6th December 2011: Tails of Black Swans and Red Dragons

 

Quote of the Day:

With freedom comes some unpredictable fluctuation. This is one of life’s packages: there is no freedom without noise – and no stability without volatility.

Nicholas Taleb and Mark Blyth

Macro Overview

Tail Risk In China

• A while ago I wrote about the tail-risks in China (Prepare for the Dragon’s Fat Tail Risk). But this was a hard concept to convey. On this piece I expressed a concern specifically on the Chinese property sector and since then the trade has largely played out. Chinese Real Estate risk assets have significantly underperforming global markets and their peers on an annualized basis – even as most of the turmoil has emanated, not from China, but from Europe!
• Why should we be worried about a risk we cannot observe and which is not statistically likely to happen? Of course, the reason we should pay attention to them is because of the magnitude of the consequence if they do happen (for the same reason, I still have a smoke alarm in my house, I still wear a seat belt in my car, for example). It is also worth paying extreme attention to the tail risks in specific asset classes or regions when probabilistically it appears the, still statistically small, tail risks may be inflating (fat-tails).

The Black Swans of Investment

• Understanding tail risk:

The critical issue in both cases is the artificial suppression of volatility – the ups and downs of life – in the name of stability. It is both misguided and dangerous to push unobserved risks further into the statistical tails of the probability “tail risks” to disappear from policymakers’ fields of observation.

• That quote [emphasis mine] was from a quite brilliant piece – The Black Swan of Cairo by Taleb and Blyth. While, in this case, they relate economic black swans to political uprisings there is a more obvious relationship between economic black swans and investment performance. You could substitute the word “policymakers” for “portfolio managers” and it would fit just nicely. This is what I was alluding to with my piece on China. But it should be noted that tail-risks can remain apparently dormant for a very long time. Many of the investors who were short sub prime CDOs could not handle the elongated and binary pay-off and bailed well before the trade finally came good.
• So this is one of the things people have difficulty understanding about tail risks. Tail risks are invisible by definition, they do not exist, until the moment they do… then they are all and everything that exists. In a complex system tail-risks often start small and then propagate through the interdependence of a highly complex lattice of relationships in a manner which is difficult to predict or quantify. Who would have thought that the ripple effects sub prime mortgages inAmericawould eventually lead to the murder of Colonel Gaddafi or riots inAthensor Treaty Change in Europe? Two years ago Greek debt collapse was a tail risk, 5 years ago sub prime CDOs presented a tail risk to the financial centre. But they are not any more, now they are front and centre risks - they went from being “unknown unknowns” to “known knowns” in an instant.
• The reality is we are complicated creatures, we live in an interdependent and “complex” world and yet we try to apply logic or “linearity” to govern it and suppress, contain or “control” the chaos (the natural volatility and cyclicality of life). Many years ago I was writing about this and many thought that it was a little “weird” to suggest that volatility, cyclicality and recessions were “good” for us because they helped us build robust defense mechanisms towards uncertainty. This is true of corporations too, even Greenspan eventually recognized this and I wrote about it in a comment (rebutting the Uncertainty vs Volatility conventionality). Here I (and the Maestro himself) suggested that the very action of trying to contain volatility/cyclicality in a complex world may succeed only in producing more volatility in the future. It is worth thinking ofChina’s centrally controlled economy in this light.
• Of course the reverse is also true, the systems have a habit of self-correcting – it’s hardwired into our natural quest for survival. So, as uncertainty in a complex world arises, people, corporations, all entities interested in self-preservation, build up massive defense mechanisms to counteract the uncertainty… which eventually suppresses the volatility again… and so the sustainable, self-healing cycle continues. Cyclicality and uncertainty is not only in our blood, we need it to survive – it is oxygen for the spirit. This is what I wrote in that piece:

The Paradoxical Effect of Uncertainty on Underlying Volatility

I admit, I have been wrong on the issue myself up until this point. Instead, I now challenge the conventional wisdom that uncertainty causes volatility. Every action deserves a reaction, perhaps even an over-reaction. In extremely uncertain times, large corporations, which are highly sensitive to market sentiment, regulation and macro policy, react by hunkering down to core business and swamping their balance sheets with cash. In doing so they counteract external volatility with internal shock-absorbers on their balance sheet. Consequently. the volatility of their share prices get suppressed and can significantly underperform the volatility of other asset classes (say commodities) and other facets of the economy. For example, small businesses (which actually account for 60% of theUSeconomy) may experience a very different environment and may have extremely high levels of volatility – just look at the unemployment numbers! But of course this environmental volatility may at times fly under the radar of the market for a simple reason – we can only trade the volatility of the extremely big companies. Indices like the VIX only relate to the biggest (most conservatively positioned) multinational businesses.

We are starting to see the effects of the Fed’s extreme monetary policy and it does not always directly lead to increased Money Supply onMain Street. Rather, one may observe the effects of an explosive monetary base in commodity prices, in stock prices, on the balance sheets of banks and on the balance sheets of corporations.

The macro-economic uncertainty is directly correlated to the uncertainty level inside the boardroom of a company. But the correlation between this and the volatility of stock prices is very inconsistent and, at times, completely uncorrelated. Paradoxically, more certainty over the economic, fiscal and monetary outlook may lead to more, not less, volatility in the markets. As Mrs Watanabe starts to splash the cash and Western Corporations see the opportunity to compete by taking more longer term risk onto their respective balance sheets.

• I’ve suggested over the years that investors indeed everybody needs to embrace a certain level of uncertainty and with it a certain level of volatility and cyclicality – even recession. We need volatility to ensure stability. But this was a controversial view point at the time, after all Greenspan, the Maestro, was eliminating volatility from our lives, he was suppressing cyclicality of the business cycle with his “Greenspan Put”. This is what I wrote in a comment (Bernanke and the Butterfly) a few years ago (well before the Sub Prime Crisis).

It’s worth reminding ourselves that it is not the Fed’s job to prevent recession, it is to manage long term inflation (and therefore present inflation expectations) and nurture long term employment and with it economic growth. I hear talk of recession now as if it were something we should never have to experience, ever. Perhaps this was Greenspan’s vision, a safety net for failing, weak and inefficient businesses. Nobody should be allowed to suffer the consequences of the natural business cycle. But yet this form of Financial Socialism has a tendency to expunge the natural existence of, what I call, the “darwinistic alpha” normally prevalent in a purer capitalist system, thus the notion of “creative creation with creative destruction”, becomes compromised.

• I really encourage you to read The Black Swan of Cairo, but here are a few choice quotes from it:

Complex systems that have artificially suppressed volatility tend to become extremely fragile, wile at the same time exhibiting no visible risks. In fact they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite. These artificially constrained systems become prone to “Black Swans” – that is, they become extremely vulnerable to large-scale events that lie far from the statistical norm and were largely unpredictable to a given set of observers.

Just as robust economic system is one that encourages early failures (the concepts of “fail small” and “fail fast), the U.S. government should stop supporting dictatorial regimes for the sake of pseudostability and instead allow political noise to rise to the surface. Making an economy robust in the face of business swings requires allowing risk to be visible: the same is true in politics.

Putatively independent central bankers fell into the same trap. During the 1990’s, the U.S. Federal Reserve Chair Alan Greenspan wanted to iron out the economic cycle’s booms and busts, and he sought to control economic swings with interest-rate reductions at the slightest sign of a downward tick in the economic data. Furthermore, he adapted his economic policy to guarantee bank rescues, with implicit promises of a backstop – the now infamous “Greenspan put,” These policies proved to have grave delayed side effects. Washington stabilized the market with bailouts and by allowing certain companies to grow “too big to fail.” Because policy makers believed it was better to do something than to do nothing, they felt obligated to heal the economy rather than wait and see if it healed on its own.

Market Overview

All Eyes on the Euro Summit

• 9^th of December is the deadline for action. The S&P stands poised to downgrade a whole host of countries including Germany (yikes!) and a potential 2-notch downgrade of France from its AAA perch (ouch!). My only quip is how come it took so long? And why isn’t Britain on that hit-list? Anyway, for now attention is not on the US economy (which doesn’t look good, actually). The market waits with baited breath to hear what Merkel and Sarkozy can conjure in the next few days.

Greece is out in the cold

• Well, I did warn that a 50% haircut may not have been enough for Greek debt. See my comment, EFSF = The Mother of All Sub Prime CDO’s:

Additionally, the amount may be less than we actually think as a huge slug of the original €440 billion has already been allocated to PIIGS. And the haircut isn’t really 50% because the massive chunk at the ECB will receive no such discount, so the Greek debt fiasco is not as “fixed” as you might think it is – especially given that the IMF thinks that a minimum haircut of 60% was needed.

• It would appear that the markets think the game ain’t over for Greece as well. While the “risk-on” has been in full swing, the Greek CDS levels are only showing more pain. See Chart of the Day for Greek CDS curve steepness.

Chart of the Day

Greek Steepness (Source: Bloomberg)

Events

Macro Events:

Update:

• Brazil GDP

Alerts:

• Australia GDP
• Belgium GDP
• Germany Industrial Production
• Japan Machine Orders
• UK Industrial Production

 

Corporate Events:

Results:

• Nothing Significant

Dividends:

• Wal-Mart [WMT]

Reading, Links:

Fat Tails:

• Fat Tail Risk #1
• Fat Tail Risk #2