“Can you run through an example of volatility being ‘episodic’ and ‘clustering’ What happens to markets when we get a cluster of volatility?”
McCullough: I think you should read a foundational book on volatility being episodic and clustering. The book you want to read is by Benoit Mandelbrot called The Misbehavior of Markets. That’s far and away the most cited book in all of my work. He shows you empirically that volatility is always going to catch a lot of investors offsides. He also shows you that you’re way off sides if you’re buying the damn dip on an asset that has clustering and episodic volatility.
That’s why I built my three factor model as opposed to looking at a 50-day moving monkey or something nonsensical like that. We’re overweighting volatility though because predicting the volatility of volatility, or whether volatility goes from non-trending to trending, is the most important thing.
By the way, Ray Dalio has built one of the biggest asset management firms on the planet by basically observing volatility rules of this nature within what he calls his four quadrant model. Dalio calls it his All-Weather model.
No, I’m not trying to be arrogant in saying I’m Ray Dalio. I’m just trying to help you understand that there’s somebody who’s got 1,400 people on his research team that have empirically proven the exact same thing that I’ve proven, which is growth and inflation are the two most causal factors when it comes to the returns in your portfolio, either at the asset class, sub-sector exposure or factor exposure level.
Dale: Exactly. I mean 90% of daily trading and daily volume in the market is systematic. This means everyone is either implicitly or explicitly employing some sort of targeting regime for volatility, whether that be at the asset allocation level or the risk management level in terms of trying to run market neutral. So volatility has increasingly become very important to risk manage and understand for investors to get their security selection and asset allocation right.
What we noticed is that there is a huge opportunity in the market. Not a lot of investors can predict the direction of volatility with any degree of reasonable accuracy. And a lot of that has to do with them not having an accurate forecast for what ultimately impacts volatility, which is grow and inflation.
Here’s another question from a listener. Can you talk a bit on how volume plays into your quantitative models outside of confirming or disconfirming price moves?
McCullough: That’s a really important question as well. Let’s break it down really simply. If you have price going up, volumes going up and volatility going down, then that’s super bullish. That’s basically what we’ve had for the last two and half year when U.S. growth was accelerating. That’s also why we were so bullish on growth stocks back then. Conversely, if price is going down, volume is going up and volatility is going up, that’s bad. It’s confirming the bearish quantitative signal in my model.
Why does that matter? The number one way that I’ve made money over the course of my career is not losing money when Wall Street does, when they’re all losing money. We don’t want to be part of that crowd, the excuse making crowd, the whining and the political bickering. We want to have capitalize them.
You want to move from ignorance to awareness. Educate yourself to do better. Learn about the overlays of history, math and behavioral psychology versus what Wall Street consensus does which is based on linear economic theory and how the market feels.
I want you to focus your eyes on the math part and the rate of change. Measure and map it along a sine curve. If you don’t know what a sine curve is, you’ve definitely got to get up to speed on that. This is what our entire model from a research perspective is built on. When the rate of change slows, that’s bad. And when the rate of change accelerates, that’s good. That’s pretty much it.
Brian Sly and Company, Inc.