- The Big Picture - http://www.ritholtz.com/blog -

CASINO WALL STREET

Posted By Guest Author On January 4, 2009 @ 6:28 pm In Bailouts,BP Cafe,Credit,Derivatives,Markets | Comments Disabled

Bill Werner is an Engineer in Missouri City, Texas. The following is his attempt to Encapsulate All of Modern Economic History (with a bonus push to the future) in one easy to swallow red pill. Turn away and think what you like. Or swallow this red pill leading down the rabbit hole to see another aspect of what I call “The Vast Matrix of Models of Mind-stuff” we abide in.

~~~

“Credit-default swaps… have become mainly side bets on whether some company, or some subprime mortgage-backed bond, some municipality, or even the United States government will go bust.”
-Michael Lewis & David Einhorn in How to Repair a Broken Financial World (2009)

“‘The good part is that no matter whether our clients make money or lose money Duke & Duke get the commissions.’
‘Well, what do you think, Valentine?’
‘Sounds to me like you guys are a couple of bookies.’”
-Trading Places (1983 movie about the commodities market)

“The one thing every trader fears more than death itself is another crash like the one in ’29. They say it could never happen again because of all the safe guards that have been set up… but in our heart of hearts no trader believes it.”
-Martin Schwartz, 1998 “Pit Bull: Lessons from Wall Street’s Champion Trader”

Wall Street hates to be compared to gambling. If one reads the stock fundamental analysts reports and diversifies or buys an index fund, and diversifies further with some agency rated investment grade bonds, investing was said to be a sure fire way to retirement riches. That model is now in serious jeopardy after last year’s credit and stock market meltdown. A quick look at a chart of the Dow corrected for inflation quickly dispels any remnants of that myth.

[1]

via Dogs of the Dow [2]

It is shocking to see the Dow, when corrected for inflation, sitting at the same level in 1995 as in the peak of 1929. That is, when inflation is factored in, the Dow was finally breaking even 65 years after the crash of 1929. With the Fed pumping eye glazing sums of money into the economy to combat the present deflation this inflation corrected chart which includes the deflationary 1930′s may be back to the future.

Being presented with both present experience and historical data demonstrating that buying and holding stocks even with diversification is not a sure thing we have no rational choice but to acknowledge we are at risk of losing some of our investment even over a period of many years. Considering the very real possibility of rampant inflation a couple of years out, we could lose it for decades if we are not careful. Take another look at that inflation corrected chart and notice the inflation infested seventies effect on actual market wealth. And then compare it to the standard non-inflation corrected chart for the same period. The standard Wall Street stock market story versus the actual stock market wealth story for that period is a slap in the face now but could be a body blow in a couple of years. It also makes it obvious why the inflationary seventies is when high interest CDs and money markets became popular investments. In other words we are dealing
with deflationary risks we have not seen since the 1930′s and possible inflationary risks we have not seen since the 1970′s. Our models of what is happening will need to be adjusted accordingly.

Just how risky the markets are was well known on Wall Street at least by the traders on the front lines. As Market Wizard Marty Schwartz put it a decade ago, when it comes to the market having crash proof safeguards “in our heart of hearts no trader believes it.” With the advance of a cornucopia of advanced instruments such as options, futures, securitized debt, swaps and other assorted custom derivatives adding both complexity and risk, Wall Street started hiring physicists and mathematicians called quants to evaluate the risk inherent in these derivatives.

The most sophisticated physicists were trained in quantum physics, the bizarre sub-nano world where particles do not have a solid form but are rather waves of probability distributions. In other words the financial derivatives became quarks. The financial quarks exist in waves of Value at Risk (VaR in quant speak) probability distributions.

Any time you are dealing with probability distributions you are gambling. But in finance it is even worse because not only the operating environment for the product is changing but also the rules (government intervention) and products themselves are always changing. Therefore there will never be enough data on the actual circumstances to construct a model with the accuracy we would like. But even if there was enough data a manager somewhere will get greedy and order the “outliers” (unexpected data) be thrown out of the model.

In finance it is as if sometimes the jokers are left in the deck and sometimes not. And when the jokers are in the deck sometimes they are wild cards and some times they are dead cards and many times the player does not know until he plays the hand. Even for financial markets with more or less stable rules and products the fact that they do not have a normal distribution but have fatter tails (higher kurtosis in quant speak, more extreme events for the rest of us) than a normal distribution increases the risks (and rewards) by definition.

For the sake of simplicity let’s assume a best case scenario where we have a market with stable rules and products and a nice neat normal distribution. Even under those ideal (and unrealistic) circumstances not having a risk of ruin component separate from the normal operating model is pure negligence. The reason finance does not take risk seriously is because they always assume a “regression to the mean” will takes place (things will return to normal) and save them, not to mention a deep faith in government bailouts, golden parachutes, master of the universe bonuses etc. Besides the concept of risk of ruin comes out of gambling and Wall Street will never admit to gambling with retirement savings.

Back in the old world of production and plants the rules are different and often more severe. In industry the risk of ruin component in a plant is called an Emergency ShutDown System (ESD, aka Safety Instrumented System (SIS)) and is always separate from the process control system controlling production. The ESD is typically double or triple redundant and much thought goes into making these systems idiot (and manager) proof. This is especially helpful if it is your turn (or my turn) to make an idiot move (or be the manager). If industry behaved like finance Three Mile Island nuclear accidents (1979), Bhopal toxic releases (1984) and Texas City refinery explosions (2005) would be common place.

And if all gamblers behaved like Wall Street firms there would be no professional gamblers. The same could also be said for independent traders. In finance, trading and investing the Emergency ShutDown (ESD) System is typically stop loss orders but can also be hedges such as options, inverse ETFs etc. Remember if you lose half your money you will have to double the remaining half to break even. And if you try doubling up on risk to get your money back and end up losing half of the remaining half you will have to quadruple your remaining money to break even. As Market Wizard Ed Seykota once put it “There are bold traders and old traders, but no bold and old traders.” So take your risks but honor your stops at Casino Wall Street and Laissez les Bons Temps Rouler (Let the Good Times Roll)!


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2009/01/casino-wall-street/

URLs in this post:

[1] Image: http://www.ritholtz.com/blog/wp-content/uploads/2009/01/dow-1925cpi-log.gif

[2] Dogs of the Dow: http://www.ritholtz.com/blogwww.dogsofthedow.com/dow1925cpilog.htm

Copyright © 2008 The Big Picture. All rights reserved.