Saturday, January 10, 2009

Jaded Thinking: Stimulus Can't Cure Turbulence

The Jaded Apprentice has been thinking a lot about what recovery really means (and how to translate that into his investment strategies). The recent obsession in Washington with stimulus is likely to be as effective in solving our economic problems as expecting calm waters to return to a lake with choppy waves by adding a few carefully placed sources of perturbation in a misguided effort to soak up the waves through harmonic cancellation. Again and again, I keep coming back to the concepts of latency, novelty, and scale as key to understanding what will happen in the marketplace as as we collectively reach conclusions about why and how The Great Correction is unfolding, and I don't like what I see. Let me explain:

  • Latency is the notion that there is a measurable period of time between cause and effect. We humans like to pretend latency doesn't exist: we fail to account for reaction time both in the way we drive and the way we run our countries, corporations, and personal finances. Even the minuscule latencies measured in nanoseconds in our microprocessors matter in nontrivial ways as they are amplified by larger scale systems and software that we directly interact with, but in this case we're also dealing with events that have latencies measured in months, years, and in some cases decades or more. Think of the latency between the time a real estate developer decides to move forward with a project and it's final completion. There are many effects of The Great Disruption (my favorite name so far for this event) that won't be felt for many years while others seem to register instantaneously. Eventually, these will create significant investment opportunities (as well as unexpected risks).

  • Novelty for our purposes is the degree to which any given idea, object, model, action, etc. has a loosely measurable sense of being new (or at least unconsidered). In 2008 much of the late sell-off could be in part attributed to panic induced by the novelty of the idea that we could see a repeat of the last century's Great Depression, and the day-to-day swings of the market are routinely attributed to their absorption of novelty in the form of recent news. As the novelty of an idea wanes we often say that the market has already "priced in" that notion, and sometimes there's truth to that idea.

  • Scale in this case should be thought of as not only the measure of how "big" something is, but also the rough measure of how far its local effects propagate, from the micro and nano levels to the national, global, and universal. Measuring latency requires a known value for scale, since a given effect typically propagates more quickly at small scales.

So what do latency, novelty, and scale have to do with the recovery? Everything. We humans tend to (1) believe the latency between the cause of most events and their resulting effects is much, much smaller than it actually is (in other words, things take longer to play out than we think), (2) overreact to novelty in the short run but over the long term underestimate the effects of anything that is novel, and (3) consistently misjudge how effects will scale up or down as scales reach very large or very small values at which we lack native experience. Then we overcorrect once we realize we're off track. Eventually, like a lake that slowly returns to stillness when the wind dies down, our corrections become unconscious and continuous as we regain equilibrium.

Great fortunes are amassed (often unconsciously) by those who take advantage of this trio of human tendencies with the right investment vehicles. And we often find the seeds of this same trio at the root cause in the most spectacular (and banal) accidents and failures. The Great Correction is the mother lode of this dynamic in action. Here are a couple of quick examples:

  • Financial institutions incorrectly assumed that (1) their proprietary risk models could be quickly adapted to reflect any fundamental changes in the global financial system and (2) widespread liquidity in many global financial markets would enable them to quickly dispose of hedging assets they no longer needed so they could acquire those they now lacked as their risk model changed. In fact, it took much longer than expected for them to realize what was happening and by the time they did a liquidity problem of historic proportions made trades that seemed trivial and quick a year ago expensively prohibitive and time-intensive today.

  • Once it became apparent in 2007 that certain debt assets held by many large institutions had become worthless, a number of highly-leveraged institutions found themselves forced to raise cash to remain solvent. In many cases, illiquid markets elsewhere meant equities were the only asset a troubled institution could sell quickly to meet liquidity demands that weren't expected to become so big so quickly. This led to a powerful negative-feedback loop for the most troubled institutions where large equity sales over such a short period drove down equity values so much that further liquidity demands were created, forcing more sales by more and more players and leading to a vicious cycle that played out much more quickly than the process that built up those asset values in the first place. The Great Unwinding was upon us (and in fact, has not fully played out, as evidenced in part by the many hedge funds still imposing significant redemption restrictions).

Now that the novelty of the facts above is wearing out, we're seeing the market turn to the novelty of the Obama presidency for inspiration. When he talks about how dire the economic situation is, we no longer see the market swoon because the novelty there has been played out. But at the same time, for every piece of bad news that is already "priced in" to markets, there is a lot of kinetic energy still left from the crash (and subsequent response) that will result in delayed and unexpected effects at scales that range from the micro (me or my neighbor) to the macro (the US and world economies). In some cases, the delays are understood end expected by some investors but there are other cases where future effects will arrive with a great deal of novelty and little or no symmetry. And even widely expected effects will seem novel to certain investors even if they are "priced in" by others.

Add to this the fact that the sudden arrival of any effect will provoke different responses by each investor (some will freeze in fear, some will flee in panic, some will step in immediately to take advantage, while others will make future plans to acquire distressed assets as they reach maximum levels of discount), and it becomes immediately apparent that resulting pricing action will both (1) move predictably in response to those response instincts as they are identified but (2) be disguised by the fact that (a) each of these responses will happen over different timelines that often intersect with each other, and (b) cannot avoid producing echos that may have further positive or negative reinforcing effects.

Said another way: even though most effects are predictable, it is hard to know exactly which effect(s) are in play at any given time and and to what degree they have been played out. There's a variation on the Heisenberg uncertainty principle in play here where by the time that you know exactly what's going going on with pricing and scale for a given effect, there may be no more latency in which to take advantage. Subsequent gains and losses are then due to the reinforcing effects of echoes or the imposition of novel effects (which kick in because prior pricing action mis-judged the scale at which those effects apply). Fortunately for investors, these reinforcing effects usually become strong enough to justify our investment decisions over time.

Therein lies the problem for the recovery. There are lots of latent echos in play with negative reinforcing effects. Credit problems for financial institutions naturally beget credit problems downstream for businesses and consumers, and attempts to counteract those latent echoes with stimulus by even the most dedicated politicians and policymakers will only add novel sources of perturbation whose positive and negative reinforcing effects are even less understood and therefore much more likely increase the time required for an long-lasting economic equilibrium to be reached. Once it became clear that stimulus is coming, those who understand and contribute to their own local areas of economic activity have to consider the potential effect of such stimulus on their own activities, and may defer investment action until the effect is known or understood. The gradual accumulation of these deferred investments on a micro level will have negative impacts upstream as a result.

Think of the interference patterns that happen when a placid lake is perturbed: everyone across the lake can see them and immediately understand where they came from. Investors in calm times stay with their investments during small understandable perturbations because they can identify and understand the fluctuations they see. Even large perturbations from a single source are easy to identify and safely ride out. But as more perturbations are added, the complexity of the interference patterns that result becomes too difficult to understand and protect against. Rogue waves can develop and isolated areas of calm can appear momentarily but don't last long. The best thing a government can do in this situation is seek out and temporarily reduce the impact of the sources of perturbation they directly control:

  • Streamline and simplify complex regulations and taxation that distorts investment decisions in unhelpful ways. In some cases, simplification can't happen without creating further perturbation - this can be mitigated by delaying the effective date of such simplification so that all those affected have sufficient time to react (an example would be removing the tax-deductability of mortgage interest, which could be removed only if the benefit was gradually reduced over time and did not take effect until the correction had run its course).

  • Avoid the temptation to introduce new legislation where existing law could work if enforced. Seek out and prosecute those that flout any existing laws and regulations that are still valid and worthwhile so that uncertainty regarding the effect of new legislation is only introduced when no other option is available.

  • Establish a culture of incorruptibility within government that fails to reward the bad behavior by private citizens and enterprises that is being poorly fought with Byzantine conflict-of-interest laws and rules that fail to rip out the soul of corruption

  • Document and research all that is known and knowable about The Great Correction and its root causes (as well as similar crashes and downturns in the more distant past). This serves several purposes: (1) it helps citizens arrive more quickly to a common understanding of the problem, (2) it helps quell misguided anger and calls for reprisal that would fail to improve our conditions, and (3) it creates the justification for future pre-emptive actions to be taken by our children when such economic conditions return.

Washington has no intention whatsoever of undertaking any of these items in a serious way. Yes, you will see superficial treatments of each, but as much as I admire Obama and the way he used a combination of pragmatic leadership and Reaganesque embrace of optimism to gain the presidency (and our confidence), he would no more disown the established rules of Washington politics than he would his white grandmother. He is a politician's politician and in is in this way completely unlike Reagan who at a personal level hated politics and sacrificed his day-to-day reputation in order to get the most critical long term results that his successors were all too happy to own as their own. (Note that I'm not suggesting he isn't the best possible choice right now - no better alternative was electable. I still believe 8 years later that had McCain been successful in 2000 he would probably have been the right man for the job at that time; in 2008, not so much).

You've got to work with what you've got, however, so you will not find me bitching about Obama's approach. Even if I had his talent and experience, I could only hope to match his effectiveness and consistency. The man is smart enough not to start a two-front war on Washington and the economy simultaneously. So the best he can do is try to make the inevitable stimulus package as understandable as possible and respond with confidence when it inevitably fails to produce the desired effect of calm economic waters within the unrealistically short expectations we collectively cling to. And we'll love Obama for it just as we loved Roosevelt (albeit with two fewer terms).

Meanwhile, I'm doing my part by placing my bets on investments that have some upside potential to produce returns in these turbulent times, and avoiding treasuries and other "safe" vehicles that are going nowhere. Thanks to the emergence of inverse ETFs, I can make volitility my friend as well, taking a two part strategy that also has the side effect of encouraging less volatility in markets over time:

  • After markets complete several days of large gains and sentiment feels euphoric, I begin buying small, cheap positions in inverse ETFs that move in the opposite direction of my holdings (like QID which has in objective of 2X the inverse daily performance of the NASDAQ 100 before fees - just keep in mind that compounding double daily performance over a year won't give give you double the yearly performance), and continue that accumulation gradually as prices rise (and their value shrinks) until the first large fall. At the same time, I trim holdings that are underperforming or overexposed. I wait to take profits on stronger positions until movement slows or starts to reverse but do not exit strong positions completely. And even when I leave weak positions, I often hold on to a few shares (enough that I wouldn't miss them if they were gone) on the premise that 20 years from now a handful of huge winners will emerge and I don't want to be tempted to touch the stock again in the interim. I also seek out stocks that may temporarily be moving in ways that are uncorrelated to the rest of the market and consider very small small entry positions in stocks that seem overpriced in some way but are worth more attention in the future.
  • After a large fall or several consecutive days of smaller falls, I stop buying inverse ETFs altogether and begin accumulating new positions or expanding existing positions that are fundamentally strong but beaten down. I continue to seek out stocks that may temporarily be moving in uncorrelated ways and adjust positions of uncorrelated holdings. As a stable bottom forms (or the first signs of optimism return and I need to rebalance so I don't hold more than 33% of my total value in double inverse ETFs) I start selling my inverse ETFs but do not completely exit them since the worst that can happen is that a sudden move upward that doubles my long positions would only take out 75% chunk of my inverse ETF holdings even if I had equivalent amounts of each at the start (meaning that on the way down I had already doubled the value of my maximum starting position at the top of the euphoria which is having an amount equivalent to half of my long holdings in a 2x inverse ETF) still gives me a worst-case 25% gain on a violent and unexpected upturn, while a violent and unexpected downturn without any inverse ETF holdings could wipe out up to half my holdings in the worst case and I'm willing to give up about 10% of my slow-growth upside in stable markets for that kind of insurance. While markets are trending down, I tend to be aggressive in taking profits from uncorrelated investments. If a very short term rise is expected to be temporary, I may briefly take a 2X or 3X long index ETF position to ride upwards briefly but otherwise I try to avoid holding long leveraged ETF positions except when they have become so beaten down that a sector-oriented pop is inevitable. Those I buy along with other long-term holdings selling cheaply as I lighten up on my inverse ETF holdings

Eventually the level of volatility reach a point where the swings are less visible, the long-term trends are clear, and the transaction costs of this strategy make it unattractive to a retail investor. But in the mean time, I've helped the market reach an equilibrium and shaved more than a few points off for myself. And since I do this with my 401(k) account, I don't need to worry about tax consequences for my trades and I help ensure the financial stability of my 401(k) provider by passing lots of commissions to them. This is just one of millions of micro-recovery plans that have become possible thanks to the Internet and other technology advances, and I'll be writing more in the future about this micro-recovery concept and how it applies to other decisions we make because I think it holds the real key to our recovery.

In fact, we may well discover in 10 years that we didn't need much of these large financial institutions had to offer us because the most important infrastructure for microinvestment across a global scale was with us all along but had been hindered by regulatory and cultural roadblocks--but that's a topic for another day. In the mean time, I'd like to hear from you. What do you think will hasten the recovery? What is spurring you on to invest and what is causing you to slow down your own investment and savings decisions?

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