Risk Management In A Nonsense World

Risk Management In A Nonsense World

One of the myriad confounding factors in what’s been variously billed as the “Great Inflation Debate” is the difficulty in assessing the veracity of claims centered around the notion that Americans haven’t experienced a serious bout of inflation in decades.

Almost immediately, that assertion is met with the following protestations: “Oh, really? What about the cost of college tuition?” And then: “Oh, is that right? How about the cost of healthcare?”

When we can’t even agree on whether Americans have or haven’t experienced inflation since the 70s, it’s hard to make much headway.

But for our purposes here, let’s just assume that it has, in fact, been decades since the US has experienced anything like “problematic” inflation. That’s one aspect of any good “whistling past the graveyard” thesis.

“When something doesn’t occur for a long enough period, we simply forget about it,” Macro Risk Advisors’ Dean Curnutt wrote this week, adding that “in the process of writing it off, we adjust our behavior, becoming more emboldened to take on tail risks that we can no longer imagine surfacing.”

In markets, that tendency can lead to what, in hindsight, looks like poor risk management. “Risk management suffers from a failure of imagination,” Curnutt said, in the same piece.

But it’s important (or at least interesting) to note that if we didn’t embrace a similar tendency in everyday life, we’d quickly find ourselves unable to do very much.

For example, in 2016, when I was on my (literal) death bed, I apparently had a seizure in the hospital due to the systemic shock associated with depriving my body of scotch and bourbon for a three-day period, the longest such stretch in decades. Because the seizure occurred a few hours outside of the “normal” window for a seizure associated with alcohol withdrawals, I was required to get a neurologist and to refrain from driving a car for six months. Had the seizure happened just ~12 hours earlier, no such precautions would have been necessary, I was told. I found that to be a ridiculous distinction. I had no other health problems whatsoever, and no history of seizures. There was no question as to the proximate cause. But I almost never drove anyway and the neurology visits would only be twice per year, so it made no sense to protest — I wasn’t inconvenienced by it, and this was long before you had to worry about catching a deadly respiratory virus from your Uber driver.

Despite being alcohol free for half a decade, there’s still a chance, I’m told, that I could have another seizure out of the blue. And yet, I’m no longer required (not by law nor by “the science,” as we habitually refer to the medical profession in the post-pandemic world) to refrain from driving a vehicle. For all intents and purposes, I’ve forgotten about that seizure, adjusted my behavior and routinely take on the tail risk associated with driving. (Admittedly, that risk is mitigated by the island being just nine miles long and having only one road with a posted speed limit above 40.)

We can conjure countless examples of the same dynamic. Plane crashes happen. Unless you’re a bird, there’s a tail risk associated with traveling high above the ground at very high speeds. Presumably, the list of “little” things that can go wrong mechanically on a plane without the tail risk being realized is virtually endless. However (and this is why I don’t fly), in the extraordinarily unlikely event that one of the handful of things that absolutely can’t go wrong does go wrong, the chances of surviving may as well be zero. But because plane crashes are relatively rare events, we quickly revert to pre-crash behavior. That is, we get back on planes. In fact, we often justify that decision by reference to the crash that just happened. Something like this: “If the odds of me dying in a plane crash on a given day are XYZ, then the odds of me dying in a plane crash after 132 people died in one last week must be even lower.”

Why do we do this? Well, because we have to. I mean, we don’t have to. But if I don’t drive, I have to take an Uber to the farmer’s market and if you don’t fly, you’ll have to swim to London. And so on, and so forth.

The same is true for markets. Just prior to the implosion of the VIX ETP complex in February of 2018 (“Volpocalypse,” as it’s known to market participants), Deutsche Bank’s Aleksandar Kocic explained the situation as only he can. “Through their communication with the markets, central banks, and the Fed in particular, have become ‘good listeners’ with their decisions and actions made with markets’ consent,” he wrote, adding that,

After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.

There was doubtlessly some “failure of imagination” for market participants who continued to engage in various manifestations of the short vol trade, but there was also an element of necessity. When the tail risk is all but unimaginable and refusing to take it on is punitive (e.g., underperformance in the market context or, in the real world, losing your job because you refuse to accept the tail risk associated with catapulting yourself across the Atlantic at 30,000 feet), “choice” is a misnomer.

The more extreme the tail risk — the more “imagination” it takes to conceptualize it — the less sense it makes to hedge. This is the North Korea problem. Investing in South Korean or Japanese assets implicitly involves taking on the tail risk associated with the Kim dynasty. Strictly speaking, it’s difficult to “hedge” the possibility that Kim Jong-un or, eventually, Kim Yo-jong, decides to make an ash heap of Seoul or Tokyo. It’s both an unimaginable and eminently imaginable scenario. Prior to their infamous “summits,” Donald Trump and Kim were seemingly on the brink of nuclear confrontation every other day. We didn’t have to “imagine” it because Trump actually described it for us (“fire and fury”). At the same time, it was unimaginable to the extent waking up to a headline that South Korea had been nuked would mean Pyongyang was either already annihilated by a US strike or about to be. That, in turn, would likely lead to a declaration of war by China within 48 hours. From there, all bets are off. So, other than a few gyrations in the won and the occasional widening in South Korea CDS, we just pretended that tail risk didn’t exist.

In the piece cited here at the outset, MRA’s Curnutt drew a parallel between subprime (2007) and inflation (2021). I should note that Curnutt was explicit in noting that this isn’t a question of the US financial system collapsing. Rather, the parallel, as he sees it, is the Fed’s willingness to look past mounting evidence that may undermine their base case, along with the growing disconnect between asset prices and fundamentals (see the scatterplot below, for example).

Curnutt quoted Bernanke from 2007: “Given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited.'” Then, he quoted Powell from this year: “We will not raise interest rates preemptively because we fear the possible onset of inflation. We will wait for evidence of actual inflation or other imbalances.”

Asset prices only belatedly acknowledged rising subprime defaults in 2007. The implication is that we may be seeing a repeat in 2021 as bond yields are now so far out of touch with inflation that words like “disconnect” no longer make much sense. As Deutsche’s Kocic put it earlier this month, “the departure of rates from inflation has become so extreme that it is meaningless to talk about dislocations anymore.”

For Curnutt, this is “a function of the challenges we have in appreciating the change afoot.” He added that,

Embedded in much of the Fed’s commentary on inflation is a misunderstanding of the nature of the time series. Like the VIX, the vol of inflation rises as inflation rises. When the VIX gets to 30 or 40, the market is forced to assign much greater probability to the potential that it gets to 60. In a similar way, inflation isn’t the kind of asset that gets to 3 to 4% and happily treads along. The process of it reaching that level means that forces are at work that may push it higher still.

This is perhaps what separates the seizure example from plane crashes. Boeing notwithstanding, one plane crash doesn’t generally increase the odds that another will occur. I was told by my neurologist that having had one seizure, the odds of having a second at some point are greater than the odds of someone who’s never had a seizure experiencing their first.

That dynamic complicates things immeasurably. Inflation can become a self-fulfilling prophecy. Once it manifests, it needs to abate quickly. If it doesn’t, the repeated experience of paying ever higher prices for everyday goods and services will prompt consumers to act accordingly. If that behavior “goes viral” (so to speak), it can be difficult to short circuit. Many market participants believe Fed officials are currently underestimating that risk.

But the (implicit and often explicit) assertion that tail risks won’t be realized is a necessary fixture both of markets and life in general. For every tail risk realized, innumerable others aren’t. Trying to hedge them all sufficiently would lead to near paralysis in everyday life. In markets, you’d bleed out on several fronts.

None of that’s to say you shouldn’t hedge. While my audience has some obvious overlap with the type of folks who might be clients of Curnutt or Nomura’s Charlie McElligott, for example, I have to cast a wider net in order to appeal to as many people as possible. A big part of what I do entails contextualizing markets through anecdotes and often through tangential socioeconomic diatribes. That has little (if any) relevance for a PM who, while willing to give the Fed the benefit of the doubt, nevertheless fears she may have too much duration risk considering current macro trends (for example).

Still, I think we spend (more than) enough time trapped in our monitors every day. And even when we’re not literally at the desk, we’re still there mentally. If we never allow for an honest appraisal of what’s real and what isn’t, we’re hostage to our own fantasies and myths which, while necessary for societal cohesion and useful for pretending life’s worth living, are fantasies all the same.

Central to appraisals of various disconnects like the one shown above, is the notion that, as Curnutt put it, “if markets are to make any sense, price and value must have some relationship.” He included a caveat: “The meme stock craze notwithstanding.”

I’ve been derisive towards the meme stock mania, but maybe I should be thanking all those involved. They exposed, albeit inadvertently, the unreality of markets. The absence of a relationship between price and value for names like GameStop and AMC wasn’t the death knell for the charade. It wasn’t GameStop at $350 that proved markets are a figment of our imagination. Rather, it was the subsequent resurrection of mostly dead businesses by sheer force of retail trader will that exposed the truth. Did GameStop and AMC really become that much more viable as businesses over the past six months? Of course not. Reddit came to realize that companies and the securities they issue need not have any relationship whatsoever to the underlying value of the business. If enough people bid up the shares, the company can raise more capital, pay down debt and even win upgrades from ratings agencies despite no material change in the underlying prospects for the business.

We’re led to believe these “aberrations” can’t exist in perpetuity. But they’re not properly “aberrations.” They’re just deviations from the way we’ve normally behaved in the course of assigning a price to assets which only exist in our minds. The same is true of Treasurys and inflation. Sure, common sense appears to dictate that ~1.3% on 10s is positively ludicrous if inflation is running at 6%. But the fact that such a conjuncture exists in the first place proves, beyond a shadow of a doubt, that there isn’t anything “natural” about any of this. An apple that drops from a tree and remains suspended in mid-air is an impossibility. That’s just not how things work in the real world. In the make-believe world of financial assets, by contrast, relationships aren’t fixed — not in the near-term (obviously), not in the medium-term and not necessarily in the long-term either.

Curnutt wrote that “because a relatively straight line between cause and effect is a must have for market participants, new valuation frameworks are conjured that satisfy the ‘why’ of prices.” That’s undoubtedly true. We make up all kinds of excuses on the way to explaining purported “disconnects” and “anomalies.” We think we need to explain the “Why?”

What we’ll never say, though, is that there’s no such thing as a “disconnect” or an “anomaly.” Prices for financial assets are always wholly arbitrary. It can’t be otherwise. There’s no “natural” or “fair” price for a 10-year US Treasury because a 10-year US Treasury isn’t something that’s real.

Of course, these aren’t popular notions for market participants. Even those who find them interesting will tell you they’re not very useful. And maybe they’re not.

Then again, the more extreme the anomalies become (whether it’s bond yields detached from inflation or some meme stock trading at an infinity multiple based solely on a 90s nostalgia premium that’s impossible to model), the more we’re compelled to question the very idea of “markets” as things that “make sense,” as Curnutt put it.

My argument is (and has always been) that they don’t make sense. Or at least not in the way almost all market participants believe they do. Curnutt wrote that,

Periods when [price and value] stray far from one another are important because the process by which they become reacquainted can lead to significant asset repricing. The market confronts its mistakes, each time at a different speed and along a different path, but a reckoning does occur as the notion that ‘this time is different’ gets tucked away, surely to be called upon again at a future date.

The idea, in the context of inflation, is simply that one way or another, the tail risk might be mispriced. There are all manner of ways a “reckoning” could manifest, some of which are mutually exclusive, others not.

But I wonder about all of this. We only remember the tail risks that are realized, which we then cite as confirmatory when we mock anyone currently parroting some version of a “this time is different” narrative. And we only bother worrying about tail risks we think we can hedge or those we can hedge without putting ourselves out of business waiting on some disaster that never happens.

This past year taught us that the “correct” way to trade a pandemic is to buy every risk asset you can get your hands on even as people drop dead by the millions and long before vaccine success is assured.

If markets only make sense when price and value have some connection, and if the reality of that connection is now being questioned not just by people prone to hopelessly long-winded philosophical musings, but by millions of retail investors who figured out, among other things, how to weaponize options dynamics to turn their trades into self-fulfilling prophecies, then how can we be any semblance of confident that an effective way to hedge, say, an inflation overshoot, is by betting that price and value will converge (e.g., through a closing of the disconnect between bond yields and inflation) so that markets make sense again? That’s an exercise in question-begging.

The better question to ask may be this: How do you hedge for a given tail risk (or set of tail risks) in a world where markets don’t make sense?

If we want risk management to be truly “imaginative,” we may want to ask what it means to manage risk in markets where we can no longer assume that disconnects between price and value must eventually correct.


13 thoughts on “Risk Management In A Nonsense World

  1. I am concluding from all this that nothing we are dealing with is ‘ real ‘ partly because of the fact that the “ship Lollypop ” is sailing in uncharted waters . It wouldn’t be so tough except that everyone is front running the inevitable second shoe to drop so it’s almost always buy the dip time…
    In reality you have to ‘ feel this market ‘ and that becomes an intuitive process probably helped along by simplification of extreme complexities. If there is one thing after years of reading here on H…Report that I cherish the most it is the Reminder to try to ID the narrative and try to stay focused on that as long as you can .. As Kevin M. used to occasionally say ‘I’m not here to tell what could be or should be but what will be ‘. I’ve learned a lot from the exposure here and it has really trashed a lot of outdated ideology in favor of more workable methodology and out looks .. Betting that our moderator usually intends for us to progress in these ways . Can’ wait for Monday sometimes…

  2. There are other ways to deal with risk, if you are only managing your own money and you basically have all spare change in the market.
    Don’t borrow, even at 0% interest; figure out what makes you happiest in life and pursue that (hopefully, it won’t cost a lot of money); live significantly below your means (starting when you are 18); don’t plan to primarily live off of harvested capital gains- unless you are rich enough to live off harvested capital losses; drive your cars into the ground (I had a 21 yr old Landcruiser with 200k miles- which I sold a few yrs ago to my son for the Kelly Blue Book value); fly coach…assuming you fly; have a plan for significantly cutting expenses if your portfolio tanks, long term.
    I don’t need or want hedges beyond those mentioned.
    Having said that, I do not think the Fed, whose members are essentially appointed by our elected leaders will ever cause a reset. We have seen that they have almost no tolerance to causing any pain and “correct” their behavior as soon as any pain is involved.
    And why should they cause or be complicit with a grand reset? It would create anarchy because it is not just the richest of the rich depending on a strong investment climate. Many of the state/local government and private pensions depend on a return at least equal to inflation, too. Even minimum wage workers depend on those further up the income ladder spending money.
    Sometimes you have to go with the flow.

  3. Good article and good commentary. The why question is human nature. I believe the old adage today’s price is tomorrow’s headline is so important. Price movement is real data. Price movement is what helps us get market feel. I think traders realize that price discovery is being suppressed, but the good/bad news is that the market is so big that it can escape the fed or any other outside force. I choose to believe there is no substitute for experience. When I get my ass kicked I label it tuition…..

  4. Gods do not die dramatically, they fade. Everything is always different this time. Inflations of yesteryear were when gold was a God. We have gotten beyond the atom being three simple definable parts You’re writing today leaves much to think about and be discussed.

  5. H

    Very thoughtful. One of your very best.

    My first real estate prof (later my dissertation chair) and I argued constantly about the relationship between value and price. Some argue that (investment) assets have some sort of intrinsic value that markets will find. But in my experience, investing since the 1970s, the market rarely knows or cares about value. It only cares about price. I was taught that prices are determined when an informed buyer and an informed seller agree to exchange an asset and consideration in an open auction which involves other buyers and sellers. Prices set in private exchanges are suspect and not representative of the actual market price (value?) After a time of driving my prof crazy we declared peace and agreed never to speak of such things again. My, I was an annoying little s… in those days. The point is that real people don’t care about the price-value disconnect, only academics do. Besides, the greater fool theory is real. I only need to find one of those fools on a good day to come out all right.

    Mid-way in my academic career someone told me that Cornell University had a policy that offered profs and senior administrators a unique opportunity when they were ready to retire. Reportedly, these folks were given a year leave, with pay, to write the book or do the research they never had time to undertake during their careers. I fantasied about such a perk. My bogey was to write a book about all the different concepts of value accepted and used throughout the world. I wanted to see how these various conceptions might coincide. Never got to that one. I did get to do others but none was as satisfying as I imagined that one would have been.

    As I moved into the realm of the technically rich, as you called it in a few weeks ago, I realized that even as my portfolio grew, I really couldn’t afford to hedge it properly because the expected cost of the most likely tail risks is lower than the actual cost of the hedge. So I hedge the old-fashioned way, putting a third of my money in stable IG fixed income funds, where I earn about 2.5% in current yield. With the rest I diversify further and for the last decade, year in year out, I have stayed on the lower part of the efficient frontier, balancing risk and return, with a stable beta of 0.5x. I’m in the latter half of my 70s and I, too, have been tapped on the shoulder by that guy in the cowl with the scythe, three times actually, and managed to avoid the final judgment. I have more money than I can spend, a high probability of a shorter life span than either of my parents or grandparents, and my daughter regularly exercises the luxury of scoffing at her legacy. So I give away as much as I can deduct to feed the poor and support the education of those who wish to acquire it.

    I’ve had two mortgages costing over 8.5% and I made it through our last bout with real inflation. On one job I had in that time frame I was in charge of filing my company’s reports required by Nixon’s price controls. My own father asked me to cheat on these reports because all our competitors did. I wouldn’t, Leavenworth scared me more than my father. But that lovely inflation also set up a 35+ year golden age of fixed income which, for me, was better than any stock market I saw. For decades buying USTs on the margin was tantamount to stealing. I still get interest from a sweet pile of 7% treasuries. Maybe you can see why I picked the handle I did. Oh and I did get the chance to live with the same woman for 54 years, as my best friend, partner, co-author, and colleague. Pure luck.

  6. Yes, a great piece. It seems markets always take and idea to do it to excess. In today’s world, the upside is privatized and the downside is socialized because central banks are so keen to prevent the downside from materializing perhaps logically because of the link between tighter financial conditions and the real economy. The fear is that the missing piece here is elevated fragility which at some point will lead of a chaotic mean reversion that few are positioned for and possibly something that central banks usual ability to cut off the left tail for some strange reason does not work in the future as it as in the past.

  7. When I think of risk management the challenge I think is to pry apart the physical economic layer where steel is welded, silicon crystallized and lithium mined vs the economic world where proxies and proxy proxies of proxies are traded like baseball cards at a school cafeteria.

    Risk management for the layer where you are trying to produce a physical result is complicated hard work which largely today is done for the sake of the proxy layer. After all if a bunch of hedge funds own a company and financial conditions are such that regardless of actual physical deliverables share prices rise… then mission accomplished. When we start to treat the financial layer as the piece that is important… then you get the world you would expect and which we occupy. Tail risks are generally not the sort of things that affect technocrats, financial elites or oligarchs as they sure are not about to starve or be homeless because a number went down. Actual outcomes are the problem of the general population. The financial layer has foregone any sort of narrative that it actually does something useful by natural principles and laws and instead has begun simply asserting itself as the means to an end it always was.

  8. H- I think the monthly rate for a subscription to your writing is one of the better deals out there, plus I get everyone’s commentary for free! Thank you all!

  9. Benny Hill joke. The chances of someone bringing a bomb on a plane is one in a million. The chances of two people bringing a bomb on a plane is one in 1,000,000,000,000. So if you want to feel safe on a plane, bring a bomb.

  10. Great piece!

    @Vlad Is Mad: Thanks for bringing “fragility” to the discussion. I take that to describe a setup (or the potential for) cascade effects. I understand leverage to be a multiplier of fragility.

    If margin debt is a reasonable measure of leverage, fragility in financial markets is far greater than ever before. Margin debt (as of July 2021) is up 400% (in current USD) since 1997 while the S&P is up ~225%.

    Indeed, total margin debt today is far beyond previous records but in terms of leverage, margin debt pales in comparison to the cumulative leverage in the form of derivatives. The implosion of Archegos Capital Mgmt illustrates the cascade effect magnified by the leverage of derivative holdings.

    Even if the so-called “mean” (to which reversion is said to return) is blurred, the principle still holds. It’s just lost its usefulness as a trading concept.

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