SMART Market

Inspiring for Smart Investing

Random walk?

by Veryan Allen

Random walk? Advance warnings were in place for a global correction. Smart money has been selling to dumb money for a while. When equity volatility and credit spreads are at lows but financial arrogance and market myopia are at highs, a bear market is usually coming sooner or later. With Sam Zell taking a lot of real estate chips off the table, Warren Buffett searching for a successor and some bottom tier hedge funds even saying they couldn’t find any shorting opportunities(!), the canaries in the coal mine could not have been singing much louder.

Since 1896 there have been 130 worse sell-offs than 27 Feb 2007, or more than 1 each year. We hadn’t had a major drawdown in ages and volatility clusters so perhaps the year of the Golden Boar will see several more. The Dow fell 3.7 sigma which randomly “should” occur every 18 years but Chinese stock indices made a 6 sigma move which, according to the random walkers “should” happen every 2 million years. The VIX rose by a percentage that “shouldn’t” have occurred since this planet was formed. There was nothing random about last week and bearish times are looming. BUYING the VIX on the rare occasions it drops below 10 ALWAYS pays – the implied volatility for daily market movement at such levels is unsustainable. 10/srqt(256)=0.625% was ludicrously low.

Random walk? No predictive information in financial data? Chinese day traders “cause” the recent global correction? On the 9th day of the Lunar New Year (27 Feb in 2007), it is custom to make an offering to ensure continued prosperity. The China “catalyst” had more to do with a desire to take profit and what better day to pay an 8.8% tithe to the Jade Emperor? That’s eight point eight. Eights are a big deal in China as with the Olympics starting at 8pm on 08/08/08. While profit-taking was overdue, it is a stretch to blame Chinese retail investors for global turbulence.

The eclipse over the weekend wasn’t the only syzygy obviously influencing recent investor behavior. Prominent business magazines lined up in a classic convergence to signal a possible pause in the euphoria; when Forbes implies the bull market might just be getting started, Fortune runs a glowing advertorial for private equity and Businessweek says we are in a low, low rate world, you just “know” there could be problems soon.

Then there is the “economies are still doing great” contention. Don’t people realise that market volatility CHANGES the fundamentals? George Soros has never received due credit for his reflexivity theories. The reminder that risk assets actually are risky will change investor and business behaviour. Private equity deals yet to be announced will not now emerge with leverage harder to get and much more expensive. Roach motel illiquid securities (you can check in but you can’t check out) will be evaluated much more closely. Some say the “Greenspan put” or “private equity put” are floors on any sustained market drop but those are myths. Some who would have qualified for a mortgage before will NOT now, which will impact real estate. Credit will be harder to get as will loans to finance other loans coming due.

Many “reasons” have been offered for the “correction”. Ben Bernanke said there was no single trigger but that is ALWAYS the case anyway. Yes subprime mortgages are a disaster but that is not “new” news though it has yet to fully impact the markets. The possibility of recession? What else could Alan Greenspan have said? He had three choices, 1) “Don’t know, don’t care” which wasn’t really an option for him in his position 2) “No way, there is never going to be a recession ever again” (wrong, obviously) or 3) Sure there is a chance. Choice 3 was the only realistic statement, but he gets blamed.

World equity, credit and most commodity markets went down because there were simply more sellers than buyers. Some say it was just a “fluctuation” in the random walk. Really? Why did the drunken man suddenly take such a Bob Beamon like big jump backwards? A corollary to random walk assumptions is that there can be no such thing as investment skill! It is amazing how this rubbish persists in the face of such overwhelming counter evidence.

Truth is the first casualty of war and liquidity is the first casualty of volatility. The second casualty however is rising risky asset correlations. Most commodities, weaker credits and equities dropped last week, almost everywhere. The popular fear gauges of equity implied volatility and credit default protection blew out massively. It is yet more confirmation that in the flat world of global capital markets, it is STRATEGY diversification more than ASSET diversification that is most likely to protect portfolios and make money when most risk assets fall.

Also worth noting is that the stock markets impacted the worst were those that make onshore short sales complicated or illegal. Every market needs such natural BUYERS during sharp corrections and taking profits is easier than cutting losses. Short sellers REDUCE the severity of market drawdowns by buying to cover those prior shorts.

There may be some “smart” investors around but there is far more “dumb” money playing the markets. There is not much connection between intelligence and financial savvy. Whether it was Isaac Newton getting blown up by the markets in 1721, Albert Einstein’s bond trading, the Long-Term Capital Management option pricing “geniuses” in 1998, or the “can’t find any short sales” superstars that got “fluctuated” recently, there is plenty of money for genuinely smart investors to extract from other market participants in bull AND bear markets. It does not particularly matter what the reasons are for a move, what matters is that alpha was extracted and risks were ANTICIPATED. There is NEVER a situation where there is nothing to short. Never.

Alpha capture is really an alpha redistribution game. I don’t know which market offers the most beta but the USA easily has the most alpha available and Japan has the second largest amount. It is trendy for pundits to talk about the US markets being too “efficient”, too “analyzed”, too much “smart money” for anomalies to remain but that is just plain wrong. Last Tuesday, even Dow Jones and NYSE computers couldn’t add up and divide the prices of 30 major stocks. The best money making opportunities are in the US markets because it is so inefficient, so liquid and has the widest range of tradeable securities, derivatives and options. The best source of alpha will continue to be the USA if only because it has the biggest and deepest markets. You have to be sceptical of investors moving into new areas because they are not making money at home. If a hedge fund can’t make money in its “own” country how can it possibly do so elsewhere?

Markets are not random just like coin tosses are NOT random. It would not be particularly difficult, theoretically, to construct a hedge fund strategy around coin flips. Coins “seem” random because most of us only witness single or very low sample sizes. If you toss many coins using the same mechanism and starting conditions the bias is 51/49 which, while sounding slim, is an exploitable edge. If the coin is spun instead, the bias is often in favor of heads, 70/30 according to empirical work by Persi Diaconis. Spin a new 1 cent penny however and the chances are it will come up tails. Look at any coin – is the centre of gravity EXACTLY half-way or isn’t there a tiny bit more metal on one side?

Returning to China, if you got every Chinese citizen to toss a known coin each day, had knowledge of the starting face and modeled a few thousand sample flips from each flipper the non-random bias would be obvious. Bet $1 on each toss and you would have a $1.3 billion hedge fund generating a high annual return from a supposedly random process called coin tossing. It is possible to develop predictive edges from ANY process involving human bias and behavior. NOTHING is random. Not coin tosses, not roulette wheels, not “random” number generators in spreadsheets and definitely NOT financial markets. Bias is omnipresent.

It is noteworthy how the smart money has been selling out while the beta players have been buying. I generated some positive alpha from the sell-off not because of some amazing foresight but primarily because I have stress tested for anything, was sufficiently diversified and am ALWAYS long of options. Vega, volga and vanna are often ignored, obscure to many, but were important recent factors in the markets.

If you have prepared for the chance of the sun not coming up tomorrow, -3.3% drops in the Dow or a steeper fall in a market previously up well over 100% don’t cause a sweat. All I know is that there is bias in EVERYTHING, that neither prices nor volatilities are stochastic and that the risk-reward equation had swung over to the negative outlook a while ago. The reasons for stock market crash don’t particularly matter. It will be interesting to see if this volatility cluster continues. Maybe it will soon blow over, maybe it won’t. But whatever happens it will not be random. It never is.

February 14, 2009 - Posted by | Capital Market Education

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