Nothing Can Go Wrong
In an interesting twist, investors have recently lost interest in betting on so-called "black swans", the term coined by Nassim Taleb to describe unexpected events that prove the market consensus wrong. Although Taleb's definition seems to imply that the "swan" should be completely unexpected, it is our impression that in practice, it describes any development that upsets the consensus view.
For instance, in terms of the strict definition, the housing crisis was not a "black swan". A number of people predicted it, and it was actually not at all difficult to predict it, even if most mainstream economists failed to do so. However, the crisis can perhaps be said to have contained a few events that for most people did meet the "black swan" definition, such as for instance the bankruptcy of the GSEs or that of a few brokers such as Lehman, that had after all even survived the Great Depression.
Anyway, Reuters recently reported that hedge funds that are specifically betting on such outlier events have been abandoned by investors. It is interesting what considerations this abandonment is based on:
“Hedge funds set up to profit from huge market slides are falling out of favor, signaling that investors are increasingly confident leading central banks can avert the kind of meltdown that followed the Lehman Brothers" collapse.
Investors are pulling out of such "tail risk" funds although economic and geopolitical bolts continue to strike from the blue, be they the messy bailout of Cyprus which has shown how the euro zone crisis can flare up when markets least expect it, or the U.S. stand-off with North Korea.
Despite such crises, shares have ploughed on to multi-year highs while volatility, as measured by the VIX or "Fear" Index, fell in mid-March to its lowest level since before the financial crisis when the U.S. investment bank went under in 2008.
Last year's promise by European Central Bank chief Mario Draghi to do whatever it takes to safeguard the euro, along with bold measures by policymakers to stimulate economies from the United States to Japan, have undermined tail risk funds.
"If the world's central banks have decided they are going to do whatever to support the economy then you are not going to have crazy volatility. You need a catalyst," Nicolas Rousselet, Head of Hedge Funds at Swiss investor Unigestion, told Reuters.
Tail risk funds aim to hedge against rare but dangerous doomsday events, as described in the "black swan" theory of Lebanese-American academic Nassim Nicholas Taleb. They initially gained popularity with investors who had lost heavily in the 2008 crisis but the appeal of what are also called "black swan funds" is now waning.
Capula, one of the top 10 largest European hedge funds, has lost close to half the assets – about $1.1 billion (723.9 million pounds) – in its Tail Risk Fund since mid-2012, two investors in the fund said. The fund, which now runs $1.4 billion, fell more than 14 percent last year as investors" belief grew that the ECB would do all it could to calm the euro zone crisis when borrowing costs were soaring for Spain and Italy. Other tail risk funds also slumped in 2012, with U.S.-based Pine River Capital's down 36 percent and its assets falling to $200 million from $300 million, a separate investor in its fund said. Both firms declined to comment.
Unigestion set up a tail risk product after the financial crisis began but shut it in 2010 as markets rallied. Last year the firm considered re-launching but decided not to proceed. "If you are a long-term investor, it just never makes you money," Rousselet said.
As a form of insurance tail risk funds lose investors money if markets are flat – and even more if prices rise – but they can pay out vast sums if markets fall precipitously. Pine River's fund, which charges no performance fee so that its managers have no incentive to stray from the mandate that it acts as insurance, is designed to lose 2.5 percent per month in flat markets.”
The above is actually the "potent directors fallacy" writ large. The entire thought process has things actually exactly the wrong way around and very likely it will also turn out that the abandonment of tail risk funds has been extremely ill-timed.
One thing that has been remarkable about the crisis period since 2008 was that the last bastion that was left standing amid the general loss of confidence was faith in the central banks. Not even governments themselves were left unscathed as the euro area debt crisis showed. Instead arms of said governments, namely their money printing centers, were and still are held to be reliable bulwarks against a general loss of confidence.
In our opinion that can only mean one thing: namely that next time, this last bastion is going to become the center of attention and that faith in it is highly to crumble.
The idea expressed in the Reuters article is fundamentally flawed: it is essentially saying that central banks are "bigger than the markets". This confuses the fact that the markets often know very little (in fact, near turning points it could well be said that they "know" absolutely nothing) with the idea that they can always be manipulated by central banks. People are seemingly forgetting that for all their statutory power – the power to create money substitutes from thin air in practically unlimited amounts is quite formidable – central banks are populated and led by flawed human beings, who by all appearances are pretty confused, to put it politely. In fact, one often gets the impression that they have no idea whatsoever what they are doing, in spite of their staff busily beavering away at mathematical models that are supposed to "prove" that what they are doing will somehow "work". People are also forgetting that the boom-bust sequences we have witnessed in recent decades were without exception caused by central bank policy.
So only five years after 2008 people think that tail risk products "just never make you any money". We are inclined to file that away as famous last words.
A Few Recent Charts
Meanwhile, although the stock market has ignored, respectively "repaired" countless divergences we have observed over recent months, another one has just popped up and we thought we should perhaps mention it:
The SPX vs. the high yield bond ETF JNK. In the past, divergences between the two have warned of both small and large corrections. Another divergence has been put in recently.
Also, following the BoJ's decision to essentially double its monetary base over the next two years, there has been extremely volatile trading in the JGB market. Below is an intraday chart of the past few trading days as well as a daily chart illustrating this:
Plunge and rebound of the 10-year JGB on Friday.
The daily candle on Friday was the most volatile trading in the JGB in a very long time. In fact, the last time weekly volatility was slightly higher was in 2008.
AEP is Wrong on Japan, and his Readers Think so Too
Ambrose Evans-Pritchard is always an entertaining read, but as readers can probably imagine, we don't exactly agree with his latest screed on Japan. We don't want to go into details here about the countless ways in which the article is misguided (just read our recent missives on Japan) and how erroneous it is in its benign interpretation of Japan's 1930s monetary history (let us just say it fails to mention how that experiment actually ended). Rather, we want to point readers to the comments section, which is quite interesting. It seems the idea that central planners can save us with their ad hoc policies is meeting with ever more resistance. One comment in particular (by one Carl Pham) stood out and is worth reproducing here:
“Ah yes, those Animal Spirits will save Japan, and us sooner or later. They can do anything! You just need to rouse them with a sufficient bonfire of your savings.
These people are like doomsday cultists, or priests of weird apocalyptic religions. No matter how many times the Build It And They Will Come theory fails to work, they are never dissuaded. This time is different! We just haven't prayed hard enough and long enough to our god! Get cracking, you slackers. And kill any mocking infidels who might sap the faith …
Here's a thought: instead of trying to change reality by first getting everybody to believe the better reality is already here — if you all wish real hard, Tinkerbell will live! — maybe it would be a better idea to try to change the reality to which people are already reacting.
If people aren't buying stuff, and deleveraging like crazy, because they see chaos and high-handed government interference with every scrap of wealth someone somehow accumulates — if people aren't confident they"ll have a job, or can sell things to other people tomorrow, because the powers that be are screwing with the market all the bloody time, and who knows what they"ll do next? — maybe change that reality. Maybe governments far and wide should just stop screwing with things, picking winners and losers, lurching from policy to random new policy, with bloviating BS from the media to argue why it's all a brilliant idea. Maybe they should just cut their spending, reduce their scope, and strive like hell to create a very, very stable regulatory and legal and financial world. Convince people the tax law won't change a word for the next 20 years. Regulations in place will be frozen for 10 years. No screwing with currency, no magical wealth taxes, no bailouts, no stimuli, no NOTHING. Just arrest and prosecute criminals, publish weights and measures, run the air traffic control system, and build roads in a patient and economical way.
Maybe if people felt the future wasn't going to be randomly jerked around by whichever party wins the next election, they might start being willing to make long-range plans again.
Nah. Too obvious! Bring on the next Big Idea! We have nothing to lose but civilization itself, comrades! There's no reason we can't duplicate the collapse of the Roman civilization and begin a new thousand-year cycle of Dark Ages.
(emphasis in original)
Obviously these are sentiments with which we heartily agree, except that we don't think they should even control air traffic or build roads.
Charts by: Bloomberg, Stockmaster.in