We think we've made it much better by expanding the economic trend. There's still no economic trend in a bolt from the blue.
It does really help you in medium to long-term bear markets. Compliance should have me rephrase that. It has really helped you.
I think it's going to help you going forward, but that is just an opinion. So if there's ever a reason for trend following, trend following I think of as insurance that usually works, doesn't always work. You wouldn't want this for fire insurance on your house that you really need, but usually works but tends to make you money on average.
Where insurance like buying puts always works in a crash, doesn't always work in a long-term bear market because if you never see the crash, it can also not work, but always works in a crash but costs you a ton of money long-term. So we think trend following is a very cheap way to get some very decent insurance against the real killer out there, an extended bear market. And I guess it's a tautology that if we think uncertainty is higher than normal, our normal – I have to be honest, we'd almost always tell you we'd have this as at least some part of a portfolio.
Probably a little more now because we do think that uncertainty, as you said, is higher than normal. Uncertainty or just in general more diversification, I guess they kind of go hand in hand. More diversification, maybe that diversification you can just roll it in and say diversifying into some trend following products.
It could just be a sub-part of diversification, but making sure you have that robust portfolio that you generally think you should have but maybe you've drifted away from as one asset, the S&P 500, but the only thing you could have done better than diversify out of that into all NVIDIA. That probably would have been a little better. It would have been a lot better.
But it was hard to beat that. And I think when that happens for a long time, people do tend to let their portfolios drift. So it's a good time to examine, am I diversified geographically, by asset class?
If I buy the trend following story, which you know I do, but I'm not going to put words in others' mouth, do I have enough of it in my portfolio to weather something or to help me weather something ugly? I think now is a good time to take that survey and at least talk about it. On the diversification, the global diversification, certainly something that we often talk about with our clients and advisors because if you're a U.S.-based investor, it's been, as you say, a fantastic experience for a number of years, naturally to have a home buys, yet sometimes we make the argument, for that to continue, think about the implications that means companies like Apple or NVIDIA just become almost like the whole global economy.
It's an absurd kind of statement, but the logical limit is, is that actually feasible? And when people start to think of what this would actually entail, other than becoming a bubble, then they kind of get, yeah, there is reasons why. But I know we are at, we've covered a lot of topics.
This has been a really good conversation. I tend to go over. We can probably go on for another hour, but I think we all have other probably commitments, but I very much appreciate your time.
This was a lot of fun. Thank you guys. Well, Cliff, Jason, thank you very much.
Cliff, very generous with your time and I do look forward to having you back at some point to continue the conversation. That would be great. Absolutely.
I'd love to come back. Thank you guys. Thank you.
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