Jun 25/15 – Name the source of the next disaster

2015-06-25 8am EDT  |  #Cohn #Fed #Goldman #quant shops

In these posts I rarely get on my soapbox to preach I know for certain where a market is headed. I view trading like being the blackjack dealer at a Vegas casino. On any single hand, the dealer can lose. The dealer can even be cash flow negative for the night. But over the long run, the odds are stacked decidedly in favour of the dealer. In trading our job is not to be right 100% of the time, but merely to set up enough trades with positive risk reward profiles and to manage that risk.

So I guess I don’t really feel I know where the market is headed. I am always amazed when these talking heads get on CNBC and proclaim with such certainty they know the price of a security six months or a year in the future. Do they have any clue of how many pieces there are in this puzzle? Do they really know how the Fed will react? Or what Putin is going to do? Or how the million of consumers will behave? All of these factors (and many more) are the inputs into the complex equation of where the market is headed. These CNBC prognosticators must all be geniuses to process this huge mathematical problem.

Yet I believe there are often recurring human behaviours that repeat decade after decade in the markets. Just like the inherent trait that humans are prone to overeat if too much food is laid out in front of them, they also repeatedly make the same mistakes in the markets.

The biggest recurring mistake is recency bias. It sometimes feels like markets have the memory of a goldfish. All too often, what passes for analysis is simply extrapolating current trends. If it is going up, then it must be a buy (maybe even a BUY! BUY! BUY!). If the price has been declining, better sell it. The most recent price action is consistently and dramatically overweighted in the collective mind of the market. This is why we get these extremes in price action that overshoot so badly. Earlier this year German bunds were rising for a host of reasons. By the end of the move, “investors” were buying for no other reason than bunds were going up. There was absolutely no way 10 year bunds at a 0.05% yield made any fundamental sense. Of course they tried to justify it with foolish theories, but at the end of the day, the recency bias of the most recent price action was the main driving force. Time and time again this cycle repeats. The urge to chase is simply a fundamental nature of human behaviour.

The other part of recency bias error involves the tendency for market participants to overestimate the chances of the last crisis returning. After the 1987 crash, thoughts of another 20% down day in stocks could happen at any moment filled investors minds. Of course it never came, but for the longest time investors were hedging against this sort of outcome. Today investors are equally convinced that if a financial calamity were to occur, it will look just like the 2008 credit crisis. My research feed is filled with traders who are all advocating hedging strategies that worked during the last crisis. I even heard crazy old Carl Icahn say something to the effect that “last time we made a lot of money shorting corporate credit, and I fully expect this next crisis to be even more severe.” I don’t know much, and far be it for me to suggest that Icahn might not be the all knowing guru he plays on TV, but I respectfully suggest that if traders are actively hedging against some unfavourable outcome, the chances of that outcome occurring are much lower than the market is pricing. The fact they are taking precautions stops the accident from happening.

Putting it all together

If you put together the tendency of markets to over weight the most recent price action, along with the fact that investors always hedge for the last crisis, you might get some clues about the surprise few are expecting.

I am always on the lookout for smarter investors that realize the risks to the system before me. Although as a group investors incorrectly hedge for the wrong crisis, there can be no denying a smart few see the mistake coming in advance. But I want to stress the word few. Prior to the 2008 credit crisis, there were some shrewd investors that set up phenomenal risk reward hedges that paid off spectacularly. Today it is easy to look back and say that the mistakes leading up to the 2008 crisis were obvious. But I call bullshit on all the history revising charlatans that proclaim this outcome was so clear. I traded through this period, and even if you were worried about the system, the surety of the mass of investors about the lack of risk was overwhelming. The only reason the special few were able to put on such advantageous hedges were because the masses were completely and utterly convinced they were right. So don’t look back at 2008 and think it was easy to take advantage of the insanity. The smart few were standing all alone, with the rest of the group yelling at them “they just didn’t get it.”

Fast forward to today. Someone somewhere has correctly identified the next crisis, that I have no doubt. It’s just the majority that will be wrong. Who is the shrewd investor that is ahead of the curve?

Recently there has been a couple of articles that have peaked my interest regarding the potential for a financial crisis to emanate from quantitative funds. The first was from the always insightful and witty Josh Brown. His article “Are Quants the New Systemic Risk” is a must read.

The difference between this year's Euro Brinksmanship and the old 2010-2011 version is that this time, the banks don't give a f**k. Literally. The ECB is buying $60 billion or so of sovereign debt securities every month and the sovereigns have most of the "Greek risk" now.

Remember back in 2011 when Bank of America dropped to six bucks on a mix of Euro exposure and mortgage lawsuit risk? Not happening now - BAC is breaking out to the upside.

Remember when Wall Street traders and short-sellers almost single-handedly put Jefferies out of business with nothing but rumor and innuendo about Euro exposure? Seriously, this was a thing that actually happened, less than four years ago.

They tried the same thing with Morgan Stanley and crushed the stock. (MF Global didn't need any help from the rumor mill, they committed suicide.)

Josh is pointing out the hedges that worked last time, will not work this time. So far, so good, I completely agree. But then Josh talks about a new idea of where the next crisis might start:

So if the banks aren't the big systemic risk these days, what is?

There's an interesting idea going around that asset management - specifically the metastasizing quantitative strategies run via black box are where the next big scare is due to come out of. Volatility has been so low, for so long, that winning trades have become crowded and leverage is bountiful. And the kicker - they're all running the same playbook, loading up in the same trades.

This is exactly the sort of out of the blue problem that might spring up. Everyone assumes it will be the next generation of Lehman Brothers that brings down the system. They are all scared about the brokers and the banks. My suspicion is the risk has not been allowed back on these balance sheets. There are simply too many regulators scrutinizing every aspect of their business. Generals always fight the last war and regulators always worry about the last crisis. The risk has morphed into some other form, on someone else’s balance sheet.

This idea that the quant shops are the next ones most likely to walk into a sharp stick is an interesting one. As the market has become more computerized, these firms have attracted capital. Whether it is the DE Shaws of the world that trade asset correlations, or the high frequency traders that zip in and out, the amount of trading done by machine has exploded since the last crisis.

The article that set off this whole discussion was a blog post from Global Slant titled ‘Black Box Trading: Why they all “Blow-Up”’. It tells the story of a quantitative trader’s rise to fame, and the insights he learned along the way.

As it turned out I had the good fortune of working with one of the world's largest and best performing hedge funds. Their black box modeling team had been at it for years....back-testing every conceivable variable from every perceived angle....twisted/contorted in every conceivable/measurable manner....truly dedicated to the idea that regression tested, quantitative trading models were the incremental/necessary "edge" to consistently generate alpha while maximizing risk-adjusted, absolutely positive returns. We worked together for some time and I became intimately involved with their quantitative modeling/trading team....truly populated with some of the best minds in the business.

While in Greenwich Ct. one afternoon I will never forget a conversation I had with a leading quantitative portfolio manager. He said to me that despite its obvious attributes "Black Box" trading was very tricky. The algorithms may work for a while [even a very long while] and then, inexplicably, they'll just completely "BLOW-UP". To him the most important component to quantitative trading was not the creation of a good model. To him, amazingly, that was a challenge but not especially difficult. The real challenge, for him, was to "sniff out" the degrading model prior to its inevitable "BLOW-UP". And I quote his humble, resolute observation "because, you know, eventually they ALL blow-up"....as most did in August 2007.

Curious, the trader pressed on to try to understand why this happens:

Anyway....to follow up on my dialogue with the esteemed portfolio manager....I asked "why do they all "BLOW-UP"? What are those common traits that seem to effect just about every quantitative model despite the intellectual and capital fire-power behind them? And if they all eventually "BLOW-UP" then why are we even doing this?"

He answered the second part of the question first....and I paraphrase...."We are all doing this because we can all make a lot of money BEFORE they "BLOW-UP". And after they do "BLOW-UP" nobody can take the money back from us." He then informed me why all these models actually "BLOW-UP". "Because despite what we all want to believe about our own intellectual unique-ness, at its core, we are all doing the same thing. And when that occurs a lot of trades get too crowded....and when we all want to liquidate [these similar trades] at the same time....that's when it gets very ugly.". I was so naive. He was so right.

You don’t need a weathervane to know which way the wind blows, and you don’t need to be a market expert to know that we are definitely in the period where “they all make a lot of money.” These quant shops have been printing cash for the last couple of years. The returns for the Citadels and other similar firms have been through the roof since the last crisis. It’s like the 2008 disaster scared away everyone except the machines.

But with this success breeds the very seeds of its demise.

Fast forward 10 years and the objectives of hedge funds are still the same. Generate positive absolute returns with low volatility....seeking the asymmetrical trade....sometimes discretionary but in many cases these "Black Box" models still proliferate. And BTW....they are all "doing the same thing"....as always....current iteration = levered "long" funds.

What has changed though is the increased dollars managed by these funds [now > $3.5T] and the concentration, of these dollars, at the twenty largest funds [top heavy for sure]. What has also considerably changed is the cost of money....aka leverage. It is just so much cheaper....and, of course, is still being liberally applied but, to reiterate, in fewer hands.

Are these "hands" any steadier than they were ten years ago? I suppose that is debate-able but my bet is that they are not. They are still relying on regression-ed and stress tested data from the past [albeit with faster computers & more data]. They may even argue that their models are stronger due to the high volatility markets of '08/'09 that they were able to survive and subsequently measure, test and integrate into their current "Black Boxes"....further strengthening their convictions....which is the most dangerous aspect of all.

These hands are no steadier than they were ten years ago. In fact, I think they are even less steady. The recency bias has convinced them all that this new environment is as benign as it appears. But underneath the illusion of stability is one of the most volatile mixtures of leverage and mis-pricing the global financial markets has ever seen. When it comes unravelled, the machines will not be able to handle it.

The GlobalSlant author summed it up nicely:

1. Strong Conviction....aka Over Confidence +

2. Low Volatility +

3. High Levels/Low Costs of Leverage [irrespective of Dodd-Frank] +

4. More Absolute Capital at Risk +

5. Increased Concentration of "At Risk" Capital +

6. "Doing the Same Thing"

....Adds up to a Combustible Market Cocktail.

I couldn’t agree more. This is exactly the sort of surprise that sneaks up on everyone. It is also difficult to hedge against a quant shop debacle. When the unwind happens, it can cause prices to go in different directions that appear to make no sense. Don’t assume it will look like a stock market crash. These funds are often short the general market and long specific names. It could be a stock market melt up with a bond crash. Anything is possible. The important thing to remember is that it will be unexpected and only obvious in hindsight.

I have some other contenders in the “name the source of the next disaster”, but I wanted to make sure I highlighted the quant shops as they are definitely near the top of the list…

Sick and tired of the Greek drama

Didn’t the Europeans say they would impose capital controls if the Greeks didn’t come to an agreement last week-end? Once again, it was more threats than action. I don’t know about you, but I am getting sick and tired of watching this charade get dragged out. I read an interesting article the other day that suggested that game theory concludes that it is in both parties interest to extend the game as long as possible. That certainly seems to be the case for the Greek negotiations because every single line-in-the-sand deadline seems to pass with no consequences except for another deadline to be drawn. I just wish it would end.

The only insight I can pass along is that every day it drags on, more money flees Greek banks, and the more the ECB is on the hook.

Some wise words from the squid

Recently Goldman Sach’s President posted a podcast to the company’s website. Gary Cohn took the time to warn the troops about the market’s lack of preparedness regarding potential Federal Reserve rate increases. From Bloomberg:

(Bloomberg) — Years of discussing when and how the Federal Reserve will raise interest rates probably isn't going to prevent market participants from being caught off guard, Goldman Sachs Group Inc. President Gary Cohn said.

"We're probably less ready than people think," Cohn said on a podcast posted Wednesday on the firm's website. "It won't at all be surprising to me if there are some interesting market reactions based on official change in rate policy by the Fed."

The head squid makes a great point. I have long argued that the most anticipated rate increase in decades will be a complete surprise to the markets. Few believe the Fed anymore. The loss of credibility will cause a real problem as there won’t be nearly as much discounting as would have been the case in previous rate hike cycles.

"When it does happen, it's usually not the first-derivative event that people are caught off guard by," Cohn said. "They're caught off guard by the second-, third- and fourth-derivative events. It's Oh yeah, when interest rates go up, that happens.'"

You might not like the squid, but ignoring their warnings makes about as much sense as listening to Yellen for investment advice…

Thanks for reading,

Kevin Muir

the MacroTourist