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Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. Keynes (1919)
A "Truman Show" World
March 14, 2014
by Doug Noland
March 13 – Financial Times (Miles Johnson): “In the ‘Truman Show’, the late nineties Hollywood film, the eponymous character lives a seemingly charmed world, snuggled comfortably into an American suburbia of white picket fences and crisply cut lawns. But gradually Truman starts to notice something is not quite right. He is actually trapped inside a film set controlled by hidden directors, and discovers to his horror that he is the unknowing star of the world’s most popular reality TV show. The question some of the world’s biggest hedge funds are starting to ask is whether overly placid investors will also wake up to discover they are living in a ‘Truman Show market’ - where central bankers’ ultra loose monetary policy has manufactured a fake reality that is bound to end. For Seth Klarman, the manager of the $27bn hedge fund the Baupost Group who recently coined the analogy in a letter to clients, investors have been lulled into a false sense of security that is creating an ever greater risk of a sharp correction. ‘All the Trumans – the economists, fund managers, traders, market pundits – know at some level that the environment in which they operate is not what it seems on the surface,’ Mr Klarman wrote. ‘But the zeitgeist is so so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end.”
I love Seth Klarman’s “Truman Show” analogy – one that has surely secured a place in market lore. This line of analysis becomes only more pertinent with serious risks unfolding in China and the Ukraine. The securities markets have been so unbelievably “pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end.” And when they inevitably falter, protracted Bubbles tend to end with a bang.
Warren Buffett was on CNBC Friday discussing Berkshire’s underwriting of the “Billion $ Bracket Challenge.” “‘I should be institutionalized,’ Warren Buffett joked on CNBC Friday—talking about how he’s feeling about Berkshire Hathaway’s part in insuring a contest by Quicken Loans to offer a billion dollars for the perfect March Madness bracket. Buffett said in a ‘Squawk Box’ interview that the odds are much better than just a coin-flip on each game—which would yield about a 1 in 9 quintillion chance in winning.”
Insuring against the possibility of an individual correctly predicting the outcome of every game in the NCAA basketball tournament is an interesting insurance risk. Buffett states that predicting each game outcome is certainly better than a coin-flip, but there is sufficient data available to give the actuaries comfort that the risk of a contest winner is extremely low. This risk can be priced (apparently in the $10 million range) to ensure a very high probability for a profitable insurance transaction.
Over the years, I’ve made what I believe is an important (and conveniently disregarded) distinction: The traditional insurance business rests upon insuring against basically random and independent events. Actuaries have an enormous amount of data that allows the effective pricing of insurable risks, such as automobile accidents, house fires and deaths. “Insuring” against market and Credit losses is a completely different proposition. These types of losses are specifically neither random nor independent. They tend to come in “waves.” And these waves tend to hit precisely when everyone is all bulled up – i.e. convinced market risk is extraordinarily low. Writing/selling such protection is more financial speculation than selling insurance. Especially during extended bull markets, it is akin to writing flood insurance during a drought.
Using Buffett’s coin-flip example, the odds of flipping “heads” in a single toss are one in two (50%). But how about the odds of ten consecutive heads? The probabilities are actually extremely low (about one in 1,000). But after 10 heads in a row, what is the probability that the 11th flip is heads? Well, it’s 50%. The outcome of the 11th flip is random and independent of the previous 10.
Market outcomes are anything but random. The market has flipped “heads” (gains) five years in a row. And after such a long period of rising stock prices, market participants perceive that the odds of another year of “heads” remain exceptionally favorable (upwards of 100%). Credit conditions have similarly turned up “heads” after “heads,” with losses declining year after year. Reflecting the low cost of market “insurance”, the “VIX” equity volatility index and Credit risk premiums have recently traded near multi-year lows.
And this gets to the heart of one of the serious issues I have with the Fed’s “Truman Show” World: Federal Reserve (and global central bank) rates, balance sheet and market intervention/backstop policies have completely distorted market prices, marketplace behavior and market risk perceptions. Securities and asset prices have been mispriced. The cost of market “insurance” has been mispriced. These mispricings have incentivized enormous speculation and leveraging. And the myriad associated costs go way beyond inflated securities prices and market exuberance.
I concluded my January 3, 2014 “Issues 2014” CBB with the following: “At this point, conventional analysis seems particularly oblivious, which increases the risk of the proverbial ‘black swan.’ And when it comes to Bubbles and ‘black swans,’ I tend to see bursting Bubbles (i.e. ‘black swans’) as high probability outcomes. What tends to make them so-called low probability events is only the uncertainty of their timing.”
Of course, such comments are completely dismissed at this phase of the speculative cycle. Nonetheless, the current backdrop prompts me to raise the “black swan” issue again this week. The “Truman Show” World is priced for minimal market risk. Fiscal and monetary policies ensure endless cheap liquidity, strong corporate profits, rising asset prices and reliable GDP expansion. Any disappointment will be met with additional QE, of course. The “Truman Show” World perceives the Fed is there attentively to backstop market liquidity and asset prices. The Fed is in complete control – not gonna allow any bad outcomes.
The “Truman Show” World assumes that Fed policymaking has eradicated market “tail risk”. Indeed, the marketplace has enjoyed an intoxicating string of “heads” coin flips and is fully positioned for more Fed-induced “heads” to come. After all, with the Fed having ensured a string of “heads,” only a complete moron would wager on the next flip coming up “tails.” Writing market risk “insurance” has been virtually free “money.”
Yet, it’s again that issue of market outcomes as neither random nor independent. Extraordinary monetary stimulus has had a profound impact on asset prices and market perceptions. Sure, the activist Fed has ensured many “heads” in a row and an emboldened marketplace has fully priced in more to come. And these bullish market perceptions do increase the odd of another “heads.” More importantly – I would argue pertinently – this backdrop also ensures that an unexpected “tails” would at this point risk serious market dislocation. Said differently, behavior and perceptions in the “Truman Show” World – certainly including the belief that the Fed won’t allow a tail risk event – have created potentially acute market vulnerability to perceived low-probability outcomes.
The germane issue is that the Federal Reserve doesn’t control China, Ukraine or Russia. The combined power of the Fed, Bank of Japan, ECB and Bank of England’s balance sheets just doesn’t command great influence on Russia’s Putin or China’s policymakers – or geopolitical issues for that matter. Actually, a strong case can be made that “Western” monetary inflation has at the end of the day had a profoundly destabilizing impact on geopolitics. Putin these days surely doesn’t buy into the “Truman Show” World. He likely despises it.
Friday from a leading Wall Street firm: “The pressure being applied to Moscow by financial markets will likely help resolve the crisis…” This is a commonly held view (within the “Truman Show” World Bubble). “Globalization” – with its heavily interdependent economies, financial systems and markets – provides the added benefit that disputes will now be handled through market pressure and sanctions – rather than tanks and missiles. It’s an element of this halcyon “tail risk”-free World.
I remember clearly the view in the marketplace back in early-1998 that “the West would never allow a Russian collapse.” It was exactly this view that had incentivized enormous speculative leveraging and excess. One might have thought the 1997 Asian Tiger collapse would have had market players on guard against a similar outcome for Russia. Instead, the view was that with the IMF and global policy makers now aggressively on the case, one need no longer fear another crisis.
So-called “black swans” are by definition unexpected, perceived very low-probability market occurrences with major consequences. While not predictable, I would argue one can identify backdrops conducive to major market dislocations. For one, there must be significant speculative leverage. Everyone would generally be on the same side of the boat (“crowded trades”). There would be potential for a series of perceived non-correlated asset classes to abruptly become highly correlated, catching those (especially speculators using leveraged) exposed to outdated notions of diversification. There would be a predominant market misperception that has been integral to speculative trading/positioning. There would likely be a major government role that has been instrumental in the performance of the economy, markets and risk perceptions. There would generally need to be an extended “bullish” (inflationary) market cycle where optimism/exuberance becomes fully embedded in market pricing, psychology and risk-taking. There would be an expectation for ongoing abundant cheap liquidity. And there would be a potential catalyst with the potential to invalidate widely-held misperceptions.
Also from the above FT “Truman Show” article (Miles Johnson): “Sir Michael Hintze, chief executive and founder of CQS, one of Europe’s largest hedge funds, has argued that loose central banks have actually increased the riskiness of markets as a result of their policies forcing too much money into the same assets, meaning any corrections are likely to be sharper than normal. ‘Everyone is thinking the same and being driven into the same trade… Shifts when moving from one state to another can be difficult and abrupt. It is not healthy to have a ‘rigged’ market’. Yet, for now, as long as markets continue to believe in the willingness and ability of central bankers to maintain current conditions, few hedge fund managers are ready to make any big bets against a reversal.”
Friday’s meeting between Secretary Kerry and Russian Foreign Minister Lavrov made little diplomatic headway. The West has warned of sanctions being imposed against Russia on Monday in the event of a Sunday referendum in Crimea. While the rhetoric was toned down by Friday, German Chancellor Merkel warned of “massive damage” if Ukraine territorial integrity was not ensured. Russia has warned that it will reciprocate with sanctions against the West. Its military has heavily mobilized. And on Thursday, China “warns of dangerous Russia sanctions ‘spiral.’” Reuters quoted China’s ambassador to Germany: “We don’t see any point in sanctions. Sanctions could lead to retaliatory action, and that would trigger a spiral with unforeseeable consequences.”
The “Truman Show” World has no role for financial and economic sanctions between G8 nations – let alone potential armed conflict between the West and Russia. And there’s no contemplation of how an unfolding financial crisis in China might disrupt global finance, economics and geopolitics. To be sure, global markets have entered a period of acute uncertainty. From my perspective, it’s only the degree of financial fragility that is open to debate.
There is today a not insignificant probability that the situation in Ukraine spirals out of control – with unforeseeable financial, economic and political ramifications. I would argue years of uncontrolled central bank inflationism have played an integral role in today’s highly unstable backdrop. At the same time, all the central bank liquidity ensures that markets are priced for the “Truman Show” World as opposed to the less-than-“resplendent” real world.
I’ll conclude with a Keynes quote from 1919 that seems more pertinent by the year: “Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
This particular quote has been used repeatedly over the years, to the point where the “one man in a million” would seem to understate the number of folks that appreciate the diagnosis. I’ll suggest Keynes’ ratio may actually still apply. I believe few recognize the degree to which central bank liquidity and assurances coupled with speculative finance on an unprecedented worldwide scale have distorted markets, spending, incomes, asset prices, economies, wealth distribution and societies at all corners of the globe. The World is simply not as perceived in today’s “Truman Show.” The more sophisticated speculators appreciate this and, perhaps, have begun to take some risk off.
A "Truman Show" World
March 14, 2014
by Doug Noland
March 13 – Financial Times (Miles Johnson): “In the ‘Truman Show’, the late nineties Hollywood film, the eponymous character lives a seemingly charmed world, snuggled comfortably into an American suburbia of white picket fences and crisply cut lawns. But gradually Truman starts to notice something is not quite right. He is actually trapped inside a film set controlled by hidden directors, and discovers to his horror that he is the unknowing star of the world’s most popular reality TV show. The question some of the world’s biggest hedge funds are starting to ask is whether overly placid investors will also wake up to discover they are living in a ‘Truman Show market’ - where central bankers’ ultra loose monetary policy has manufactured a fake reality that is bound to end. For Seth Klarman, the manager of the $27bn hedge fund the Baupost Group who recently coined the analogy in a letter to clients, investors have been lulled into a false sense of security that is creating an ever greater risk of a sharp correction. ‘All the Trumans – the economists, fund managers, traders, market pundits – know at some level that the environment in which they operate is not what it seems on the surface,’ Mr Klarman wrote. ‘But the zeitgeist is so so damn pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end.”
I love Seth Klarman’s “Truman Show” analogy – one that has surely secured a place in market lore. This line of analysis becomes only more pertinent with serious risks unfolding in China and the Ukraine. The securities markets have been so unbelievably “pleasant, the days so resplendent, the mood so euphoric, the returns so irresistible, that no one wants it to end.” And when they inevitably falter, protracted Bubbles tend to end with a bang.
Warren Buffett was on CNBC Friday discussing Berkshire’s underwriting of the “Billion $ Bracket Challenge.” “‘I should be institutionalized,’ Warren Buffett joked on CNBC Friday—talking about how he’s feeling about Berkshire Hathaway’s part in insuring a contest by Quicken Loans to offer a billion dollars for the perfect March Madness bracket. Buffett said in a ‘Squawk Box’ interview that the odds are much better than just a coin-flip on each game—which would yield about a 1 in 9 quintillion chance in winning.”
Insuring against the possibility of an individual correctly predicting the outcome of every game in the NCAA basketball tournament is an interesting insurance risk. Buffett states that predicting each game outcome is certainly better than a coin-flip, but there is sufficient data available to give the actuaries comfort that the risk of a contest winner is extremely low. This risk can be priced (apparently in the $10 million range) to ensure a very high probability for a profitable insurance transaction.
Over the years, I’ve made what I believe is an important (and conveniently disregarded) distinction: The traditional insurance business rests upon insuring against basically random and independent events. Actuaries have an enormous amount of data that allows the effective pricing of insurable risks, such as automobile accidents, house fires and deaths. “Insuring” against market and Credit losses is a completely different proposition. These types of losses are specifically neither random nor independent. They tend to come in “waves.” And these waves tend to hit precisely when everyone is all bulled up – i.e. convinced market risk is extraordinarily low. Writing/selling such protection is more financial speculation than selling insurance. Especially during extended bull markets, it is akin to writing flood insurance during a drought.
Using Buffett’s coin-flip example, the odds of flipping “heads” in a single toss are one in two (50%). But how about the odds of ten consecutive heads? The probabilities are actually extremely low (about one in 1,000). But after 10 heads in a row, what is the probability that the 11th flip is heads? Well, it’s 50%. The outcome of the 11th flip is random and independent of the previous 10.
Market outcomes are anything but random. The market has flipped “heads” (gains) five years in a row. And after such a long period of rising stock prices, market participants perceive that the odds of another year of “heads” remain exceptionally favorable (upwards of 100%). Credit conditions have similarly turned up “heads” after “heads,” with losses declining year after year. Reflecting the low cost of market “insurance”, the “VIX” equity volatility index and Credit risk premiums have recently traded near multi-year lows.
And this gets to the heart of one of the serious issues I have with the Fed’s “Truman Show” World: Federal Reserve (and global central bank) rates, balance sheet and market intervention/backstop policies have completely distorted market prices, marketplace behavior and market risk perceptions. Securities and asset prices have been mispriced. The cost of market “insurance” has been mispriced. These mispricings have incentivized enormous speculation and leveraging. And the myriad associated costs go way beyond inflated securities prices and market exuberance.
I concluded my January 3, 2014 “Issues 2014” CBB with the following: “At this point, conventional analysis seems particularly oblivious, which increases the risk of the proverbial ‘black swan.’ And when it comes to Bubbles and ‘black swans,’ I tend to see bursting Bubbles (i.e. ‘black swans’) as high probability outcomes. What tends to make them so-called low probability events is only the uncertainty of their timing.”
Of course, such comments are completely dismissed at this phase of the speculative cycle. Nonetheless, the current backdrop prompts me to raise the “black swan” issue again this week. The “Truman Show” World is priced for minimal market risk. Fiscal and monetary policies ensure endless cheap liquidity, strong corporate profits, rising asset prices and reliable GDP expansion. Any disappointment will be met with additional QE, of course. The “Truman Show” World perceives the Fed is there attentively to backstop market liquidity and asset prices. The Fed is in complete control – not gonna allow any bad outcomes.
The “Truman Show” World assumes that Fed policymaking has eradicated market “tail risk”. Indeed, the marketplace has enjoyed an intoxicating string of “heads” coin flips and is fully positioned for more Fed-induced “heads” to come. After all, with the Fed having ensured a string of “heads,” only a complete moron would wager on the next flip coming up “tails.” Writing market risk “insurance” has been virtually free “money.”
Yet, it’s again that issue of market outcomes as neither random nor independent. Extraordinary monetary stimulus has had a profound impact on asset prices and market perceptions. Sure, the activist Fed has ensured many “heads” in a row and an emboldened marketplace has fully priced in more to come. And these bullish market perceptions do increase the odd of another “heads.” More importantly – I would argue pertinently – this backdrop also ensures that an unexpected “tails” would at this point risk serious market dislocation. Said differently, behavior and perceptions in the “Truman Show” World – certainly including the belief that the Fed won’t allow a tail risk event – have created potentially acute market vulnerability to perceived low-probability outcomes.
The germane issue is that the Federal Reserve doesn’t control China, Ukraine or Russia. The combined power of the Fed, Bank of Japan, ECB and Bank of England’s balance sheets just doesn’t command great influence on Russia’s Putin or China’s policymakers – or geopolitical issues for that matter. Actually, a strong case can be made that “Western” monetary inflation has at the end of the day had a profoundly destabilizing impact on geopolitics. Putin these days surely doesn’t buy into the “Truman Show” World. He likely despises it.
Friday from a leading Wall Street firm: “The pressure being applied to Moscow by financial markets will likely help resolve the crisis…” This is a commonly held view (within the “Truman Show” World Bubble). “Globalization” – with its heavily interdependent economies, financial systems and markets – provides the added benefit that disputes will now be handled through market pressure and sanctions – rather than tanks and missiles. It’s an element of this halcyon “tail risk”-free World.
I remember clearly the view in the marketplace back in early-1998 that “the West would never allow a Russian collapse.” It was exactly this view that had incentivized enormous speculative leveraging and excess. One might have thought the 1997 Asian Tiger collapse would have had market players on guard against a similar outcome for Russia. Instead, the view was that with the IMF and global policy makers now aggressively on the case, one need no longer fear another crisis.
So-called “black swans” are by definition unexpected, perceived very low-probability market occurrences with major consequences. While not predictable, I would argue one can identify backdrops conducive to major market dislocations. For one, there must be significant speculative leverage. Everyone would generally be on the same side of the boat (“crowded trades”). There would be potential for a series of perceived non-correlated asset classes to abruptly become highly correlated, catching those (especially speculators using leveraged) exposed to outdated notions of diversification. There would be a predominant market misperception that has been integral to speculative trading/positioning. There would likely be a major government role that has been instrumental in the performance of the economy, markets and risk perceptions. There would generally need to be an extended “bullish” (inflationary) market cycle where optimism/exuberance becomes fully embedded in market pricing, psychology and risk-taking. There would be an expectation for ongoing abundant cheap liquidity. And there would be a potential catalyst with the potential to invalidate widely-held misperceptions.
Also from the above FT “Truman Show” article (Miles Johnson): “Sir Michael Hintze, chief executive and founder of CQS, one of Europe’s largest hedge funds, has argued that loose central banks have actually increased the riskiness of markets as a result of their policies forcing too much money into the same assets, meaning any corrections are likely to be sharper than normal. ‘Everyone is thinking the same and being driven into the same trade… Shifts when moving from one state to another can be difficult and abrupt. It is not healthy to have a ‘rigged’ market’. Yet, for now, as long as markets continue to believe in the willingness and ability of central bankers to maintain current conditions, few hedge fund managers are ready to make any big bets against a reversal.”
Friday’s meeting between Secretary Kerry and Russian Foreign Minister Lavrov made little diplomatic headway. The West has warned of sanctions being imposed against Russia on Monday in the event of a Sunday referendum in Crimea. While the rhetoric was toned down by Friday, German Chancellor Merkel warned of “massive damage” if Ukraine territorial integrity was not ensured. Russia has warned that it will reciprocate with sanctions against the West. Its military has heavily mobilized. And on Thursday, China “warns of dangerous Russia sanctions ‘spiral.’” Reuters quoted China’s ambassador to Germany: “We don’t see any point in sanctions. Sanctions could lead to retaliatory action, and that would trigger a spiral with unforeseeable consequences.”
The “Truman Show” World has no role for financial and economic sanctions between G8 nations – let alone potential armed conflict between the West and Russia. And there’s no contemplation of how an unfolding financial crisis in China might disrupt global finance, economics and geopolitics. To be sure, global markets have entered a period of acute uncertainty. From my perspective, it’s only the degree of financial fragility that is open to debate.
There is today a not insignificant probability that the situation in Ukraine spirals out of control – with unforeseeable financial, economic and political ramifications. I would argue years of uncontrolled central bank inflationism have played an integral role in today’s highly unstable backdrop. At the same time, all the central bank liquidity ensures that markets are priced for the “Truman Show” World as opposed to the less-than-“resplendent” real world.
I’ll conclude with a Keynes quote from 1919 that seems more pertinent by the year: “Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
This particular quote has been used repeatedly over the years, to the point where the “one man in a million” would seem to understate the number of folks that appreciate the diagnosis. I’ll suggest Keynes’ ratio may actually still apply. I believe few recognize the degree to which central bank liquidity and assurances coupled with speculative finance on an unprecedented worldwide scale have distorted markets, spending, incomes, asset prices, economies, wealth distribution and societies at all corners of the globe. The World is simply not as perceived in today’s “Truman Show.” The more sophisticated speculators appreciate this and, perhaps, have begun to take some risk off.
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