Sunday, October 13, 2019

"On Markets and Reality"

This is an older piece from Alphaville's Izabella Kaminska and is a nice bookend to today's little series on risk:
Oct 09 2012
Welcome to the ‘Desert of the Real’ — a postmodern economy
Volatility guru Christopher Cole, who heads up the volatility fund Artemis Capital Management, is known for making interesting arguments when it comes to volatility and risk. Previous philosophical thoughts have questioned the concept of volatility, proposed that risk itself is changing, and that QE and other forms of government intervention are warping volatility beyond recognition.

His latest note, though, takes us to an entirely new dimension of market abstraction.

Here’s a starter sample:
Modern financial markets are a game of impossible objects. In a world where global central banks manipulate the cost of risk the mechanics of price discovery have disengaged from reality resulting in paradoxical expressions of value that should not exist according to efficient market theory. Fear and safety are now interchangeable in a speculative and high stakes game of perception. The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.

Likewise how certain are we that the elevated two-dimensional prices of risk assets and low spot volatility have anything to do with fundamental three-dimensional reality? In this brave new world volatility is an important dimension of risk because it can measure investor trust in the market depiction of the future economy. The problem is that the abstraction of the market has become an economic reality unto itself. You can no longer play by the old rules since those rules no longer apply. I know what you are thinking. You didn’t get your MBA to be an amateur philosopher – your job is to make cold-hard decisions about real money – not read Plato. You are out of luck. For the next decade this market is going to reward philosophers over students of business. Why? Because the modern investor must hold several contradictory ideas in his or her head at the same time and none of them really make any sense according to business school case studies. Welcome to the impossible market where…
We, for one, like where he’s going with this.

His point seems to be that it’s not just a question of the old rules changing. More that we may be standing on the edge of a paradigm shift so unexpected that nobody has yet been able to imagine it. A shift, we dare say, that could take conventional business and investment practice and spin it on its head entirely.
For now that means volatility is both cheap and expensive, according to Cole.
In many respects it’s a quantum investing universe.

This makes sense to us since it suggests that value itself can only really be determined by an independent observer, subjectively. Until it’s observed, it can be both valued and not valued simultaneously. Or perhaps, weirder still, there is no universal value system at all?

If that’s not mind-bending enough, here’s some more reflective thought from Cole:
The perfectly efficient market is by nature random. When the market has too much influence over the economic reality it was designed to mimic, the flow of information becomes increasingly less efficient with powerful consequences. Information becomes trapped in a self-reflexive cycle whereby the market is a mirror unto itself. Lack of randomness ironically leads to chaos. I believe this is what George Soros refers to as “reflexivity”. The impossible object is a visual example of reflexivity. Deeper dimension markets like volatility, correlation, and volatility-of-volatility are important because they measure our confidence in the financial representation of economic reality....