Giant squids, black swans, and the financial sector.

One of the most popular passages from the book Black Swan by Nassim Taleb has a chart illustrating the growth of a turkey. (I presume it’s popular because Taleb often talks about this). However, the image of a turkey has been much abused in relation to a Black Swan. Hence I’m going to replace the turkey instead with a giant squid reared in a fish farm.

Imagine you’re the squid. Each day, you get fed more than the last day, and your weight goes up, you feel healthier and happier, and life is good. Humans are the most wonderful creatures on this planet. Such a happy state exists right until harvesting, when the fat happy squid gets butchered. A chart of squid’s growth looks something like this:



This event was entirely unpredictable to the squid right until the day it happened. This illustrates the concept of the black swan, the impact of the highly improbable.

Well I was browsing through a report called “Small lessons from a big crisis”, issued by the excellent folks from BIS.

An excerpt :

Imagine having placed a hedged bet back in 1900. A £100 long bet is placed on UK financial sector equities together with a £100 short bet on general UK equities. In effect, this is a gamble on the UK financial sector outperforming the market. How would that bet have performed over the intervening 110 or so years?

For around 85 years, this would have been a boring strategy, returning 2% per year. However, during the golden years of finance from 1986-2006, this would have risen to deliver an annual return of over 16%.

Well, the strategy’s staged a giant mean reversion since then, down almost 80% in 2008.



The similarity between the excess returns to finance and the Giant Squid are unmistakable. These were both black swan events waiting to happen.

Most of the excess gains in the financial sector were illusory in nature, an artifact of increasing leverage. The leverage juiced the sector’s equity returns, resulting in the spectacular growth shown above. Strip away the leverage, and the return on assets were miniscule.



Of course we might argue whether 2008 was a black swan, or was entirely predictable given how fragile the system had become because of the extreme leverage. (That’s a topic for another forum.)

Hopefully though, the era of excessive(and ever increasing) leverage is behind us and we are not giving birth to baby poults or squids right now for the next harvest or Christmas season.

Disclaimer: Any resemblances to real life turkeys or giant squids is entirey coincidental. No animals were harmed during the making of this article.

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Using stock market like ratios in personal finance.

Came across an interesting personal finance article which evaluates a person’s financial health using personal financial ratios similar to those used to analyze companies.

Just as stock ratios are primarily based on a company's earnings, the personal financial ratios are based on an individual's income. There are three ratios: savings to income (S/I), debt to income(D/I), and savings rate to income (SR/I). Benchmarks are then created for each ratio at different ages. The ratios are designed to serve as a road map so that investors can compare their individual ratios with the benchmarks to determine whether they are on track to retire by age 65, or any other desired retirement age. The ratios are derived from a series of assumptions including household budgets, post-retirement income replacement, rates of return, and retirement distribution rates.

Kind of shows you where you need to be at different stages of life to fund a retirement income. The ratios are designed to reasonably move people through their lives.

Households or advisers may design their own tables using whatever assumptions they believe are reasonable. The foundational theory for the ratio table, however, would remain constant, which is that there is a fundamental relationship between one's earnings, debt, and savings rate, and these ratios must change over time.

More here!

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PIMCO’s Mohamed El-Erian on "A New Normal" : Part two.

This is a continuation of the summary of PIMCO’s secular outlook, "A New Normal". For part one, please click here.

On the international economy:

• Financial rehabilitation in the U.S. to occur in the context of low growth and eventual inflation down the road.
• The U.K. faces greater vulnerability to domestic and/or external financial instability.
• Core Europe will be limited by its historical inflation phobia and concerns for the integrity of the European Union.
• Japan’s growth will be hindered by fiscal and demographic issues.
• Emerging economies: Those with weak initial conditions will alternate between austerity and financial instability, while those with strong initial conditions will maintain their development breakout phase at a slower rate.

The new normal: A world of muted growth, in the context of a continuing shift away from G-3 and toward the systemically important emerging economies, led by China. (This shift towards domestic consumption in emerging economies becoming another global growth engine is something he advocated pretty strongly in his book "When Markets Collide")

On Risks: El-Erian states that the "balance of risk" picture is tilted to the downside.

• Will low global growth result in stagflation?
• Will the current efforts to repress real interest rates through quantitative easing succumb in a disruptive fashion to higher inflationary expectations and sovereign risk spreads?
• Will political feasibility (rather than economic desirability) dictate economic policy responses?
• The set of implicit contracts required for functional markets and societies are being subjected to major shocks. A disturbingly large number of parameters that anchor key behaviors have become variables. The longer it takes to restore normalcy, the higher the risk of recurrent financial instability.
• The management of public debt in industrial countries will be a delicate process. The average maturity of outstanding U.S. debt is at its lowest. Large unfunded entitlements (Social Security and Medicare) will start to significantly hit the budget.
• Any further erosion in the autonomy and mission of key economic institutions, including the Fed and FDIC would be terrible.

On the investment baseline :

1. El-Erian favors the front end of yield curves in many countries, as the authorities overstay with negative real policy rates.
2. Income-generating instruments instead of pure equity premium.
3. International orientation.

The new normal:

• Exploit periodic anomalies associated with clumsy internal and external handoffs.
• Favor credit spreads higher up in the economic and capital structure and on an international basis.
• Premiums across risk factors and markets will go up to reflect the disruption to the sanctity of contracts, the capital structure, as well as to the autonomy of key economic institutions.
• Renewed depreciation of the dollar, though the magnitude of depreciation against other currencies could be outpaced by that of real assets.
• Equity risk premium will now reflect a permanently higher threat of subordination

In his discussion of the "new normal", I’m reminded of this Peter Bernstein article which came out shortly after the credit crisis broke out. In summary, El-Erian raises several excellent points and the article is definitely worth perusing carefully. Certainly puts the whole “green shoots” euphoria in context!

Further reading:

Peter Bernstein
The Shape Of The Future
http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2008/03/24/the-shape-of-the-future.aspx

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PIMCO’s Mohamed El-Erian on “A New Normal”

I’ve written quite often in the past about PIMCO’s Mohamed El-Erian and Bill Gross. In particular, I had reviewed El-Erian’s book "When Markets Collide" which I highly recommended. It still remains one of the must read well-researched books of 2008.

El-Erian recently came out with an excellent write up discussing PIMCO’s 3 to 5 year secular outlook from their annual forum, titled "A New Normal". He has characterized the current situation as a "bumpy journey to a new normal" for a long time now. While both Gross and El-Erian have discussed in detail several of the factors below, this article neatly captures PIMCO’s thought process from a secular perspective.

The new normal: El-Erian calls for a prolonged pause, or a violent reversal, in certain key market concepts currently taken for granted. They call it the demise of the “great age” of private leverage, asset and credit-based entitlements, self-regulation, policy moderation, and shrinking direct government involvement. With the magnet of the Anglo-Saxon model in retreat, he says that finance will no longer be accorded a preeminent role in post-industrial economies. Moreover, the balance of risk will tilt over time towards higher sovereign risk, growing inflationary expectations and stagflation.


On context: The critical events which provided the context for this year’s forum were:

• The global system became unable to continue on its recent path due to debt exhaustion and poorly capitalized activities, yet also incapable of embarking smoothly on a different path as the ravages of de-leveraging resulted in disruptive overshoots and considerable collateral damage.
• The disorderly failure of Lehman Brothers was a “sudden stop” (a cardiac arrest) to the global economy and markets.
• The new normal: Recent events broadened the de-leveraging dynamics with longer-term consequences, a self-reinforcing mix of de-leveraging, de-globalization, and re-regulation

On public sector: El-Erian calls the unconventional government responses as uncertain in their effectiveness yet consequential in disrupting long-standing relationships. He compares this to a drug trial.

The public sector has become a notable price setter in certain markets. El-Erian finds it discomforting to see it own and control some modes of production, exchange and distribution that normally reside only in the hands of private enterprise. The public sector’s role as major supplier and allocator of credit is also unsettling. The socialization of losses has ignited popular anger, confusion and “a morality play” in parliaments around the world. Click here to read about the Top 10 political fat tail events due to the banking crisis.
The new normal: The public sector will overstay as a provider of goods that belong in the private sector.

On Financial sector: According to El-Erian, the central banks will find it difficult to undo smoothly some of the recent emergency steps.
The new normal: The banking system will be a shadow of its former self. The financial system will be de-levered, de-globalized, and re-regulated.

On structural changes to the economy: There exists insufficient demand buffers and fast-acting structural reforms to provide for a spontaneous and sustainable recovery in the global economy.

El-Erian predicts lower global growth on a structural basis. He cites several reasons for this:

1. Obsolescence of entire economic sectors/structural change.
2. Excessive regulation, taxation and nationalization reducing productivity.
3. Legislation reducing factor flexibility and mobility.
4. Existence of zombie institutions.
5. Decaying capital stock due to subdued investment activity.
6. Destruction of endogenous credit factories which fooled people into believing that the increase in leverage-based economic activities was sustainable.

According to El-Erian, other structural changes to note would include:

• How savings are mobilized and allocated, nationally and across borders.
• The shifting balance between the public and private sectors.
• The erosion of trust in basic market parameters like the sanctity of contracts and property rights, the rule of law, and the robustness of the capital structure.(I can’t believe something like this has become a factor to watch out for.)

The new normal:
• Lower global growth.
• Higher unemployment.
• Price formation influenced by the legacy and continuation of direct government involvement.
• Burden sharing to become a feature of government's hand in economic life.

On US Inflation: Given the severity of the collapse in global demand and the resulting output gap, inflation may not be an imminent concern. Yet, supply also matters.

Unknown: Will the massive US fiscal and monetary stimulus erode confidence in the public goods that the country provides to the rest of the world – namely, the dollar as the world’s reserve currency, and deep and predictable financial markets to intermediate excess savings?

The new normal: The U.S. faces the prospect of a shift in sovereign risk and the return of higher inflationary expectations .

For the second half which summarizes El-Erian’s take on the international economy, risk factors and the investment baseline, please click here.

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