While, by definition, we can't 'know' or predict what the event is that becomes a Black Swan, it is nevertheless useful to consider which large risks are relatively underpriced by the market currently and perhaps more so - what to keep an eye on to consider the odds of such an event. Biancerman (or should it be Bideranco) take on Europe (the pace of the disaster is accelerating and the hope for a Draghi-save is overdone), US Inflation (focus on 3% as a 'problem' and owners-equivalent-rent), The Debt Ceiling (will Geithner get 'extraordinary' again or will it become the political hot potato that proves the deficit will never be cut) , and The Fiscal Cliff (the entire gain in income from the 2009 lows will be removed if this occurs - that doesn't seem like a positive) in this thought-provoking clip. Reflecting on these realities, Biderman so eloquently notes "means the smelly stuff is likely to hit the fan" and Bianco reminds us that, just as in 2008, "hope [in equities] can be a very powerful drug".
As Nassim Taleb described in The Black Swan these kinds of trades — betting large amounts for small frequent profits — is extremely fragile because eventually (and probably sooner in the real world than in a model) losses will happen (and of course if you are betting big, losses will be big). If you are running your business on the basis of leverage, this is especially dangerous, because facing a margin call or a downgrade you may be left in a fire sale to raise collateral. This fragile business model is in fact descended from the Martingale roulette betting system. Martingale is the perfect example of the failure of theory, because in theory, Martingale is a system of guaranteed profit, which I think is probably what makes these kinds of practices so attractive to the arbitrageurs of Wall Street (and of course Wall Street often selects for this by recruiting and promoting the most wild-eyed and risk-hungry). Martingale works by betting, and then doubling your bet until you win. This — in theory, and given enough capital — delivers a profit of your initial stake every time. Historically, the problem has been that bettors run out of capital eventually, simply because they don’t have an infinite stock (of course, thanks to Ben Bernanke, that is no longer a problem). The key feature of this system— and the attribute which many institutions have copied — is that it delivers frequent small-to-moderate profits, and occasional huge losses (when the bettor runs out of money).
What's important is that good markets are for selling and bad markets are for buying; it's counterintuitive. Your perception of how events will play out in the future is determined mostly by your experience in the immediate past; and if the last three investment decisions that you've made have rewarded you – if you feel good about your precepts – you begin to do something natural, which is confuse a bull market with brains, and you begin to become very aggressive. If your last three decisions – irrespective of whether they were well thought out – haven't played out so well, you become cautious. What you need to do is teach your brain to overwhelm or overrule your heart and understand that cheaper is better and more expensive is less good. It's difficult, but it must be done. Many things that are rewarding are difficult.
There is really no argument whether there will be a recession in our future — the only question is the timing and cause of it. The latter point is the most important. Recessions do not just happen — they need a push. In 2011 the economy was just a breath away from a recession due to the dual impact of the Japanese earthquake and tsunami and the European debt crisis. Had it not been for the combined efforts of the Fed through "Operation Twist" and the Long Term Refinancing Operations via the ECB, a drop in oil prices and a plunge in utility costs due to the warmest winter in 65 years, it is entirely likely that that we may have already been discussing a "recession." The ECRI launched a debate that was literally heard around the world with their recessionary call in 2011. The weight of evidence as shown by our composite economic output indicator index shows that the ECRI call was most likely correct. However, the restart of manufacturing, primarily automotive, after the crisis in Japan combined with an effective $90 billion tax credit due to lower oil and utility costs, turned the previously slowing growth rate of the economy around over the last couple of quarters. Sustainability is becoming the question now as weather patterns return to a more normal cycle and the effects of the lower energy costs began to dissipate. In a more normal post recessionary recovery the third year should be closer to a 6-8% economic growth rate versus 2%. While 2% growth is much better than zero — the current sub-par pace of growth leaves the economy standing on the edge of the pool with very little stability to offset any unexpected "push" into the cold waters of recession. The problem is identifying what that "push" could likely be.
Throughout the postwar period, banks have almost always lent out all the way up to the reserve requirement. So, does the accumulation of excess reserves lead to inflation? Only so much as the frequentation of brothels leads to chlamydia and syphilis. Excess reserves are only non-inflationary so long as the banks — the people holding the reserves — play along with the Fed-Treasury game of monetising debt and trying to hide the inflation . The banks don’t have to lend these reserves out, just as having sex with hookers doesn’t have to lead to an infection. But eventually — so long as you do it enough — the condom will break. As soon as banks start to lend beyond the economy’s inherent productivity (which lest we forget is around the same level as ten years ago) there will be inflation.
I thought I'd post an entirely useless article for all you busy folk. Yes, it's about that country about half the size of an Istanbul or New York. Or whatever the exact proportion is. So sorry to bother those who expect more insight from the articles on this site.
I've been busy getting my garden allotment up and running, so that's part of my answer to what's going on ALL around us. I don't give a flying about making the best timed trade in gold and think there are other productive things to do with my life. Sorry to be the contrarian on a contrarian site and being so trite.
From Morgan Stanley: "In our mind, many of the approaches to algorithmic execution were developed in an environment that is substantially, structurally different from today’s environment. In particular, the early part of the last decade saw households as significant natural liquidity providers as they sold their single stock positions over time to exchange them for institutionally managed products... While the time horizon over which liquidity is provided can range from microseconds to months, it is particularly shorter-term liquidity provisioning that has become more common." Translation: as retail investors retrench more and more, which they will due to previously discussed secular themes as well as demographics, and HFT becomes and ever more dominant force, which it has no choice but to, liquidity and investment horizons will get ever shorter and shorter and shorter, until eventually by simple limit expansion, they hit zero, or some investing singularity, for those who are thought experiment inclined. That is when the currently unsustainable course of market de-evolution will, to use a symbolic 100 year anniversary allegory, finally hit the iceberg head one one final time.
In a few weeks the Treasury will most likely launch Floating Rate Notes. Will that be the signal to get out of Dodge? If history is any precedent, and especially the 1951 Accord... you bet.
The black swan is probably the most widely misunderstood philosophical term of this century. I tend to find it being thrown around to refer to anything surprising and negative. But that’s not how Taleb defined it. Taleb defined it very simply as any high impact surprise event. Of course, the definition of surprise is relative to the observer. To the lunatics at the NYT who push bilge about continuing American primacy, a meteoric decline in America’s standing (probably emerging from some of the fragilities I have identified in the global economic fabric) would be a black swan. It would also be a black swan to the sorry swathes of individuals who believe what they hear in the mainstream media, and from the lips of politicians (both Romney and Obama have recently paid lip service to the idea that America is far from decline). Such an event would not really be a black swan to me; I believe America and her allies will at best be a solid second in the global pecking order — behind the ASEAN group — by 2025, simply because ASEAN make a giant swathe of what we consume (and not vice verse), and producers have a historical tendency to assert authority over consumers. But black swans are not just events. They can also be non-events. To Harold Camping and his messianic followers who confidently predicted the apocalypse on the 21st of May 2011 (and every other true-believing false prophet) the non-event was a black swan. Surprising (to them at least) and high impact, because it surely changed the entire trajectory of their lives. (Camping still lives on Earth, rather than in Heaven as he supposedly expected). To true-believing environmentalists who warn of Malthusian catastrophe (i.e. crises triggered by overpopulation or resource depletion), history is studded with these black swan non-events.
In simple terms, this time around, when Europe goes down (and it will) it’s going to be bigger than anything we’ve seen in our lifetimes. And this time around, the world Central Banks are already leveraged to the hilt having spent virtually all of their dry powder propping up the markets for the last four years. Again, this time it is different. I realize most people believe the Fed can just hit “print” and solve everything, but they’re wrong. The last time the Fed hit “print” food prices hit records and revolutions began spreading in emerging markets. If the Fed does it again, especially in a more aggressive manner as it would have to, we would indeed enter a dark period in the world and the capital markets.
Much of the fiscal and monetary insanity that has come out of the EU over the last two years can be summated by one of my central global theses: politics determine Europe's policies, not economics. And Europe now appears to be shifting towards a more leftist/ anti-austerity measure political environment. If this shift is cemented in the coming Greek, French, and Irish elections/ referendums, then things could get ugly in the Eurozone VERY quickly.
Because of its interventions and bond purchases, ¼ of the ECB’s balance sheet is now PIIGS debt AKA totally worthless junk. And the ECB claims it isn’t going to take any losses on these holdings either. No, instead it’s going to roll the losses back onto the shoulders of the individual national Central Banks. How is that going to work out? The ECB steps in to save the day and stop the bond market from imploding… but the minute it’s clear that losses are coming, it’s going to roll its holdings back onto the specific sovereigns’ balance sheets?
Taking Bernanke’s statement to indicate that QE is coming in April is wishful thinking at best. Bernanke’s actual words imply, if anything, that the Fed may have failed to fix the US economy. This is more of the Fed playing damage control because the reality is that Bernanke is well aware of this: by the Fed’s own data we’re clearly in a structural Depression, NOT a cyclical recession.
If there is one thing 2011 taught us is that one totally unpredictable and unexpected event, such as the great March 11 Tohoku earthquake, tsunami, and Fukushima disaster, can wreak massive havoc on otherwise stable economic ecosystems, models and forecasts. According to many, most certainly the Fed, the events in Japan had a major spillover effect on global GDP that lasted for months, in turn forcing fiscal and monetary responses around the world. A true black swan. As the following brief video summarizes, 2011 was the year of earthquakes. Has the earth become increasingly unstable? Will the pattern from 2011 continue into 2012 and beyond? Is mother nature getting angrier? We have no idea, but we do know that the following clip is quite awesome: make sure you have your volume turned up high.
While he does have some new philosophy (at X% off MSRP of course, coming to a Kindle near you) to preach, Nassim Taleb's re-emergence from the darkness of the media spotlight starts with a bang: "I realized that something wrong is going on, and only one candidate 'Ron Paul' seems to have grasped the issues and is offering the right remedies". He was given quite a lengthy period to proselytize as he outlines the Big Four problems he sees with the USA (and for that matter the world): Deficits (metastatic governments), The Fed, Militarism, and non-Bailouts (what is fragile should break early). As Ron Paul notes, "It's an illusion that the USD can bailout the world", Taleb makes many interesting, though a little murmur-some for our liking, points like "you don't gamble with hyperinflation" and his comparison between the US and the Soviet Union will surely raise some headlines as he rants of the growing divide between public and private employees standards of living, our "need to do something drastic about it" and on Obama/Government and deficit reduction that "the whole thing is rotten".