Someone called The Epicurean Dealmaker (TED), found via Felix Salmon’s finance blog at Condé Nast’s Portfolio magazine, got me thinking. Now I think I like this TED guy, not least for his slavish adherence to a dead philosopher, and not just because the one he chose is the classical philosopher most like MY dead philosopher, who too “considered an imperturbable emotional calm the highest good and . . . held intellectual pleasures superior to transient sensualism.” He also, like me, has no readers.
Anyway, one of the interesting things that exercises Thinking Minds in the money business at the moment is the sheer resilience of the markets, for so long, in the face of:
- the lack of any follow-through from the suprime collapse,
- the blowing-up of highly levered multi-zillion hedge funds like Amaranth;
- the noticeable lack of any serious emerging market financial crisis (unless you count Iceland) in the 9-10 years since the last Asian meltdown;
- the refusal of stocks to freak out in the face of both rising inflation and slowing economic growth in the US,
- the carry trade seems largely over, the USD collapse has seen to that
- blah blah blah etc etc etc ad infinitum if not nauseam (god cues stockmarket crash, right now, just to serve me right for my lack of respectful capitalisation).
Yes, there was the 2000-2002 bear market, but if you look at e.g. the Dow, the FTSE, and a whole bunch of other indices, the long term uptrends from the 1980s are pristine, intact, and enticing.
Sadly, most Thinking Minds in the market tend to be bearish. It always seems smarter to be negative about stockmarkets, as the vast majority of investors (qua investors) sort of have to be bullish, duh, and smart people have got to go against the crowd, if only because if they don’t, no-one will know how smart they’ve been when they’re proven right. The Thinking Minds at the FT (who never had an actual, money position on anything in their desk-bound lives) are consistently bearish in their stentorian editorials and their ridiculous LEX column. Those arrogant morons at the Economist are, too. We are conditioned to think of them as smart.
There also exists, however, a semi-smart argument explaining the puzzling strength, which said TED links to, put forward by Nobel Prize winner and spectacular LCTM hedge-fund loser Robert Merton. He believes that the resilience of the market comes from the huge increase in derivative volumes. Everyone uses them. I use them. They are cool. They transfer risk, which would otherwise have gathered up in concentrated pools, into many hands. A shock which would have wiped out a sector of the market in the past, causing knock on effects throughout the financial system, merely succeeds in blowing up a few. The rest of us suffer minor losses, shrug, have lunch, and go and buy Pets.com stock next day.
TED doesn’t buy it. Or rather he sees the point but remains sceptical.
But note his (Merton’s) critical distinction that derivatives “transfer” risk. They do not eliminate it. . . people argue that this broad-based, system-wide transfer of risk has indeed made the world’s financial markets safer and better able to withstand shocks. . . But can we say that systemwide risk has indeed been reduced? To say that convincingly, you would have to argue that the hedge funds and others buying credit risk are somehow “better owners” of such risks.
TED fears they are not, and worries that there might be, somewhere out there, “correlated pools” of risk waiting to blow up in the faces of the “horses asses”, the hedge fund managers who own them. It is a cleverer rebuttal of the semi-intellectual bulls than you will read in the Pearson-owned rags above. Anyway: I have 2 points.
1) We do not need the horses arses to be better owners of risk. We only need another group of equally ridiculous idiots to bet on the other side. The beauty of the credit default market, for instance, is that what was once only a destroyer of wealth, a corporate bankruptcy, can be the source of a great many speculative fortunes. Maybe not enough wealth is created to offset the destruction of a really big blowup, but it’s a start.
2), and this is less easy to explain pithily, I have an idea in my head that the increasing complexity of the financial system creates extra resiliency. It is hard to argue that something we understand less and less can be more stable, but that is what I think. I am beginning to view markets as enormous, self-sustaining computing entities, which compute nothing but themselves. They exhibit some of the traits of modern, distributed computing. We could speak of “multiple cores”; bond markets and equity markets may not be discrete, but each has a different set of practitioners who rarely talk with each other, who necessarily interact, but may sometimes do so out of differing motives which generate diferentiated outcomes. Inverted yield curves have predicted recession for some time now; equity markets have been consistently, and rightly (so far) bullish on corporate earnings. We can add the various derivative markets to the mix.
Adding to the complexity, where before in say 1987 the vast majority of the market was plain vanilla long-only, we have vastly different approaches to investing all coexisting at once: macro funds take equity positions no vanilla long short manager could justify on fundamentals; god knows what strategies the infinite number of quants out there are following right now; I know most of my current positions are shorted by someone else, I can ask my stock lending department, who do brisk business; someone is crossing or writing the options I buy; speculative default protection buyers hover, vulture like, over the very names value longs are thinking will make their fortunes; Chinese domestic guys bid PEs up to the 40s, 50s and 70s, while Hong Kong investors won’t touch largely the same type of equity stories over 20x next year. I could go on. There’s a lot of stuff happening all at once; I am not saying there hasn’t been in the past. There is just more and more of it, in more places, in a bewildering display of variety, calculating clearing prices, providing shock-dampening liquidity to the participants.
The craziest thing of all is how in this system expectations adjust, how the perceived behaviours of the participants change the behaviours themselves. This is where things get whacky in my head, and I have to stop with my complex computing metaphor. The power management system doesn’t try to screw around with the graphics processor.
Maybe someone gets to read this one day. I am off to bed now, I have to lie down. I hope I made my point.