Right, said TED

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.

5 responses to “Right, said TED

  1. Sheesh. I read your post, and I have to go lie down now. I think there is some truth to what you say, but I may have to go off and earn a PhD in finance just to confirm that.

    You don’t mind waiting, do you?


  2. No, take your time. Relax.

  3. I fall, I’m afraid, into your category of “thinking minds” but trust you’ll nonetheless accept a few comments offered in a spirit of pure enquiry.

    TED seems to me to be on the right track but doesn’t in this case go quite far enough. The vaunted dispersion of risk is, I think, an illusion. When all the derivatives, short trades and general financial jiggery-pokery is netted out, all outstanding underlying securities must still, by definition, be owned by someone.

    What this byzantine, headache inducing financial superstructure has done instead is to provide the means for the creation of a far greater quantity of such securities than would have otherwise existed, thereby adding to net risk rather than reducing it.

    My suspicion is that the apparent resilience is primarily the result of an apparently limitless fount of speculative funds eager and willing to take on risk. So long as nothing sufficiently drastic happens to douse this appetite, hordes of willing sellers of risk insurance act like shock absorbers, dampening swings and corralling the markets.

    The real question is how they’ll react when a Black Swan finally arrives (an inconvenient one as opposed to the convenient one you rather cleverly posit in a later post about Taleb). The strategies which have to date generated buying into weakness and selling into strength (although this latter has not been terribly obvious) may at that point, in my view, become accelerants.

    On the other hand, perhaps I’ll have to spend more years clumly observing the carnival from the sidelines.

  4. Basho, I have a soft spot for anyone who thinks any of my remarks are “clever”, and who reads (or at least claims to) more than one post on this blog. So I have to say I like you very much.

    That said, do you think a complex order (which is what the market is) which we humans have designed and understand is necessarily more stable than a “byzantine” one we have not designed and do not understand ? Interesting choice of words, by the way: Byzantium existed as a separate entity much longer than the Roman empire which it grew out of; it should not follow that a Byzantine stucture is less stable or enduring. Complex systems, in the way of many interconnected things doing many slightly different things, may be much more stable/resilient than simple ones.

    Markets on this reading become dangerous when everyone leans the same way. This is likely not happening yet, or this situation has only just emerged. Right now, the shorts are everywhere, all the stock I own, and you put it as if that was the end of it, is lent out! That means there is someone short of the stocks I own, someone will make the money I lose. Yes, everything is owned, but do not dismiss the jiggery pokery.

    As I note, the markets have been pretty lively in the face of some pretty bad news. How do you know that we have not had a -ve Black Swan already? Buttonwood, for example, is distraught that we did not recognise subprime as the disaster it will no doubt imminently prove to be. Also if you expect a Black Swan, unlike the Spanish Inquisition which no-one expects, surely that means that whatever you are in fact waiting for CANNOT BE A BLACK SWAN. Think about that.

  5. Appreciate the quick reply, Baruch. It seems, though, you may have taken me both too literally in parts and not literally enough in others.

    In using Byzantine, I intended no particular comment on longevity nor was it expressing an implied preference for simple, designed systems vs complex, self organising ones. Indeed, like you I think the latter are likely to be more stable and creative.

    The problem, as I see it, is that to endure, adapt and prosper such complex, self organising systems need to have constant real world feedback. In the case of our financial architecture, that loop has for decades been clogged and distorted. Implicit or explicit central bank guarantees and various government support schemes have over time fundamentally altered the perception of risk. This, in turn, together of course with central bank accommodation, has enabled credit growth to far exceed all historical parameters. Put simply, if the financial system is to be deregulated (which I certainly favour) then participants must not be saved from their own foolishness. If the political decision is made that protection is to be provided, then fairly stringent regulation ought to continue. What we have is the worst of both worlds.

    Danger, in a true secular sense, is not in my view so much a consequence of everyone leaning the same way (an analogy that has more application to cyclical moves) but rather arises when gearing becomes sufficiently widespread and extreme to seriously distort the prices of one or more asset classes. In arriving at such a point, holdings will necessarily become concentrated in weaker and more indebted hands. Such extremes are by definition multi-generational (hard experience must have time to fade) and ours excess is truly sui generis. Not only in its extent but also in the proliferation of financial instruments, all designed to facilitate the trading and manipulation of risk.

    Now, I readily grant you much of this cancels out and some of it is no doubt even used for the sensible management of otherwise unavoidable risks. Still, when all the netting out is finished, and all the derivative paraphenalia is notionally stripped away, every real remaining security is a net exposure to risk. Any given participant can trade or hedge it away but the market can’t. What derivatives and financial engineering have done – amongst many other things of course – is facilitate the creation of a veritable Zambezi of fresh securities. The slicing and dicing, the ability to offload loans, the resulting separation of origination from responsibility, all these acted to supercharge an already overheated financial system.

    I certainly don’t know what Black Swan will finally come along, or when, although I clearly have my suspicions. My expectations, or anyone else’s, won’t make the slightest difference to its eventual arrival. It isn’t that Black Swans are literally unexpected, it’s that few expect them. When conditions are ripe, any number of triggers can conjure one seemingly out of the air. Indeed, as you suggest, we may already have had one or more; the massive compression of volatility you noted, for example, or perhaps the entry of China et al into our global extravaganza. Still, as I said, these were convenient, friendly, with the trend Black Swans. I think what we all really mean when we use this phrase is something quite different, something that inspires fear and loathing.

    Great blog, by the way. I arrived here via TED and find the combination of amused distain, informed analysis and intelligent discussion you both display most enjoyable.