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Guest Post: The Center Can Hold - More On Playing With Tails
By JM
The Center Can Hold: More on Playing with Tails
Every time series of prices reflects the ongoing valuation of worldviews in a collective sense. These prices can be used to generate a probability distribution that reflects that worldview. Is it best to buy the tails that reflect extreme events, or to be long the center, where the majority of views dominate?
Buying the tails is a barbell. Buying the center is well, a center bet. Which is best?
Here is an approximate answer from contemporary history. Center bets beat barbells pretty consistently. BB (XOver proxy) all beat other comers, followed by BBB (HiVol proxy), CCC (proxy for distressed debt), then AAA from 2010-2011.
What you get with AAA is low volatility offered by stable liquidity features and cashflow performance. What you get with CCC gives you huge volatility to be exploited by trading. The center, true to the intuition behind it, offers better credit risk profile than distressed debt plus lower liquidity than AAA debt.
In fact, seldom does a barbell constructed this way outperform the center bet. Barbells lose too much from CCC defaults even during good times. In bad times, the AAA position doesn’t come close to covering the losses. Center bets outperform pretty much all the time. Check out the barbell and center I constructed below with AAA and B rated bonds instead of CCC, just to keep it close.
Barbell and Center Bet Total Returns, 1996-2011
Guess what? The more extreme times are, the worse the barbell does. The barbell started massive underperformance in late 2008 and has performed even worse since then. Why because the extreme cancel each other out to an extent that makes them undesirable. Center bets cancel each other out less.
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Happy Chewbacca
Don't forget the Air Jordans!!!!!! :o)
-John
http://www.youtube.com/carmarketer
I'm going BB.
Problem is, they may rotate pretty fast.
Where is Greek debt?
Spanish? French?
When will the U.S. two year be a BB?
Hmmmm....
Good perspective, thank you.
Sometimes "Fair to middling" is better than AAA, eh?
Or...is it "Fare to Midland"?: http://www.youtube.com/watch?v=fcuIHgTCG0M
Thanks. You're right about the roll. These trades I built don't reflect trading and execution cost.
Sovereign credit ratings have little value in my opinion, because their is less distinction between a country with a pringing press at their disposal and countries at the mercy of someone else'sonetary policy than is warranted.
You get the serious money at the risk premium where you trade and get positioning right (choosing the right tail). Harder to do than it seems, because you get stopped out.
Not a valid sample. A very different story over long periods of time.
I was concerned about the very issue you bring up, but it looks like total returns to the center bet beat the barbell going back to 1999.
Please pick holes in things that I am doing wrong here.
Exactly right m.i.c
If this were true, we"d all be speaking Latin. The reality is that center bets do in fact work for LONG periods of time, but in the long run they are in fact ALWAYS bad bets.
As ZH's very own tag line goes, "on a long enough timeline the survival rate of everyone drops to zero". The thesis in the above post would suggest (incorrectly) that this is actually not the case.
On a short timeline the barbell appears the weaker position. But...The barbell always ultimately wins as all power structures are transitory and entrenchment leads to inflexibility which in turn leads to weakness.
Ultimately the true nature of the universe is entropic.
Your different story over a longer (or, different) period of time doesn't make this sample any less valid. Id propose to you that any sample which one would argue is descriptive could easily be changed by a number of variables, merely to conclude such as thing as you did, because its easier to criticize then to go out, do your own work, and then post on here and see what kind of feedback you would get.
We wait for your contribution.
BB, AA, Junk...whatever. None of this happens without energy.
peak coal past and gone.
http://www.energybulletin.net/stories/2011-05-13/peak-coal-year
India and China shutting down power plants. Go to google news and type in coal shortage. The US has a little bit of coal left, but after using it for 200 years, it's starting to show. India, where one of their principle exports is coal, is now on schedueled rolling black outs so expect to pay a premium for clothing and anything made of metal soon.
I'm long ammo and awareness. Short on T.P.T.B.
In other words, I'm likely screwed but I'm also free and at least my concience is clear (as far as that goes).
And jm: If you are trading and not just gambling, in other words, acting with conviction, lower your entry and widen your stop. I have been burned countless times by entering what I knew was a good trade and then folding to soon only to have the veracity of my initial reasoning confirmed after cutting/or stopping out. Don't mean to be corny but it really comes down to timelines?
I suspect they figure out the logical stops and violate them. I like illogical and/or no stops with smaller trades executed on shorter timeframes. I suppose you could call it flow trading. Lots of action between S/R lately.
The point is, enjoy it while you still can.
Absolutely mindboggling how many Americans here cry for the downfall of our currency.
What your FRNs can buy right now is far more precious than whatever today's equivalent in "gold" might buy you in a FRNless future.
This is what hardcore gold freaks don't understand.
You live NOW
You may have your knickers in a twist over precisely why Goldbugs are arguing for the downfall of FRN's
First off you shouldn't credit what is available to buy from productive society to its bills of exchange (currency).
Second FRN"s are a monopoly money system with no backing. The latter is the Goldbugs main contention as money has historically had something of worth to back it or indeed been valuable in and of itself, such as Silver and Gold coinage.
This keeps politicians/Royalty from printing the crap out of it (debasing the currency) because all (monopoly) regimes go out of control, cannot discipline their spending or debt levels and financially rape society for their own greed (sounds familiar with our day yes?)
I disagree with Goldbugs that the currency in itself is the solution to these problems. You cannot solve human greed with an inanimate object (currency)
The solution is to remove the monopoly over money and open it up to a competitive market in money with competing currencies
The problem is we have a monopoly (on money). The additional problem is that monopoly is in political control
Competition (the free market) is the solution to a problem caused entirely by monopolists and their practices
I agree, basically. You can be right in theory but still be wrong in practice. A lot of late-19th century Russian aristocrats ended up being right after being dead
That is true, without a legal tender the vast majority of items would not be available under any price in an economic collapse scenario.
And as far as the math is concerned, no fuckin shit.
Center bets have made and destroyed traders since the beginning of recorded financial history.
For some reason the author thinks it's worth quantifying the fact that unexpected results occur less often.
WOW
WOW indeed!
I think it is interesting because barbells are so popular right now, and the point generalizes beyond these index arguments. Buying the mid-curve vs. selling the wings. I talked about soem others in a prior post.
People often seem to have a hedge motive in mind when they put them on, hedging defined as smoothing volatility. Is it worth the underperformance?
Well, the author did not tell if he is speaking on corporate credits of EM or DM or Sovereigns, so it is hard to tell. Being a distressed trader, I can tell that 2011 was not a good year at, all. But, I also can tell that cumulative returns since 07, at least for global distressed corporates were much better than that center bet. But, again, we are in 2011 and if things get uglier, which it would most probably, I agree for the time being, center bet, it is
the point is that you will never make enough money to even buy a 0.0625 share in netjets if all you do is bet on apocalypse now
The data comes from the ML/BofA cash pay indices. CCC did terrific in 2010, but not in 2011. AAA underperformed in 2010 but outperformed in 2011, but not enough to beat the center.
I agree with your point that everything has a price where it outperforms.
good point, and sounds like you are a credit dude, youself, as well. Do you have any data on CDX tranches to replicate what you showed in that graph? Maybe that is easier to replicate / reflect in portfolio? I tend to think that Selling HYCDX15 15-25 vs Buying 25-35 tranche on equal notionals is a good apocalypse bet.. HYCDX15 because it covers all the sh1tty / over-levered 2007 LBOs, etc.
I've been working on some CDX.NA stuff. A thought about this:
CDX is different kind of animal: funds and insurers sell CDX IG while they wait for new issues in the cash market. It is just a place to drop money and desks will always source the liquidity. I think that this doesn't apply outside of the most liquid IG. It seems liquidity driven... something the center has @5Y but HY doesn't.
Does this imply victory before the game even starts, or should I not care about this issue?
Hmmmm.....sounds boring
F**k it!....Let's open up another casino for betting on irrelevancy.
The Pork Bellied Meat Market....move over COMEX, make way for the NADEX
Since elections are already rigged....might as well start betting on them
http://www.youtube.com/watch?feature=player_embedded&v=xYybxYD3BtY#!
So are we using Egan-Jones' ratings, their competitors' ratings, or some methodology of our own to classify the center vs the BB?
The reades are composed of the ML/BofA cash pay bond indices. Domestic corporate debt only with rating based on an avaerage of Moody's, S&P, and Fitch.
These indexes aren't investable, but they serve as well-understood proxies to make a point. Synthetic indices are investiable, but require a lot of cost to replicate tough to do right on the fly here.
Thanks for response and info. Wouldn't try to synthesize an index that is costly to replicate, but would try to emulate the performance by selecting the appropriate individual bonds and/or funds with strong correlation. I appreciate the point that you make, though I do suspect the methodologies, external influences/pressures, and even motivations of those major agencies. So I would look to a more independent agency for the ratings.
I think you're right about the rating agencies, but keep in mind that a lot of trading systems will dump on downgrades at the algo level. So they do matter even when they are obviously flawed.
Topcallingtroll down below thinks to trade off of flawed ratings, which is a good idea if you are not swing trading.
If credit rating agencies actually had any true predictive ability in their rating there would be no risk adjusted inefficiencies to exploit in bonds.
If young women actually knew they were attractive, no one would ever get laid
attractive to whom; its this unknown that makes seduction and getting laid imperatively probable, inevitably possible. That's why strangers are the best ephemeral lovers. Its like theological notion : "uncreation". What is created is mundane as known, visible, tangible; but the "uncreated", Ah, the divine woman in her shell, has to get "created" ie: laid, in prosaic, primal terms. After that she is like the rest. Sad commentary on male lust more akin to rust n dust than divine, forever "innocent", thrust.
Dude what are you on? I'd like to know so that I can get some.
This article is a real Zerohedge cliff hanger.
Although purposly constructed as an abstract statement it curiously ends abruptly and leaves the reader wondering if participation is appropriate.
Firstly I would like to see your assumptions listed.
Too, you leave this reader to assume Zero Copulas in your secret sauce.
You state that "Center bets beat barbells pretty consistently" then follow with "Barbells lose too much from CCC defaults even during good times" and "In bad times, the AAA position doesn’t come close to covering the losses".
Good times, bad times their frequency commeth with greater unpredictability.
I would argue for a barbell strategy of safety with a small percentage of wild risk. Yes this is exposure to the unquantifiable. Why should this be considered? We must observe Fisher Separation, the ramifications of having a bank in the system whilst understanding The Efficient Frontier.
What does your article imply to me? Modest allocations....
Read this first:
http://www.zerohedge.com/news/guest-post-playing-tails-fundamental-probl...
Looks like nice stuff, I'll get to reading it later tonight.
We need more lil quant fukers here JM! I look forward to your posts.
Merry | Happy;
JM,
Thanks for your contributions I appreciate them very much.
With Vix 22 or whatever it's hard for me to agree that certain fat tails are overpriced.
There's money to be made here. OCC will still pay out, I think, for another year.
As for gold, I take your point, it's intelligent and wel argued. For me ownership of physical gold is purely and simply an insurance policy. I have aquired "wealth" in the form of numbers on my computer which have no real meaning and have reduced them a little .
Good luck to us all!
Merry Christmas and a well-fed New Year!
The Center will NOT! hold.
The Center will suffer the Largest Losses due the Center being up to its neck in AAA+ rated Sovereign Debt!
The 6% crowd that is now the ?% crowd, Instatutional, HNW and the smart money are going to get killed!
and when they start bleeding (any second now) the overall drop will be 40%.. and that is the BEST Number! anyione with a Brain and spit out.
The Center is DOOMED! to Loose half if they are LUCKY!