Pimco's Richard Clarida Explains The Schizophrenic "Risk On, Risk Off" Market

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The Mean of the New Normal Is an Observation Rarely Realized: Focus Also on the Tails

“The ‘New Normal’...turns
out to be a world where scenarios move from impossible to inevitable
without even pausing at improbable. Flocks of black swans go winging by
with a frequency that is dulling our sensitivity to just how
extraordinary these financial times are. Call it crisis fatigue.”

– Mark Gilbert, Bloomberg, June 2010

July 2010 marks the third anniversary of the onset of
the global financial crisis. No, I’m not celebrating and I don’t know
anyone who is. But anniversaries – even those associated with disruptive
events – serve the useful purpose of reminding us to ask ourselves what
we know now, what we don’t yet know and what we can never know about
major historical events. This is especially important today because,
like generals plotting military victories, policymakers and regulators –
as well as the legislators drafting laws that will govern their actions
– have every incentive to “fight the last war” and fight it well. In
fact – at least in the U.S. – the track record posted by policymakers in
fighting the last war is impressive. But while some experts may be
reassured that we have learned how to avoid another Lehman
Brothers–style disaster, it should also give them pause to remember a
few other moments: 

  • Twenty years ago we learned how to avoid another savings and loan crisis;
  • A dozen years ago we learned how to avoid another Long-Term Capital Management; and
  • Eight years ago we learned how to avoid another
    Enron. (So far, though I fear Enron accounting may be making a comeback
    in certain countries as they allow national champion banks increasing
    accounting forbearance in an effort to buy time as they repair tattered
    and mismarked balance sheets.)

I recall a
conversation six or seven years ago with a very senior policymaker in
which he said the number one problem facing the global financial system
today is hedge funds, because unlike tightly regulated banks, hedge
funds are unregulated. He invited me to react (I then advised a hedge
fund), to which I replied, “A hedge fund is a compensation scheme, not
an investment strategy. The prop desks at all the major banks you
regulate have the same trades that hedge funds have. Does this make you
more or less nervous?”

Financial history suggests “never again”
eventually becomes “this time it’s different” and, as Kenneth Rogoff and
Carmen Reinhart remind us, throughout history “this time it’s
different” eventually sets the stage for the next financial crisis. This
is especially true when, as emphasized by Hyman Minsky, the “this time
it’s different” wisdom supports and encourages greater and greater use
of leverage.

In the case of the current crisis, the “this time
it was different” embodied the logic that securitization and the
expertise of the ratings agencies in assessing default risk in tranches
of structured products could, in theory, diversify and distribute credit
risk among a large global pool of sophisticated investors and away from
an excessive concentration on the balance sheets of the too-big-to-fail
institutions that were issuing these securities. It was supposed to be
the brave new world of “originate and distribute” and for a while it
was, until it wasn’t. An explicit assumption deployed by the rating
agencies and the investment banks to price these complex structures was
that default probabilities – and, crucially, their correlations – were
drawn (to paraphrase Donald Rumsfeld) from an “old normal” distribution,
in which realized cash flows from different tranches would
cluster close to historic means. In reality, they didn’t, and hundreds
of billions of dollars’ worth of AAA-rated CDO tranches were downgraded
to junk. What should have been a Six Sigma event in an “old normal”
world became an everyday occurrence in a New Normal reality.

title of this essay distills what I have come to believe will be one of
the significant and enduring consequences of the global financial crisis
for investors: Now and for the foreseeable future, we are in a world in
which average outcomes – for growth, inflation, corporate and sovereign
defaults, and the investment returns driven by these outcomes – will
matter less and less for investors and policymakers. This is because we are in a New Normal world in which the distribution of outcomes is flatter and the tails are fatter.
As such, the mean of the distribution becomes an observation that is
very rarely realized, creating at least three fundamental consequences
for investment strategy.

Getting the Tails Right
First, since the price at which investors can buy an asset will tend to reflect the ex ante
mean of the distribution of returns, realizing alpha in the New Normal
world when selling the asset will require getting the tails right.
Selling after a left tail event is realized (or after the market gets
news that a left tail event is more likely – think Greece) will likely
result in big losses. Selling after a right tail event is realized (or
after the market gets news that it is more likely – think J.P. Morgan
shares after the conference committee vote on the Dodd-Frank bill) will
likely result in big gains. On average, the investor’s returns will
likely be modest, but only rarely if ever does any investor realize
those average returns.

“Getting the tails right” will be easier
said than done. Rules of thumb and historical correlations will likely
prove to be irrelevant or, even worse, misleading guides to portfolio
positioning. Examples abound: V-shaped recoveries may not inevitably
follow deep recessions (as the incoming U.S. data are now confirming);
tripling the monetary base may not inevitably lead to double-digit
inflation (as the Treasury Inflation-Protected Securities [TIPS] market
is telling us); and half-trillion-dollar official sector rescue packages
may not inevitably be sufficient to address sovereign liquidity
disruptions (as is reflected in Greek government bond prices). Regarding
the euro, as my colleague Andrew Balls points out in a recent essay: 

There are a range of possible outcomes for the eurozone. At one
extreme is successful fiscal adjustment, the creation of a deeper fiscal
union and the creation of a European Monetary Fund – built on the
foundations of the special purpose vehicle (SPV) – to ensure that this
never happens again. At the other extreme it could involve exit from the
eurozone by one or more countries, and it may not be just the
eurozone’s weakest members that will have to leave. It is possible that
Germany may one day see the benefits of a return to the deutschemark
outweighing that of European solidarity. The unthinkable has become

Risk On, Risk Off
a New Normal world is likely to be one with frequent flips between
“risk on” and “risk off” days. With so much profit and loss riding on
tail events and so little profit and loss tied to the cluster of
outcomes near ex ante means, repositioning will likely be more
frequent. This is because many investors lack conviction in their
understanding of the true distribution, so that each passing day
provides an opportunity to learn or unlearn how likely the relevant tail
events are. Positioning for mean reversion will be a less
compelling investment theme in a world where realized returns cluster
nearer the tails and away from the mean. 

Carville said twenty years ago that he wanted to be reincarnated as the
bond market because the vigilantes had so much clout over policymakers.
But in the New Normal world, he might wish to be reincarnated as the
Asian equity markets because they are where traders in Europe and the
U.S. look to see if it is a “risk on” or “risk off” day. With so much
money chasing fewer assets with known return distributions, and with
reliable investment rules of thumb scarce, frequent flips between “risk
on” and “risk off” days will likely be a continuing symptom of the
Knightian uncertainty that still, to some extent, hangs over global
financial markets. Uncertainty is less chronic and its impact less
systemic than in the first year or so of the global financial crisis,
but it has not disappeared. Unlike October 2008, markets are now open
and assets trade, but they trade at clearing prices that reflect daily
news about the relevant, headline-grabbing tail events. For example, a
Chinese growth slowdown suggested by a leading indicator report signals
“risk off,” while the Dodd-Frank bill passing the conference committee
with a watered-down Volcker rule signals “risk on.”

Lower Leverage
Third, because harvesting alpha in the New Normal will require getting the tails right, successful investment strategies in a New Normal world will generally be less levered than during the Great Moderation.
Note that this is a consequence of the New Normal itself and not merely
the outcome of tighter regulation, which itself is almost surely to
discourage leverage. The contrast is instructive: In the Great
Moderation years (roughly 1987–2007) of predictable policy, low
inflation, and modest business cycles, generating alpha meant adding
leverage to boost the returns realized by bunching close to the mean. As
more leverage was piled on to the system, spreads shrank, which induced
adding even more leverage to reach return targets. In a New Normal
world, the cost of debt financing to fund speculative trades must go up.
The lender does not benefit from the fatter right tail of borrower
profits if that right tail is symmetrically matched by a fatter left
tail of borrower losses. And the bias against leverage is only more
pronounced if (as I suspect) left tails are not only fat but
asymmetrically larger. As my colleague Paul McCulley likes to say,
“Markets usually don’t melt up.” 

Bottom Line
it is now widely accepted we are in a New Normal with fatter tails,
many investors don’t fully appreciate the key implications: First, rules
of thumb and investment strategies based on mean reversion will likely
be less effective or even unsuccessful in a world where realized returns
rarely cluster near the mean, even though distributions with fat tails
have means too! Second, with so much profit and loss riding on getting
the tails right, fluctuations in risk appetite will be more frequent, a
symptom of the Knightian uncertainty that still overhangs the markets
and a fact illustrated by the uncertainty over policy in Europe now.
Third, the cost of debt financing to fund speculative trades must go up.
The lender does not benefit from the fatter right tail of borrower
profits if that right tail is symmetrically matched by a fatter left
tail of borrower losses – this will be true regardless of the inevitable
regulatory response that will further discourage leverage.

Investors had 25 years to get comfortable with the Great Moderation. The sooner they recognize those days are over, the better.

Richard H. Clarida
Executive Vice President
Global Strategic Advisor