Introducing Quant's Law
GODWIN'S LAW -- more a theory than a law -- speaks to the inevitable half-life of debate on the internet. Per Wikipedia, Godwin's Law states the following:
As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches one.
The natural corollary to Godwin's Law is that, as soon as Hitler or the Nazis pop up, the debate is effectively over. Whoever resorts to the cliché first is the automatic loser, being clearly void of anything more intelligent to say.
In that spirit -- and in light of the latest Wall Street disaster -- we propose the following "Quant's Law."
Whenever a quantitative fund manager makes reference to a "100 year storm (or flood)," a "10,000 year event," or an "X standard deviation occurrence," where X is any double-digit number, the probability of devastating financial loss approaches one.
Corollary to Quant's Law: In the financial markets,"10,000 year events" generally occur every 5 to 7 years.
The inspiration for Quant's Law comes from David Viniar, Chief Financial Officer of Goldman Sachs. In reference to the spectacular multi-billion-dollar meltdown of two quant-driven Goldman funds, Mr. Viniar made apologetic reference to "25 standard deviation moves, several days in a row."
Twenty-five standard devations, hmm. How to put such a wild statistic in perspective?
Well, considering it only takes three standard deviations to cover 99.7% of the bell curve, we unscientifically estimate the likelihood of a twenty-five standard deviation move to be on par with Britney Spears getting elected President of the United States.
Hit me baby one more time.
Too big for their britches
The most remarkable thing about these quant funds (ignorance of history aside) is their seeming lack of acquaintance with basic market realities. One would think that rocket scientists (actual rocket scientists!) would have at least passing acquaintance with the laws of physics; specifically, the physics of what happens when everyone piles into the same handful of trades.
One would think so, but apparently not.
Rick Bookstaber, seasoned risk manager, accomplished quant, and author of a timely book called A Demon of Our Own Design, thinks the problem ultimately comes down to size. These guys simply let their positions get so big, and so correlated, there was no one left on the other side. Bookstaber writes:
...in aggregate these quant funds may be operating beyond the capacity of the markets... right now that is pretty much true by definition, since it seems they can't get out of each other's way while they try to liquidate. But even during less crisis-prone times, the money employed by these strategies might be more than the market can absorb.
Again we say, hmm. Shouldn't a minor factor like "how much the market can absorb" be an integral part of any black box management strategy? Shouldn't the impact of one's own market footprint be taken into account, especially when staggering leverage is employed?
In a latticework piece titled The Principle of Ever Changing Cycles , we wrote about how the zero-sum nature of markets resembles the parimutuel structure of the race track. The "Principle" itself was taken from a half-century old book, long out of print, called "The Secrets of Professional Turf Betting" by Robert Bacon.
The flailing quants (and their investors) would have done well to absorb Bacon's dog-eared wisdom. Taking huge risks in pursuit of vanishingly small returns rarely makes sense; it shouldn't take a supercomputer to figure that out. The old lesson, underscored once again, can perhaps be stated thusly: If you look around and see everyone doing the same thing you are -- and doing it in huge size no less -- then SOMETHING IS PROBABLY WRONG.
Time to buy gold stocks
Moving on from the quants and their crowded house... let us now enter a nearly deserted house. We refer here to those few crazy, or contrarian enough, to like gold stocks at current levels.
The title says it bluntly. We think it is time to buy gold stocks, and will here present our basic top down argument as to why. But first, two caveats:
- We're talking established producers. There are fortunes to be made in the junior gold stocks, no doubt, but picking juniors is not a top-down business; it's a rock-kicking business, in which detailed knowledge of management teams and exploration sites is key. Our argument here is macro in nature, and applies more to the "seniors" with proven reserves.
- This is an investing call, not a trading call. Gold stocks aren't necessarily about to turn on a dime. They could be yet lower a week from now, or even a month from now. Still, we feel gold stocks could put in a triple or quadruple from current levels -- over the course of months to years -- and it isn't clear when the move will begin in earnest. Given that it could be sooner rather than later, we think it's time to buy.
Cash to the rescue?
Let's begin with a quick recap of current events.
In the past few days, we've heard a lot about central banks making emergency injections of liquidity into the markets. For example, Bloomberg reports:
The ECB, the Fed and other central banks injected $154 billion into money markets on Aug. 9 and $135.7 billion on Aug. 10 amid fears that U.S. subprime mortgage losses will curtail lending.
...Central banks in South Korea, the Philippines, Singapore, Indonesia, India and Malaysia have said they are prepared to add cash to their systems if required to prevent a squeeze on credit...
The International Monetary Fund said last week that ``prompt action'' by central banks to add cash to the banking system should help avert a crisis in credit markets.
"Prompt action" won't save the day of course. It may ease the pain temporarily, but that's about it. Show us someone who thinks a modest injection can fix things, and we'll show you someone who swore things would never get this bad in the first place.
Inflation still looms...
Keep in mind that the global central banks, so ready and willing to avert this crisis with cash, were up until recently dealing with inflationary pressures... the result of having too much cash on the books.
Chinese inflation has accelerated to "the highest rate in more than 10 years," Bloomberg reports. Australia's central bank has raised inflation forecasts to "the top of its target range." Official inflation numbers for oil exporters in the Gulf ran as high as 11.8 percent last year. (Who knows what the real numbers are.) Russia's inflation is three times that of any other G8 country. In Europe, Ireland is sweating. (As for the likes of Venezuela and Iran, don't ask.) And food prices are rising everywhere, though government statistics deny it; the cost of milk, for example, just hit record highs in the United States. The beat goes on.
In brief, this pressure can be traced to two phenomena: the vendor finance arrangement and the petrodollar pump. The vendor finance arrangement is shorthand for the "Bretton Woods II" setup in which the United States sent mountains of dollars to Asian exporters, exchanging paper for "stuff." The Asian exporters, in turn, extended credit in pursuit of local job creation.
The petrodollar pump is a related version of the same, in which oil exporters took paper dollars for barrels of crude, and then pumped those dollars back into US assets.
In this manner, huge quantities of money were recycled back through equities and treasury bonds (fueling the party we just lived through). Those dollars also exerted slow-building inflationary pressure on the local economies piling them up. A country taking in truckloads of greenbacks has to print up currency of its own, you see, as exporters deposit dollars in the local bank and swap them for yuan, rubles, dinar, etcetera. The only alternative to printing is letting the home currency rise... which no one wanted to do for fear of slowing down exports.
...As subprime goes global
So thanks to their taste for mercantilist job creation and paper currency accumulation, the world's central banks are in a tough spot. They have to wrestle with inflationary pressures in the teeth of a global credit crunch.
And don't assume the subprime problem is contained to the United States, by the way. According to some accounts, other countries could have even more serious issues of the same flavor.
The South China Morning Post quotes Yi Xianrong, an academic with the Chinese Academy of Social Sciences, as saying "The quality of housing loans [in China] are much worse than the subprime loans in the United States." From his perch in London, Bloomberg columnist Matthew Lynn adds that "not only does the U.K. face its own subprime crisis, it could be far worse than in the U.S." And we have seen in recent days how truly international the debacle has become, with banks in Germany and hedge funds in Australia getting whacked.
This all feels like the tip of a credit-contraction iceberg as bleeding creditors turtle up. US banks now "refuse to accept subprime collateral," the Financial Times reports; meanwhile the New York Times notes that high-end real estate properties aren't selling -- even when someone wants to buy -- because even the worthiest of borrowers are having trouble securing loans.
Keep it Coming
The point of the above is not to predict disaster for equities or the onset of global depression. There is still a lot of money sloshing around. As we wrote a few weeks ago, in Make Way for the Sovereigns , Sovereign Wealth Funds by themselves have the heft (and the cash) to put a floor under the markets if they choose to do so.
Whether Sovereign Wealth Funds step up or not, though, we suspect the liquidity will have to keep coming; financial interventions can be long, drawn out affairs. As trend follower John Henry has observed, the Fed does not just "raise" and "lower" interest rates willy nilly. The tendency is to lower, lower, lower (repeat a few more times)... and then, when the tide turns, to raise, raise, raise and so on.
The global central bank pattern for the foreseeable future -- months stretching into years perhaps -- could be inject, inject, inject as gunshy creditors and wounded borrowers demand medication.
A Vicious Circle turns Virtuous
This is where the enthusiasm for gold stocks comes in.
Up until now -- that is, up until a few weeks ago -- upside for gold stocks was capped by at least three negative perceptions.
-- Modest inflation expectations. Food and energy aside, the general consensus of investors (until recently) was that inflation is "contained." (Kind of like subprime was contained, eh?) This belief was supported by the idea that low-wage competitors export deflation along with low-priced goods, and that global economic growth is robust enough to outpace monetary growth.
-- High and rising production costs. Mining companies were simultaneously blessed and cursed by the developing world's insatiable demand for raw materials; while accelerating demand led to higher metals prices across the board, it also led to labor shortages, tire shortages, transport bottlenecks, and killer production costs in general. The high price of production was seen, correctly, as cutting sharply into gold miner's profits.
-- Better alternatives in a rosy environment. When the sky is blue and the sun is shining, who really needs gold anyway? An environment in which everything is rosy, and inflation appears "contained," is not an environment supportive of gold stocks. Better to invest in emerging markets, multinationals, and private equity takeover plays in such times... anything linked to the cheery phrase "global economic boom."
Now consider the outlook ahead for gold stocks... particularly the possibility that all three factors could soon be turned around.. Let's revisit each in turn:
-- Rising inflation expectations. Seeing the worth of Wall Street's assurances, does anyone trust the word "contained" anymore? When various central banks are forced to continue injecting liquidity into the system -- and when the Fed is finally forced to cut rates -- the growing problem of inflation could reveal itself to all. (A diving dollar could underscore this also.) The general best-case scenario, we suspect, is one in which inflation rises quickly but not too quickly. The worst case scenario is a deflationary downward spiral... in which case "Helicopter Ben" earns his nickname, and gold becomes the only stable proxy for cash.
-- Flatlining, or even declining, production costs. The high price of crude oil is a function of supply and demand; more specifically, it is a function of the "lack of slack" between daily global supply and daily global demand. This means that oil is priced at the margins; any increase or decrease in the amount of slack could have powerful psychological effect. A short-term decline in demand, from the United States or elsewhere, could open enough slack in the system for the price of oil to fall. Oil will eventually just go back up again, of course, as world demand always comes back around. But if the global economy takes a breather, we could see temporarily lower energy prices and lower base metal demand. This relief could lead to lower production costs for gold miners -- fuel not so expensive, labor not so tight, truck tires not so hard to find etcetera -- even as general inflation expectations rise due to stimulus as noted above.
-- More focus on risk in an uncertain environment. In an uncertain world with storm clouds on the horizon, gold takes on a new luster. If investors express a desire to stay in equities but avoid financial tomfoolery, they could well focus on the sectors and industries that are "derivatives-free," featuring straight forward companies with unleveraged balance sheets. Gold mining can be an ugly business, but it's a solid one that the public (and institutionals) can understand.
Not Crowded
So that about sums it up. Gold stocks previously looked unappealing in a world of high and rising production costs, subdued inflation expectations, and wanton disregard for risk. All those factors look set to shift.
If you pull up a chart of your favorite gold stock right now, of course, you probably won't be impressed... if anything the chart probably stinks.
That's a function of being early, we suspect. Everyone is still gawking at the market carnage, wondering how bad things are going to get. Few are thinking about the next leg of the cycle, where the money is going to flow, and so on. Starting with some partial gold positions -- and a full helping of patience -- allows one to wait comfortably for the crowd to catch up.
Speaking of crowds and carnage, one last word on those crazy quants. The recent meltdown saw the phenomenon of good stocks going down even as bad stocks went up. The WSJ reports:
The stock market in the past few days has looked like it has gone haywire. Shares that would have been expected to fall have risen, and shares that might be considered safe have taken big hits.
Behind the bizarre behavior: quantitative hedge funds. These funds rely on computer models to pick which stocks to bet on and which to bet against. They've been liquidating positions to raise cash. They sold stocks they liked, forcing prices lower. For the stocks they sold short, the opposite occurred; to exit from those positions, they were forced to buy.
The point? You can't trust a crazy market, and charts don't always give the whole picture. If more funds are forced to liquidate positions over the coming weeks, there will be an even greater variety of bargains to be had. And, paradoxically, the best opportunities could temporarily look like the worst.
Profitably Yours,
Justice
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