“You never know what is enough, until you know how much is more than enough”
Someone once told me Myron Scholes said the folks at Long-Term Capital Management thought they had their risk buttoned down. In their minds, they were walking down Madison Avenue, eyes trained on the tops of the buildings, looking for falling safes, when they were suddenly struck at an oblique angle by a comet.
To understand what Dr. Scholes meant by a comet, I think one first has to understand the difference between risk and uncertainty. Risk is the chance that some unwanted but quite conceivable outcome occurs. You’re in the casino. You bet on black. It comes up red. Uncertainty, on the other hand, is the chance you’re affected by some unwanted outcome you’ve never even considered. You’re leaving the casino with your winnings when suddenly you’re hit by … a comet. We’ll leave history to decide whether LTCM was hit by a comet or whether LTCM was the comet.
I’m not here to pick on Myron Scholes. He is a brilliant and literate man, whose new fund, Oak Hill, seems to have addressed the risk issues from every angle. But the thing is, sooner or later, there’s always a comet. I’ve learned to keep one eye trained on the night sky looking for them while I sleep. They are wired into the DNA of the free market system. As Eugene Fama, father of efficient market theory and Dr. Scholes’ thesis adviser many years ago, told Roger Lowenstein in When Genius Failed, “Life always has fat tails.” The extreme end of the left tail of the distribution is where the “comets” live. That this tail is “fat” simply means there are more comets out there than investors care to suppose.
The markets–in fact, societies–have a long and infamous history of death by comet. 1994 was full of them. We had them in emerging markets, currencies and interest rates. That year started with the Fed raising rates, ending a long cycle of aggressive easing, the monetary policy response to the recession of 1991 and 1992. In the eyes of many observers at the time, the logic was that that was a way for the Fed to create liquidity for ailing commercial banks and California Savings & Loans. They were afraid of having to go through another RTC debacle if the California housing market went south. The answer: Drop short rates, let the banks borrow short term at low rates, invest the money longer term at higher rates and, pretty soon, their balance sheets would look a whole lot better. Your basic carry trade.
The problem was that banks weren’t the only one doing it. Hedge funds, ever quick to spot a market anomaly, were all over it, in size, with leverage. So, when the Fed announced its first quarter-point rate hike, 11 enormous, levered hedge funds and 19 massive prop desks thought to themselves, “Perhaps we should unwind a billion or two,” all within roughly 10 minutes of each other. The ensuing massacre left banks in distress, hedge funds with double-digit drawdowns and Orange County, Calif., broke. David Askin, the mortgage-backed trader, was next. And you didn’t even need a telescope to see that comet coming.
The year ended on a similarly sour note with the second Mexican peso crisis. This one, interestingly, was aggravated by the assassination of a Mexican finance minister, leading foreign investors to conclude that the political situation was out of control and causing them to pull their money out of the country at an accelerated rate. Only later did it come out that the murder was the result of a family conflict.
Taking a quick tour back through the years, we had 9/11 in ’01, the bursting of the dot-com bubble in ’00, LTCM in ’98, the Asian Contagion in ’97, the carry trade and the Peso crisis in ’94–and that’s just 10 years. We had the Hunt brothers in ’81, the LDC crisis in ’82, the crash of ’87, the S&L crisis in ’89. Anyone see a pattern here?
Market shocks are roughly as predictable as the buses on Madison Avenue. More so, according to most New Yorkers.
Life always has fat tails.
But why do they recur? Given all we’ve learned about risk, wouldn’t it seem we could sidestep a debacle or two? It’s worth trying to understand the ground-state conditions that set the stage.
One thing all those past debacles had in common was a sudden, mass liquidation. No one ever went broke trying to get into a position, Pets.com notwithstanding.
The incomparable Edward O. Wilson noted in his wonderful book, “Consilience,” that Immanuel Kant, in 1784, had observed that “man’s rational dispositions are destined to express themselves in the species as a whole, not in the individual.” I find this largely to be true, unless of course, mankind is using leverage. Leverage is like an echo chamber to the emotions of the investor, and leverage has been a culprit in more than one of these bloodlettings.
Perhaps more to the point is the herdlike behavior of crowds. Investors have shown, time and again, that they prefer the company of others. It’s reassuring, particularly when we are invested in markets we might not understand as well as we should. The company of others, expressed in a chosen security, tends to make the price go up, creating profits for the investors, who all too often use them to buy more of the aforementioned security, extending the cycle. And because this feels good, we tend to keep doing it. We tend to climb the proverbial “wall of worry” in packs, then herds. The stampedes come on the way out.
Steve Waite, in his book Quantum Investing, distinguishes between exogenous risk, which is risk that comes from outside events, and endogenous risk, which is risk that has built up internally. The terrible events of 9/11 were exogenous. The crash of ’87 was endogenous. I find most market shocks are from endogenous risk. No one yells fire in the movie theater. It just gets too crowded. The tipping point tips. Someone moves toward the door, and suddenly it’s too late.
The final dynamic is the almost unanimous opinion that exists prior to the event. Even when most of us know better, we tend not to act. Stocks in ’87 and ’99, the carry trade in ’94–we knew these markets weren’t going to go on forever, but, lemminglike, we marched steadfastly cliffward. George Elliot, the English novelist, saw through to the essence of why we overstay our welcome when both history and common sense argue for a prudent departure:
“The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.”
Put simply, the fact that it’s been a long time since the last market shock now convinces us that there will not be another one, all evidence to the contrary.
Life always has fat tails.
A pretty big statement. Notice that Fama said “life” and not “markets.” In fact, cataclysmic events can be found throughout nature. Seismic stresses create earthquakes rather than a gentle shifting of tectonic plates. Snowfalls create avalanches, storm clouds turn into tornados; we see the process everywhere. The same thing happens in societies. The Enlightenment ends in the French Revolution. The assassination of Archduke Ferdinand of Austria by a secret Serbian nationalist group called The Black Hand sets in motion a mindless series of events that culminates in the First World War. On and on.
Finally, I think, this is about camels and straws. A straw can’t break a camel’s back any more than a snowflake can cause an avalanche or one sell order can cause a market to crash–yet ultimately, they do. And then, as William Blake said, you know how much is more than enough.
So, what conditions exist today? Which markets could be setting themselves up for a dislocation?
If I am coldly rational, I am actually more sanguine about prospects when I apply the criteria mentioned above. Some friends had an interesting dinner conversation recently. They asked whether the markets were currently being driven by fear, greed or uncertainty. The decision was uncertainty. Iraq and the election were enough to keep most investors on the fences.
Uncertainly does not create unanimity of opinion. Are we so comfortably long with either stocks or bonds that they are now prone to sudden mass liquidation? Probably not. At least not here and now.
How about leverage? Not really. Margins debt is not extreme in equities relative to where it has been, and bonds have had two years of sideways action. Greenspan has raised the short end 0.75% while the long end has traded back down to a 4% yield, gently deflating the carry trade.
There are areas that concern me, though. The first is credit. I can’t find anyone who’s worried about it. Even I can’t find a good reason to worry about it, and that’s got me nervous. Spreads are as tight as they have been in years, and complacency is rampant. I know corporate balance sheets are in great shape, but I’ve seen credit sliced and diced and repackaged in more ways than Oscar Meyer has meat products and there would be hell to pay if spreads went south.
Then there is the consumer. I’ve seen all the new metrics about household net worth relative to debt service. I also know that the U.S. consumer has not retrenched in 12 years. That’s a long time. And no one is really looking for it. And they are levered.
Housing also meets my checklist. Everybody’s long (including me), everybody’s levered (including me), and if housing ever turns down, The Wall Street Journal will read like a Stephen King novel.
Finally, there are hedge funds. I’ve written about that in the past. I believe there are structural and leverage issues that could become problems under the wrong circumstances. And the thing about hedge funds is that they don’t tolerate outflows very well.
Am I predicting a market shock in one of these areas? Not necessarily, but I’ll make book we’ll see a systematic shock someplace, and I’ll give odds it will be in the next 18 months. By then, we’ll be well into the first term of the new presidential cycle and lots of bad stuff tends to happen then. And while I’m not smart enough to tell you what asset or investment class is going to get hit, my strong suspicion is that it will be one we are not focused on.
That’s the part of the night sky my telescope is trained on.
Contact Bob Keane with questions or comments at: firstname.lastname@example.org.