What is uncertainty?

Let me regurgitate my view that I do not have a view until post election.

Seriously boring, I know.

But almost always necessary.

I mean, take cable for example.

I have no idea how you would manage your trade here, how I would cope with re-entering (especially since there are so many conflicting Brexit headlines, as well as election based drama affecting the USD's intraday trajectory), nor would I be able to have a gauge on how much risk I should have on...

So I've stayed out of it and had one little trade on it in the last 3 months.

It was a winner, funnily enough, but not the point.

The point is, the market right now is tricky, and even technically focused guys are saying it too...

What turns a market into this hellish landscape then?

Let's try and answer this today and get you thinking a little deeper about uncertainty and why it comes about...

The efficient market hypothesis is a myth

Market prices do reflect the information that is known...

If we consider information right now to be on an extremely short timescale...

But it's the unknown parts that we want to focus on.

Economists will focus on their models to prove that the EMH exists, but we know as traders that it doesn't, and in fact, what we as traders probably look to do is to weigh up the extent that unknown information will become 'known'.

What the EMH boils down to is that markets are indeed rational at every price.

Have a read of this column from Winton about the EMH myth.

See, the market isn't always right at all given points of time.

Take the Great Financial Crisis, for example.

Value at Risk models were used extensively to judge how risky or not a book was.

See, rather than using VaR as a tool, banks tended to use it as an ultimatum for risk management - this is what we'll use and this is the consensus in the industry.

When you get a consensus opinion in an industry, you generally get a skew towards a certain type of behaviour.

In this case, that skew was literally a skew - fat tails were largely ignored or at least underestimated by these consensus models.

And fat tail risk is what caused the 2007/8 financial crisis.

So no, markets are not always rational or efficient...

At all.

So what do we know?

From the above, we know that market stability is derived from both known and unknown information sets.

For us as traders, there is a balancing act to be conducted.

We know what information is available to us currently.

But what we need to know to action a decision is what information is going to become more relevant going forward.

This is an almost impossible task to consistently achieve a correct prediction on all unknown outcomes.

Which makes things even more fun.

What our goal is is to achieve a good probabilistic view on what is going to happen across specific durations, based on what we know now...

And no, this doesn't mean knowing that a global shutdown is going to happen because of a virus.

This brings me back to wanting to mention uncertainty.

This election is fraught with uncertainty, but not simply uncertainty surrounding which policies or regime will be thrown out or maintained.

No, the primary problem with this election boils back down to the liquidity addiction that I have spoken about so much over the time that I have been doing Macrodesiac.

'Will they or won't they conduct stimulus?'

'To what extent will stimulus be conducted?'

'How will this be achieved (direct transfers, government infrastructure spending etc)?'

For us, inflation is the key theme here, and we have two stages to hit before we'll have any idea whether the inflation goal will be met, if at all...

Why's inflation important?

It boils back down to yields.

Check out this chart of the 5s30s spread.

In mid 2018, the curve started to steepen.

This was likely in conjunction with Trump upping spending to a bigger level than previously.

Note the pretty rapid increase in spending relative to past presidential offices over the same time period.

The market might have been expecting a rapid rise in inflation, since that's a curve steepener trade going on there.

Why do I say that there are two stages to be hit before we might see the market truly believe that inflation is on the cards (and this comes down to the uncertainty right now; the choppy market we are witnessing)?

Well, we have to see firstly who is elected, which can then guide us on the second part.

What will the stimulus look like?

Right now, we are at the pre-known stage...

What are polls saying?

What are betting markets saying?

But what is ironic is that the market isn't telling us much - it's still just digesting the effects of the last 6/7 months.

Shit, does that mean the EMH is right?

Well, no.

Betting markets are gambling on two outcomes.

Markets are far more dynamic, so you need to factor in so many different other outcomes to be able to make the best bet on the best asset at the best time.

And polls?

Well, we know they face the same issues with modelling as risk managers pre GFC (and still today, but I'll get onto Basel at another time for those who haven't heard me rant about it in a while)!

Think back to Brexit (and even Trump's first election) as an example.

Why wait?

Well, you don't have to wait to action your thesis.

You can do what you like and I encourage you to.

That said, there's nothing on for me til after the election in terms of a longer term position.

I am happy maybe taking a nice technical follow through for 20-30 ticks, but nothing more (mainly because I'm crap at intraday trading).

Here's what the BIS says on positions when financial institutions are exposed to higher market uncertainty...

In my view, when there is uncertainty, we should follow the same kind of policy.

De-risk, take less trades, don't get overexposed.

Simple, right?

Let me know if you've got any questions!