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More Similarities To 2007/8 Quant Crash
Our earlier post regarding the harrowing quarter that our dear friends at GS Global Alpha are having brought back some memories of a bygone age when all one needed was a multi-factor risk model and access to a massive marketing/propaganda arm. Of course as we pointed out earlier, the reason for the demise of so many of these long/short or even long-only quant-managed funds was simple - everyone following the same signal as it pulled them further and further away from benchmark performance - until finally, one after the other, they disregarded their factor models as redemptions (from underperformance) and pure-and-simple psychological trauma hit them hard.
The point is that the factors were ex-post derived to be the main drivers of huge underperformance are once again heavily over-exposed in current portfolios - i.e. factors that have in the past caused chaos when their own volatility day-to-day causes a portfolio to be slowly but surely demolished are once again at work here and we humbly suspect that this is what is hurting not just Goldman but many of their brethren in the PhD-ridden fields of quant fund management.
What did this modeling error look like in 2007? Well, feast your eyes on this little beauty...comparing what the model had forecast risk to be and the actual market's movements (does that look familiar to anyone from the middle weeks of August 2001 also?). We can only imagine what that current period looked like - given the swings in vol were even greater.
Quant funds (whether long-only optimized against a benchmark or long-short / market-neutral) use multiple regression (factor) models to discern what factors are most/least responsible for risk. Add to this some expectations of alpha for these factors (a factor could be Growth or Value or Leverage or more simply a factor could be a Sector/Industry) and one ends up with a rather neat (mathematically anyway) model for asset allocation across a broad portfolio that enables a manager to make great claims about both his/her performance, rigor, and risk expectations.
Thanks to a number of excellent studies by MSCI-Barra (one of the leading providers of factor models), we now know (again ex-post) what the proximate causes of gross underperformance were back in AUG07 and Q1 2008. MSCI describes August's 2007 underperformance thus:
Anecdotal evidence indicates investors running quantitative strategies based on style factors were hit by extreme movements in a few main factors – Value, Earnings Yield, and to a lesser degree, Momentum and Earnings Variability.
and furthermore, the Q1 2008 underperformance of quant funds was summarized:
...what factors have been driving the recent poor performance in Long/Short funds. We focus on two subgroups of these funds—Long Bias (Directional Funds) and No Bias (Non-Directional Funds). We find that these funds’ underperformance in recent months can, in large part, be attributed to declines in well-know systematic sources of return and risk. In particular, we find that generally:
1. Directional funds appear to have been hurt by biases towards the following Barra Hedge Funds Risk Model factors:
Positive Overall exposure to US and European markets
Positive exposure to US earnings variability factor
Negative exposure to European yields factor
Positive exposure to European growth factor
Negative exposure to European size factor
Slightly positive exposure to Emerging markets
2. Non-Directional (or Market Neutral) funds appear to have been hurt by biases towards the following Barra Hedge Funds Risk Model factors:
Positive overall exposure to US and European markets
Negative exposure to US leverage factor
Positive exposure to US earnings variability factor
Negative exposure to European yield factor
Negative exposure to European size factor
So Earnings Variability was a culprit in both periods (always happens at cycle turns as analysts straight-line extrapolations meet macro/systemic slow-downs). Also at work is Negative exposure to Size and positive exposure to Value factors.
Well - the long and winding path has led us to the current exposures of a broadly optimized portfolio created by Bloomberg's multi-factor risk model benchmarked against the S&P 500 (ex-financials). Guess which factors are at the extremes? Yes - positive exposure to Earnings Variability and Value factors and negative exposure to Size - oh dear.
Chart: Bloomberg
As an aside: we also note that the Trading Activity (Turnover) factor is very overweight in the current period - one has to wonder how this factor is interfered with by HFT algos?
What was critically important to the crashes in the past was the correlations between all these factors shifting and causing the xFx models of the factor-kind to entirely miss the contemporaneous day-to-day whipsaws of these factors as correlations converged to 1 for everything (as we have been vociferously discussing for weeks).
Perhaps this table is also replaying itself during the current crisis:
The bottom line is that the factors that quant funds have tended to be over-/under-exposed to at times of maximum underperformance (and market chaos) appear to be front-and-center once again among quant fund holdings. Whether this means even less liquidity or reflexively more volatility is to come in Q4 2011 / Q1 2012 (about the lag in 2007/8) is anyone's guess, but for sure, we are heading towards a perfect storm and Goldman's news seems, anecdotally at least, to confirm suspicions that something is afoot in quant-fund-land.
Names with large Earnings Variability Factor scores include Apple, RIM, Valero, Reliance Steel, Whole Foods, and Best Buy. The lower factor scores interestingly include Utilities (makes sense) and Financials (hhmm - seems like well manipulated earnings vol to us). Apple, Valero, and Best Buy also rank high in the Trading Activity (Turnover) factor and RIM, Valero, and Best Buy rank very near the top in the Value factor score...seems like lots of focus in a few names coule easily be a problem - but its not like we did not know this already.
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The Large Hadron Collider is an improbability drive, which creates 6 sigma or greater events to occur more frequently, culminating in a fat tail probability distribution.
Consider all the 6 sigma or greater events (environmental, financial, biological) that have occured, since the LHC started.
Quant models can't compensate for a non-normal distribution of events. They should try to get the LHC to shut down, if they want those models to work again.
haters gonna hate.
what the > sigma 6 event of a black man named Barrack Hussein Obama becoming the US president didn't clue you in?
I thought it was funny
Zero love for Douglas Adams' concepts on ZH tonight, I guess.
nice Dorm Room. I'd never thought of the LHC as an active element (as in pushing the boundaries).
It's a bit of a chicken and egg thing though, as in, did these times bring on the LHC or did the LHC bring on these times.
Regardless, the 6+ sigma events on the rise are clear signs of tipping points into systemic instability.
ORI
Of Tipping Points
Anyone want to buy S&P turnip transformation puts?
I figure, using that logic, the entire S&P somehow turning into a turnip now becomes extremely likely.
I would have said a whale, but that's been predicted before.
On a more serious note, Steve Keen has successfully mathmatically modelled an approximation of the past market performance. After the 'great moderation' the system swings wildly for a while before total collapse.
His modelling program is called Minsky. Look it up. His perspective is compelling in many ways.
Funny, we have been operating the Tevatron at these energies since 1989. The LHC hasn't hit full intensity yet.
Adam Hamilton at Zeal Intelligence has a good point here. History does not support the idea of two epic crashes back to back. There is too much residual caution and less overall participation now.
If we are going down it will likely be a slow grind.
I love a slow grind by the way, but not with my investments.
So because we have yet to see back-to-back epic crashes they can't occur? Gambler's fallacy much?
RESIDUAL CAUTION??? Paying off fifty maxed out credit cards with 5000 more credit cards is cautious?!
We've just pumped untold trillions of dollars into the economy, and while it briefly goosed the stock market, it was a cocaine rush on a dying addict - it made him feel better briefly, but now he's going into withdrawal worse off than ever. This isn't a vanilla secular recession; it's a massive structural change in the economy, one that the TPTB are doing everything in their power to keep from happening ... and failing.
Systems die when one part of the system fails; everything else might be relatively healthy, but the chaos caused by interdependencies mean that other parts of the system soon also collapse. That's why endings are very seldom "fading away". They are instead one collapse followed by the next, until either a new lower energy equilibrium is met or the system loses cohesion and dies. That's what we're facing now.
Dr. Shaw, your thoughts please
here let me fix it for you
"We're looking for someone to build skynet"
EPIC Fail.
All of those skills are commodities now. Sripting? Please!
If these are the sorts of systems we are competing against where the process involves the cheapest labor possible as support then I need to get busy building my own. I have (all American) two PhD Mathematicians working for me, 1 EE, 3 very senior devs w/C++ and a few friends that manage a wealth fund out of Seattle. What the hell am I doing trying to make products people want for a living. I need to build the death-star seeding it with ZeroHedge algos and let it rip. This recruitment ad tells me the owners of the system are going into Legacy mode which means lack of serious investment going forward. Seen this *sign* many times before.
Fuck Hyperbad and it's smelly cheap-ass curry script kiddies playing big boys throwing around Design Patterns and WCF jargon. I have spent the last 10 years rewriting financial systems from India here in the States. Time to get revenge.
Very nice analytical piece. Bold in all the right places.
Disc: The bargain hunting continues, but a little disappointed Greece is not going to provide the beautiful entry point I have been waiting on. Time to look closer at balance sheets vs technical analysis IMO. Plenty of companies doing well. Fundamentals will reassert themselves in time. Safety in some strong large caps at 52 wk lows right now. Watch that dolla.
Anybody see a bottom in spy price action. 5% above the low here. Gee that's one days worth of price swings
Soon as the bots get through raping all the short stops to get to where they want to be short..they'll flip the switch to retest the Aug lows. Could be anytime but more than likely they try to get this past the Fri options close out unless a big boy jumps the gun. Soon...very soon. This could get ugly real quick cause this market is very nervous.
Chaos theory is a field of study in mathematics, with applications in several disciplines including physics, economics, biology, and philosophy. Chaos theory studies the behavior of dynamical systems that are highly sensitive to initial conditions, an effect which is popularly referred to as the butterfly effect. Small differences in initial conditions (such as those due to rounding errors in numerical computation) yield widely diverging outcomes for chaotic systems, rendering long-term prediction impossible in general.[1] This happens even though these systems are deterministic, meaning that their future behavior is fully determined by their initial conditions, with no random elements involved.[2] In other words, the deterministic nature of these systems does not make them predictable.[3][4] This behavior is known as deterministic chaos, or simply chaos.
A divine theory. Modern economics and fund management still rely on deterministic factors.
Well put BORT. Did you come up with that on your own?
I understand chaos theory, I think, but the reference here is Wiki, as noted. Try to quantiify the human response to a new system. The Fed spending Trillions to prop the market caught me. I try to learn, but.............
Pretty much sums up the Austrian perspective.
Pretty much sums up the Austrian perspective.
Yes market chaos has a knack and taking out leveraged funds. So yeah a pre 2008 quant/hedge fund beatdown.
Hence the panic buyups at the moment. So we got a major liquidation sell off coming and it aint going be next yr.
Where does QE3 come into play then? I realize it is priced in but not fully in terms of psychological terms.
Try as I might I still can't see the bottom. Looks like we have further to go.
Fasten your seat belts boys and girls because this is gonna be a doozy.
Off-topic
This was posted on Yahoo board.
JPM Charged For Spoof Silver Orders 14-Sep-11 07:32 pm
From Bart Chilton to Harvey Organ. JPM is charged with...."The complaint alleged that JPMorgan, on various occasions between 2007 and 2010, manipulated silver markets with “large, uneconomic sales to depress prices.” Plaintiffs said the bank intentionally drove silver futures lower “through large volume trades and ‘spoof orders’.”
In other words, JPM is a criminal market manipulator, and Ted Butler was right from the beginning, according to the CFTC.
Yawn. JPM will pay a fine, admit no wrongdoing, and do it again.
No they'll create a technical default in international settlements and make people wonder why china has nothing but pissy things to say for a while. Same thing bear stearns llehman did. Llehman just flat out nuked korea and tawain and other places before scuttling the valuables back home for "default".
Exactly. Yawn. Who cares about dishonesty? Six sigma events in quant-land are way more important. Until they're not.
These funds only work in bull mkts. This mkt of short steep drops and months of sideways action are a quant killer. Design a trading strategy and the mkt will trade opposite to it.
These funds only work in bull mkts...
They merely simulate a bull market by playing ping pong with themselves. When real selling comes in &/or they have to dump the market is too thin to support it.
HFT algo= keeping trading till portfolio goes red then stop trading. ie no bid. How does a computer lose unless you tell it it's ok to lose?
Strange game. The only winning move is not to play.
Whopper
From: War Games
Speaking of no bid..I saw the strangest thing this am. I'm watching 60 stocks on 2 screens about mid-morning when everything just stopped for about a minute. No shares traded, no bids/offers changed. I thought my feed was out but then shares slowly started trading again. Still thought it was my end when a buddy called and yelled "Did you see that?" I'm like dude, there's a hole in the matrix or we just had a Mexican standoff. Twenty years and I've never seen that happen. This thing is seriously unstable.
Here's a news flash. The next crash is gonna turn bullshit into dust inside of 48 hours.
I'd put the mortality rate at 85%. Anyone else notice that even Karl D. has gotten into shape of late? I'd love it if someone pointed out a call that dude got wrong. Bueller? What's up?
If you haven't thought about just how fucking bad things can get, you'd better get real smart, real fast.
six sigma, bitches
oh, deer!
more OT from libya: (paste from mrgan strong Summary of the American and International Press on the Libyan Revolution - <i>Morgan Strong</i> ,al-jazeera):
Meanwhile, Mustafa Abdul-Jalil, the head of the NTC, urged a cheering crowd in Tripoli to strive for a civil and democratic state.
Abdul-Jalil addressed a crowd of thousands in Martyr's Square, a site that until recently was famous for pro-Al Qathafi rallies.
Flanked by a few dozen revolutionary leaders in their largest public gathering since their forces stormed the capital, the NTC chief called on Libyans to build a democratic state based on Islamic law.
okey-dokey, and Islamists take aim at Libya rebels' secular leaders
(L.A. Times) - An Islamic scholar accuses Mahmoud Jibril and others in the transitional council of guiding Libya into 'a new era of tyranny and dictatorship.' The broadside points up a simmering conflict.
A struggle between secular politicians and Islamists seeking to define the character of the new Libya burst into the open Tuesday, highlighting the challenge authorities face with reconciling demands repressed for decades by Muammar Al Qathafi that are now suddenly coming to the surface.
Even as the Transitional National Council tries to establish itself in the capital, restore Libya's oil industry and public order, and crush remaining pockets of support for Al Qathafi, Islamists have focused their ire on Mahmoud Jibril, a US-educated political scientist who is serving as de facto prime minister.
and (follow the money): World Bank recognises Libya's new rulers
(France 24) - The World Bank said on Tuesday it recognises the National Transitional Council as Libya's official government, after the new regime promised moderate Islamic rule and to investigate alleged war crimes.
Explaining its decision was based on "evolving events in Libya and the views of member countries," the bank pledged to take a major role in rebuilding after seven months of an insurrection that ousted dictator Moamer Al Qathafi.
...evolving, BiCheZ!
Your right, correlation is a very, very big deal. Statistics 101: When all the variables in your regression equation are correlated, your model no longer provides any useful information.
Simply put: with correlation this high, the quant models are driving blind - and we all know what happens when the blind get behind the wheel of a car.........
actually the blind can probably drive better than most drivers out there. texting while driving is pretty much driving blind.
We really are watching the WOPR run through global thermonuclear war.
CUT THE HARD LINES, CUT THE HARD LINES!!!!!
I am an ex-Barra quant from before it was MSCI. Although most of what you covered is well known, I am impressed with how easily Tyler can speak intelligently of both precious metals and xFx.
http://www.youtube.com/watch?v=vekPWVNLw68
glenn beck on his knees trying out his gold plated tungsten knee pads sucking israhole cock....