The Blowing Winds of Financial Change
Tomorrow is already summer solstice – mid-summer, in celestial terms.
How did it get here so fast? Where’s the summer?
This morning we walked along the Thames. ITV frequently has its reporters and cameramen along the Southwark quay, interviewing people – for the day’s chatty news coverage, we suppose. Today, there was a young woman in a bikini, her back to the river, her face to the camera…talking to a newsman.
The poor thing; it was freezing cold, with strong winds blowing across Waterloo Bridge as though a tempest was coming.
Yesterday, too, the rain pelted down on London, and the wind whipped it against road-signs and windows.
But our beat is not the physical weather. No, instead, our métier is gloomier. It involves trying to take the temperature of the financial markets…and to figure out its seasons. But like any good meteorologist, we begin by looking out the window!
And what a view it is.
Last night, we had dinner with a friend at the Savile Club. There, we met one of London’s most successful hedge fund managers.
“Well, there is no doubt that we have a worldwide liquidity boom,” he offered. “And there is no doubt that it will come to an end sometime. But a lot of money has been lost guessing when it will be. I don’t mind guessing, of course. It’s part of the job. And my guess is that this boom/bubble will run for another five or six years. There are just so many more players in the financial markets…and so much more money coming in. None of the restraints of the past are in force now. Remember, many of them were just customary – people felt awkward taking too many risks…or raising too much money…or paying too high a price. Now, the new players don’t seem to have those kind of hesitations.”
The City of London, which is the equivalent of New York’s Wall Street, used to be run by stuffy old men in stuffy old suits in stuffy old offices. A friend of ours worked there in the ’60s. He recalled.
“Oh, it was so quaint and so civilized. The partners all wore Derby hats. And a butler would bring around tea twice a day. At 11 and at 4. He wore a morning coat and served the tea, with white gloves, on a silver platter. After tea-time, everyone went home.”
Then, how it all changed! The old boys were out. And the new boys were very different. They wore open collared shirts and had degrees in mathematics. And now they work around the clock.
But what are they working at? Ah…that is a good question. You can stand in front of one of their office buildings all day, dear reader. You will see no products coming out of it. Not even smoke rising from its chimneys. For all their sweat, the ultra-smart professionals seem to produce nothing – at least nothing you can see. Nothing you can eat. Nothing you can sit on. Nothing you can use to brush your teeth…or read for amusement…or kill a varmint with. Neither animal, vegetable nor mineral. The output of the City is intangible.
But people must like it. They pay heavily for it.
Looking out our window, we see what it is. London is covered in molasses. Credit is flowing everywhere, pouring in from every corner of the globe. Rich, sticky…a source of decay. Russians drive around in Lamborghinis. Arabs fill up restaurants. Japanese and Chinese shoppers raid the boutiques.
London is not the most expensive city in the world (that dubious honor falls to Moscow). But London is not far behind, as number two. On the list of the world’s most expensive cities, no American burg even makes the top ten. Does that mean the dollar is undervalued? Or does it mean that Americans just don’t have very much money…that they can’t afford to have a really expensive city?
We don’t know. But we have a feeling that the winds of financial climate change are blowing ill to the United States of America. After the storm in subprime lending blew through the United States in the spring, it looked as though the bad weather was over. But there’s more where that came from, reports USA Today. Foreclosures in Minneapolis rose 100% in 2006. And they’re expected to rise another 100% in 2007. More than a million houses may be foreclosed this year – of which, 60% are the victims of subprime mortgage lending. Nor is the damage expected to stop when the New Year is rung in on January 1st, 2008. There will be even more foreclosures next year, says the Mortgage Bankers Association. Bears Stearns (NYSE:BSC) has got a fever in the subprime chill. Even Goldman Sachs (NYSE:GS) has a few sniffles.
But so far, the pain is being felt only down in the lower depths of American society. The poor, minorities, the disfavored, the underprivileged lads in bad neighborhoods – those are the one who are losing their homes. Naturally, the bleeding hearts are coming forward with the dopiest solutions. The NAACP proposes a moratorium on foreclosures – an act of desperate foolishness, which would almost surely cut off mortgage credit to poor people for decades. And the clowns are rushing in, too – proving once again that there is no situation so bad that earnest politicians can’t make worse. The Buckeye State has come up with a cockeyed plan to bail out troubled borrowers. Ah yes…hacks rush in where the seasoned pros of the subprime industry now fear to tread.
But enough of the troubles of the unwashed…let’s turn our heads in a different direction. In New York City, another trophy building has changed hands – the old New York Magazine headquarters. It is being sold for $313 million – which works out to $660 per square foot. How much can you rent a place like that for? Well, current rents are about $64 a square foot, not even 10% of the purchase price. Let’s see. If the cost of money were only 6%…that would leave the buyer with less than 4% to pay all the expenses…depreciation…maintenance…taxes…management. We’re not experts at commercial property investing, but we don’t see how these numbers are going to work out.
The Daily Reckoning
Wednesday, June 20, 2007
Addison Wiggin, reporting from Baltimore…
“The ‘godless dollar’ is back.
“Back in March, the Philadelphia mint gaffed. They struck the new George Washington dollar coins without ‘In God We Trust,’ ‘E Pluribus Unum.’ The year and mintmark normally inscribed on the edge were missing, too. The minters fixed the problem – but not before an unknown number of coins were distributed.
“Today comes word they’ve gaffed again. This time the mint has released the Adams dollar without the edge inscription ‘In God We Trust.’
“It’s too early to put a final price tag on the collector value of Adams presidential dollar errors because no one knows how many others will turn up,” says Ron Guth, a coin grader.
“The Washington and Adams dollars are the first two in a series of presidential coins that will be released annually up to 2016. At this rate, there will be “godless dollars” all over the place. Oooh, so rife with irony, isn’t it? We won’t go there today.”
To see where Addison will go today, check the latest issue of The 5 Min. Forecast
And more views:
*** Oh, dear reader…the life of a tax exile…how miserably lonely.
Yes, it has been about a week since we began our exile from kith and kin, home and hearth, friends and foes. And we can barely stand it any longer. We have been forced away from Paris…Paris, France, we mean, not the vapid hotel heiress…by the peculiarities of international tax conventions. We would like to live in Gaul, with our wife and children. But we’re too rich; we can’t afford it. France’s tax collectors would hit us so hard, it would be a crime against our family – which is to say, we would be giving the French government a big part of our children’s inheritance.
And so, here we are on the banks of the Thames, separated from those we love. The boys are growing up without us. We will not be able to see them at their piano recitals. We will not be able to wait up for them (Henry has been going to end-of-the-year parties and not coming home until 6AM!). We will not be able to take part in family squabbles or take out the trash, or argue about French politics or American monetary policy. We will not be able to hear Jules practicing the electric guitar…or watch Edward on his skateboard. Oh, dear reader, you can imagine the angst, the anguish that reigns in our poor, lonely heart.
Instead, we will have to make do with our own meager entertainment…such pitiful diversions as we can scrape up to help pass the hours of isolation and estrangement. Here, in our self-imposed exile, what will we do? Go to the theatre, maybe? Frequent clubs and bars to ease our pain…perhaps catch dinner at a fancy restaurant? Or maybe we’ll spend the lonesome evenings with our daughter Maria and her young actress friends. Sigh. Or, later in the year, we’ll be forced to slip away to Madrid and Buenos Aires. We will make the best of a bad business, of course. We’ll squeeze in a visit to our son and some old associates…perhaps we will learn to tango with a sultry Argentine…or improve our Spanish… or maybe just hang around the outdoor cafes until the wee hours…anything really, to break the awful gloom of separation.
We’ll let you know how it works out, dear reader.
The Daily Reckoning PRESENTS: When looking at the markets, traders, more often than not, try to find patterns and theories to make a profit without any sort of risk-taking. Nassim Nicholas Taleb is not one of those people…he thrives off of his “skewed bets…”
A WORLD OF RANDOMNESS
The general press floods us with concepts like “bullish” and “bearish,” which refer to the effect of higher (bullish) or lower (bearish) prices in the financial markets. But also, we hear people saying, “I am bullish on Johnny” or “I am bearish on that guy Nassim in the back who seems incomprehensible to me,” to denote the belief in the likelihood of someone’s rise in life. I have to say that the notion of bullish or bearish are often hollow words with no application in a world of randomness – particularly if such a world, like ours, presents asymmetric outcomes.
When I was in the employment of the New York office of a large investment house, I was subjected on occasions to the harrying weekly “discussion meeting,” which gathered most professionals of the New York trading room. I do not conceal that I was not fond of such gatherings, and not only because they cut into my gym time. While the meetings included traders, that is, people who are judged on their numerical performance, it was mostly a forum for salespeople (people capable of charming customers), and the category of entertainers called Wall Street “economists” or “strategists,” who make pronouncements on the fate of the markets, but do not engage in any form of risk taking; thus having their success dependent on rhetoric, rather than actually testable facts. During the discussion, people were supposed to present their opinions on the state of the world.
To me, the meetings were pure intellectual pollution. Everyone had a story, a theory, and insights that they wanted others to share. I have to confess that my optimal strategy (to soothe my boredom and allergy to confident platitudes) was to speak as much as I could, while totally avoiding listening to other people’s replies by trying to solve equations in my head. Speaking too much would help me clarify my mind, and, with a little bit of luck, I would not be “invited” back (i.e, forced to attend) the following week.
I was once asked in one of those meetings to express my views on the stock market. I stated, not without a modicum of pomp that I believed that the market would go slightly up over the next week with a high probability. How high? “About 70%.” Clearly, that was a very strong opinion. But then someone interjected, “But, Nassim, you just boasted being short a very large quantity of SP500 futures, making a bet that the market would go down. What made you change your mind?” I answered, “I did not change my mind! I have a lot of faith in my bet! As a matter of fact, I now feel like selling even more!”
The other employees in the room seemed utterly confused. “Are you bullish, or are you bearish?” the strategist asked me. I replied that I could not understand the words “bullish” and “bearish” outside of their purely zoological consideration. My opinion was that the market was more likely to go up (“I would be bullish”), but that it was preferable to short it (“I would be bearish”), because, in the event of its going down, it could go down a lot. Suddenly, the few traders in the room understood my opinion and started voicing similar opinions. And I was not forced to come back to the following discussion.
Let us assume that the reader shared my opinion, that the market over the next week had a 70% probability of going up and 30% probability of going down. However, let us say that it would go up by 1% on average, while it could go down by an average of 10%. What would the reader do? Is the reader bullish or bearish?
Accordingly, bullish or bearish are terms used by people who do not engage in practicing uncertainty, like the television commentators, or those who have no knowledge in handling risk. Alas, investors and businesses are not paid in probabilities, they are paid in dollars. Accordingly, it is not how likely an event is to happen that matters, it is how much is made when it happens that should be the consideration. How frequent the profit is irrelevant; it is the magnitude of the outcome that counts. It is a pure accounting fact that, aside from the commentators, very few people take home a check linked to how often they are right or wrong. What they get is a profit or loss. As to the commentators, their success is linked to how often they are right or wrong. This category includes the “chief strategists” of major investment banks the public can see on T.V., who are nothing better than entertainers. They are famous, seem reasoned in their speech, plow you with numbers, but, functionally, they are there to entertain – for their predictions to have any validity they would need a statistical testing framework. Their fame is not the result of some elaborate test, but rather the result of their presentation skills.
Outside of the need for entertainment in these shallow meetings I have resisted voicing a “market call” as a trader, which caused some personal strain with some of my friends and relatives. One day a friend of my father – of the rich and confident variety – called me during his New York visit. He wanted to pick my brain on the state of a collection of financial markets. I truly had no opinion, nor had made the effort to formulate any, nor was I remotely interested in markets. The gentleman kept plowing me with questions on the state of economies, on the European central banks; these were precise questions no doubt aiming to compare my opinion to that of some other “expert” handling his account at one of the large New York investment firms. I neither concealed that I had no clue, nor did I seem sorry about it. I was not interested in markets (“Yes, I am a trader”) and did not make predictions, period. I went on to explain to him some of my ideas on the structure of randomness and the verifiability of market calls, but he wanted a more precise statement of what the European bond markets would do by the Christmas season.
He came away under the impression that I was pulling his leg; it almost damaged the relationship between my father and his rich and confident friend. For the gentleman called him with the following grievance: “When I ask a lawyer a legal question, he answers me with courtesy and precision. When I ask a doctor a medical question, he gives me his opinion. No specialist ever gives me disrespect. Your insolent and conceited 29-year-old son is playing prima donna and refuses to answer me about the direction of the market!”
The best description of my lifelong business in the market is “skewed bets,” that is, I try to benefit from rare events, events that do not tend to repeat themselves frequently, but, accordingly, present a large payoff when they occur. I try to make money infrequently, as infrequently as possible, simply because I believe that rare events are not fairly valued, and that the rarer the event, the more undervalued it will be in price. In addition to my own empiricism, I think that the counterintuitive aspect of the trade (and the fact that our emotional wiring does not accommodate it) gives me some form of advantage.
Why are these events poorly valued? Because of a psychological bias; people who surrounded me in my career were too focused on memorizing Section 2 of the Wall Street Journal during their train ride to reflect properly on the attributes of random events. Or perhaps they watched too many gurus on television. Or perhaps they spent too much time upgrading their PalmPilot. Even some experienced trading veterans do not seem to get the point that frequencies do not matter. Jim Rogers, a “legendary” investor, made the following statement:
“I don’t buy options. Buying options is another way to go to the poorhouse. Someone did a study for the SEC and discovered that 90 percent of all options expire as losses. Well, I figured out that if 90 percent of all long option positions lost money, that meant that 90 percent of all short option positions make money. If I want to use options to be bearish, I sell calls.”
Visibly, the statistic that 90% of all option positions lost money is meaningless, (i.e., the frequency) if we do not take into account how much money is made on average during the remaining 10%. If we make 50 times our bet on average when the option is in the money, then I can safely make the statement that buying options is another way to go to the palazzo rather than the poorhouse. Mr Jim Rogers seems to have gone very far in life for someone who does not distinguish between probability and expectation (strangely, he was the partner of George Soros, a complex man who thrived on rare events – more on him later).
One such rare event is the stock market crash of 1987, which made me as a trader and allowed me the luxury of becoming involved in all manner of scholarship. Many traders aim to get out of harm’s way by avoiding exposure to rare events – a mostly defensive approach. I am far more aggressive than those traders and go one step further; I have organized my career and business in such a way as to be able to benefit from them. In other words, I aim at profiting from the rare event, with my asymmetric bets.
Nassim Nicholas Taleb
for The Daily Reckoning
June 20, 2007
Editor’s Note: Editor’s Note: You can hear Mr. Taleb (along with all of your favorite DR editors) speak at this year’s Agora Financial Investment Symposium in Vancouver, British Columbia. This year’s theme is “Rim of Fire: Crisis & Opportunity in the New Asian Era” – and it’s your first look at investment opportunities, global market concerns, and the best investment bets across the globe.
Nassim Nicholas Taleb is an essayist principally concerned with the problems of uncertainty and knowledge. Taleb’s interests lie at the intersection of philosophy, mathematics, finance, literature and cognitive science, but he has stayed extremely close to the ground, thanks to an uninterrupted two-decade career as a mathematical trader. Specializing in the risks of unpredicted rare events (“black swans”), he held senior trading positions in New York and London, before founding Empirica LLC, a trading firm and risk research laboratory.
The above essay was taken from his book, Fooled by Randomness. His latest, highly acclaimed book, The Black Swan: The Impact of the Highly Improbable, was released in April of this year. Purchase your copy by clicking on this link: