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

Tyler Durden's picture

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

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pyite's picture

I think it was Robert Rubin who said that quote.  </nitpick>


snowball777's picture

Does this work off of growth in domestic demand in China, or belief that there'll be someone to whom they can export products in a year?

trav7777's picture

And I'm sure he was very bullish on Enron too.

Lemme ask these people something, these china bulls...do you have ANY visibility whatsoever into the Chinese banks?  Chinese companies?  Do you have any accounting statements?  Any transparency?

So why the fuck would you believe the same talking head idiots who were saying to buy the Qs at 5000 and who said LEH was a buy, and all the rest of this shit?

What PIMPCO is saying in the article is that they have modeled all their "strategies" after distribution curves where they make assumptions about the probable distribution of events.

I have said on this forum many times that the economists are now all clueless, they are like a fish out of their tank, or I have analogized that they are a navigator using a compass after the magnetic poles have flipped telling us we are going east as we fly into the setting sun.

The world has very CLEARLY met a significant epoch where we transition from the 400 year trend of growth to a trend of contraction of uncertain duration.  The Growth Era was longer than any of our lifetimes, so long as to seem permanent and immutable by humans just as surely as the Grand Canyon or the Hawaiian Islands, despite both of those being babies in geological time.

Everything the economists do revolves around an assumption of how to attenuate or modulate growth.  They do not know what to do about contraction.  Everything they try seems to fail because the world has changed.  This is what is so confusing.  The PIMPCO guy is trying to rationalize with all this "fat tail" shit because he is desperate to make sense of the data he is seeing.  The problem is that every piece of training he has is now irrelevant.

A big fat tail and wide sigma and all of this is telling you in mathspeak that the outcome is becoming highly random, that the distribution is becoming more uniform.  Consequently, investment managers' math modeling and their entire profession essentially becomes obsolete.

ABeautifulMind's picture

Amen.  Dinosaurs with broken tools.  Our kids have a better shot at understanding the world we live in then these guys do.


Clayton Bigsby's picture

great post!  I can't say I totally agree because I think the tools that guys like Clarida uses are adaptable, if they're approached with an open mind, but I really liked the logic of what you had to say and agree that there is a certain modality of thought re. the investment markets that I'm sure will have to be reappraised

DR's picture

We are at the end of The Great Age – the modern economic era that stretches back three hundred years and encompasses the European Enlightenment, the Industrial Revolution, and the lives of all the classical and orthodox economists from Adam Smith, David Ricardo and Karl Marx, to Irving Fisher and Franco Modigliani.

The outstanding feature of this Great Age was an explosive population growth never before observed in human history and perhaps never to be seen again.

  • From the birth of Christ to the mid-eighteenth century, mankind expanded less than one-tenth of one percent per year.
  • In the three centuries from 1100 to 1400, population grew only twenty percent. From 1400 to 1700, the human count did not even double – increasing just seventy percent.
  • However, in the three centuries from 1700 to 2000 – the Great Age – the number of people expanded tenfold!

All of what we know as economic theory has been postulated and developed in an environment of constantly increasing population.

Not only did the number of men and women increase substantially each year since Adam Smith was born, but the population of the monetary economy grew even faster.

dhfry@yahoo.com's picture

Interesting if I knew what he means by "the tails" which I only know from retail sales experiences. I'm not shy about asking what the hell it means even if I paint myself as an old fart.

trav7777's picture

visualize a bell curve.  The tails are the little parts that go out to the right and the left edges of the curve.  What these mean is the few number of low probability outcomes.

a "fat tail" means that the probability of those outcomes is higher than would be expected given a standard gaussian distribution.

For example with IQ, you see a bell-shaped distribution.  Most people have IQs near the mean and statistically few people are out at the very high or very low end.  It's not like throwing dice where a 6 has the same odds as a 1.  In normal distributions, the odds of a high disparity from mean are much much lower than a low disparity.  The same is true with average height.

scratch_and_sniff's picture

I have a fat tail...I only use it on low probabiity events though.

Cognitive Dissonance's picture

Risk On, Risk Off.

Sounds innocent enough. Like that movie, wax on, wax off. Or many a pulse generator or vibrator working at a low frequency. Nice and respectable, even soothing.

Over the last 3 months, the number of 90/10 days up or down (meaning 90% of the market flow is either sales or buys and only 10% is on the other side) has accelerated at an alarming rate. I count at least 17 that fit that bill and maybe more. This is a sign of increasing frenzy and indecision, of panic either to get in before it's too late to feed or to get our before the world ends in a bang. This is a sign of underlying fear, not of confidence.

Most engineers are familiar with the effects certain vibrations have on structures, how sympathy or resonant vibrations can occur for whatever reason with increasing frequency until suddenly the structure suffers a massive weakening, leading to a partial or total collapse. Brings to mind the Tacoma Narrows Bridge, of which nearly everyone has seen the video of.

The Tacoma Bridge swaying started small, gently even. But over a few hours, the rocking back and forth steadily increased until a resonance frequency was reached between the sway, the wind and the natural vibration of the bridge itself. It came apart very quickly after that. Anyone looking at that bridge would not have been considered crazy if they postulated that it looked like it was going to collapse.

Why are so many people saying exactly the opposite regarding our markets? These massive swings up and down are not normal and not healthy. And yet we're told it's just a little vibration on the road to recovery. We would all be served well if we watched the video of the Tacoma Narrows Bridge one more time.



Cognitive Dissonance's picture

Free will is what's making the bridge/market swing. Or free will as embodied by HFT computer algorithms.

trav7777's picture

made the same observation awhile ago, when the nasdaq was doing these wild oscillations.  Was the time to GTFO if you're long.  saw it in some individual stocks and seemed to always be a sell signal.

primefool's picture

Good article. The fatter tails also have another implication: You need deep pockets to play. You need to be able to withstand big swings. Helps if Timmy has your back in this trading environment.
Or - maybe this trading environment is designed to shake out everyone who does not have access to deep pockets - or Bennie's magic money machine.
Clearly many stocks look enticing relative to Zero returns in cash. They probably will be great longer term - but have to be willing to withstand the 20-30% drawdown in order to play. So who's gonna play? Not the mom/pop watching every penny and saying there goes my lunch money - no sir. The goodies aint for them - only for the big boys.

williambanzai7's picture

Better to study the behavior of schools of fish.

Cognitive Dissonance's picture


I was actually studying this a few weeks ago and what I found was amazing. It seems that the rate at which the fish (that were studied) changed their direction of travel was faster that the brains of the fish worked. Somehow the fish were recognizing the groups change and adjusting to the group quicker than their brains functioned when conducting all other individual tasks.

In effect, the fish were reacting faster than they could "think" or process the brain stimulus to move. Similar to saying something moves faster than light. The conclusion was that the "school" of fish were acting as one rather than as individuals. They couldn't explain how.

pong's picture

Interesting study, CD-- happen to have a copy or the title of the study?

I'm an electrical engineer-- and I have seen first-hand what happens when certain oscillations occur-- Many of the North-Eastern electrical power outages were caused by oscillation events as well (as a side note, this is why I'm glad TX only interconnects via HVDC with our neighbors).

RE your post on 90/10 flow days: What data are you using to measure?  Trades executed at the bid/ask netted out as a percentage of volume?

Wyndtunnel's picture

So much analysis when what he is trying to say is:

You got to know when to hold 'em, know when to fold 'em
Know when to walk away and know when to run
You never count your money when you're sittin' at the table
There'll be time enough for countin' when the dealing's done

Every gambler knows that the secret to survivin'
Is knowin' what to throw away and knowing what to keep
'Cause every hand's a winner and every hand's a loser
And the best that you can hope for is to die in your sleep

Geoff-UK's picture

"You can't lose if you don't play."  --The Wire, episode 2