Yesterday I read two different articles that were different in a lot of ways but actually quite similar. They were similar, IMO, because they both tried to tackle somewhat intangible aspects of the financial crisis.
The first article was by Rob Arnott for IndexUniverse that was quite lengthy talking about behaviors to avoid that usually make for poorer returns. The other was a guest post by Richard Alford, Dennis Santiago and Chris Whalen and on Barry Ritholtz' site that tried to break down whether the various things that went wrong over the last couple of years really were Black Swans and if not what we can learn from the non-swans. That was my take anyway--the article was pretty meaty.
The Arnott piece, despite being the shorter of the two, seemed very long winded to me and not particularly useful. Arnott is unquestionably smarter than I am and knows more than I do but I find his articles to be far too text-book like. You know the saying about asking someone what time it is and they tell you how to build a watch, that is what I feel like when I read Arnott, and I do read him for the reasons mentioned above and because I might miss something. But that was not the case in the above linked article.
The Alford, Santiago, Whalen post on the other hand was at a more intellectual level that spurred thought process. For people who had been paying attention for a while wasn't some sort of trouble visible for a while? Jimmy Rogers had been poo-pooing Fannie and Freddie since the 1990s. Home prices went on a great run immediately after internet stocks did. We just had some spectacular failures in 2000-2002 so spectacular failures occurring again so soon after things started to come apart couldn't have been completely out of left field.
I believe I have some credibility here in that I thought something bad was coming to the financial sector but I did miss by a wide margin on the magnitude.
When I first started this blog in 2004, so before too many people saw what was coming including me, I mentioned quite a few of what I would call building blocks or truism that stand up regardless of the circumstance. They were true in 2004 about the then next scary event and are true today about future scary events.
These include the failure of companies that could never fail (is this any truer than with GM?). During the next scary event, whenever that is, there will again be spectacular failures. When things move up abnormally fast they eventually go down in a manner that is inconceivable. Think about it this way, the internet lived up to the hype, maybe it even exceeded the hype, yet many of the companies went bust and of the ones that held on, a lot of those dropped 90% and have not come anywhere near where they were.
Bear markets and fast declines come along every so often and they always cause the same reactions. People panic and are convinced this one is far worse than anything that has ever happened and they sell a meaningful amount of stock at the worst possible time. I don't think anyone says ahead of time well if the market crashes I'm going to panic sell after the drop but a lot of people do.
The Alford, Santiago, Whalen post is very useful for trying to learn how to assess these things proactively at a higher level which I believe is a better path then getting caught up in a bunch of jargon.
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20 comments:
Roger, would you share the bad things that you see coming today?
From previous blogs, I presume that (hyper)inflation would be on your list. The loss of reserve status for the US dollar?
I read an article yesterday (Niall Ferguson in the FT, I think. Sorry, no link.) that basically posited economic warfare with China but graciously deferred an actual shooting war until well into the future. Sheesh.
Alford et al make some sensible points and provide a plausible alternative framework to "Black Swan" -- that is, a relatively sudden shift to a new equilibrium rather than a stable distribution with fat tails. Although the transition is likely to be chaotic, the shift to new equilibrium at least allows a return to normalcy and predictability (within ranges) and, eo ipso, risk management can proceed largely as it did before.
That is, risk management can proceed as before provided some means of anticipating and/or hedging tipping points can be found.
But if price changes are not normally distributed then the "Black Swan" alternative is that they follow some power law. This implies much greater extremes of price movement than those predicted under the assumption of a normal distribution even at shifted equilibria and also implies that statistics such as standard deviation and correlation could be extremely misleading; i.e., both standard deviation and correlation are defined in terms of variance and since variance is can be infinite for stable distributions that are not normal (ISTR these would technically be Levy skew alpha stable) neither standard deviation nor correlation can actually be defined.
My guess is that it probably depends on which market you are looking at -- e.g., Mandelbrot demonstrated fairly conclusively that cotton pricing followed a power law IIRC -- but if uncertainty is higher than risk tolerance it would probably be wise to assume power function (Black Swan) and hedge or avoid.
@ 5:55 AM, the loss of reserve status for the dollar looks unlikely to me anytime soon. Panama has been using the dollar alongside the Panamanian balboa as the legal tender since 1904 at a conversion rate of 1:1. Ecuador (2000), El Salvador (2001), and East Timor (2000) all adopted the currency independently. The former members of the U.S.-administered Trust Territory of the Pacific Islands, which included Palau, the Federated States of Micronesia, and the Marshall Islands, chose not to issue their own currency after becoming independent, having all used the U.S. dollar since 1944. Two British dependencies also use the U.S. dollar: the British Virgin Islands (1959) and Turks and Caicos Islands (1973).
Some countries that have adopted the U.S. dollar issue their own coins: see Ecuadorian centavo coins and East Timor centavo coins.
Some other countries link their currency to U.S. dollar at a fixed exchange rate. The local currencies of Bermuda and the Bahamas can be freely exchanged at a 1:1 ratio for USD. Argentina used a fixed 1:1 exchange rate between the Argentine peso and the U.S. dollar from 1991 until 2002. The currencies of Barbados and Belize are similarly convertible at an approximate 2:1 ratio. In Lebanon, one dollar is equal to 1500 Lebanese pound, and is used interchangeably with local currency as de facto legal tender. The exchange rate between the Hong Kong dollar and the United States dollar has also been linked since 1983 at HK$7.8/USD, and pataca of Macau, pegged to Hong Kong dollar at MOP1.03/HKD, indirectly linked to the U.S. dollar at roughly MOP8/USD. Several oil-producing Arab countries on the Persian Gulf, including Saudi Arabia, peg their currencies to the dollar, since the dollar is the currency used in the international oil trade.
The People's Republic of China's renminbi was informally and controversially pegged to the dollar in the mid-1990s at ¥ 8.28/USD. Likewise, Malaysia pegged its ringgit at RM3.8/USD in 1997. On July 21, 2005 both countries removed their pegs and adopted managed floats against a basket of currencies. Kuwait did likewise on May 20, 2007 and Syria did likewise in July 2007. However, after three years of slow appreciation, the Chinese yuan has been de facto re-pegged to the dollar since July 2008 at a value of ¥6.83/USD; although no official announcement had been made, the yuan has remained around that value within a narrow band since then, similar to the Hong Kong dollar.
Belarus, on the other hand, pegged its currency, the Belarusian ruble, to a basket of foreign currencies (U.S. dollar, euro and Russian ruble) in 2009.
In some countries such as Peru and Uruguay, the USD is commonly accepted although not officially regarded as a legal tender. In Mexico's border area and major tourist zones, it is accepted as if it were a second legal currency. Some stores near the US border in Canada also accept the U.S. dollar. In Cambodia, US notes circulate freely and are preferred over the Cambodian riel for large purchases, with the riel used for change to break 1 USD. After the U.S. invasion of Afghanistan, U.S. dollars are accepted as if it were legal tender. Prices of most big ticket items such as houses and cars are set in U.S. dollars.
So you see a lot of people prefer it this way.
I really don't know if you can call the current crisis or the internet crisis a Black Swan. One, there were plenty of legitimate prognosticators who were calling for a big downturn (not just end of the world believers). Roger points out Jim Rogers on housing, but there was Shiller for both the internet stocks and housing. Two, both situations were really identifiable if you looked at historical data. Internet stocks with astronomical p/e (if they had earnings) and the market overall with a 40 p/e. Housing was exceeding inflation/wage growth by more than a five-to-one margin. Of course, timing the demise is the tough part as the markets can remain delusional longer than you can remain solvent.
So there are tons of Black Swan theories out there right now: demise of the dollar, Central bank printing worldwide, rise of and conflict with China, looming tax increases, peak oil, etc. All of them have strong premises, and once one of them comes to fruition it will be blatantly obvious to all as the signs were there.
And, as Roger probably points out, people will talk about how this time it is worse than ever.
But, I do think that the recent troubles dating back to the tech bubble are driven by, to a great extent, the Fed. One can clearly see the rise in overall debt through the 1990s until the present. And, the current response to this crisis has been more of the same. Either you believe that a cartel of bankers can control a $14 Trillion economy by easing money in and out. Or, you believe that an economy grows by investment and productive consumption. Unfortunately, the vast majority of folks fall in the former category. So, as these panics keep popping up, we will be subscribing more easy money to fix...until a breaking point is reached. Then people will be saying it was a Black Swan.
The article by Alford was good, but I think they could explain things better. The problem is people are too myopic and their time frame is to small.
To put it in simple analogies it is like studying trees by only focusing on leaves. When some one eventually hands you a piece of wood some might think the wood is a black swan when in reality they are just not seeing the big picture.
Similarly it is like the tourists at Daytona beach who park there cars on the beach far enough from the waves having looked at a dozen waves come to shore. They come back to their submerged car after a walk because the tide has come in.
If your time frame is to small or you do not look at the big picture a lot of things will start looking like black swans.
If you were reading http://www.calculatedriskblog.com/ in and 2006 you would have seen the big picture and easily have predicted the housing bubble and the eventual stock market crash. Although getting the timing exactly correct is not as obvious IMO.
The USD is going to be replaced - eventually.
There is no replacement on the horizon right now IMO, but eventually one will evolve.
For now it will be the currency everyone loves to hate. Except in a crisis - then everyone will want dollars.
Not to put too fine a point on it, but isn't a Black Swan event unpredictable? Options (or whatever one chooses) become like insurance, protection from the catastrophic and unexpected, which has the potential to occasionally off big.
Good post, Roger. I received some abuse for a post on a similar topic:
http://alephblog.com/2009/01/30/creating-a-black-swan/
The mantra is: if you could predict it, it wasn't a black swan, even if few others did. I don't find that intellectually appealing, because we can usually find a few that called the negative event in advance.
Hi Roger: I have been a fan of your blog for quite some time now. I recall in the past how you lightened up on financials and REITS (due to the yield curve and other consideratuon) I also seem to remember you saying are REITS really financials and therefore are not great diversifiers. All great calls.Now that the bear market seems to be ending in these sectors (famous last words), I am wondering if you would be so kind as to give your latest thoughts on these sectors. Do you have any exposure? If not, when do you see re-entering these sectors and how much % wise do u think u might be buying?
I hope this is not to presumptuous to ask these questions....
THanks, Michael H.
Panic Selling???
The pundits usually say panic selling is wrong for your portfolio. But let's talk about real-life situations.
I had holdings in AIG, Wachovia, and Wellpoint. I never thought AIG and Wachovia would go bust. During the Black Swan event I unloaded these companies for a small loss. Should I have held on and not sold in a panic? I unloaded Wellpoint when the current administration decided to have a government-run plan. So yes, I made a mistake on this one as it has come back.
So, panic selling may be incorrect...but not always!
There may be some misunderstanding about what a "Black Swan" refers to here: It is not an intrinsically "unpredictable" event, it is an event far outside the variance of what is expected that, in retrospect, may actually appear relatively unsurprising (it seems that it ought to have been predictable) or even "common;" e.g., all swans were white with, at most, a little dark patch here and there at most -- a statistically normal distribution in other words -- until Europeans got to Australia and black swans were everywhere.
So you can assume as Taleb (and his mentor Mandelbrot) do that swan coloration and a lot of other things (like stock markets) are not normally distributed at all but are in fact more consistent with a stable power distribution in which very large deviations from the mean are probable; i.e., you are better off expecting the unexpected because it is frankly quite likely to happen ...if you've never seen a black swan you still need to prepare for the possibility you'll see one tomorrow.
OR
you can argue, as Alford et al do, that instead of assuming a very wide variance in a stable power distribution it may make more sense to visualize the system as rather unstable such that unexpectedly strong shifts can move the average (mean) of one normally distributed equilibrium state to another normally distributed state; i.e., you need to be able to anticipate those shifts but are otherwise able to operate within normal ranges ...if you are in Europe you're not likely to see a black swan but if you're in Australia the situation is reversed, it's the white swans that are more rare.
The two frameworks imply quite different risk management disciplines (sometimes using the same tools however) but both frameworks strongly suggest that the current state of risk management, depending as it does upon a stable AND normal distribution, is deeply flawed and ...well, much more risky than many realized.
Stated another way, in a normal distribution, the chance of getting even one 16-standard deviation event between the big bang and the heat death of the universe is vanishingly small but last March there were price moves this large several times. There is no way to interpret this as a stable normal distribution, it is very clearly something else.
Huh?
you need to be able to anticipate those shifts but are otherwise able to operate within normal ranges ...if you are in Europe you're not likely to see a black swan but if you're in Australia the situation is reversed, it's the white swans that are more rare.
The two frameworks imply quite different risk management disciplines
RW,
How does one anticipate these shifts? If you are in Europe, how do you realize a move to Australia is coming?
MikeC,
The article gives some ideas about that assuming you buy the authors' premises. I think they're plausible as I said but, obviously, if I knew of ways to be more certain of "where we are now" I'd probably be wealthier than I am: Only probably however because certainty has a way of becoming a habit which increases the odds of being certain at exactly the wrong time.
Frankly I learned long ago playing poker who the suckers were and the few times it started looking like it was me I left the table rather than fight the evidence: That's a matter of personal approach and that is ultimately what most investment decisions boil down however they are rationalized.
So, could this rally prove sustainable or at least find a higher resistance level (meaning the lows will not be retested until the next exogenous crisis)? It could happen, sure. Would I bet on it? No, the main players still seem to be those who are trying to catch up, but I would be the last person to trivialize the difficulty of the decision.
I can say that even though I am short commercial RE I've been getting solid, stable returns from residential rentals (via a limited partnership) and see this as a growing national trend, a theme as Roger might say, for many years to come: Stagnant wages, increasing numbers of forced part-time workers, collapsing housing bubble and continuing waves of foreclosures and bankruptcies made this as close to inevitable as death and taxes IMHO. FWIW
@RW,
Really appreciate the reply. Your comments always get my brain percolating.
"certainty has a way of becoming a habit which increases the odds of being certain at exactly the wrong time.
This is a great line. Some of my biggest mistakes have been when I was certain. I think I'm going to print that line out and post it next to my computer in huge lettering.
So, could this rally prove sustainable or at least find a higher resistance level (meaning the lows will not be retested until the next exogenous crisis)? It could happen, sure. Would I bet on it? No, the main players still seem to be those who are trying to catch up, but I would be the last person to trivialize the difficulty of the decision.
Saw an interview with Doug Kass and he said this is one of those times when you should focus on potential loss of capital instead of potential loss of opportunity. He whipped out this quote which relates to your comment about certainty.
"The best lack all conviction, while the worst are full of passionate intensity."
William Butler Yeats
Some believe differently though. Post of the Day from Motley Fool
http://www.fool.com/community/pod/2009/090821.htm
Thanks MikeC. I certainly hope Fool "sonnypage" at your link is correct (even though this period bears scant macroeconomic resemblance to 1982 IMO) because I remain modestly net long; i.e., risk of opportunity cost still trumps risk of capital loss.
Perhaps if I were younger and market sponsorship was stronger w/ less insider selling I'd feel differently ...nah.
"All I say is by way of discourse, and nothing by way of advice. I should not speak so boldly if it were my due to be believed." - Michel de Montaigne
@RW,
Just curious if you don't mind me asking (hope I'm not being nosy) but what is your background and training. I thought you mentioned once you were retired. Did you work as a portfolio manager?
Don't mind. Background is in science, research and education (discounting about a decade as a mechanic and carpenter when I was younger and a bit more limber). Did some work in financial data analysis and have run my own business but never managed a portfolio other than my own and immediate family's
RW,
Thanks for the answer. I was particularly interested to see what “formal training” you had in economics and investments given the obvious depth of knowledge and wisdom that is abundantly clear from your comments.
There is a blogger who I won’t name (not interested in stirring up a hornet’s nest) who is an academic type with a PhD. He posts some really good stuff that is thought-provoking, but has also gotten some stuff really wrong big-time like stocks were cheap in Oct 2007 because the Fed model said so.
To make a long story short we got into a bit of a heated back and forth about what constitutes true skill and knowledge and “real economists” versus “pseudo-economists”..
I think in general in our society there is too much emphasis on degrees acquired, and “formal” training and education as being necessary and sufficient to demonstrate true skill and expertise. I reject this view in favor of the man who through continual self-study, life experience, and a continual feedback loop of reflection and implementation may be 10x the expert of the man who is locked into a rigid dogma learned at the university. And I say that as someone with a MBA in finance and having passed CFA Level 1. More was learned reading Graham and Buffett.
It is interesting to me that many of the professionally trained economists and investment managers saw none of this train wreck coming while many without formal training yet students of history, human behavior, and other views of economics at least partially understood what could happen.
Getting things badly wrong in a complex system is all too easy to do. I appreciate economists who show willingness to engage the world as it is rather than as they wish it to be (they are out there) and study macroeconomics myself because I believe it can help me set the play in the main probability, the fattest part of the curve. But the play can not be everywhere by definition so it rarely pays to be stubborn; e.g., points are only granted in total risk adjusted dollars, bragging rights are how pros generate business but are otherwise pretty useless, at least from the individual investor's POV. JMO
The Fed Model is not really what I would consider academic level work though. IIRC it does have some empirical and theoretical support (at least if you buy into equilibrium models) but, as with certainty, it can mostly steer you the right way until just the wrong time; e.g., at tipping points. That is, using consensus forward earning estimates provides an explicit result for equity valuation that always contains an implicit result for analyst sentiment (analysts are not immune from bias or herding effects needless to say).
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