black swans


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“I don’t know.” That was the only answer I had to each of my dad’s questions. It was very dark as we wandered the streets near my Upper East Side apartment in the early hours of October 20th, 1987, discussing the events of the prior day, Black Monday.

I was 25 years old and had been on John Meriwether’s Arb Desk for just over a year, following two years working in Salomon’s Bond Portfolio Analysis Group. My memories from the day the US stock market dropped 22% didn’t seem very noteworthy when my friend Rich Dewey asked to interview me for an article, Black Monday Revisited, he was writing for Bloomberg to mark its 30th anniversary. After all, compared to the other people Rich was interviewing—Paul Tudor Jones, Howard Marks, Stanley Druckenmiller, Ed Thorp and my former Salomon colleagues Eric Rosenfeld and Michael Lewis— what could I add?

I’ve been thinking that my recollection of some things that didn’t happen might be interesting. First of all, Salomon’s Arb Group didn’t do a single trade on October 19th, or pretty much for that whole week. It wasn’t that we didn’t see great opportunities, but rather that it was clear to everyone that this was a crisis and a time to preserve capital. Salomon was first and foremost a financial intermediary. Our capital was limited, and it would be sorely needed for providing liquidity to clients and projecting financial strength to all our counterparties. Salomon had about $3.5 billion of capital supporting a balance sheet of $100 billion.

We borrowed money to finance our long positions in bonds primarily through the repo market, but we also had to borrow securities to support our short positions. When we shorted a bond, such as the 9.25% of 2/15/2016 that we were running a big position in at the time, we needed to borrow that specific bond from someone who held it in order to make good on the sale. We could borrow money from anyone– a client, a bank or as a last resort even the Fed. But the only party who could lend you a security was someone who owned it free and clear, and hadn’t lent it already. And the lending market was mostly overnight, so we had to roll every day.1

Our biggest fear was that clients who were lending us the securities we were short might ask for them back, forcing us to cover our shorts and unwind our trades. It’s almost axiomatic that when you’re forced to unwind a trade, you lose money on it. With these concerns in mind, John holed us up in a room off the desk, and we put our efforts into methodically triaging our portfolio. We kept the trades we’d be most able to hold to convergence, and cut the ones that were least defensible. We had been having a solidly profitable year up until October, but gave back most of our gains in the few days around Black Monday. The firm’s decision to let us keep our best positions was rewarded with a very profitable 1988.

The defensive orientation on our desk was echoed across the whole firm, and it was probably the same at Goldman, Bankers Trust and all the other trading houses on the Street. As a highly levered financial firm, dependent on short-term funding of our balance sheet, our crisis mentality was about surviving the storm, not trying to profit from it. While the most popular 1987 crash stories celebrate the trading acumen of the likes of Tudor Jones, Druckenmiller or Taleb, the less publicized story of how so much capital was constrained or frozen—an essential ingredient in all market panics– might be the more important takeaway.

Another thing that I don’t remember happening was an economic depression following the stock market crash. Well, I guess that’s because it didn’t! It was supposed to though, just as the Great Depression followed the Black Tuesday of October 1929. In fact, in December 1987, 33 prominent economists (5 with Nobel prizes) issued a statement predicting that “the next few years could be the most troubled since the 1930s.”2 The fact that we moved forward with barely a blip to the real economy makes us feel that October’s stock market crash was bogus, a market move that had nothing to do with fundamentals. But it didn’t have to turn out that way. It’s important to remember what didn’t happen: an alternative future in which the Fed didn’t act as it did (would Volcker have reacted as Greenspan did?), the stock markets fell even further, financial firms started failing, and we got a long and deep recession.3

Could it happen again? Of course it could. And it has. Extreme market moves of the magnitude of Black Monday’s 20-times normal daily move have occurred periodically since then, just not in the US equity market or on the one-day time scale. For example, two years ago, the Swiss Franc put in a 40 times daily upward move against the Euro when the Swiss National Bank suddenly abandoned the policy of capping its value.4 If we look at more arcane, but still important, markets, we find further examples, such as changes in swap spreads or long-dated equity volatility in October 1998 (what is it with October anyway?), or diversified equity momentum trading strategies that lost close to 90% in 2009, or the melt-down of equity quant strategies the week of August 6th, 2007.

Plus ça change. Humans, with all our behavioral foibles, are still important players in the markets. While the presumed cause of Black Monday, Portfolio Insurance,5 is now defunct, it has been superseded by vast amounts of capital dedicated to algorithmic trading or trend-following, both strategies expressly designed to make money, not to stabilize markets. Risk management systems based on VaR (recent volatility of positions) or a tight stop-loss discipline are inherently destabilizing too. And then we have the Volcker Rule and other post-financial crisis regulatory changes, which have the unintended consequence of dramatically reducing the ability and incentive of the banks to provide liquidity in normal market conditions, let alone in a crisis. What do we have against all this? More circuit-breakers and a tradition of Central Bank intervention to stabilize markets in every crisis since Black Monday.6 Hopefully, they will continue to do so, but we should be prepared for when they don’t.

You may wonder, how did this prepare me for another tumultuous October, eleven years later, when I was a partner at LTCM? Stay tuned, its 20th anniversary is just twelve months away.

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While it is clearly not a black swan, black swans being a random surprise, N. Korea could certainly be under-estimated by investors.

 

While the Dow Jones Industrial Average, S&P 500 Index and Nasdaq Composite index hit all-time highs (again) last week and with volatility hovering near a 24-year low, Secretary of Defense James Mattis gave an underreported speech that should cause investors to rethink their complacency.

In an address to a security conference in Singapore, the retired Marine Corps general who headed Central Command from 2010 to 2013 called North Korea’s burgeoning nuclear program a “clear and present danger” and an “urgent military threat.”

By my reading, that ratchets up the already sharp war of words between the Trump administration and North Korea’s ruler, Kim Jong-un. Secretary of State Rex Tillerson had said failure to control North Korea’s accelerated testing of missiles and nuclear weapons could have “catastrophic consequences.” In April, Lt. Gen. H.R. McMaster, the president’s national security adviser, said the problem of North Korea’s nuclear arsenal is “coming to a head” and that it poses a “grave threat” to the U.S. and its allies.

All three officials stressed that diplomacy, particularly with North Korea’s chief ally, China, was the best way to deal with the problem. But earlier this year, Tillerson declared that the policy of “strategic patience” was over and that “all options are on the table.”

North Korea’s ‘gift package’

Kim Jong-un’s rhetoric has become more overheated than our own president’s Twitter account. Last month, North Korea warned that U.S. “provocation” (presumably our joint military exercises with ally South Korea) would mean “a total war which will lead to the final doom of the U.S.” He has threatened the U.S. with a “super-mighty preemptive strike” and vowed to “send a bigger ‘gift package’ ” to the U.S. (The 33-year-old baby-faced tyrant sure has a way with words, doesn’t he?)

Meanwhile, in nearly six years as ruler, Kim Jong-un has tested 78 missiles; his father Kim Jong-il tested only 17 in a 16-year reign. And they’ve improved markedly: Recent tests of solid-fuel missiles, which “would give the United States little warning of an attack … were clearly successful,” The New York Times reported, while the U.S.’s own $330 billion system to intercept incoming missiles has had a failure rate above 50%.

North Korea is believed to have enough radioactive material for up to 25 nuclear weapons now, but “by 2020, [it] could have a nuclear stockpile of 100 warheads that can be mounted on long-range ballistic missiles capable of reaching the United States,” Robert S. Litwak of the Woodrow Wilson International Center for Scholars wrote in USA Today. “North Korea is essentially a failed state on the verge of a nuclear breakout.”

Kim Jong-un, several analysts write, is determined to avoid the fate of Libya’s Moammar Gadhafi, who gave up his effort to acquire nukes only to be deposed and killed in “regime change” after the Arab Spring.

Possibility of preemptive strike

So, without massive diplomatic and economic pressure on North Korea by China, a U.S. preemptive strike becomes ever more likely. George Friedman, founder and chairman of Geopolitical Futures, recently warned that the U.S.’s big military buildup off the Korean peninsula — including two aircraft carriers and daily exercises by more than 100 F-16 aircraft (which also preceded Operation Desert Storm in 1991) — means a U.S. attack on North Korea is imminent.

If it happened, almost everyone agrees the consequences would be disastrous. In the first Korean War (which technically never ended), 2.7 million Koreans, 800,000 Chinese and 33,000 Americans died. Now, North Korea has a million-man army and is hiding weapons, troops and material in a massive network of bunkers, shelters and tunnels that would likely allow it to survive U.S. airstrikes with enough firepower to retaliate heavily against Seoul, the world’s fifth-largest metro area with a population of 24 million. It also has nuclear and chemical weapons and medium-range missiles that could reach Seoul, Tokyo, or even U.S. bases in Guam.

In 1994, General Gary Luck told President Bill Clinton a second Korean war could result in a million dead and $1 trillion in economic damage. Today, Northeast Asia is a critical hub of global commerce: Together, Japan and South Korea’s GDP is over $6 trillion, and of course China borders North Korea.

From crisis to chaos

It’s hard to tell how many of Kim’s (and our) threats are saber rattling and how much are real. Historically, geopolitical crises have had no lasting effects on markets, but crises can spin out of control, especially with the paranoid Kim facing a flailing President Donald Trump desperate to change the subject from James Comey and the Russia investigations.

The recent rhetorical battle may not lead to armed conflict, but war on the Korean peninsula would be massively unpredictable, and investors are woefully unprepared for the potentially cataclysmic consequences. If that isn’t a black swan, I don’t know what is.

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Our current state of affairs – this is an overgeneralization – two versions of the American existence are emerging as separate entities.

There’s the Knowledge Economy and there’s Trumpism, with a lot less overlap between the two with each passing day. We’re not exactly forced to pick the one around which we’ll coalesce, it’s more that we increasingly feel compelled to. Your choice depends on where you live, what your community looks like, which media outlet you get your news from, how religious you are, what level of education you’ve attained, the industry you work in and the amount of exposure you’ve had – in real life – to people from different walks of life and ethnic backgrounds.

Social media has aggravated these differences and recent political contests have hardened them.

Former Vice President Joe Biden spoke at the Cornell commencement last week, akin to making a direct address to the Knowledge Economy. The crux of his remarks:

I thought we had passed the days when it was acceptable for political leaders at local and national levels to bestow legitimacy on hate speech and fringe ideologies. But the world is changing so rapidly…

There are a lot of folks out there who are both afraid and susceptible to this kind of negative appeal. We saw the forces of populism not only here but around the world call to close our nation’s gates against the challenges of a rapidly changing world…

The immigrant, the minority, the transgender, anyone not like me became a scapegoat. Just build a wall, keep Muslims from coming into the United States.

‘They’re the reason I can’t compete, that’s why I don’t have a job. That’s why I worry about my safety.’ And I imagine, like me, many of you have seen this unfold. It was incredibly disorienting and disheartening.

Biden’s audience – remember, we’re talking about Cornell graduates and their families – is extraordinarily divorced from Trump’s audience. They won’t compete for jobs or real estate or potential mates with the Trumpists. They’ll consume information from different sources and have an almost entirely different life experience as they build their careers and raise their families in the coming years.

It’s sad that this is where we are. I don’t think most people want to be compelled to choose a team within one country, but the environment we’re in now practically demands it. This is deeper than political affiliation or just the usual city versus rural heuristic. It’s cultural. We’re supposed to be one culture, generally speaking. Maybe once we were. Or maybe we never were and it’s only becoming more obvious now. Differences in income and opportunities, magnified by Instagram glamor shots and Facebook status updates, are driving people crazy and forcing them onto teams. And teams discourage independent thought.

There is an implicit conceit within the Knowledge Economy that if everyone would just get with the program, the future would be brighter. From the outside, this can be taken as a chide or a scolding. We know what’s best for you. You shouldn’t be surprised that the kneejerk reaction to this sort of thing is a big f*** you and even votes cast out of spite. No one wants to be lectured by people who presume to be better than them. No one wants to be constantly presented with evidence that their life choices have been self-destructive – especially on social media, which is like one giant, raw nerve ending, continually being rubbed the wrong way.

But what if it flipped?

What if, all of a sudden, the Knowledge Economy didn’t look so hot. By publicly denigrating climate science and prioritizing the re-opening of coal mines, it sometimes seems as though this is an explicit aim of the Trumpists – a reactionary counter-revolution rolling back decades of social progress and industry-specific obsolescence. Re-shuffling the deck of cards. Flipping over the roulette table. Letting the chips fall to the ground and the players starting from scratch.

One current White House advisor said last year that “2016 is the Flight 93 election: charge the cockpit or you die. You may die anyway. You—or the leader of your party—may make it into the cockpit and not know how to fly or land the plane. There are no guarantees.” The implication being that complete destruction is preferable to allowing things to keep going in the current direction. This is a desperation that is utterly inexplicable to those who are currently toward the top of the income and education scale.

In the event of a “complete destruction” of society, how would the denizens of the Knowledge Economy fare?

I came across an extreme example in the novel World War Z. Author Max Brooks explored this idea back in 2006, a full decade before the election that would crystallize these two renditions of American life. His narrator interviews the fictional Director of the Department of Strategic Resources in the aftermath of a global zombie epidemic, which humanity has just barely managed to survive. Having non-Knowledge Economy people as instructors may have saved the world…

America was a segregated workforce, and in many cases, that segregation contained a cultural element. A great many of our instructors…these were the people who knew how to take care of themselves, how to survive on very little and work with what they had. These were the people who tended small gardens in their backyards, who repaired their own homes, who kept their appliances running for as long as mechanically possible. It was crucial that these people teach the rest of us how to break from our comfortable, disposable consumer lifestyle even though their labor had allowed us to maintain that lifestyle in the first place…

Imagine the typical Cornell grad in this sort of scenario. What is she bringing to the table? I imagine my own paltry set of skills and realize how unhelpful they would be as the Department of Strategic Resources classifies us all and puts us to work in staving off the undead hordes at the gate…

You’re a high-powered corporate attorney. You’ve spent most of your life reviewing contracts, brokering deals, talking on the phone. That’s what you’re good at, that’s what made you rich and what allowed you to hire a plumber to fix, which allowed you to keep talking on the phone. The more work you do, the more money you make, the more peons you hire to free you up to make more money. That’s the way the world works. But one day it doesn’t. No one needs a contract or a deal brokered. What it does need it toilets fixed. And suddenly a peon is your teacher, maybe even your boss. For some, this was scarier than the living dead.

Substitute “corporate attorney” for graphic designer or evening news anchor or financial advisor or web developer in your mind. Imagine a world in which those skills suddenly had no meaning, no utility. Now think of the millions of your fellow Americans who have been made obsolete by technology or foreign trade over the last few decades – or live in constant fear that they are about to be.

Once, on a fact-finding tour of LA, I sat in the back of a reeducation lecture. The trainees had all held lofty positions in the entertainment industry, a melange of agents, managers, “creative executives,” whatever the hell that means. I can understand their resistance, their arrogance. Before the war, entertainment had been the most valued export of the United States. Now they were being trained as custodians for a munitions plant in Bakersfield, California.

100,000 retail jobs have been lost over the last year. Hiring in e-commerce positions – from web design to fulfillment and shipping – does not offset these job losses on a one for one basis. And if these workers remain out of work for long, or end up doing something they’re unhappy with, whose message will they be more susceptible to, the Knowledge Economy’s or the Trumpists’? Which team will they join?

How about the 3 million Americans who list their occupation as “driver”? As automated vehicles take their place on the road, will Biden’s appeal resonate? I don’t think so. It’s much more likely that the rhetoric of “the experts were wrong, burn it all down” will get through and take hold.

Can anyone or anything turn this tide of our growing separation from each other? I can’t imagine what could do it in the short-term. And I still can’t change an oil filter.

 

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Suppose that over time traders have experimented with trading rules, drawn from a very wide universe of trading rules, perhaps tens of thousands of different iterations. As time progresses the rules that happen to perform well historically, attract more attention and are considered serious rules by the trading community, while unsuccessful rules gradually fall by the wayside.

If enough trading rules are considered over time, some rules, by pure luck, even in a large sample, will produce superior performance, even if they do not genuinely possess predictive power.

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Moral hazard, easy money, and cheap credit have never produced good results. History is littered with examples of financial disaster brought about by monetary manipulation originating in central banks and then spreading to other parts of the system. One would think that the 2007/8 credit crisis, whose effects have not quite withered away, would teach politicians, central bankers, corporations, and consumers something about the causes of credit crunches and meltdowns.

Consumer credit markets are the ones already signaling distress.

Think again. The world’s four largest central banks have pumped more than $9 trillion into the system since the last financial crisis and brought about a world of absurdly low and even negative interest rates. The incentives generated by these policies and their effects – moral hazard, easy money, cheap credit – will lead, at some point, to the bursting of new bubbles.

Which ones? It’s never easy to say, but the United States has seen an unhealthy growth of subprime credit, and credit in general, in three markets – credit cards, auto loans, and student loans. It would not be a surprise if one of these brought about the next credit crunch.

Big Debt

Total credit card debt has surpassed the $1 trillion mark for the first time since 2009, student loans now amount to a total of $1.4 trillion, and auto loans are not far off at $1.2 trillion – an amount that dwarfs the pre-financial crisis peak.

Over the past five years, U.S. corporations have issued more than $7 trillion of new debt, showing that the incentives created by these perversely low interest rates go beyond the markets mentioned before.

However, those consumer credit markets are the ones already signaling distress, so we better pay some attention. Capital One, a big lender to subprime borrowers (particularly through credit cards and auto loans), has had to write off a lot of debt lately – for a total of more than 5 percent of its outstanding loans, the level usually considered the threshold of very dangerous territory.

Predictably the auto industry is now experiencing defaults.

The auto loan sector is especially alarming. Auto sales doubled in the last seven years and are now at an unprecedented level. As happened with mortgage loans before the 2007/8 debacle, money was thrown around in the form of auto loans with no down payment and extended periods.

Predictably the industry is now experiencing defaults (delinquencies are at the highest point since 2009). The result is a heavily increased supply of used cars that have driven down their price. A large part of the auto industry, including manufacturers who lend money to purchasers and rental companies, rely on the sale of securities backed by used cars to fund their operations. Rental companies also rely on the sale of used cars in order to purchase new ones.

Déjà Vu

These symptoms point to risks not dissimilar in nature to what was happening before the housing-related financial meltdown. Banks are beginning to reduce outstanding corporate lending for the first time since that crisis – total loans at the fifteen largest U.S. regional banks in the first quarter of 2017 were $10 billion below the previous quarter, a very significant reversing of the trend.

Standard and Poor’s downgraded 1,088 companies in the United States last year, and analysts are predicting a wave of junk-debt defaults, perhaps encompassing one in every four high-yield debt issuing companies.

One can never tell exactly when a bubble will burst or which corner of the financial system will be the epicenter of the earthquake. But if and when these looming bubbles explode, the main culprit will be the irresponsible policies that were supposed to prevent future bubbles and that created the perfect storm of moral hazard, easy money, and cheap credit once again.

 

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For centuries, cross-border trade has come with a currency problem. The expansion of globalisation has not made it any less pressing. The dilemma identified by the economist Robert Triffin is a powerful – and alarmingly current – reminder that a worldwide foreign exchange crisis is only one big mood change away.

The Scottish philosopher and economist David Hume identified the fundamental issue in 1752. While the sum of global exports always equals global imports, countries can run persistent trade deficits. In Hume’s time, the deficit country shipped gold to pay for overseas goods. Today, creditors have to accept large quantities of deficit countries’ currency.

Hume thought the free market would correct these imbalances, through what we now call currency devaluations. Exports would rise, imports would fall, and the gold would return. But it turns out that the economic patterns which lead to trade deficits are remarkably stubborn. They persist as long as importers can find a way to pay for their lifestyles.

When the gold runs out or the lenders finally give up, default is almost unavoidable. Usually, such national financial failures cause only small ripples in the world economy. But that is not always the case. As Triffin pointed out in 1960 the effects would be much more serious if creditors lose faith in the global reserve currency – the unit which is readily accepted for trade and commonly used for savings pretty much everywhere.

A flight from a reserve currency would throw the global trading system into disarray. As in Triffin’s day, the currency in question is the U.S. dollar. As the Belgian-American economist understood, the dollar will remain solid until the day of reckoning. Foreigners will be willing to accumulate more greenbacks because holdings of the global reserve currency help trade run smoothly. So they are more than happy to finance America’s trade deficit.

But the more the United States spreads dollars around the world, the more likely holders are to question America’s creditworthiness. Economists named the simultaneous desire for dollars and the danger involved in holding them the Triffin dilemma. Valéry Giscard d’Estaing, then the French finance minister, called it America’s “exorbitant privilege”.

The United States has exercised its privilege abundantly ever since. As the chart shows (tmsnrt.rs/2rPeJRw), the net U.S. international investment position – basically the market value of dollars invested from America minus the value of dollars lent to it – first turned negative in 1988. After some gyrations, a firm trend has set in. By 2016, the deficit had reached around 11 percent of global GDP.

That is an awful lot of dollar value at risk. But the development is not surprising. Cross-border trade has increased from 17 percent of world GDP in 1960 to 45 percent today, according to the World Bank. The first horn of the Triffin dilemma explains that this growth leads to more expatriate dollars. The other horn points out that a currency crisis now would be very disruptive.

Suppose some American irresponsibility or arrogance exhausts the patience of the Chinese government, prompting it to sell some of its vast stock of dollar-denominated assets. Others would follow, rushing to currencies still perceived as relatively safe. That creates political discontent in countries such as Japan and Switzerland. Capital controls would come and cross-border trade would go.

Meanwhile, the U.S. Federal Reserve would probably raise interest rates to defend the dollar. Leveraged investors would be forced to sell, creating market mayhem. Big banks could topple over. Though they are better capitalised than a decade ago, they still rely extensively on the ready global availability of supposedly risk-free U.S. government debt.

The unity of that global quasi-government is fraying, though. Central bankers have tested politicians’ patience with years of ultra-low rates. And global politics are troubled. President Donald Trump does not generally behave like a believer in cross-border solidarity. The euro zone has become more inward looking. China has become larger but also more nationalistic. Japan has become smaller.

Ultimately, all profound financial problems must have political solutions, because only governments have enough authority to allocate damage and restore confidence. This explains why cross-border financial problems are especially hard to solve – there is no international government to intervene.

The U.S. dollar’s reserve status has withstood numerous shocks and a succession of profligate presidents. If the Triffin dilemma turns into a crisis, though, everyone will wonder why the dollar was allowed to underpin the global economy in a political near-vacuum.

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