Baruch is worried these days, Bento, lying in bed staring at the ceiling till the early hours unable to sleep. Two weeks ago he made the mistake of re-reading the last chapter of Bookstaber’s Demon of our own Design, and it made a sudden connection with something which had been knocking about in his head for a while — and he had a brainwave that made him quite depressed.
He hasn’t wanted to use this site to make market predictions, but he has to accept a doom-laden prediction is sort of implicit here. He is quite embarrassed about it, and uncomfortable, especially as the stockmarket is going up. Of course, as said before, this is not investment advice. If you trade off tips and ideas you picked up from anonymous websites, well then you are a very silly person indeed.
Basically, if you think we have seen weird unintended consequences of financial markets’ collapse, we may not have seen anything yet when it comes to the real economy. It may also explain why corporate spreads remain so stubbornly high.
We should spare a thought for Richard Bookstaber. Taleb is getting all the glory for “predicting” our current difficulties, is on TV more the whole time, can charge gazillions for speaking engagements etc. “Black Swan” is now part of the popular argot, like “Perfect Storm”, and is a staple of letters from hedge fund managers explaining how they lost you all that money even though they are supposed to be independent of market movements. Bookstaber wrote an equally timely and prophetic book and we don’t hear much about it any more.
Now, Baruch read Demons and disagreed with a lot of it, specifically with the idea that we can “design” market structures. I still stand by this, but there is a lot more to Bookstaber than a bunch of regulatory proposals. What struck Baruch particularly on this third reading were Bookstaber’s thoughts on the importance of specialisation, “coupling” and optimisation in financial markets. Baruch apologises for not getting this 1st time round.
Bookstaber makes the contrast between the furu, or chiclid, and the humble cockroach. The furu is or was a genus of fish found until recently in spectacular variety in the evolutionarily pristine Lake Victoria in Africa. Its particular feature, he writes, is that it
specialised to a remarkable degree. . . over the . . . 12,000 year life of the lake to at least 300 species, ranging in size from 4-12 inches. There are furu that survive as scavengers living off the organic waste of the lake bottom; algae scrapers that feed off shoreline rocks: snail crushers [with] a second set of powerful teeth. . . snail shellers that have developed long teeth to pull the snail out. . . larvae eaters. . . prawn eaters. . . and “child eaters” that eat the newly hatched eggs of other furu just after they are released from their mothers’ mouth, or in some cases by first ramming the mother to dislodge the eggs from her mouth.
Most types of furus are now extinct; bigger, tastier and highly voracious nile perch were introduced to the lake by enterprising fishermen in the 1950s. The various furu species didn’t know what hit (ate) them.
Now the cockroach is stupid. It is uninteresting, without subspecies variation. A country cockroach is the same as a town cockroach. It doesn’t actually seem to do anything special, like run fast, jump high, have interesting teeth or interesting colours. Cockroach risk management is crude but effective. “Its defense mechanism is limited to moving away from slight puffs of air. . . that might signal an approaching predator,” says Bookstaber. This response doesn’t even depend on a brain to work. Nerves in those little cockroach legs take care of this, leaving the brain to think higher cockroach thoughts, probably about filth and how to frighten my wife, you would think. Actually no. Theyhave no brain. They are so very stupid you can chop their heads off and they’ll lead a normal cockroach life for the 3-4 weeks it takes them to starve to death or die of dehydration. They can eat everything, even live off the glue on the back of stamps. A masterpiece of simplicity, the cockroach has survived for hundreds of millions of years “through many unforeseeable changes,” concludes Bookstaber, “jungles turning to deserts, flatland giving way to urban habitat, predators of all kinds coming and going”. To which I would add, even the invention of the flip-flop.
Presumably you can see where this is going. Cockroach behaviour is coarse. It is limited. It misses lots of things. It is not optimised for a particular time or location. It is a simple, foolproof creature, and while it never dominates any ecosystem it exists in, its behaviour allows it prosper in almost any environment. As such it has been moderately successful over an extremely long time.
Now re-read Bookstaber’s description of the furu and ask yourself: isn’t that a spectacular metaphor for the idea of the multi-strategy hedge fund? Except the “child eater” bit. Shooting out in all directions into specialised, fragile niches, like convertible arb, fixed income arb, merger arb, stat arb, quant and others, their spectacular exposion has been predicated, like the prisitine waters of Lake Victoria, on a special environment of low risk, low volatility and easy money. The longer that persisted, the more leverage could be used to goose returns. And more leverage had the effect of increasing the viable population following the strategy; the 2-3% returns these originally innovative but eventually over-used strategies were really earning could be turned into 20%-30% for more players than the unleveraged strategies could ever really support. They were all furu now.
Of course what was also happening is that the structure was getting more and more vulnerable to a internal or external shock. For the multi-strategy hedge fund, the shock was the collapse in mortgage markets; for the furu, it was the nile perch. But eventually what did for them both was entropy, or “life.” The structures they existed under were set to fall apart under stress. The conditions that underlay their growth had seemed to persist for a very long time in the lives of the market participants. But the 12,000 years the furus thrived in Lake Victoria was a blink of an eye in biological time. Similarly the last 30 years or so of bull market, certainly the last 5, marked by what I and others call the Great Moderation, was a shake of a lamb’s tail in the history of functioning stockmarkets. Both the furu and the multi-strategy hedge fund had made a similar mistake — they suffered from sample period error.
Forget the furu, now we need investors who trade more like cockroaches. The most classic cockroach strategies have to be fundamental, sector-based, directional ones. These strategies have been around for hundreds of years. They purposefully cut themselves off from certain statistical information they do not understand, do not need leverage, but have drawbacks: they are not terribly scaleable; they are costly in terms of research; they can produce variable results which while solid over time are rarely spectacular. They persist and prosper in a limited way. They never take over the world, they merely inherit it.
Now it’s time for the depressing brainwave. This would all be fine. A few furu-like hedge funds blowing up won’t matter so much. Many will probably miss the actual furu-fish much more, especially those in the rare fish collecting business. But what keeps Baruch up at night at the moment was the realisation that we have “optimised”, in a bad way, many of our industrial ecosystems as well.
What do I mean by this? “Just in time” production, outsourcing, and specialisation is now all-pervasive. Look at the production ecosystem of a humble mobile phone; it is mind-bogglingly complex. Nokia designs it, then farms out a whole bunch of contracts to a whole series of companies, many of whom subcontract themselves. For instance, Texas designs the chip, but it gets made by a foundry company, which sends it on to a PCB assembler, who gets delivered the memory and other semi content from other providers, quite often the same foundry, or another one. The PCB assembler may make many of the mechanical parts components itself but the more specialised parts get sent from specialised component makers who make things like the camera lens and module, or the microphone, anyway, blah blah blah, you get the idea. Eventually it all gets delivered to a big warehouse, trucked off in a big box with a bunch of its brothers and sisters to Carphone Warehouse and sold with a contract from a big telecoms operator.
How many companies are involved in this process? Tens, dozens, a hundred? How many are critical to the process, or could not be replaced by someone else in the chain? More and more of them. It is a massive web of complexity, inter-relatedness and specialisation. This is just the handset space. There are similar spontaneous ecosystems that spring up around PCs, cars, aeroplanes, and for all I know, pogo sticks and chocolate. It’s the fricking furu of Lake Victoria all over again.
So you see where I’m going, right? Do you understand my paranoia about this? Could this be why corporate spreads remain so high? Why the bondmarket is discounting a wave of corporate default? Right now we are undergoing a massive reset in global demand for just about everything. These fragile ecosystems have sprung up to supply us with 10% to 20% more stuff than we seem to want right now, and in markets which remain incredibly competitive. There was not always very much profit for the companies involved in the first place, margins of 5-10% in many cases. Many of them have too much debt. They probably won’t make it. Not enough of them are cockroaches.