Tuesday, 25 August 2015

Liquidity needs the return of the heroes.

The China meme has sucked in macro tourists and armchair generals and we know we have peak armchair generalness when Field Marshall Robert Peston BBC TWT(bar) takes to the field telling us how the world's biggest calamity has emerged over the last 3 weeks. 'Tail end Charlie' research units (those who are last to notice a change that they have to follow and are more concerned with following herding biases than being first with an idea) are now calling Chinese recession where four weeks ago everything was fine. Not saying there won't be, but the flip of opinion over the course of three weeks with respect to long term forecasts, that should be influenced by slow changing indicators, is laughable. There has been a polarisation of opinion with regards to China (the root cause of all this).

Some look for resolution of the fight between the 'buy the dippers'  and the 'doom 'n' gloomers through watching the stock volatility index (VIX) but I am watching all the usual culprits and oil especially. To get a really good 'muppet bottom' the whole lot should go up again, commodities, equities, HY, the lot. They haven't yet and so I'll leave fine tuning VIX micro trigger levels to the quant gurus and take a higher top down view. If this is make or break we can afford to lose the odd 3% of move for the sake of information resolution rather than trying to be point picking heroes.

I have some very clever friends who are telling me this is the start of a new economic phase and that China is having its own 1929. Not just those predictable overlay 'these look similar if I change the scales' charts, but in society's overall investment and development phase. I have sympathies with this but the problem, as ever, with China is that it is so hard to work out what is really going on there. Which makes me laugh all the more as we are getting some exceedingly detailed prognostications over not only China's outcome but the 3rd derivatives of it in individual Western stocks.

Should I be fading consensus in a market where we can't be that sure what is really going on as I also cannot know what is going on? Well yes. Probably more surely than in a market where I know it is easy to see what is going on and it is only me who doesn't know what that 'going on' is. If the majority of people bet that the next lottery draw will be 17 36 02 28 13 04 it doesn't change the odds of it coming up and I will happily bet against their guess being the result.

Price is rubbish, volatility is killing VaR models and the reduction in risk and willingness to establish positions, when the variance of perceived value to priced value can be so huge, means that liquidity vanishes. The 50 points SPX fall in the last hour of trading was a good example. What was that due to? News? Not that I saw. Some change in the economic outlook of everything? Don't bother asking an economist why the value of everything has fallen 10% versus fiat cash (now there's the irony) in the last couple of weeks as you will know that everything that follows will be rubbish.

These markets aren't for economists as they are too fast moving.  The best economists can do is to take the prices that you yourselves are creating via market actions and input them as fast as they can into their own models to predict new prices. Which is pretty irrelevant as the input prices will have changed by the time that they have done so and you will have stopped listening to them. Economists, like trading models, do fine as long as there aren't any sharp turns in the road to upset the predictive powers of their rear view mirrors. These markets are for psychologists. The brave and the bold will turn out the winners. These are the markets where realising true value and taking the position with little heed to traditional VaR measures will lead to gains and also to more stable markets.

There has been a lot of complaint from the buy side that banks are no longer there to provide the liquidity the markets need, the banks having reduced their proprietary books. But lack of liquidity being due to books having been reduced is only part of the reason. A bank trading book does not provide you with liquidity unless it is willing to take on your trade and it will only do that if it doesn't price the way you do, otherwise whenever you will be wanting to sell so will it.

So I postulate that the real missing ingredient here is diversity in trading and risk management style across the whole industry - banks and fund managers alike. With a standardisation of risk and trading models everyone will tend to want to do the same thing at the same time. What we actually need,  to add liquidity and normality to the markets, is a return of the old fashioned trading god. The superhero who would stand in when a price reached  'stupid' levels and pick it up with both hands rather than selling more because the money management model is telling him to reduce exposure, even if it is at stupid levels. Investment banks had their gods, Morgan Stanley and Goldman Sachs rates desks of the 90's had characters of whom films are yet to be made because they were too savvy to have themselves publicised. But these days the model is king and when things go doolally there is no sensible hand to steady things. The only hand expected being that of the Central bank. Oh pity the nannied generation.


Hwa Jurong said...
This comment has been removed by a blog administrator.
Anonymous said...

awesome piece AGAIN, but please do remember hetrogeneity is frowned upon nowadays-look at education, hoop jumping not applied learning! Lifestyles might well be different from the "old days" but that is all a front for groupthink in people's perceptions of the economy and how soceity "should" work. Try it, make a statement challenging the accepted narrative and see people spontaneously combust!

VandalsStoleMyHandle said...

I think the issue is more that the community has been destroyed. In a market-maker system, the market-maker is constrained by reputation amongst their peer group. Okay, they can and will screw you over if they think they can, but nonetheless, they're embedded in a community, which has certain expectations and notions of fair play, and will ostracise offenders.

Now, it's utterly changed. You're dealing with faceless savants openly trying to rip you off, with zero ties to any community, and zero obligations whatsoever. There is no society whatsoever, no social norms. It's Mad Max out there.

Polemic said...

Thank you Hwa Jurong,

Itt is most kind of you to consider me. I would be interested to know if you have instead thought of extending your services to a ready client set of 1.1 billion people not, I would guess, that far from your own global headquarters of Hwa Jurong, Private Money Lender Conglomerate Inc, in a place called China. From what I am being informed, their global shadow banking system is in a dire situation and I can only imagine that this will lead to huge opportunities for a private money lending business of high reputation and professionalism such as yours. If you have already approached this sector and found the terms they demand prohibitive I would be delighted instead to pass on your details to some friends of mine who own mining operations in Australia, as they have already expressed their need for additional funds via personal messages to 'lend me a few billion please mate'.

There are two other organisations that may be interested in your services so I will pass your references to them. Do you already know the FCA and SEC? I hope that they will be in touch.

All the best

Polemic said...

Vandals. It is nuts.
In dismantling the old system the regulators have left a landscape not good for purpose. They are the antibacterials that kills 99% of germs dead, leaving the 1% of resistant ones to become the new 100%.

John David said...

Liquidity can be created in two ways: through production and the resulting profits or through debt creation. Profits are recycled through the economy and build liquid capital. This is synonymous with equity. Conversely, central banks and governments have taken it upon themselves to manage the business cycle and have spent the last 25 years levering the system to accomplish their "growth" goals. This ever growing leverage became unsupportable (not enough income to pay off interest and principal)in 2007-2008 and collapsed. Since then central banks and governments have created another $57 trillion in debt, most of it completely unproductive, in an effort to support the unsupportable. As debt growth slows so does liquidity and at this point is almost non-existent: asset prices have been the primary recipient of the debt increase since 2008 and when you lever assets you by definition increase risk. When asset prices start going down margin and risk must be lowered. Time preferences become narrow quickly causing increased volatility, which is the antithesis of liquidity.