The Aleph Blog » Blog Archive » The Rules, Part XXXIV

The Rules, Part XXXIV

“Once something is used for hedging purposes, it becomes useless for predictive purposes.”

I know this is kind of a trivial insight now, but when I originally wrote it, it was more cutting-edge.  That said, it is still not fundamentally understood by most.  Most still look at a fragment of the puzzle.  Few look at the whole.

My poster-child for fragmentary thinking is this article: The end of stock market crashes? Do I disagree that correlations begin rising among risky assets toward the end of a bull market?  Not at all.  I have even written about it on occasion.

But if few understand this, then only a few will take shelter when correlations get high.  The rest will continue the disorderly party until the “market cops” show up in the bear market.

If it becomes a widespread idea, a market rule, etc., it may constrain behavior for some time, leading to no large crashes, but after a long while with no crashes some will assume that such crashes are not possible, and the rule is out-of-date.  Four  examples:

  • Stocks should yield more than Treasury bonds.
  • Stocks should yield more than 3%.
  • Q-ratio
  • CAPE10

Many items that have intermediate-term wisdom, and are known to have that wisdom, eventually get ignored.  The first two I listed were common market nostrums in their day.  The second seem to have more long-term validity, but get ignored by many who say, “It’s different this time!”

But even if everyone agrees that a certain risk measure is a correct risk measure, and it becomes a part of the market’s furniture, that doesn’t mean risk ceases.  It does mean risk takes a different form.  I think of all of the people decided not to take equity risk during 2000-2007, and decided to invest in residential real estate, or take risk through CDOs, subprime RMBS, etc.

Yes, they avoided risk in the stock market.  They ran into something far more fundamental.  The risk from all risky assets, public, private, leveraged, unleveraged, is everywhere, and it is very difficult to hide while taking risk.

The markets incorporate a lot of rules that have partial validity.  They are known variably, and apply variably.  At some points these rules seem sharp and prescient.  At other times they seem weak and outmoded.

This brings me back to my view that the market is an ecosystem where no strategy has permanent validity.  Strategies ebb and flow as many parties search for scarce returns.  There are well-known limits to markets, like the Q-ratio and CAPE10.  If the markets come up with another one, like risky asset correlations, it will have validity, restraining speculative behavior, until people overwhelm it, and a new bust happens.

The boom-bust cycle cannot be repealed.  But it takes many forms.

 






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One Response to The Rules, Part XXXIV

  1. [...] David Merkel, “(T)he market is an ecosystem where no strategy has permanent validity.  Strategies ebb and flow as many parties search for scarce returns.”  (Aleph Blog) [...]

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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