Nothing Can Go Wrong

In an interesting twist, investors have recently lost interest in betting on so-called 'black swans', the term coined by Nassim Taleb to describe unexpected events that prove the market consensus wrong. Although Taleb's definition seems to imply that the 'swan' should be completely unexpected, it is our impression that in practice, it describes any development that upsets the consensus view.

For instance, in terms of the strict definition, the housing crisis was not a 'black swan'. A number of people predicted it, and it was actually not at all difficult to predict it, even if most mainstream economists failed to do so. However, the crisis can perhaps be said to have contained a few events that for most people did meet the 'black swan' definition, such as for instance the bankruptcy of the GSEs or that of a few brokers such as Lehman, that had after all even survived the Great Depression.

 

 

 

Anyway, Reuters recently reported that hedge funds that are specifically betting on such outlier events have been abandoned by investors. It is interesting what considerations this abandonment is based on:


“Hedge funds set up to profit from huge market slides are falling out of favor, signaling that investors are increasingly confident leading central banks can avert the kind of meltdown that followed the Lehman Brothers' collapse.

Investors are pulling out of such "tail risk" funds although economic and geopolitical bolts continue to strike from the blue, be they the messy bailout of Cyprus which has shown how the euro zone crisis can flare up when markets least expect it, or the U.S. stand-off with North Korea.

Despite such crises, shares have ploughed on to multi-year highs while volatility, as measured by the VIX or "Fear" Index, fell in mid-March to its lowest level since before the financial crisis when the U.S. investment bank went under in 2008.

Last year's promise by European Central Bank chief Mario Draghi to do whatever it takes to safeguard the euro, along with bold measures by policymakers to stimulate economies from the United States to Japan, have undermined tail risk funds.

"If the world's central banks have decided they are going to do whatever to support the economy then you are not going to have crazy volatility. You need a catalyst," Nicolas Rousselet, Head of Hedge Funds at Swiss investor Unigestion, told Reuters.

Tail risk funds aim to hedge against rare but dangerous doomsday events, as described in the "black swan" theory of Lebanese-American academic Nassim Nicholas Taleb. They initially gained popularity with investors who had lost heavily in the 2008 crisis but the appeal of what are also called "black swan funds" is now waning.

Capula, one of the top 10 largest European hedge funds, has lost close to half the assets – about $1.1 billion (723.9 million pounds) – in its Tail Risk Fund since mid-2012, two investors in the fund said. The fund, which now runs $1.4 billion, fell more than 14 percent last year as investors' belief grew that the ECB would do all it could to calm the euro zone crisis when borrowing costs were soaring for Spain and Italy. Other tail risk funds also slumped in 2012, with U.S.-based Pine River Capital's down 36 percent and its assets falling to $200 million from $300 million, a separate investor in its fund said. Both firms declined to comment.

Unigestion set up a tail risk product after the financial crisis began but shut it in 2010 as markets rallied. Last year the firm considered re-launching but decided not to proceed. "If you are a long-term investor, it just never makes you money," Rousselet said.

As a form of insurance tail risk funds lose investors money if markets are flat – and even more if prices rise – but they can pay out vast sums if markets fall precipitously. Pine River's fund, which charges no performance fee so that its managers have no incentive to stray from the mandate that it acts as insurance, is designed to lose 2.5 percent per month in flat markets.”

 

(emphasis added)

The above is actually the 'potent directors fallacy' writ large. The entire thought process has things actually exactly the wrong way around and very likely it will also turn out that the abandonment of tail risk funds has been extremely ill-timed.

One thing that has been remarkable about the crisis period since 2008 was that the last bastion that was left standing amid the general loss of confidence was faith in the central banks. Not even governments themselves were left unscathed as the euro area debt crisis showed. Instead arms of said governments, namely their money printing centers, were and still are held to be reliable bulwarks against a general loss of confidence.

In our opinion that can only mean one thing: namely that next time, this last bastion is going to become the center of attention and that faith in it is highly to crumble.

The idea expressed in the Reuters article is fundamentally flawed: it is essentially saying that central banks are 'bigger than the markets'. This confuses the fact that the markets often know very little (in fact, near turning points it could well be said that they 'know' absolutely nothing) with the idea that they can always be manipulated by central banks. People are seemingly forgetting that for all their statutory power – the power to create money substitutes from thin air in practically unlimited amounts is quite formidable  – central banks are populated and led by flawed human beings, who by all appearances are pretty confused, to put it politely. In fact, one often gets the impression that they have no idea whatsoever what they are doing, in spite of their staff busily beavering away at mathematical models that are supposed to 'prove' that what they are doing will somehow 'work'. People are also forgetting that the boom-bust sequences we have witnessed in recent decades were without exception caused by central bank policy.

So only five years after 2008 people think that tail risk products 'just never make you any money'. We are inclined to file that away as famous last words.

 

A Few Recent Charts

Meanwhile, although the stock market has ignored, respectively 'repaired' countless divergences we have observed over recent months, another one has just popped up and we thought we should perhaps mention it:

 


 

SPX-JNK

The SPX vs. the high yield bond ETF JNK. In the past, divergences between the two have warned of both small and large corrections. Another divergence has been put in recently – click for better resolution.

 


 

Also, following the BoJ's decision to essentially double its monetary base over the next two years, there has been extremely volatile trading in the JGB market. Below is an intraday chart of the past few trading days as well as a daily chart illustrating this:

 


 

JGB-15 min

Plunge and rebound of the 10-year JGB on Friday – click for better resolution.

 


 

JGB-daily

The daily candle on Friday was the most volatile trading in the JGB in a very long time. In fact, the last time weekly volatility was slightly higher was in 2008 – click for better resolution.

 


 

AEP is Wrong on Japan, and his Readers Think so Too

Ambrose Evans-Pritchard is always an entertaining read, but as readers can probably imagine, we don't exactly agree with his latest screed on Japan. We don't want to go into details here about the countless ways in which the article  is misguided (just read our recent missives on Japan) and how erroneous it is in its benign interpretation of Japan's 1930s monetary history (let us just say it fails to mention how that experiment actually ended). Rather, we want to point  readers to the comments section, which is quite interesting. It seems the idea that central planners can save us with their ad hoc policies is meeting with ever more resistance. One comment in particular (by one Carl Pham) stood out and is  worth reproducing here:

 


Ah yes, those Animal Spirits will save Japan, and us sooner or later. They can do anything! You just need to rouse them with a sufficient bonfire of your savings.


These people are like doomsday cultists, or priests of weird apocalyptic religions. No matter how many times the Build It And They Will Come theory fails to work, they are never dissuaded. This time is different!  We just haven't prayed hard enough and long enough to our god!  Get cracking, you slackers. And kill any mocking infidels who might sap the faith …


Here's a thought: instead of trying to change reality by first getting everybody to believe the better reality is already here — if you all wish real hard, Tinkerbell will live! — maybe it would be a better idea to try to change the reality to which people are already reacting.


If people aren't buying stuff, and deleveraging like crazy, because they see chaos and high-handed government interference with every scrap of wealth someone somehow accumulates — if people aren't confident they'll have a job, or can sell things to other people tomorrow, because the powers that be are screwing with the market all the bloody time, and who knows what they'll do next? — maybe change that reality. Maybe governments far and wide should just stop screwing with things, picking winners and losers, lurching from policy to random new policy, with bloviating BS from the media to argue why it's all a brilliant idea. Maybe they should just cut their spending, reduce their scope, and strive like hell to create a very, very stable regulatory and legal and financial world. Convince people the tax law won't change a word for the next 20 years. Regulations in place will be frozen for 10 years. No screwing with currency, no magical wealth taxes, no bailouts, no stimuli, no NOTHING. Just arrest and prosecute criminals, publish weights and measures, run the air traffic control system, and build roads in a patient and economical way.


Maybe if people felt the future wasn't going to be randomly jerked around by whichever party wins the next election, they might start being willing to make long-range plans again.


Nah. Too obvious! Bring on the next Big Idea! We have nothing to lose but civilization itself, comrades! There's no reason we can't duplicate the collapse of the Roman civilization and begin a new thousand-year cycle of Dark Ages.


Forward!”


 


(emphasis in original)

Obviously these are sentiments with which we heartily agree, except that we don't think they should even control air traffic or build roads.


 

Charts by: Bloomberg, Stockmaster.in



 

 

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4 Responses to “Investors Lose Their ‘Black Swan’ Fears”

  • Praxeologue:

    Re Takahashi, a quote from a recent piece by Sean Corrigan

    ‘But if the ongoing suspension of disbelief regarding China is one of the great enormities of the current mini-bull market, the effort to disregard the sorry history of Japan’s last two decades by a semi-mystical appeal to the half-remembered exploits of eighty years ago is surely the other.

    For now it seems, after twenty-plus years of evergreening loans while covering whatever real verdure there was in swathes of economically otiose concrete, the ‘one more heave’ generalship of the LDP will finally enact all of Paul Krugman’s wildest fantasies by further unbalancing its budget – this time with the untrammelled assistance of the central bank – and thereby repeat Finance Minister Korekiyo Takahashi’s feat of ‘rescuing’ his country from the clutches of the Great Depression.

    That Takahashi’s real achievements are still somewhat moot is, of course, besides the point even though debate still rages about whether it was his 60% devaluation of the yen in late 1931; his reliance on proto-Keynesian pump priming and his insistence that the BoJ monetize at least some of the resulting deficits (not a small fraction of which were incurred by the country’s simultaneous annexation of Manchuria); his elimination of the capitalists’ ‘wasteful competition’ via his promotion of industrial cartelisation; or whether it was simply that the wider world was already coming out of the worst of its trough by the time his policies were being put into effect. Suffice it to say that a multitude of PhD dissertations and many a professorial citation count still depends on the construction of intricate counterfactuals about this episode, together with the conducting of exhaustive econometric testing of this ultimately untestable dispute.

    We should perhaps first pause to take note that Takahashi is an unlikely hero, given that he once declared, in reminiscence of his mentor: ‘After two days of talking with Maeda, I realized that my concept of the state was shallow. The state was not something separate from the self. The state and the self were the same thing.’ Mussolini would have been proud of him.

    Moreover, this particular ‘genius’ seems to have subscribed to the same old canards of the underconsumptionist school, with all of its superficial appeals to the so-called circular flow mechanism. Hence, we have this pronouncement from the lips of the great man:-

    “If someone goes to a geisha house and calls a geisha, eats luxurious food, and spends 2,000 yen, we disapprove morally. But if we analyze how that money is used, we find that the part that paid for food helps support the chef’s salary, and is used to pay for fish, meat, vegetables, and seasoning, or the costs of transporting it. The farmers, fishermen, and merchants who receive the money then buy clothes, food, and shelter. And the geisha uses the money she receives to buy food, clothes, cosmetics, and to pay taxes. If this hypothetical man does not go to a geisha house and saves his 2,000 yen, bank deposits will grow, but the efficacy of his money will be lessened. But he goes to a geisha house and his money is transferred to the hands of farmers, artisans, and fishermen. It goes in turn to various other producers and works twenty or thirty times over. From the individual’s point of view, it would be good to save his 2,000 yen, but when seen from the vantage point of the national economy, because the money works twenty or thirty times over, spending is better. ”

    No wonder his shade is being summoned as the tutelary deity of what is inevitably being termed ‘Abenomics’. Martin Wolf must be positively beaming with delight.

    Our own thoughts on this matter should need little exposition so let us content ourselves by citing the wise words of a man who is being sacrificed to this kami of inflationism, outgoing BOJ head Masaaki Shirakawa. In a speech given almost two years ago, he pointed up the dangers of overplaying the supposed similarities between 1930s Japan and the country of the 2010s before issuing a stark warning regarding the dangers of embarking upon a like course to that followed on that earlier occasion:-

    “As many of you know, Mr. Takahashi was assassinated in 1936 by militarists when he was trying to stop ever-growing demand for military spending, and the course of events led to the eventual rampant inflation. I would argue that the introduction of the scheme of the Bank’s underwriting of government securities itself paved the way for eventual ballooning of fiscal spending, precisely because the scheme lacked the checking process through the market mechanism.”

    “We often use the words of ‘entrance’ and ‘exit’ to discuss the conduct of monetary policy nowadays. In that terminology, we should interpret that the ‘entrance’ of the introduction of the Bank’s underwriting of government bonds in the early 1930s led to the ‘exit’ of the failure in containing growing demand for fiscal expenditure. In retrospect, we should note that the Bank’s underwriting of government bonds started as a ‘temporary measure’.”

    “Though Mr. Takahashi stated that he issued government bonds by a means of the Bank’s underwriting just temporarily in his address at a Diet session, history tells us that it was not temporary.”

    For reference, the toxic legacy of a government debt of 200% of GDP (sound familiar?), a vast monetary overhang, and shrunken markets eventually cast the defeated nation into a rapid inflationary whorl. After a one third reduction in 1946 as a result of that year’s currency conversion and capital levy, money supply shot back up by a factor of six between the end of that year and 1951/2, as official wholesale prices rose one hundredfold (even if the more representative black market ratio was closer to a more proportionate fivefold).

    As a noted economist of the time, Martin Bronfenbrenner, remarked:

    “…no serious attempt was made… to control either the volume of currency printed or the volume of bank deposits created to support not only the Government deficit but also the similar deficits of private firms…”

    We can only hope that the contemporary Japanese will not suffer too much from what seems to be an active programme of decontrolling such an efflux.

    And what of those hoping for a mercantile boost for Japan as the currency falls at its second fastest rate of the past generation? Well, perhaps it will turn out not to be the smartest thing to prosecute a policy guaranteed to increase input costs from abroad during a period when the country’ trade gap is the highest on record, when the terms of trade have already fallen by a fifth over the cycle, and when the ratio of imports to national income has only briefly been exceeded at any time in the modern era for the four quarters leading up to 2008’s global peak.

    Rather than waiting in vain for some instant miracle, it would be as well to heed the caution of Toshiba Executive Vice President Makoto Kubo who told a press conference recently that:

    “The semiconductor-related business will benefit from a weak yen, but the rapid fall in the currency will increase costs because it uses a massive amount of electricity.”

    Or might we be led to doubt by noting, as was long ago remarked:
    “…because each farmer and the situation in each farm village differs, it would be wrong to impose a comprehensive relief program. Each region has its unique disease. We must begin by investigating these sicknesses and applying the correct cures. If we scatter money uniformly from the centre to the regions, we cannot eliminate the diseases.”

    Who said that, you ask? Why, a certain beatified inflationist by the name of Korekiyo Takahashi.’

  • No6:

    The collapse of the Roman empire took hundreds of years. If only the West could duplicate it.
    The reality is that this collapse is running 10x faster.

  • Animal spirits=running off the cliff with the rest of the lemmings?

  • Calculus:

    What’s so sad is that the current problems are as easy to fix as Carl D suggests in his Daily Telegraph comment. Yet we all know they haven’t a chance in hell in happening.

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