Designing better futures

On systemic collapse

Many like to yell "systemic collapse" in a crowded system.  Most studies of complex systems or networks of interactions realize there are 3 zones in which a system exists.

 Economies are systems.  In this example I label the 3 zones, stable, interesting and random.  Some use the term chaotic, for the 3rd zone, but this or "complexity" is really a gradient between zones 2 and 3. Lets not get started on a debate about Kolmogorov constants.  

The energy or system inputs in the model above range from 0 to infinity.  A basic example of this model is given by the carbon in #2.  The states are Diamond (Stable), interesting (organic) and finally gaseous (CO2) which could be paired on temperature gradient.

Moving out of stable interesting in the middle to the right or to the left is usually considered a "collapse" by those within the system.  We still don't know where the US is going to end up,  Hyperinflation volatility Latin America style on the right or Japan Land of the Living dead economic tomb on the left.  The dollar shoe has yet to drop (pun intended). 

Ideally we get back to the middle zone rapidly, but US debt and unfunded government liabilities causes this to be a challenging assumption.

In an economy or any complex system it is impossible to understand the relationships and dynamics in the interesting zone.  This impossible understanding of "inter" relationships however doesn't stop the lazy practitioner from modeling co-relationships and thus assuming detailed knowledge of the system dynamics.  Co-relationship analysis is useless and flawed in systems, such as economies or portfolios of loans or portfolios for that matter.  We are now witnessing these flaws of mis-understanding in the early stages of the US meltdown.  Common sense never got in the way of a large vocabulary or a good "working" model.

Don't even bring up options models, which are only really lucrative if you understand their flaws.  The myopia of the model builders can be quite a gold mine for the good gambler.

Common sense rules of thumb were overrun by correlations.  For example, imagine if the continuum above were leverage for a bank or economy.  Leverage runs from 0(no leverage) to infinite leverage.  Historically banks would use a rule of thumb such as 12:1 for our cultures fractional banking system.  Think of this as the tier 1 capital requirement.  A regulator can't understand the dynamics of the system so tells everyone to operate within a safe zone.  There are no further assumptions made such as sub zones etc.  The entire system has a single regulating variable, namely leverage.

This left the system "economy" safely in the interesting zone where it could evolve and grow maybe not the fastest, but safely.  No one really understood all the components or co-relations and if they did they were just deluded economists or some other garden variety charlatans.

The dangers in the system occurred when US banking regulators 5 years ago allowed entities to leverage up 30:1 etc. based on correlation or covariance analysis.  Basically a lot of very bright people who had no idea about system dynamics and lacked the humility to utter the words "I don't know" (Jim Crameritis), or god forbid, "I can't model it".    When a person tells you they can model a CDO,  they may as well tell you they can model a meadow.  You should thus leverage your CDO or bank accordingly. Basel 2 is a disaster waiting to happen, for it assumes knowledge of interactions within the system.

This leverage pushed the system to the point where it would inevitibly suffer collapse.  The pertinent question today is how much of the system is collapsing, housing, banking etc.  The system dynamics are too complicated for me to understand, but months ago on this blog, I made suggestions of more currently "stable" regions for investment consideration.

A person who understands the edge of statistics is Nassim Taleb.  Check out his great essay on "the limits of statistics" His pen and mind are far sharper than mine in these areas.

CDS Systemic risk: a primer about chain settlement risk.

There is a lot of talk about the +$60 trillion notional outstanding CDS (credit default swaps). 

There are a few types of risk associated with CDS, but the most esoteric and least well understood is systemic failure due to settlement failure cascade and or related counterparty seizure.  Basically this occurs when one party can't make good in the short term during a default event and other market participant halt outgoing payments.  This is topical as the Freddy & Fannie defaults are a large default event.

The interesting thing about systemic OTC settlement  risk is that it is actually increased due to the offsetting of risk individually.  It is a case of the tragedy of the commons, the commons in this instance is systemic integrity and faith in counterparties ability to interact, the interbank  financial system if you will.

A grossly simplified example will explain it.  Party A wishes to place a bet on Frannie default risk by purchasing CDS protection on Frannie.  Party A buys protection from B.  B is now exposed to the risk of a Frannie default and decides to hedge this risk by buying Frannie CDS protection from party C.  C holds the position with net exposure for awhile, gets nervous and then offsets by purchasing protection from Party D, who then offsets the exposure with Party E. 

For the sake of simplicity we will assume the default event of Frannie requires $10m in cash or securities to be delivered within 5 business days of the acknowledged default event.  Now all of the parties involved have done their risk assessments of their downstream counterparty using various estimates of the counterparties credit quality and liquidity.  They have each come to the conclusion, that their next counterparty has a .001% chance of failure at any point in time.  They could thus assess the counterparty risk exposure in crude nominal terms as being $10mx 0.01% = $1,000.  This feels safe.

Looking individually each party assumes they have $1,000 in risk.  In reality A faces $4,000 in probable risk.  The chain is only as strong as it weakest link.  The end settlement party A has $4,000 exposure (1-(1-.0001)^4)*$1,000.  Party B has a $3,000 exposure etc.  The longer the chain the greater the systemic risk for the initiator and the potential for a failure to deliver on time etc. 

There are currently various initiatives to "compress" the risk by netting out the exposure via centralized clearing by the bigger parties.  Another risk associated with CDS is that a party in the chain may dispute what determines an EOD and hold up payment until resolution.  Fortunately with the Fannie and Freddy situation 13 major banks have agreed to declare a default.  What is unknown is the length of the chains and notional amounts outstanding relative to available liquidity.  Settlement failure due to liquidity is known as Herstatt risk.

Let's hope the CDS interbank settlement "system" passes the "buck" around in a timely fashion.  It should be noted that a single break in the chain won't necessarily cascade through the chain as each bank should have excess liquidity as a buffer. 

A single failure does drain a single bank and system liquidity (due to fear) and cause counterparties to typically suspend settlements.  This occurred when Barings went down. Before the Bank of England stepped in there was $22b in settlements held up by groups exposed to Barings and not wanting to settle trades for fear of not getting the counterpart of the transaction,(yen/swiss franc for example).  This was caused by a $2b problem and could have cascaded out not from just Barings but a cascading ring of those know to have Baring exposure in the 1st, 2nd or 3rd degree of separation etc. 

The simple model above is illustrative more than demonstrative.  That being said, liquidity is tight these days and fear made many banks offset risk thus growing the chains recently.  Local risk reduction behavior of offsetting positions and exposures may actually have increased system settlement exposure. Keep your fingers crossed as writing extreme out of the money options contracts like CDS is a bit like putting out Black Swan food.  Banking and money are social institutions built on faith, they don't adhere to the laws of physics.  It is important to remember that all social institutions ebb and flow over time.

What are US equity investors expecting to happen?

The S&P 500 represents $10.8 trillion of US equities.  It is trading at roughly 20.6 times trailing earnings.  This works out to a current yield of 4.86%.  The S&P 500 has historically traded at a mean yield of 7.45% and a median yield of 6.46% since 1938. 
If the S&P 500 reverts to mean it would indicate one of the following things happening in the next year

• a 30% equity price decline or
• a 30% increase in earnings or
• a mix of both

I am curious to hear from some bulls, actively buying equities what do you see? Is the expectation of future debt yield so low that 4.86% seems like a fair equity risk premium even with zero growth.  Here is the data from S&P Download copy_of_sp500pe_ratio.xls

Here is a simple model to play with earning changes. 

Download modelequityearnings.xls

So what are you people seeing, low yields, increased revenues, decreased COGs & SG&A?  For the buy and hold crowd, I get it, don't time the market, but for someone piling in right now, what is it?

The metric system & investor value biases (lets start talking basis points)

Most people think "the market" is the Dow Jones and hear talking heads tell ever greater tales of markets, swooning, plummeting, soaring etc. connected to some number.  The market collapsed 10 points or jumped 50 points etc.  The TV character then attributes this activity to some random event and thus a fictive narrative is born.  These stories and storms in teacups then sell Escalades, soap and insurance etc.

The average person has no idea what Dow point movements mean.  Even experts who watch the market day to day use them as relative metrics.  Familiarity gives Dow points relative meaning.   For example, if the Dow Jones Industrial Average moves 50-60 points typically then  a 100 or 300 point move is understood to be a big thing. 

What counts is percentage of change

The DJIA maintains its dominance as a market barometer due to human cognitive failure.  The DJIA as a market barometer is horrible in both scope and construction comprising only 30 shares weighted in an abstract manner.

We get psychologically anchored to thinking about values in a relative way and thus become trapped within a mental framework.  Our perceptions get skewed.  Think about people who bought homes based on comparables across the street, the mental framework made sense from a relative value perspective, but was useless in terms of absolute value.

My suggestion for financial journalists would be to talk about index Basis Point moves.  So a 2% move in the dowjones would be 200 basis points.

This is the perfect time to do it with the dow near 10,000 the relative Point value of the Dow and Basis point value of the dow are about the same.  Basis points allow people to talk about something meaningful (i.e. relative percentage moves). 

People are anchored to the relative nature of Dow points, this is why the S&P 500 or other indexes will  never usurp the Dow's position for average people discussing the US equity markets.  There is an anchored value perception.  For all of you value investors out there, Dow Jones has a great moat with this.

This suggestion to discuss equity indeces in basis points of has about as much chance of succeeding as America's "war on english units" move to the metric system in the 1970's.  People are still blaming Jimmy Carter for that one. 

There are 3 countries in the world who haven't adopted the metric system, Burma, Liberia and the US

Once people gets used to a relative unit of value their mind gets anchored there.  The smart investor can use this to their advantage as the ast majority of people are too lazy to shift a relative frame of value to an absolute one.  This advantage become ever greater as values move to extremes.

One of the funnier quotes about value shifting came from the humorist author P.J. O'Rourke who wrote," Drugs have taught an entire generation of Americans the metric system", sad but probably true.  Don't expect the US equity market to be discussed in basis points anytime soon, expect it to keep swooning, leaping and generally carousing around in Dow points, and that folks sells advertising.

Beat the Market with Ed Thorpe

I have been studying for the CAIA Chartered Alternative Investment Analyst exam coming up.  It is a bit like the CFA but only 2 exams and focuses on alternative investments.  It may be geeky to admit but it is fun stuff.  I used to build trading models as a kid and play with neural networks and t-bond futures in college back in 1990. 

One of the areas that is new for me is Convertible bond arbitrage which is a great way to get back into math a bit.  The strategies and approaches are as I used to be a runner in the 10 year t-note options pit at the CBOT. 

Awhile back I reviewed Fortune's Formula which was all about Gambler's, gangsters and information theory.  It also had great stuff on portfolio allocation and risk which is a subject much like Taxation that few investors think about at their peril.

Successfully growing wealth via compounding returns needs tax deferment and minimal impacts from Siegel's Paradox (the fact that money lost beyond 13% has to work harder to get to break even.)   Risk management and portfolio allocation is sorely un-respected in the field of investing for the long term.  A simple understanding of portfolio auto-correlations and re-balancing approaches can add 100's of basis points to a portfolio at the fund or even asset class level every year.  Of course this mean thinking about 10-20 year horizons.

One of the Gurus of Convertible arbitrage was and is Ed Thorpe who runs a multi-billion dollar fund in New Port Beach, California.  He still publishes and is revered by Nassim Taleb and the Wilmott quantitative finance crowd for his pioneering work.

He published a book in 1965 called Beat the Market that is now out of print.  I found a copy via my grandmother in Iowa of all places and had it scanned.  You won't learn anything new in there, but it is interesting to see a pioneering piece of work and the historical bits such as:

• Spreads of 30-40% on warrants
• A capital gains rate of 25% considered long term after holding a position for 6 months
• Today we call them investment "ideas", back then they were "situations"
• and this view of the future: "We are misguided  when we exalt ourselves by insisting that the psychology of the marketplace and of man are unknowable.  The sciences of man are now emerging from the Dark Ages.  Economics and psychology stand today at Koestler's watershed just as astronomy did in the time of Tycho Brahe.  Our superstition, blind belief, and ignorance are being swept away forever by the scientific accumulation and analysis of data.  There will be predictability in the affairs of men."

Funny how the technology always gets better but the folly and fickleness of men never changes.  Glad a I took anthropology study psychology and sociology in my spare time. That scientific prediction of man is a little over the horizon.

If anybody is interested in a PDF of Thorpe's book Beat the Market for educational purposes drop me a line.