The World We Invest In, Go Figure Volatility... And Black Swans
The news this past month:
Report shows consumer borrowing rose more than expected A report from the Federal Reserve shows that U.S. consumer borrowing increased by $7.78 billion in May. Analysts surveyed by Reuters had expected consumer debt to rise by $7 billion. April's figures were revised from an increase of $8.95 billion down to $7.76 billion. CNBC/Reuters (08 Jul.)
Fed hovers between a rock and a hard place Although the U.S. has thus far avoided recession, it is precariously poised to fall at any time. The situation puts the Federal Reserve and its chairman, Ben Bernanke, in a tough position as dismal economic data continue to mount. Even the resilience of the economy in the first half of this year may be more worrisome than previously thought. The Economist (subscription required) (17 Jul.)
Paulson: Months of work ahead to get through crisis Treasury Secretary Henry Paulson expects it to take months to work through the financial crisis. He made his comments as he sought to reassure the public that the banking system is sound. "Our regulators are on top of it. This is a very manageable situation," Paulson said. CNNMoney.com (20 Jul.)
Pimco head sees $1 trillion in U.S. mortgage losses The manager of the world's biggest bond fund said sliding U.S. home prices will wipe about $1 trillion off the balance sheets of the world's financial firms. About 25 million U.S. homes are at risk of negative equity, which could lead to falling home prices and more foreclosures, said Bill Gross of Pacific Investment Management Co. These factors could lead to less lending and a downward economic spiral. Bloomberg (24 Jul.)
Distressed sales more common on housing market: Four out of 10 homes sold in California and Nevada last quarter were foreclosures or some other distressed sale. BusinessWeek.com and Moody's Economy.com ranked 20 states where home sales were most influenced by forced sales. Michigan and Ohio, which did not have the overbuilding of Sun Belt states but continued to suffer big job losses, made the top 10. Affluent Connecticut was in third place. Massachusetts was No. 8. BusinessWeek (25 Jul.)
Mortgage rates up because of trouble at Fannie, Freddie Mortgage rates approached a five-year high as regulators and the White House strive to rescue Fannie Mae and Freddie Mac. Trouble at the mortgage giants could compound problems in the already-struggling housing market. HSH Associates said the average interest rate on a 30-year fixed-rate home loan increased from 6.44% on Friday to 6.71% on Tuesday. The New York Times (registration required) (23 Jul.)
Mortgage losses spur banks to reduce corporate loans Banks are significantly reducing forms of credit vital to American companies in the backlash from the subprime-mortgage crisis, and the slowdown threatens to further hamper the U.S. economy. Even healthy businesses are finding it difficult to borrow money as banks, burned by the fallout from looser lending standards, overcorrect and take a much closer look at repayment ability. The New York Times (28 Jul.)
Inflation presses reluctant retailers to raise prices As major manufacturers prepare to raise prices yet again, retailers that have avoided passing the increases to consumers may soon find themselves left with little choice. Retailers walk a fine line between keeping prices steady and reducing profits or raising prices and risking decreased sales. BusinessWeek/Associated Press (27 Jul.)
Analysis: Despite inflation, Fed likely to hold rates Inflation is at its highest level in 17 years, but the Federal Reserve is unlikely to change interest rates unless it makes a sudden, drastic leap. Oil and commodity prices, which are the underlying causes of the weak economy and high inflation, are directing the Fed's expected decision to keep rates at 2%. Reuters (29 Jul.)
Poll: Economy lost 75,000 jobs in July Economists expect a government report, scheduled for release Friday, to show that the U.S. economy lost jobs for a seventh straight month in July. A median estimate of 80 economists expects the report to show 75,000 lost jobs, which followed a decline of 62,000 in June. Bloomberg (01 Aug.)
Hedge funds suffer worst first half since tracking began Hedge funds have suffered an average year-to-date loss of 0.75%, their worst first-half performance since Hedge Fund Research started tracking returns in 1990. In 2002, the $1.9 trillion industry recorded its only losing year. Antonio Munoz of EIM Management USA in New York said investors have shifted assets to traders who have proven that they can succeed in turbulent markets. "We don't see investors pulling the plug across the board and putting their capital into cash," he said. Bloomberg (09 Jul.)
The World We Invest In, Go Figure Volatility… and Black Swans
It is always nice to check the news, the noise we live with, but what if we could suddenly soar to 10,000 feet and see the whole playing field below, see through the lens of some of this century’s greatest thinkers and then know, that you can’t know.
My grandmother told me that, on her deathbed, she said, “Danny, some things in life are a mystery, and that’s OK!”
Well, trying to make sense of the stock markets is a mystery too. Is that OK, I don't think so, so let’s get into it!
“Black Monday” on the 19th of October in 1987 provides a memorable starting point. On that single day, the Dow Jones Industrial Average dropped an astonishing 25%, nearly twice the drop of the largest previous daily decline of 13% back on the 24th of October 1929, known as “Black Thursday”. On that single day in 1987 the total stock market value lost $1 Trillion dollars, erased.
The point is not only can anything happen in the stock market, but anything does happen. What’s more, changes in the nature and structure of our equity market and a radical shift in its participants are making shocking and unexpected market aberrations ever more probable, ever more predictable.
For example, just recently:
SEC lengthens ban of short sales to mid-AugustThe Securities and Exchange Commission, which plans to implement broader rules to avert stock manipulation, announced that it is extending to Aug. 12 a ban on "naked" short sales of shares in 17 brokerages as well as troubled lenders Fannie Mae and Freddie Mac. The ban intends to protect companies of which collapse might lead to losses for the U.S. government. Bloomberg (30 Jul.)
Congress passes bill to rescue housing marketThe broad housing-rescue legislation passed by the House on Wednesday and the Senate on Saturday offers emergency funding to Fannie Mae and Freddie Mac along with establishing a $300 billion fund to help struggling homeowners. President George W. Bush, after dropping his opposition to the bill last week, is expected to sign the bill quickly. Reuters (26 Jul.)
Paulson unveils rescue plan for Fannie Mae, Freddie Mac After a weekend of discussions with Federal Reserve Chairman Ben Bernanke and New York Fed chief Tim Geithner, U.S. Treasury Secretary Henry Paulson announced a plan for the government to support Fannie Mae and Freddie Mac. The Fed will give the mortgage giants access to emergency funds similar to the access that banks have. Meanwhile, the government will ask Congress for permission to lend money to Fannie and Freddie. Most market participants did not expect such an aggressive plan, which reflects the authorities' fears about the consequences if one or both of the companies should fail. ClipSyndicate/Bloomberg (14 Jul.) , Financial Times (14 Jul.) , The Washington Post (14 Jul.)
Freddie, Fannie draw big bets on bonds Some of the world's biggest bond investors are snapping up debt sold by Fannie Mae and Freddie Mac as the best alternative in troubled times. Not only has the U.S. government agreed to back the beaten-down housing-finance companies but their yields compared with Treasuries also make the bonds a bargain. Bloomberg (28 Jul.)
And during 2007 we witnessed an unprecedented series of amazing market swings. In the 1950s and 60s, the daily changes were in the level of stock prices changing more than only 2%, only three or four times a year. In the second half of 2007 alone, we saw 15 such swings, 9 downward and 6 upward. Based on past experience, the probability of that happening was… zero.
The point is that the application of the laws of probability to our financial markets is badly misaligned. The truth is that an event, although never happening in the past, is not reason for such an event happening in the future.
Black Monday, then, is a rarity, an extreme event. Now, everyone knows that swans are white, right? So, a black swan would be an extremely rare event, like Black Monday.
And just because it has never happened doesn’t necessarily mean that it can’t happen, and conversely, just because an event is expected to happen, doesn’t mean it does. Unlike the 1929 antecedent, Black Monday did not prove to be an omen of dire days ahead, in fact, quite counter-intuitively, a harbinger of the greatest bull market in recorded history, ending when, in 2008?
None the less, despite the recent wild disturbances in both the stock and bond markets, market participants seem confident that future returns will resemble those of the past.
For example, Investors see huge GM losses as temporary The third-worst quarterly loss in General Motors' 100-year history left investors sobered but optimistic about the automaker's prospects. GM announced that its second quarter ended with a $15.5 billion loss, four times more than analysts expected, but that included $9.1 billion in one-time charges and expenses in North America. "That was about as ugly as you can get," said Mirko Mikelic of Fifth Third Asset Management. "But they did throw a lot of junk in there." ClipSyndicate/Bloomberg (04 Aug.) , Detroit Free Press (02 Aug.)
IMF backs U.S. measures, thinks upturn a year away The U.S. economy has been more resilient than expected but probably won't improve until the middle of 2009, as losses in home values depress consumption and worsen credit conditions, according to the International Monetary Fund. The dollar was near its equilibrium, though still overvalued by as much as 10%, the IMF said. Officials said they are in favor of new housing-support legislation. Reuters (30 Jul.)
And so the knowledge that black swans can and do occur, according to the work of Sir Karl Popper (1902 – 1994) holds important lessons for how we should think about risk. Writing about, Sir Karl Popper,in the New Yorker, journalist Adam Gopnik (2002) described Popper’s reasoning in this way:
No number of white swans could tell you that all swans were white, but a single black swan could tell you that they weren’t… Science, Popper proposed… didn’t proceed through observations confirmed by verification; it proceeded through wild, over-arching conjectures, which generalized way “beyond the data”.
Yet most of us, in our investment ideas and in our political ideas do exactly the reverse of this “scientific thought” that Popper pointed out, that is we continue to expect to see, in all probability, a white swan; that is, we remain confident that future returns will resemble the past. We search for facts to confirm our beliefs and hopes, not for facts that would negate them. For example, the news stories I started this article out with, which for most of us, negates what we want.
Thus, in the markets, few theories are advanced with the search for what is wrong with our ideas, because the language of finance uses terms like forecasts and probabilities. We are talking about probability, and probability is a slippery concept when applied to our financial markets. We use the word “risk” all too casually and the word “uncertainty” all too rarely.
The distinction was made first by Frank H. Knight, (1885 – 1972). In Knight’s view, the two things, risk and uncertainty are different. Risk is properly used as a measurable quantity to which probabilities and distributions are known (as with the roll of dice). Uncertainty is immeasurable, and therefore, not subject to probabilities.
According to Peter Bernstein, “Considering the consequences of being wrong is essential in decision-making under uncertainity”. In 2004, Glyn A. Holton pointed out in an article that uncertainty accounts for only one aspect of the idea of risk. The second aspect is exposure. People must have a stake in the outcome; it must matter to them.
Applying abstract theories of Popper and Knight to financial markets is what people do. That’s what Benoit Mandelbrot, the inventor of fractal geometry, did. Fractal geometry, simply defined, is about patterns that repeat themselves continually scaling up or down. This is observed in nature as well as geometry, where growth is not linear, but logarithmic.
Mandelbrot applied this concept to the daily price movements of the Dow. Since 1915, the standard deviation of the Dow has been 0.89 %, that is two-thirds of the fluctuations were within the 0.89 percentage points of the average daily change of 0.74%. None-the-less, the occasions when the standard deviation has been as high as 3 or 4 have been frequent; occasions when it has exceeded 10 have occurred infrequently, only once, and that was on that Black Monday back in 1989. The odds against such a happening are about 10 to the 50th power.
The fact is that the infrequent but extreme daily changes in the stock market can overwhelm the frequent, but usually humdrum fluctuations that take place each day within normal ranges. For example, since 1950, the S & P 500 Index has risen from a level of 17 to a recent level of 1,260. But, if we deduct the returns achieved on only the 40 market days in which the S & P 500 had its highest percentage gains, 40 out 14,588 days, then the level drops to 288. Contrarily, if we eliminate the 40 worst days, the S & P 500 will be sitting at 11,550.
That so much can happen on so few days and so unpredictably, suggests the perils of jumping into and out of the market and the value of simply staying the course. Put another way, investors are more volatile that investments. Economic reality governs the long-term returns earned by our businesses, and black swans in business are unlikely. But emotions and impressions, the tides of hope, greed and fear among the participants in the financial system govern the short-term returns generated in the markets. These emotional factors magnify or minimize the central core of economic reality, and in such an environment, a black swan may appear at any time.
More than 70 years ago, the great British economist John Maynard Keynes (1883 – 1946) recognized the critical distinction between the rational and the irrational in the stock market. And he remarked that in American markets, the influence of speculation is enormous. It is rare for an American to invest for “income” only, rather, he will probably purchase an investment in his hope for capital appreciation. This is another way of saying that the American is attaching his hopes to a favorable change in the conventional basis of valuation based on enterprise, to one based on speculation. This also was Keynes’s great concern.
Corporate earnings in the United States have grown with remarkable consistency at about the rate of the U.S. GDP. There have been no black swans in long-term U.S. investment returns. However, having said that, certainty about the future never exists, nor are probabilities always borne out, so applying reasonable expectations to both investment and speculation returns combined, has proved to be the sensible approach to projecting returns to the stock market over decades. In deed, despite the black swans of the stock market history, ownership of U.S. business of investors who have stayed the course has been a remarkably successful strategy.
Then along comes a U.S. economist Hyman Minsky (1919 – 1996) who observed the fundamental link between finance and economics with these words: “The financial system swings between robustness and fragility, and these swings are an integral part of the process that generates business cycles.” He noted the symbiotic relationship between finance and industrial development which came to a head in the 1980s when institutional investors became the largest repositories of savings in the country and exerted there influence on financial markets and the conduct of business enterprises. Minsky’s key concept was that the financial economy, focused on speculation, should not be considered separate and distinct form the productive economy, focused on enterprise. This expectation and fear of Minsky, like that of Keynes, was that speculation would come to overwhelm enterprise. Recent history seems to confirm their fears, as rampant speculation in the markets has added a new elements of uncertainty into our economy.
This change in the structure of capitalism has been dramatic. A half-century ago, individuals owned 92 % of US stocks and institutions owned but 8%. Currently, individuals own 26% and institutions own 74%. Critically, in this new environment for money managers, where they are held accountable for the maximization of the value of investments made by their clients as measured in periods as short as years or even quarters. This means that institutional managers have turned increasingly to speculation (versus investment) just as Keynes had predicted and business executives became increasingly attuned to short-term profits and the stock market valuations of their companies.
This brings us up to our current situation, with the growing role of institutional investors to foster continued evolution of the financial system by providing a ready pool of buyers of securitized loans, structured finance products, and a myriad of other exotic innovations whose complex risks are shaking the financial markets of today.
Indeed, over the past two centuries the United States has moved from an agricultural economy to a manufacturing economy, to a service economy, and to what is predominantly a financial economy. The U.S. is becoming a country where no business actually makes anything. Where we merely trade pieces of paper, swap stocks and bonds back and forth with one another, and pay the financial croupiers a veritable fortune. Led by Wall Street’s investment bankers and brokers and mutual funds, followed by hedge funds, pension fund managers, financial advisers and all the other participants in the system. These costs have soared to staggering proportions. Aggregate annual costs incurred by market participants have risen from an estimated $2.5 billion as recently as 1988 to something like $528 billion in 2007, an increase of more than 20 times.
Even more staggering is the increase in financial transactions of all types, a global phenomenon whose implications are far from clear. Although the world’s GDP is about $60trillion, the aggregate nominal value of global financial derivatives is said to be $600 trillion, fully 10 times larger than all the goods and services produced in our entire world. Among the riskiest of these derivatives are credit-default swaps, which alone total $45 trillion, an amazing 9 fold increase in the last three years. These swaps are five times the size of the U.S. national debt and three times the U.S. GDP.
What do they look like? Consider the CDO, collateral debt obligations, which became more and more complex and more and more concealed. The US SEC registered rating agencies placed their imprimatur on hundreds of new issues of CDOs that were created entirely out of subprime mortgages that would likely been considered as rated B, C or even D in quality and then transformed 75% of them into series (traunces) of AAA, 15% into A and 5 percent were rated BBB. Only a remaining 5% carried a rating of B. One might as well call this magical conversion of low quality into high quality akin to turning lead into gold.
We all know, by early 2007, when mortgage defaults started to snowball, that the financial crisis in mortgages was upon us, and at great and growing cost to U.S. citizens and society. This crisis, although not yet a black swan, is a classic example of the impact of the financial economy on the real economy. Issuance of such bonds in the United States in the past five years totaled $2 trillion, of which the investment banks generated an estimated 80 billion. I conclude with Oscar Wilde, that the only thing that the banks could not resist was temptation.
And again, risks in our financial sector are not the only risks investors face. Some huge, seemingly unacknowledged risks also characterize U.S. society. Consider: the Social Security and Medicare payments committed to by our national government; the string of huge deficits in the U.S. federal budget; our enormous expeditions (soon to reach $1 trillion) on the wars in Iraq and Afghanistan; terrorism; the threat of global warming and the cost of dealing with it; unfettered global competition, our trade deficit, and the decline in the value of the US dollar.
Other risks are more subtle in nature: a political system dominated by money and by vested interests; a Congress and an administration seemingly focused entirely on the short term, the vast chasm between the wealthiest among us and those at the bottom of the economic ladder (the top 1% holds more than 33% of our total wealth), our self-centered, “bottom-line” society focused on money over achievement, charisma over character, and finally the paucity of leaders who are willing to lead, to defy the conventional financial wisdom of these times, and to stand up for what is right and noble and true.
Whatever the case, some surprising event out there, far beyond our expectations, will surely come to pass, an event that will carry an extreme impact, and one for which, once it happens, we’ll quickly concoct an explanation as to why it was so predictable after all. That event, if and when it comes, will just be one more black swan, something akin to “Disaster Capitalism” perhaps.
So, be watchful of the news and the noise of the news, and look into it not to support what you want to believe and hope for, but for what is actually happening. And to this end, I return you to the clips from recent news stories as I have come to collect and present in my blog lately.
Keep your powder dry and recognize that these times, they’re a’changing.
Credit crisis far from over, IMF warns Citing "fragile" global financial markets and softening European home prices, the International Monetary Fund warned that further reductions in U.S. credit growth are possible. The July update to the fund's Global Financial Stability Report reiterated the IMF's contention that losses this cycle could reach as much as $945 billion as the subprime-mortgage crisis continues to reverberate. Financial Times (28 Jul.)
Industry insiders expect more bank failures After the seizures of First National Bank of Nevada and First Heritage Bank of California, market professionals said more bank failures are expected before a recovery in the financial markets. "My real concern is that we're not finished," said Kathy Boyle, president of Chapin Hill Advisors. "Wall Street would like to think that the worst is over, but we've been saying that for a while." CNBC (28 Jul.)
And yet, More U.S. banks to issue covered bonds Three more U.S. banks said they would begin issuing covered bonds, a tool common in Europe that could free up mortgage financing. Citigroup, JPMorgan Chase and Wells Fargo said they would begin issuing the debt. The bonds are backed by mortgages but kept on a bank's books and backed by a layer of high-quality mortgages. Bank of America and Washington Mutual previously issued the bonds, but their appeal was limited because of regulatory uncertainty about where investors stand if a bank collapses. The Wall Street Journal (subscription required) (29 Jul.)
Investors worldwide bet big on plummet of stock pricesAround the globe, investors have wagered more than $1 trillion by speculating that the price of stocks will drop. In July, managers made at least $1.4 billion on bets against Fannie Mae and Freddie Mac, Bloomberg data show. Hedge funds and other financial firms have made large sums by short selling. "It's a huge amount of money," said Peter Hahn, a research fellow for Cass Business School. "Shorts have come a long way. They are getting into the mainstream, and long holders need to understand the shorts are not evil." Bloomberg (21 Jul.)
Analysis: Liquidity takes priority in Fannie, Freddie rescueThe U.S. government has made preventing a crisis in liquidity its top priority in rescuing troubled lenders Fannie Mae and Freddie Mac, and rightly so. But policymakers shouldn't overlook the longer-term problems of capital and structure that must be addressed if the two government-sponsored enterprises are to survive. Financial Times (15 Jul.)
Soros warns of more crises to come after Fannie, FreddieBillionaire investor George Soros said the latest financial crisis involving Fannie Mae and Freddie Mac will not be the last. Soros labeled the turmoil in the markets that has marred the last year as "the most serious financial crisis of our lifetime." He also said Federal Reserve Chairman Ben Bernanke might not be able to prevent the U.S. economy from deteriorating even further. "His options are limited -- he is boxed in," Soros said. Reuters (15 Jul.)
G-8 leaders indicate inflation is primary concernLeaders from the Group of Eight said the global economy is being threatened by rising oil and food prices. "We have strong concerns about the sharp rise in oil prices," they said in a statement before their annual summit. "The world economy is now facing uncertainty, and downside risks persist." The leaders proposed holding a discussion between consumers and energy producers with a focus on energy efficiency. "Production and refining capacities should be increased in the short term," the group said. Bloomberg (08 Jul.)
World Bank predicts 8%-plus inflation in Latin AmericaHigher food prices will push Latin America's inflation to an average of more than 8% this year, the World Bank's chief economist for the region said. The rapid rise in commodity costs will especially hurt importers in Central America and the Caribbean, while boosting major oil exporters such as Venezuela and Mexico. Bloomberg (30 Jul.)
Author’s note: This discussion paper is for the dental audience and is largely re-edited content taken from CFA Institute's private wealth resources which include edited portions of a speech delivered to the Risk Management Association on 11 October, 2007 by John C. Bogle. Its academic use and private study is permitted under the "fair dealing" guidelines which allow for its use here for the purposes of criticism and review.
