Tuesday, August 14, 2007

An Autopsy

Here are my observations on the recent, errrr ..... hiccup (?) in quant-land (note for the squeamish that the photo is of an "Autopsy Dummy", available by mail order for those parents looking for an out-pf-the-ordinary gift for their pre-med inspired offspring):

1. Obviously some folks puked in July. You know who you are (either because it is YOU, or because YOU are an investor), so there is no need to repeat the roll-call here.

2. The usual suspects (as in the past) are "Macro-oriented Multi-Strats", de-leveraging, probably as a result of losses elsewhere (replay of same old song).

3. As is apparent to all, others vomited positions sympathetically, either because they panicked, they were told to, they had to as a result of external forces, or because of some type of stop loss.

4. It is unlikely that IBs predated funds since they all have rather large similar positions of their own.

5. Smallcap value got hit the worst , providing an eye-opening wake-up call to principals, risk-managers, and portfolio managers alike as to the true potential cost of trading this type of inventory in the modern age of limited dedicated liquidity provision. (Truc du chef: when grilling Quant PMs insure you ask them about the cost of liquidation during times of others liquidating. Any single digit whole number percentage estimate should be viewed with suspicion).

6. "Short-interest" IS a fine proxy for pari-passu risk. Anal-retentive types can have some confidence in piecing together competitors' portfolios with quarterly 13F-HRs, the absence of positions within these disclosures, and published short-interest even with the poor granularity, data quality and omissions.

7. The biggest contributor to out-sized (and yes, unprecedented) moves, in my opinion, was NEITHER the size of unwinding of positions, NOR the pari-passu or its concentration (though young 'uns who got spanked should take note), but the fact that the quantitative & stat-arb communities are the dominant liquidity providers in the US equity markets. It was their withdrawal from providing liquidity, exacerbated by mimetic liquidation and prevailing market structure that made it seem so bad. Likewise, when the news was "out", and rumour was fact, and demands for liquidity reversed direction, so too were the liquidity-providers absent permitting the similar magnitude reversal on Fri and Monday.

8. We all have known that (like US energy policy) US equity market structure is fragmented and sucks. One couldn't have designed such a byzantine order even if that were one's expressed objective. We know that specialists are the scum of the earth having been granted monopoly front-running privileges (which they pursue in earnest), and that, in their place, the new breed of liquidity provider (DEShaw, Two-Sigma, Citadel, Tykhe, Highbridge, and the IBs) are purely discretionary in their dedication and application of capital. This should serve to heighten awareness of what it might cost to "get-out", and lead EVERY participant to qualify any answer regarding the cost of trading, and b y extension the value of "mark-to-market" in general, and the cynicism and discounts that an investor may wish to attribute to such values ascribed to holdings by agent-managers.

9. Lots of Capital remains deployed in relative value long vs. Short strategies. Short-interest remains asymmetrically high on the tails of this deployment in aggregate, particularly i "expensive" thematic high-growth, high-earnings momentum situations. On the long-side a reasonable amount remains dedicated to smaller-cap and value-biased situations that en-masse, have a higher-sensitivity to market-wide earnings . Some of the recent poor performance is related to exposure to this "spread" and the market herd's current preference for earnings stability and growth "at any price" rather than suffer the humiliation (and pain) of the long-side higher-probability earnings torpedoes. This is a secular preference of the market and will diminish only with evolution of new macro info.

10. SO: We've large dislocation. Large reversal. Some cuts, scrapes, and bruised egos. But being back where we started, I cannot help but think the conditions that led to "the event" remain: excessive leverage in a deteriorating credit and risk-appetite environment, high- pari-passu, shitty market structure, uncertain behaviour in respect to stomaching losses, and portfolio assymetries that have the potential to continue to yield negatively skewed risk vs. reward in the short-term. Look for some backfill as participants look to take advantage of the bounce to reduce leverage further.

11. Last but not least: Four-dollars of long position and four dollars of short position short per dollar of equity?!?! These guys really are either extremely stupid, or have a cigarette-smoking like death wish. I am not going to preach and moralize about it, but IF during "normal" times, one is carrying the kind of gearing, it simply leaves no margin for error in the event of the unforeseen, and as I have said before "Sometimes shit just happens...". I guess there are still somethings that a PhD at Stanford, MIT or UChicago cannot teach you....

7 comments:

The Olive Oil Gazette said...

Down the road, the whole episode of the last few years kind of taints a whole large data set with the investigating officer's fingerprints, doncha think?

"Cassandra" said...

I dissuade all from data-mining, though it is difficult to fully escape all tinges of data-snooping. For example, even though I demand all potential strategies to "make sense" (i.e. NOT be too divergent) both behaviourally or financially, "what makes sense" itself is already tainted by future information. This alone should make one and all suspicious of the world-class idiot savants with PhDs who havn't had their his hides handed to them by tail events, from the get-go. I put to you that it remains an art form and not a science - at least in part - and that even the best PhDs are best harnessed when tethered to practitioners with sufficient cynicism and awareness to bridge the gaps between stats, the workbench, and reality.

Anonymous said...

The issues of risk assesement go even deeper than quants, stats, workbench etc . . .

What do I mean?

A study published in June 05 in the journal Psychological Science found that emotionally impaired people are more willing to pursue aggressive growth investing strategies. Researchers asked 41 people with normal IQs to play a simple investment game. Fifteen of the group had suffered lesions on the areas of the brain that affect emotions.

The result? Those with brain damage outperformed those without. The scientists found that emotions led some subjects to avoid risks, even when the potential benefits far outweighed the losses.

Antione Bechara, an associate professor of neurology at the University of Iowa, says the best investors are those able to feel no emotions while trading. He called such investors "functional psychopaths."

-pi

Anonymous said...

Nonetheless, one can imagine the niggling doubts about seeded drill samples that cores extracted from the hardwired trading bedrock (sorry, it just jumped up and got hold of me. Sick bags are available from your shift supervisor.) are going to present to future prospectors - at least until its forgotten.

pi - I remember that, but were they the best when whatever it was stopped working? Or were they doing it all to eventually get 'caught', as is a little typical?

CB

Anonymous said...

The Japanese housewives have spoken. "We don't like your Yankee dollars." My ouija board says 108-109 then to 100.

-pi

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