Exploiting black swans

One of the main reasons why asset managers lost so much money in this crisis was because their risk metrics in most cases failed to account for extreme events, and in those few cases where they did, the probability of occurrence they attached to it was too small to have any significance on their strategy (i.e. the gaussian tails where way too thin and therefore distorted reality).

If the standardized risk measures adopted by our industry fail to take appropriate account of extreme events and if black swan events occur more frequently than expected, their destructive impact should come as no surprise. The challenge remains, however, that even if we are aware and accept that black swan events do occur, how do we integrate them into our strategy? A good analogy may be drawn from past military strategy with the example of the "Maginot" line whereby a series of concrete fortifications were built by the French along its border with Germany during the inter war period. The idea was to dissuade Germany from attacking or invading France, and although in the end it did work, it did not stops the Germans from invading France as they simply circumvented the line by invading Belgium first and then proceeding to cross the border into France. The example shows us that planning for an extreme event such as an invasion does not guarantee success. In portfolio strategy, it may not suffice to protect against large moves in the market. In an environment of great uncertainty, we need to take into account other extreme events such as hyperinflation, no matter how unlikely the probability of occurrence may be.

Inflation and other worries...

Markets have been heading south over most of the week in response mainly to the growing complacency that there may be too much stimulus out there. The most visible confirmation of this came from the G8 meeting over the weekend in which leaders hinted that they may ease on their stimulus plans in light of growing confidence that the economic downturn may not be as bad as it seems.
It is indeed true that shortly after the Fed entered into the liquidity trap territory after bringing the target rate down close to zero, market worries started to focus on the future inflation implications of the overwhelming stimulus package. This worry grew more recently as economic indicators started to reveal a marked deceleration from the accelerating freefall of early weeks and months and as banks now seem to be in much better shape than just a couple of months back.
Trouble is that it is very difficult to predict if the economies of the world are indeed close to taking off again or if the slump is here to last for a while more. Although it is true that a deceleration in the negative statistics could imply that the worst may be behind us, it is a whole different thing than a bottoming out or, even better, an acceleration in the opposite direction. By taking action to reduce the stimulus firepower out there, authorities risk prolonging the recession significantly, as was the case with the great depression of the 1930's or, more recently, Japan's deflationary slump of the 1990's.
As mentioned in the previous blog, unless there is some yet to be accounted for event occurring, the anticipated correction should bring markets to a level above the low that was reached in March of this year.

Green shoots, take 2

Markets continue to defy gravity with the MSCI ACWI index within arms length of a 40% return since mid March, prompting a growing number of investors to wonder whether the economy may be gently pulling itself out of the crisis. After all, a look at the economic releases (most recently the jobs report) continues to show signs of improvement. As mentioned in a previous post, the optimism is based on the fact that although most of the economic figures continue to worsen, they do so at a decelerating pace. Granted, that in itself is indeed good news because it signals that the economy is stabilizing and that things are more or less in control. As such, it would justify the first leg of this rally. It is its sustained pace which is most troubling as optimism is steadily replaced by euphoria brought about probably by those investors that lost big time earlier on in the crisis and are now playing catch up to at least partially cover what has become a gaping hole in their nest eggs. To that I would add another class of investors who probably think that the recession is at its last throes.

In conclusion, we should be prepared for a sharp correction, although I would add that we are unlikely to come down to the levels that existed in the middle of March since there is genuine improvement going on. The worst may indeed be behind us but that certainly does not mean that we are out of the woods. A cursory look at fundamentals suggest that a protracted recession is still the most likely scenario going forward. I would also pay attention to growing inflation risk considering all the stimulus fire power out there.