Wednesday, June 11, 2014

In The Golden Age of the Central Banker- Don't Be a Hero

Via Zero Hedge

Unfortunately, these bi-modal market expectation structures (my note- more explanation via the link above) are now the rule rather than the exception in this, the Golden Age of the Central Banker. Why? Because monetary policy since March, 2009 has explicitly established itself as an emergency bridge for financial markets, a bridge between the real world of an anemic, under-employed, under-utilized economy and the hoped-for world of a vibrantly growing, robust economy. On its own terms, this has been an entirely successful experiment, I suspect surpassing the wildest dreams of Bernanke et al. Stock markets have been “bridged”, reflecting what the world would look like if the global economy were off to the races, while bond markets reflect what the world actually looks like with the global economy sputtering in fits and starts. The problem today is that the experiment has been too successful. Whether you are in Europe or the US or Japan or China or wherever, the only investment questions that matter are whether central banks will continue their emergency monetary policies and what happens if the bridges are removed. These are not small, incremental policy questions. These are existential questions, reflecting binary expectations of the world with an enormous chasm in-between. With a hat tip to Milton Friedman, we are all bi-modal now.

So what’s the moral of this story for portfolio management? There are four, I believe.

In the Golden Age of the Central Banker …
1) the VIX is not a reliable measure of market complacency. Remember that the VIX itself is an implied volatility construct, built on the prices paid for options on the S&P 500 two to three months in the future. We assume that whatever the VIX is reported to be, that’s the consensus market expectation, with a lot of people holding that particular view and progressively fewer people on either side of that number. This is not necessarily the case, and when binary events raise their ugly heads it is almost certainly not the case. A low VIX level might indicate a complacent market, or it might indicate two sets of investors – one very complacent and one non-complacent – who see the world entirely differently. You have no idea what the underlying market expectations look like, and this makes all the difference in determining what the VIX means.

2) the wisdom of crowds is nonexistent. I believe in the efficiency of emergent behaviors. I believe that there is a logical dynamic process to crowd behaviors. But I also believe that crowds are extremely malleable when confronted by powerful individuals or institutions that understand the strategic interaction of crowds and make a concerted effort to master the game. There’s no inherent “wisdom” here, no emergent outcome where the crowd acts like an enormous set of parallel microprocessors to arrive at Truth with a capital T. The Common Knowledge Game is controlled by the Missionary, and our current Missionaries – central bankers, politicians, famous investors and media mouthpieces – know it.

3) fundamental risk/reward calculations for directional exposure to any security are problematic on anything other than a VERY long time horizon. Game-playing has always been a big part of the market environment, and it dominates successful directional bets on a very short time horizon. Similarly, stock-picking on a fundamental basis has always been a big part of the market environment and dominates successful directional bets on a very long time horizon. Between the very short-term and the very long-term you have this mish-mash of game-playing and stock-picking. One impact of the pervasiveness of the Common Knowledge Game today is that it pushes out the time horizon on which stock-picking on a fundamental basis can really shine. If you’re in the stock-picking business the value of permanent capital has never been greater.

4) I’d rather be reactive and right in my portfolio than proactive and wrong. I started this note with an acknowledgment of the weakness of risk assessments based on realized or historical volatility – it’s inherently backwards looking and you will always, no matter how finely calibrated your system, be late to respond to changing market conditions. But here’s the thing. This is what it means to be adaptive. You can’t be adaptive without something to adapt TO. Will you miss the market turns? Will you occasionally get whipsawed in your reactive process? Without a doubt. But you won’t get killed. You won’t be on the wrong side of a binary bet that you really didn’t need to make. You won’t discover that your pretty little sand box is really filled with quicksand. The Golden Age of the Central Banker is a time for survivors, not heroes. And that’s the real moral of this story.

The moral of story here is that market and expectations are manipulated and hiding the underlying risk structure. Although the article claims don't be hero- which has some merit. One can always bet against the debt/monetary structure.

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