From The Milken Institute Review, November 11:
Before every financial bubble bursts, wise as well as unwise prophets issue warnings, sometimes years in advance. (Timing is part of the problem, as we’ll see later.)
Yet seldom has there been so much agreement, and so many signs, that securities markets and the U.S. economy are in a bubble that may soon peak:
- The hedge fund manager Michael Burry, featured in Michael Lewis’s book The Big Short for his winning bets on the 2008 housing market crash, has taken short positions (through options) in some of the highest-flying AI companies.
- The big AI corporations are so interlocked through a network of 11-figure investments that trouble in one could easily cascade through others and the wider economy.
- The disparity between affluent shareholders and the rest of the population has been growing steadily – just as in the Roaring Twenties, when soaring stock prices of the day’s high-tech corporations such as RCA encouraged indifference to structural economic weakness, notably severely depressed farm income. That period ended in the Great Depression.
- Despite the recent truce with China, Donald Trump’s tariff drive recalls the infamous beggar-thy-neighbor Smoot-Hawley Tariff Act of 1930, which deepened the Great Depression.
- The explosion of day trading and rise of meme-driven mass speculation, along with regulators’ seeming difference to letting unsophisticated small investors join the volatile world of private equity, raises warning signs about Main Street investors betting their farms on speculative ventures.
- Donald Trump and his family’s embrace of cryptocurrencies creating dangerous conflicts of interest in public policy, which when combined with increasing integration of cryptocurrencies with the banking system, is inherently destabilizing.
- Alarm bells are ringing over bad loans at regional banks, including Zions Bank, Western Alliance and Jefferies.
- Bankruptcies are spreading in the auto-supply sector, with problems not limited to embattled First Brands.
- Major technology firms, including Amazon and Microsoft, which in the past have always seemed to be hiring, have announced tens of thousands of layoffs.
Each of these straws in the wind may be less than dire news, yet together they suggest alarming weaknesses in the economy. The most convincing source of alarm may be the celebrated expert on bubbles, Yale economist and Nobel Laureate Robert Shiller. In a recent market forecast he noted that “history offers a cautionary tale: past technology booms produced only a handful of long-term winners.”
Shiller’s forecasting record is reassuring – or daunting, depending on your perspective. His book, Irrational Exuberance, whose title was borrowed from Alan Greenspan’s 1996 warning of a market collapse to come, was released with timing rare in the publishing industry, at the very peak of equities markets in March 2000. Not coincidentally, the $37 million, eight-story high Nasdaq sign in New York’s Times Square, commemorating the new dominance of tech stocks in the equities firmament, had been completed the previous month.
he four-year gap between Greenspan’s warning and the bursting of the bubble points to the difficulty of profiting from the eventual pop. It’s analogous to the challenge that blackjack gamblers faced in the days when skilled play based on statistical insight, if undetected by Las Vegas casino security, could win against the house. In practice, this meant casino surveillance would let a team executing carefully choreographed deception accumulate significant earnings. The so-called MIT blackjack team of the ’80s and ’90s was thus a meticulously trained theatrical troupe as well as a gang with formidable memory for hands played.
If the odds are against you, you will eventually go broke. But what if the odds are slightly on your side as in the case of the MIT gang? It is still essential to have a bankroll large enough to withstand losses until your advantage kicks in. Skilled individual bettors without those resources risk going broke, even without facing today’s ubiquitous casino countermeasures.
One poster child for this risk is the hedge fund manager Michael Berger....
....MUCH MORE
Very related:
Markets, Risk and Gambler's Ruin
From the Wall Street Journal:
Old Pros Size Up the Game
Thorp and Pimco's Gross Open Up on Dangers
Of Over-Betting, How to Play the Bond Market...MORE
From 2011:
Dreamtime Finance (and the Kelly Criterion)
I've been meaning to write about Kelly for a couple years and keep forgetting. Today I forget no more.
In probability theory the Kelly Criterion is a bet sizing technique used when the player has a quantifiable edge.
(When there is no edge the optimal bet size is $0.00)
The criterion will deliver the fastest growth rate balanced by reduced risk of ruin.
You can grow your pile faster but you increase the risk of ending up broke should you, for example bet 100% of your net worth in a situation where you have anything less than a 100% chance of winning.
The criterion says bet roughly your advantage as a percentage of your current bankroll divided by the variance of the game/market/sports book etc..
Variance is the standard deviation of the game squared. In blackjack the s.d. is 1.15 so the square is 1.3225.
As blackjack is played in the U.S. the most a card counter can hope for is a 1/2% to 1% average advantage with much of that average accruing from the fact that you can get up from a negative table.
Divide by 1.3225 and you've got your bet size.
It's a tough way to grind out a living but hopefully this exercise will stop you from pulling a Leeson, betting all of Barings money and destroying the 233 year old bank....
....MUCH MORE
In casino gambling it is the ultimate idle fantasy that one will find a game where the house miscalculate the payouts and offers up a positive expectation game to the customer. I found one once, a side bet in blackjack that was set up with a ~3% advantage to the player. Unfortunately the two limiting factors, a) number of resolved hands per hour—around 60 at a full table and b) a maximum bet limit of $25 dollars on the side bet meant that your expected win rate was $25 x 60 x 3% = $45 dollars per hour. Not exactly a get rich quick scheme but an amusing way to pass a couple hours.
I think of that evening when I see people talk about someone or something being on the wrong side of the market and attempt to calculate the odds the house is giving up and the optimal bet sizing to accelerate the accumulation of loot while minimizing the risk of gamblers ruin (the Kelly Criterion, see after the jump).
And then I wake up from my reverie.
From Neue Zürcher Zeitung's The Market.ch....
And some of the math:
Finally, another rule of life:
Cassandra's (Not so) Golden Rules About Investing (And Not Investing)
#21. NEVER
double-down (except when you have material non-public information and
deep pockets) or if you're Ed Thorp, or if you're playing at The
Martingale Room.
Don't double down, double up.
