Monday, July 20, 2009

Markets Evolve & UnCoil....Get Used To It.

As markets have gotten crushed, people always tend to blame one hypothesis over another.

Efficient Market Hypothesis VS. Behavioral Finance.
Leverage vs. Complexity
Deregulation vs. Regulation
Sub Prime Vs. Predatory Lending
Nationalization Vs. Socialized Losses

Who is right? is there an argument to be made that any one of these ideas are to blame?

Its a draw, Everyone one of these are somewhat to blame, but they all equally share one trait.

They all failed to evolve with market dynamics.

Bottom line....Markets Evolve.

Investors have to adapt to changing dynamics.

We all know what happens in any type of asset bubble. People think they are behaving rationally when they make investment choices, only after the fact, when they are holding the bag will they realize that their thinking was flawed.

But, in defense of Efficient Markets, they are only relying on information that is currently available.

So its a little bit of are neither exclusively efficient nor behavioral.

Logic and emotions have to be in proper balance for markets to be relatively efficient. When Black Swan events happen, both logic and emotions get swept away.

So pitting one hypothesis over another is fruitless if you don't understand the basic premise that markets always evolve and recalibrate.

The best way to look at it is the wave of quantitative models that set the market. These models are based off of some rational expectations of past data. When things go off, we have whats called "QUANT QUAKE".

Most statistical arbitrage hedge funds are market neutral, meaning they employ long/short trades that they think will converge over time, what ever profits are made are more then enough to offset losses.

The only problem here is when one particular hedge fund strategy is overused, any type of quake can lead to dire consequences, as investors are not properly hedged.

For example, August 2007 was a bad time for global hedge funds who put on the Statistical Arbitrage Trade. These funds got totally crushed for no apparent reason other then the start of the credit crisis evoking margin selling. Quite simply, the models worked until a time they didn't, too many people were in the same trade. The ensuing correction was due to a significant "Quantitative Quake". The models no longer worked because the liquidity/margin/leverage needed to support these programs were no longer in existence.

This was a situation where the entire market got taken down viciously because of statistical arbitrage funds forced liquidation.

Most Stat Arbitrage hedge funds were obliterated and were shut down.

I know this is hard to believe that Goldman actually losses money, but back then Goldmans Global Alpha Fund got rocked losing 30% of its value in one month!

As you can see...someone sneezed.

Take a look way back to LTCM.

The markets had a worse correction, but the damage was contained away from hedge funds. The only reason was that not that much money was in stat arb funds compared to 2007-2008, there was not a cascading effect on the entire market. Simply, investors started to fund and invest in hedge funds that didn't get hurt during this time. What were they doing not to get shelled? The entire hedge fund industry evolved from this moment.

Many hedge fund strategies were deployed using complex quantitative models just because they didn't lose their shirts because of LTCM.

Pension funds and retirement funds started funneling money into these strategies because of their cross market tendencies, as well as their low volatility and high performance.

As the money flowed into stat arb, the volatility post 2000-2002 for all US stocks diminished.

Why? Statistical Arbitrage is a market neutral strategy, meaning a form of mean reversion. You buy the losers and sell the winners...this way it dampens fluctuations. Year over year the SP 500 Volatility went down as stat arb assets went up.

From this alone, investors perceived less risk in the market and increased their leverage accordingly. The leverage built up right into the mouth of the August 2007 correction. Everyone was in the same strategy, a small blip in the market caused severe damage.

When the bottom fell out of the stat arb trade, you will notice that Volatility exploded to the upside, the entire basis for stat arb was destroyed.

So many hedge funds were born from LTCM's demise, most of them died in the sub prime collapse. But markets evolve, and there will be many more hedge funds that look at what went wrong and go out and start to raise money for the next time.

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