black swans


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A month ago, I noted that prevailing valuation extremes implied negative total returns for the S&P 500 on 10-12 year horizon, and losses on the order of two-thirds of the market’s value over the completion of the current market cycle. With our measures of market internals constructive, on balance, we had maintained a rather neutral near-term outlook for months, despite the most extreme “overvalued, overbought, overbullish” syndromes in U.S. history. Still, I noted, “I believe that it’s essential to carry a significant safety net at present, and I’m also partial to tail-risk hedges that kick-in automatically as the market declines, rather than requiring the execution of sell orders. My impression is that the first leg down will be extremely steep, and that a subsequent bounce will encourage investors to believe the worst is over.”

On February 2nd, our measures of market internals clearly deteriorated, shifting market conditions to a combination of extreme valuations and unfavorable market internals, coming off of the most extremely overextended conditions we’ve ever observed in the historical data. At present, I view the market as a “broken parabola” – much the same as we observed for the Nikkei in 1990, the Nasdaq in 2000, or for those wishing a more recent example, Bitcoin since January.

Two features of the initial break from speculative bubbles are worth noting. First, the collapse of major bubbles is often preceded by the collapse of smaller bubbles representing “fringe” speculations. Those early wipeouts are canaries in the coalmine. For example, in July 2000, the Wall Street Journal ran an article titled (in the print version) “What were we THINKING?” – reflecting on the “arrogance, greed, and optimism” that had already been followed by the collapse of dot-com stocks. My favorite line: “Now we know better. Why didn’t they see it coming?” Unfortunately, that article was published at a point where the Nasdaq still had an 80% loss (not a typo) ahead of it.

Similarly, in July 2007, two Bear Stearns hedge funds heavily invested in sub-prime loans suddenly became nearly worthless. Yet that was nearly three months before the S&P 500 peaked in October, followed by a collapse that would take it down by more than 55%.

Observing the sudden collapses of fringe bubbles today, including inverse volatility funds and Bitcoin, my impression is that we’re actually seeing the early signs of risk-aversion and selectivity among investors. The speculation in Bitcoin, despite issues of scalability and breathtaking inefficiency, was striking enough. But the willingness of investors to short market volatility even at 9% was mathematically disturbing.

See, volatility is measured by the “standard deviation” of returns, which describes the spread of a bell curve, and can never become negative. Moreover, standard deviation is annualized by multiplying by the square root of time. An annual volatility of 9% implies a daily volatilty of about 0.6%, which is like saying that a 2% market decline should occur in fewer than 1 in 2000 trading sessions, when in fact they’ve historically occurred more often than 1 in 50. The spectacle of investors eagerly shorting a volatility index (VIX) of 9, in expectation that it would go lower, wasn’t just a sideshow in some esoteric security. It was the sign of a market that had come to believe that stock prices could do nothing but advance in an upward parabolic trend, with virtually no risk of loss.

As I’ve emphasized in prior market comments, valuations are the primary driver of investment returns over a 10-12 year horizon, and of prospective losses over the completion of any market cycle, but they are rather useless indications of near-term returns. What drives near-term outcomes is the psychological inclination of investors toward speculation or risk-aversion. We infer that preference from the uniformity or divergence of market internals across a broad range of securities, sectors, industries, and security-types, because when investors are inclined to speculate, they tend to be indiscriminate about it. This has been true even in the advancing half-cycle since 2009.

The only difference in recent years was that, unlike other cycles where extreme “overvalued, overbought, overbullish” features of market action reliably warned that speculation had gone too far, these syndromes proved useless in the face of zero interest rates. Evidently, once interest rates hit zero, so did the collective IQ of Wall Street. We adapted incrementally, by placing priority on the condition of market internals, over and above those overextended syndromes. Ultimately, we allowed no exceptions.

The proper valuation of long-term discounted cash flows requires the understanding that if interest rates are low because growth rates are also low, no valuation premium is “justified” by the low interest rates at all. It requires consideration of how the structural drivers of GDP growth (labor force growth and productivity) have changed over time.

Careful, value-conscious, historically-informed analysis can serve investors well over the complete market cycle, but that analysis must also include investor psychology (which we infer from market internals). In a speculative market, it’s not the understanding of valuation, or economics, or a century of market cycles that gets you into trouble. It’s the assumption that anyone cares.

The important point is this: Extreme valuations are born not of careful calculation, thoughtful estimation of long-term discounted cash flows, or evidence-based reasoning. They are born of investor psychology, self-reinforcing speculation, and verbal arguments that need not, and often do not, hold up under the weight of historical data. Once investor preferences shift from speculation toward risk-aversion, extreme valuations should not be ignored, and can suddenly matter to their full extent. It appears that the financial markets may have reached that point.

A second feature of the initial break from a speculative bubble, which I observed last month, is that the first leg down tends to be extremely steep, and a subsequent bounce encourages investors to believe that the worst is over. That feature is clearly evident when we examine prior financial bubbles across history. Dr. Jean-Paul Rodrigue describes an idealized bubble as a series of phases, including that sort of recovery from the initial break, which he describes as a “bull trap.”

Screen Shot 2018-03-08 at 7.14.53 AMI continue to expect the S&P 500 to lose about two-thirds of its value over the completion of the current market cycle. With market internals now unfavorable, following the most offensive “overvalued, overbought, overbullish” combination of market conditions on record, our market outlook has shifted to hard-negative. Rather than forecasting how long present conditions may persist, I believe it’s enough to align ourselves with prevailing market conditions, and shift our outlook as those conditions shift. That leaves us open to the possibility that market action will again recruit the kind of uniformity that would signal that investors have adopted a fresh willingness to speculate. We’ll respond to those changes as they arrive (ideally following a material retreat in valuations). For now, buckle up.

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These are true market ‘crashes’. The [almost] 5% drop hardly qualifies yet. That of course is the question, is this just the start, or is it simply a return of volatility?

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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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