There has been little, if any, reduction in either the appetite for or assumption of risk in the several weeks since I have last written. In fact, there has been a clear increase in both. That alone, as 2003 more than proved, has meant little to financial markets: volatility remains low and prices remain buoyant. But whether a trader looks at fundamentals, technicals, sentiment, macroeconomic statistics, quantitative data, or heck, lunar cycles, all good investing comes down to an exercise in probability determination.
Of course, there are substantial differences in determining probability based on the exercise one is engaged in: calculating the probabilities behind flipping a coin is easier than that of thrown dice and easier still than blackjack. And each of those is child's play when determining financial market probabilities: the added coefficient of sentiment and psychology (and the resulting herding impulse that attends all collective human endeavors) making it a thoroughly more difficult proposition.
But probabilities are, of course, just that; showing a face card to your jack and queen, the dealer can still, however low the probability, have a six face down and then draw a five. I've seen it happen. And it never fails to flabbergast me. But if the weighted outcomes were skewed in your favor, those are trades you should take, everytime. For example, let's say I flipped a coin and gave you two dollars for each flip you called correctly and you paid me one dollar for each time your call was wrong. You'd be a fool not to take that action: you know the outright probability (even) and you risk $1 to make $2, so the weighted probability is decidedly in your favor. That's not to say you couldn't lose money, and perhaps a substantial amount of it over a short period of time, but the probability of losing money is very low over any meaningful period of time.
I have thought a lot about the probability environment over the last few weeks. John's and Toddo's commentary in the last few days about volatility hedge funds shutting down in the face of historic declines in volatility is but an extreme realization of an improbable event. It is the equivalent of losing a coin toss 10 times in a row. What hurts most about hearing doors like those shuttered, beyond the very real personal hardships inflicted on those folks involved, is the weakening of the collective financial firmament. A properly functioning financial system - like the human body, like governments, like social contracts - relies on checks and balances.
For its part, human digestion couldn't work without hydrochloric acid in the stomach; but hydrochloric acid in the intestine will kill you. So the pancreas produces sodium bicarbonate that neutralizes hydrochloric acid as your food enters the small intestine. The pancreas and the stomach: each essential to life, but only when they are both balanced by each other. Financial markets are no different. Volaltility arbs, just like short funds, are vital cogs in the healthy functioning of the financial markets. Without them, markets become more prone to exogenous events, which is a fancy way of saying that they can't absorb shocks without coming unglued.
With that background, let's canvas the current environment with an eye toward risk. After all, you can't know what the probabilities are of certain outcomes without knowing the set of initial conditions under which those potential outcomes are borne. Of note, some of which are well known, some of which are not:
The Fed's reflation efforts have been historic in size, speed, and length
Global reflation among the G7 too, has been historic in proportion
Fiscal reflation efforts are the largest since LBJ's 'Vietnam/Great Society' era
The current account deficit, at 5.3% of GDP, is a record for a developed economy
Foreign public capital flows into US debt is setting records of pace and size
The US$ is declining (q/q) at a pace only seen once before in history
MZM and C&I loans are contracting at near historic rates
The Fed is targeting asset prices in an effort to bolster consumer spending
Household debt and debt service ratios are at all-time highs
Employment trends have never been this weak at this stage of a recovery
Wage and salary trends have never been this weak at this stage of a recovery
Consumer spending has not contracted for 47 straight quarters; an all-time record
Multiple stock market bullish sentiment measures are setting all-time records
VXO at 8 year lows
INDU hasn't seen a 5% correction since 7/03; longest record since 1987
92.6% of stocks above their 200 day moving average; all-time record
Wall Street strategists recommended equity allocation level at all-time high
Insider sell-to-buy ratio all-time high (36:1 in 2H:03)
55% of tech stocks valuation greater than market multiple: same as March 2000
Junk bond funds record inflows: 60% more than 2000, '01, and '02 combined
At current valuation levels, expected total return for SPX is 0.1% for the next decade
If I told you in either October of 2002 or March of 2003 that dozens of all-time records for macroeconomic, financial markets, and sentiment figures would be set inside a year, you would have scoffed. Mostly because the probability of the above taking place was extremely low against 40, 60, and in some cases 100 years of statistics. Just as improbable as the dealer drawing a 5 when holding a 16. It can happen. Betting it will, over time, will make you poor.
Understand that, though I appreciate all of the above risks, and that we are "overdue" for a 5-10% correction, they aren't helpful from a timing standpoint. We're in uncharted waters here, so keeping a stern hand on the helm and a watchful eye on the horizon will be pretty important over the next several weeks.
The risk environment being what it is has other costs beyond simply making a long position more risky than at most times in the last 100 years of equity ownership. Those other costs revolve around the stability of the financial system itself: those costs involve systemic risks. John and I have touched upon this systemic risk obliquely in various posts over the last year: the Fed's intervention creating moral hazards, malinvestments, over-indebtedness, and across-the-board increases in risk appetites.
But there are two new things that investors should note: (1) this risk environment is eliminating the checks and balances that are essential to a healthy financial system by removing the desire to short stocks, to arbitrage volatility, or to play defense with portfolio allocation. These things don't come back quickly, just like they don't go away quickly. (2)The second thing to note, and this is an important development, is Fed Chairman Greenspan's end-zone dance on January 3rd via a speech given to the AEA in San Diego. When one considers that no central bank intervention of this magnitude in the history of economics has ended with anything other than dire consequences, such hubris is even more remarkable.
The path from gold-standard advocate in 1964, as Greenspan was, to economic central planner in 2004 must have taken an intellectual path of enormous complexity: a Gordian knot of a road. But know this: economic central planning, whether it be from Soviet-era apparatchiks or modern-era central bankers, has never worked. Never.
Joining Greenspan in his endzone dance is akin to betting $10 to win $1 that it will this time.
PS: It's good to be putting pen to paper again after a hiatus to take care of some family issues. Thanks for all the emails and concern. We're still fighting the good fight every single day; please understand that, sometimes, our arms get tired from the punches, our breathing becomes labored, and we get an uppercut that we didn't see coming. So it's tough to get back to one of our favorite posts - Minyanville - without a breather. Thanks
PSS: Relative to the technical studies I had been describing in November and December, clearly we are now in uncharted waters, as some of the statistics above suggest. Those studies don't currently offer much in the way of definitive edge for the intermediate term. If they do, I will be sure to pass them on.
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