October 23, 2008

Sheer Panic

I don't like being an agent of panic transmission but Nouriel Roubini has been prescient for so long that people ignore him at their peril. According to Bloomberg, this is what he said today to a group of hedge-fund managers:

"We've reached a situation of sheer panic. There will be massive dumping of assets and hundreds of hedge funds are going to go bust."

I can only imagine the look on the hedgies' faces. But wait, there's more:

"Systemic risk has become bigger and bigger. We're seeing the beginning of a run on a big chunk of the hedge funds and don't be surprised if policy makers need to close down markets for a week or two in coming days."

The Triangle is Still Alive

October 22, 2008

It's Like Fishing

"It's like fishing. In the past, when you wanted to catch fish, you threw your line out and waited. Now there are many fewer fish out there, which means you have to use better technology than just throwing your line out. Only a few places understand that, and they are catching a lot of fish. Nevertheless, we're pushing the world toward equilibrium, where risks and expected returns line up and making money from active management becomes more and more difficult."
Bob Litterman (Goldman Sachs) in early 2007, describing his vision of what a quantitative portfolio manager does.

Let's keep the fishing metaphor to try and describe the events of the past year. 
The quantitative portfolio managers (the fishermen in our tale) became so obsessed with catching the remaining tiny fish hiding in calm waters, they totally forgot they were actually in the middle of the ocean and not on a small pond. Therefore, when a major storm hit, they were caught totally unprepared and basically... drowned. 

Now, a year into the stormy conditions, it's a totally different sea out there with a totally new ecosystem, new fish to catch (new market inefficiencies to exploit) but our poor fishermen are not here to catch them anymore. A new breed of fishermen is slowly appearing and, having learned their trade during the stormy season, they will really thrive when calm waters return. 

And then...the cycle will start anew.

October 19, 2008

Risk Management is not Risk Eradication

I've been reading Peter Bernstein's Capital Ideas Evolving (2007)on and off lately (after reading his Capital Ideas (1992) for continuity's sake). I must say that it is quite distasteful for a technically-oriented person to read such odes to the heroes of fundamental analysis and modern portfolio theory more than an hour at a time.

I did run into an interesting paragraph though, a cautionary note from the author (who partly redeems himself with such reminders that complex risk management does not lead to risk eradication) that applies perfectly to our current predicament. He talks about what Martin Leibowitz dubbed "dragon risk, taken from ancient mythology when people believed the earth was flat and feared there be dragons in the spaces beyond or to put differently, beyond-model risk whose precise nature and structure are unknown". He goes on to list some of them: "underdeveloped financial markets, liquidity concerns, limited access to acceptable investment vehicles or first-class managers, problematic fee structures, regulatory or organizational strictures, peer-based standards, headline risk and insufficient or unreliable data". All these risks have some relevance to the ongoing financial crisis. But it is what follows that really resonates and is prescient in a way, the risk that "these assets will perform entirely differently from expectations or that the distribution of outcomes will include higher probabilities for extreme outcomes than allowed for in the original planning. Under these circumstances, the whole process could turn into a disastrous mess that would be far from easy to unwind." 

And when would such a mess materialize? "The whole scheme could fall apart if the field becomes overcrowded. [...]the arrival of too many investors drives up asset prices and reduces prospective returns." Bernstein concludes with what was a footnote a year and a half ago and is a front-page truism now:
"When new and different players are entering asset markets they never even considered before, and when the whirlwind of new derivatives affects every corner of the financial markets, the pricing, volatility, and expected returns of asset classes are not stable."
(All emphasis mine)

October 17, 2008

Warren's Very Public Contrarian Call

Here's a tough one for the contrarians out there. What do you make of Warren Buffet's article in today's New York Times? 

One of the most successful investors of all time is right there in a major newspaper essentially telling the investing masses: "Fear not. Buy stocks." Is the fact that it's such a visible call a contrarian indicator and therefore a bearish signal? But what of Mr. Buffet's historical record of correct bullish calls? Does one cancel the other out? Hmmm, like I said, that's a tough one to crack. Hindsight seems to be the only way to go here: we'll know one day if his call was totally wrong (i.e. we still have a long painful descent ahead of us), just early (we still have a little bit to go on the downside time-wise and level-wise but we strongly rebound from there) or prescient (this month marks the bottom of this bear market).

October 13, 2008

Paul Krugman

Paul Krugman, one of the most informed, rational and reasonable (hard qualities to find in one person lately) economists out there has just been awarded the Nobel Prize in Economics. I know some people fault him for his pronounced liberal bias but you have to admit he has been right about a lot of things. Plus he seems like a real nice guy. His blog has been one of the rare beacons of sanity these past few weeks.

October 11, 2008

Price Insensitive Selling

In times of intense short-term moves and I would think this past week qualifies, it's good to step back and take a look at the bigger picture i.e. a longer time frame. So let's consider the monthly chart for the S&P 500 index since 1998 shown above (click to enlarge).

A few things jump out:

1. The double-top, obviously.
2. The sheer velocity and ferociousness of the selling that make the 2000-2002 bear market seem gentle in comparison. The selling we've witnessed the past 2 months is equivalent to 2 years of selling then (2001 and 2002). The 14-month RSI, a good measure of selling momentum, has plunged from overbought to oversold a lot faster than 7 years ago and is more oversold now than at any moment then.
3. All Fibonacci retracement levels were blown through as if the Italian mathematician had never existed. The last stand, a full retracement to 768 is so tantalizingly close and the downside momentum so strong that we might break it without even noticing.

October 2, 2008

Covert Helicopter Money

(picture courtesy of businessweek.com)

For anybody wanting to never look at the bailout plan the same way again, I suggest the Wikipedia entry for Liquidity trap.

In the paragraph summarizing Milton Friedman's view, we learn that:

"A monetary authority can escape a liquidity trap by bypassing financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money. The term helicopter money is meant to portray the image of a central banker dropping money on people from a helicopter. Political considerations make it difficult for a monetary authority to grant the money gift, because individuals and firms not receiving free money will exert political pressure. The monetary authority must act covertly to give gift money to specific individuals or firms without appearing to give money away." (Emphasis mine)

There you have it, the bailout plan as the ultimate covert financial operation. When one knows Helicopter Ben Bernanke's devotion to all things Miltonian, one is excused for thinking that at least part of the reasoning behind the plan is to overpay for bad assets (giving money away to banks) and hope it somehow shocks the system back into action. Which is not to say that it's a bad plan and that it won't work (the odds are kind of long though), just that the covert part might be what some people are rebelling against, if only subconsciously.

Interestingly enough, this is one situation where Friedman advocates government intervention in and interference with the market. The Austrian school on the other hand would embrace the current bust as the only effective cure for the excesses of the boom and would strongly advise against any kind of government intervention as that would only make the bust last longer and delay any type of recovery (see Japan).