‘Until It Blew Up’…

By way of introduction, recall this from an article I wrote for DealBreaker last month called “The Wave Paradox“:

Right, so I’ve got a theory I like to call the “wave paradox.”

Maybe it’s nonsense, maybe it’s got some merit, but whatever the case, it’s starting to seem like a lot of ostensibly “smart” folks are expressing the same idea only using less colorful language than I typically employ.

The concept is simple: market participants of all stripes are no longer able to discern whether they are capitalizing off the prevailing dynamic or creating the dynamic that they’re capitalizing on.

This can be posed as a question: “Am I making good decisions or are the decisions I’m making only turning out good by virtue of my having made them?”

That might sound like the worst kind of tautological bullsh*t, but it’s not.

Keep that in mind as you read the following piece by Eric Peters.

By One River CIO Eric Peters as originally published on his LinkedIn

Heisenberg Principle: “My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation,” admitted our Fed Chairwoman. “Our understanding of the forces driving inflation is imperfect, and we recognize that something more persistent may be responsible for the current undershooting of our longer-run objective,” she said, blinking, blinded by flashing photographers. “The influence of labor utilization on inflation has become quite modest over the past 20 years, implying that the inflationary consequences of misjudging the sustainable rate of unemployment are low. But we cannot be sure that this modest sensitivity will persist in the face of strong labor market conditions, given that we do not fully understand how it came to be so modest in the first place,” whispered Yellen, unsure of anything, eyeing the exit.

Arbitrageurs: Oxpecker stood atop Rhino. Feeding freely on the ticks and larvae that infected the fearsome beast’s many open sores. Yet Oxpecker had a taste for the largest parasites, leaving smaller ones to aggravate Rhino. And the little bird craved Rhino’s blood, drawing its share day by day, sip at a time. At the first sign of danger, nervous Oxpecker flapped it wings just so. And Rhino, terribly shortsighted, understood the signal, steeled itself for attack, saving them both. It could have gone on forever, but one day, Oxpecker grew to be the size of Rhino.

Summer 2007: The statistical arbitrage models had made such strong returns. But as money flowed in, their Sharpe ratios declined from exceptional to great. Then great to good. So on, so forth. But by doubling leverage the Sharpe ratios could be magically restored to their former glory. Doubling leverage required doubling positions, which in turn supported prices, and this lowered volatility – producing strong profits without an appearance of an increase in risk. And that all worked incredibly well, as of course it should, until it blew up. 

Coiling: The British Raj grew concerned by the abundance of venomous cobras in Delhi. A reward was offered for every dead snake. And in they slithered. One by one at first. Then in baskets, barrels. “Our strategy has proved a great success,” announced the Raj, yet still the number of captured cobras swelled. You see, the breeders had entered the business. When Raj learned of this betrayal, the law was abruptly abandoned. And the captive snakes, as worthless as they were abundant on a scale never before seen, were set free. Coiled throughout Delhi.

Fair Enough: Merrill produced a measure called “Percent Cheap.” It allowed you to monitor where convertible bonds traded in relation to fair value. The measure explained the profitability of convertible arbitrage strategies throughout the cycle. The strategy was profitable, consistent. As money flowed in, the funds swelled, until the assets of all convertible arbitrage funds multiplied by their leverage equaled more than the sum of all global convertible bonds. Returns naturally declined to zero. Turned negative. Sparking small redemptions. Then it all imploded.

Setting Targets: King Leopold set rubber gum quotas. Failure to meet them was punishable by death. Congo soldiers were ordered to provide a severed hand to the Belgium post commander to prove each execution. Soon, rubber quotas were being paid in part or whole using severed hands. When quotas were too high to fill, villages raided one another to sever their neighbor’s hands – which became a currency, an end in itself. Soldiers were rewarded for outsized hand collections. And in time, baskets of hands laid before Belgium post commanders became a symbol of Congo.

Onehanded Applause: “The objective of monetary policy is to maintain price stability,” declared the Sveriges Riksbank Act. Stability is defined as 2% inflation, itself an oxymoron. “Sustainable growth and high employment are to be supported,” says the Act, though they’re of secondary importance. Inflation is now at the 2% target, a consequence of overnight interest rates at -0.50% and central bank bond buying, which weakened the krona, sparked +5.3% IP growth, +4.1% services output, unprecedented real estate speculation, and surging consumer debt.

Anecdote: “When a measure becomes a target, it ceases to be a good measure,” said the Englishman, stepping outside of himself. “That’s Goodhart’s Law.” Charles Goodhart observed that central banks measured money supply, and found certain M1 growth rates to be optimal. But once they targeted that optimal range, M1 lost its value as a measure. Market and economic actors adjusted their behavior to game the M1 system. So central bankers shifted to M2, then M3, and M4. “Investing is obviously not a science, but if it were, we would say that you can’t act on something and observe it at the same time.” French colonialists discovered this in rat infested Hanoi, when they offered a bounty for killing rodents. To receive the reward, the Vietnamese were required to produce severed tails. Soon thereafter, tail-less rats scurried throughout the city. The bounty hunters removed their tails and released them to the filthy sewers to breed. Boosting their bounty. “Investors discover pricing anomalies from the past. And they pile into them, ensuring that for a time they persist.” They mistake the distortions of their wall of money for the wisdom of their observations. They interact with the market as if they’re exogenous, when, in fact, they’ve become endogenous. “Today’s greatest example of Goodhart’s Law in action can be found in volatility markets.” The VIX index measures the expected volatility of the S&P 500, and is calculated by multiplying expected 30-day variance by 100. As a measure of market fear, it was quite useful, until it became something that could be traded.“The sheer size of outstanding positions in VIX futures, VIX options, ETFs, ETNs and bank volatility selling programs is such that those trading these markets can no longer separate the true measure of volatility from their own actions.”