The Trader-Economist Hybrid
Nassim Nicholas Taleb. This is a great honor. Not only is Taleb one of Wall Street’s finest options traders, but he is also the author of one of Wall Street’s finest books, Fooled by Randomness. We submit no book has the potential to influence your trading methods as much as this one. In today’s essay, we meet Carlos the emerging markets trader…
I used to meet Carlos at a variety of New York parties, where he would show up impeccably dressed, though a bit shy with the ladies. I used to regularly pounce on him and try to pick his brains about what he did for a living, namely buying or selling emerging market bonds. A nice gentleman, he complied with my requests, but tensed up; for him, speaking English, in spite of his fluency, seemed to require some expenditure of physical effort that made him contract his head and neck muscles (some people are not made to speak foreign languages).
What are emerging market bonds? "Emerging market" is the politically correct euphemism to define a country that is not very developed (as a skeptic, I do not impart to their "emergence" such linguistic certainty). The bonds are financial instruments issued by these foreign governments, mostly Russia, Mexico, Brazil, Argentina and Turkey. These bonds traded for pennies when these governments were not doing well. Suddenly, investors rushed into these markets in the early 1990s and pushed the envelope further and further by acquiring increasingly more exotic securities. All these countries were building hotels where United States cable news channels were available, with health clubs equipped with treadmills and large-screen television sets that made them join the global village. They all had access to the same gurus and financial entertainers. Bankers would come to invest in their bonds, and the countries would use the proceeds to build nicer hotels so more investors would visit. At some point these bonds became the vogue and went from pennies to dollars; those who knew the slightest thing about them accumulated vast fortunes. Carlos supposedly comes from a patrician Latin American family that was heavily impoverished by the economic troubles of the 1980s, but again, I have rarely run into anyone from a ravaged country whose family did not at some juncture own an entire province or, say, supply the Russian czar with sets of dominoes. After brilliant undergraduate studies, he went to Harvard to pursue a Ph.D. in economics, as it was the sort of thing Latin American patricians had gotten into the habit of doing at the time (with a view to saving their economies from the evils of non-Ph.D. hands). He was a good student, but could not find a decent thesis topic for his dissertation. Nor did he gain the respect of his thesis adviser, who found him unimaginative. Carlos settled for a master’s degree and a Wall Street career.
The nascent emerging market desk of a New York bank hired Carlos in 1992. He had the right ingredients for success. He knew where on the map to find the countries that issued "Brady bonds," dollar-denominated debt instruments issued by less-developed countries. He knew what gross domestic product meant. He looked serious, brainy and well spoken, in spite of his heavy Spanish accent. He was the kind of person banks felt comfortable putting in front of their customers. What a contrast with the other traders, who lacked polish! Carlos got there right in time to see things happening in that market. When he joined the bank, the market for emerging market debt instruments was small and traders were located in undesirable parts of trading floors. But the activity rapidly became a large, and growing, part of the bank’s revenues. He was generic among this community of emerging market traders; they are a collection of cosmopolitan patricians from across the emerging market world that remind me of the international coffee hour at the Wharton School. I find it odd that rarely does a person specialize in the market of his or her birthplace. Mexicans based in London trade Russian securities, Iranians and Greeks specialize in Brazilian bonds and Argentines trade Turkish securities. Unlike my experience with real traders, they are generally urbane, dress well, collect art, but are nonintellectual. They seem too conformist to be true traders. They are mostly between 30 and 40, owing to the youth of their market. You can expect many of them to hold season tickets to the Metropolitan Opera. True traders, I believe, dress sloppily, are often ugly and exhibit the intellectual curiosity of someone who would be more interested in the information-revealing contents of the garbage can than the Cézanne painting on the wall.
Carlos thrived as a trader-economist. He had a large network of friends in the various Latin American countries and knew exactly what took place there. He bought bonds that he found attractive, either because they paid him a good rate of interest, or because he believed that they would become more in demand in the future, therefore appreciating in price. It would be perhaps erroneous to call him a trader. A trader buys and sells (he may sell what he does not own and buy it back later, hopefully making a profit in a decline; this is called "shorting"). Carlos just bought – and he bought in size. He believed that he was paid a good risk premium to hold these bonds because there was economic value in lending to these countries. Shorting, in his opinion, made no economic sense.
Within the bank, Carlos was the emerging markets reference. He could produce the latest economic figures at the drop of a hat. He had frequent lunches with the chairman. In his opinion, trading was economics, little else. It had worked so well for him. He got promotion after promotion, until he became the head trader of the emerging market desk at the institution. Starting in 1995, Carlos did exponentially well in his new function, getting an expansion of his capital on a steady basis (i.e. the bank allocated a larger portion of its funds to his operation) – so fast that he was incapable of using up the new risk limits. The reason Carlos had good years was not just because he bought emerging market bonds and their value went up over the period. It was mostly because he also bought dips. He accumulated when prices experienced a momentary panic. The year 1997 would have been a bad year had he not added to his position after the dip in October that accompanied the false stock market crash that took place then. Overcoming these small reversals of fortune made him feel invincible. He could do no wrong. He believed that the economic intuition he was endowed with allowed him to make good trading decisions. After a market dip he would verify the fundamentals, and if they remained sound, he would buy more of the security and lighten up as the market recovered. Looking back at the emerging market bonds between the time Carlos started his involvement with these markets and his last bonus check in December 1997, one sees an upwardly sloping line, with occasional blips, such as the Mexican devaluation of 1995, followed by an extended rally. One can also see some occasional dips that turned out to be "excellent buying opportunities."
It was the summer of 1998 that undid Carlos – that last dip did not translate into a rally. His track record up to that point included just one bad quarter – but bad it was. He had earned for his bank close to $80 million cumulatively in his previous years. He lost $300 million in just one summer. What happened? When the market started dipping in June, his friendly sources informed him that the sell-off was merely the result of a "liquidation" by a New Jersey hedge fund run by a former Wharton professor. That fund specialized in mortgage securities and had just received instructions to wind down the overall inventory. The inventory included some Russian bonds, mostly because yield hogs, as these funds are known, engage in the activity of building a "diversified" portfolio of high-yielding securities. When the market started falling, he accumulated more Russian bonds, at an average of around $52. That was Carlos’s trait, average down. The problems, he deemed, had nothing to do with Russia, and it was not some New Jersey fund run by some mad scientist that was going to decide the fate of Russia. "Read my lips: It’s a li-qui-da-tion!" he yelled at those who questioned his buying.
By the end of June, his trading revenues for 1998 had dropped from up $60 million to $20 million. That made him angry. But he calculated that should the market rise back to the pre-New Jersey sell-off, then he would be up $100 million. That was unavoidable, he asserted. These bonds, he said, would never, ever trade below $48. He was risking so little to possibly make so much.
Then came July. The market dropped a bit more. The benchmark Russian bond was now at $43. His positions were under water, but he increased his stakes. By now he was down $30 million for the year. His bosses were starting to become nervous, but he kept telling them that, after all, Russia would not go under. He repeated the cliché that it was too big to fail. He estimated that bailing them out would cost so little and would benefit the world economy so much that it did not make sense to liquidate his inventory now. "This is the time to buy, not to sell," he said repeatedly. "These bonds are trading very close to their possible default value." In other words, should Russia go into default, and run out of dollars to pay the interest on its debt, these bonds would hardly budge. Where did he get this idea? From discussions with other traders and emerging market economists (or trader-economist hybrids). Carlos put about half his net worth, then $5 million, in the Russia principal bond. "I will retire on these profits," he told the stockbroker who executed the trade…
Nassim Nicholas Taleb
for The Daily Reckoning
September 7, 2004
Editor’s Note: 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. Fooled by Randomness has been published in 14 languages, and the author’s ideas on skeptical empiricism have been covered by hundreds of articles around the world.
Labor Day was declared because there are more employees who vote than employers. Otherwise, we would have been celebrating Capital Day yesterday.
Marxists believed that making money on Wall Street was a sin and a fraud. What was really happening, according to Bolshevik fantasy, was that one class was exploiting another; people with capital were taking advantage of the poor schmucks who had none.
The only true wealth creation, they believed, came from work…from labor…from the sweat of their brows. The idea that you can "get rich while you sleep," as Francois Mitterand once put it, was both preposterous and perverse – they thought.
Of course, we know it is not labor alone that produces value, but skill, luck, genius and capital. Here at The Daily Reckoning headquarters in Paris, we could sweat oceans and still not make a hat anyone would want to wear. But there are two sides to every story and, as happens so often, one of them is no more absurd than the other. American economists and ordinary investors have turned a silly idea all around – so that, looked at from the other end, it is just as dopey! The communists believed they could get rich without capital. The lumpen capitalists of America, 2004, think they can get rich without labor!
America has become a nation of capitalists. Nearly everyone wants to get a college degree and work in an air- conditioned office; nearly everyone wants stocks in his pension portfolio. People do not dream of getting rich while they sleep; they expect it. The average investor believes he can earn compound rates of return of 10-20% year after year, rates of return far above the typical yield on lending money. He’s heard that Warren Buffett did it. He’s read Peter Lynch’s book. He sees no reason why he shouldn’t do it too.
But the Marxists are right about one thing – labor may not be all you need, but all wealth has sweat stains on it. When you lend money, what you are really doing is lending accumulated sweat, yours or someone else’s. Every dollar represents some effort by someone, somewhere…somewhere, someone, sometime humped, bussed or schlepped in order to transform the natural elements of the world into what we know as "wealth."
Whether you made it yourself…or inherited it…you can either consume wealth or pass it on to someone else – either for consumption or production. Either way, the accumulated sweat represents a claim on resources.
It takes an effort – of sorts – to forego consumption, sometimes it’s harder not to spend money than it is to earn it in the first place. The saver/investor is rewarded because he does the right thing, the honorable thing, the good thing: He gives up the immediate pleasure of spending money so that others may have life and have it more abundantly. His savings enter into the pool of resources that others can draw upon to build a new factory…or a new house.
Forbearance is like labor itself – it requires self- discipline and consistency. Savers are not rewarded all at once, but over time, like a plumber or draper; the longer they refrain from calling on their savings, the longer those resources are available to others, and the longer the saver’s "earnings" grow.
Imagine that a man saves enough to buy a new car. He can use the car himself. Or he can rent it out to others, earning money on his savings, by not using them himself. People who do this are knows as "capitalists" or "rentiers" – they earn money by saving; they are paid NOT to consume.
This labor of saving is rewarded – but not at the fantastical rate imagined by Wall Street investors. In the West, the going rate for not consuming is only about 3% per year, inflation adjusted. In societies where the risk of loss is high or where few people do the labor of saving, return rates are higher. Still, it is this low rate of interest, compounded over a long period of time, that really makes people rich – collectively and, occasionally, individually.
Yet in modern America, economists think a society can get rich if people will just spend more money. And the people themselves – ready to believe anything if it is flattering or convenient – think they can get rich from rising house and stock prices. They actually seem to think that rising asset prices allow them to consume more – while still increasing their wealth! They think they are paid to consume, not to save. They think they can have their cake and eat it too…get something for nothing…eat all they want without getting fat…go to heaven without dying… and lose their virginity every night.
On this Labor Day 2004, millions of Americans think they can get rich. No sweat.
Here’s more news from our U.S.-based news team…
Tom Dyson, laboring in Baltimore…
– Readers may have seen the president’s acceptance speech last Thursday. "Another priority for a new term is to build an ownership society," he said, "because ownership brings security, and dignity and independence. Thanks to our policies, homeownership in America is at an all-time high."
– Sure! Why not? Give everyone a house! Like many political theories, the idea is a laudable one…"Tonight we set a new goal: 7 million more affordable homes in the next 10 years so more American families will be able to open the door and say, ‘Welcome to my home.’"
– And it’s working, too, seemingly. Home ownership is up from 67.5% of the population at the end of 2001, to 69.2% by Q2 2004. And over the same time period, the number of American households owning mutual funds has risen by 1.6 million, to 53.3 million. These, trumpets el presidente, are great strides in the attainment of "ownership."
– Here at The Daily Reckoning, we like these ideas, and we admire Bush’s single-minded approach. Unfortunately, they are not worth the breath they were uttered upon. Bush is dangerously disillusioned. In the words of John MacKay, "Legislators are as powerless to abrogate moral and economic laws as they are to abrogate physical laws. They cannot convert wrong into right nor divorce effect from cause."
– The economic law working against George W. is debt. You see, dear reader, the president fails to account for the unintended consequences of his actions when shaping policy, no matter how honorable his policies may be.
– More houses and stocks? Come on. Whatever George Bush means or intends or dreams, the whole policy is flawed. There can be no greater ownership. This is not an ownership society, it is a debt society. And Bush – and his ally Greenspan – have done their best to impress it on America.
– And the evidence keeps mounting. Today, we see the Congressional Budget Office has released its latest projection for this election year’s federal deficit. At $422 billion, it’s the greatest deficit the republic has ever seen, by far. The current record is at $375 billion, hit last year.
– The future is pretty bleak to "Whatever the short-term deficits, most analysts agree the budget picture will worsen considerably within the coming decade," says a source at AP. "That is when the huge baby boom generation will begin relying increasingly on Social Security and Medicare, driving those programs’ costs upward."
– These deficits must be financed with debt. Accordingly, federal debt has risen from about $3.4 trillion at the end of 2000 to $4.15 trillion in the first quarter of 2004 – a gain of 22%.
– Likewise, total U.S. nonfinancial debt – debts held by the government, households and companies outside the financial sector – has risen from $18.1 trillion in 2000 to $22.8 trillion in Q1 2004. "As a result," says the Moneybox column at Slate.com, "after holding steady for much of the 1990s, the ratio of nonfinancial debt has risen in each of the last few years and has topped 2-to-1 for the first time."
– "Every component of that debt has been rising in alarming ways," explains Slate. "Total household debt has soared from $7 trillion at the end of 2000 to $9.5 trillion in the first quarter of 2004, up 36%…the amount of outstanding mortgage debt has risen 43% in Bush’s first term, while consumer credit is up 20%. State and local government debt has risen sharply, too, up 33% since the end of 2000. And with investment banks and hedge funds taking full advantage of Alan Greenspan’s near-free-money policy, financial debt, too, has risen 35% since the end of 2000."
– Here at The Daily Reckoning, we find these numbers truly staggering…and we keep our eyes fixed on the bond markets for any sign of imminent crackup. On Wednesday, the 10-year Treasury bond yield hit a 4-month low of 4.08, before reversing sharply higher on Thursday and Friday. It settled at 4.29% when trading ceased for the weekend.
– Usually, equities move in the opposite direction to bonds, but not on Friday. They both fell. The Nasdaq fared worst, declining 1.55%, to 1,844. The Dow gave away 30 points, landing at 10,260 at 4 p.m. on Friday.
– We hate to throw cold water on Bush’s clever-sounding political ideologues and lofty posturing, but debt has to be repaid. And repaying debt directly inhibits increasing ownership…think increased personal bankruptcies and home foreclosures. Think less money diverted into 401(k) plans and medical savings accounts. Think less ownership.
– At least, less American ownership…and greater Asian ownership.
Bill Bonner, back in Paris…
*** Markets were closed on Monday. But the dollar went up on Friday.
Gold, bonds and commodities went down.
Is that surprising?
Well, not really. Things go up and down. Besides, none of these things are very far from where they began the year.
Whatever is going to happen is not happening yet.
*** "America has much worse regulation than France," said our friend Michel over lunch on Friday.
Michel reads the news. OSHA, SEC, EEOC, FDA, IRS – he knows them all…and has come up with an insight that will be novel to Americans.
"You Americans think France has worse regulation because you’ve heard horror stories about our 35-hour work week, European Union employment rules and so forth. But what you don’t understand is that France is a Latin country. We put laws on the books, but we don’t try to enforce half of them. There’s much more flexibility and negotiation in the traditional French system than in the Anglo-Saxon model.
"Americans have much more respect for rules and regulations. They take them much more seriously. They try to enforce them. That’s the problem.
"And it’s a growing problem in France too…our ruling elites have all gone to Harvard or Stanford. They love the American system of regulation, because it gives them much more power. They’re trying to apply it here. It’s the worst of both worlds: lot of rules…and now they want to enforce them!"
Michel recently received a tax bill from a local government. It was one of those curious little charges designed to cover the cost of sewage treatment.
"It’s outrageous," he explained. "I’m out in the country, not even connected to the communal sewage system."
"What did you do?" we asked.
"I didn’t pay it. They addressed me as ‘Dear Client.’ I’m not a client. So I threw it away."