Once Something is Used for Hedging, it Becomes Useless for Predicting

Once Something is Used for Hedging, it Becomes Useless for Predicting

“Once something is used for hedging purposes, it becomes useless for predictive purposes.”

I know this is kind of a trivial insight now, but when I originally wrote it, it was more cutting-edge.  That said, it is still not fundamentally understood by most.  Most still look at a fragment of the puzzle.  Few look at the whole.

My poster-child for fragmentary thinking is this article: The end of stock market crashes? Do I disagree that correlations begin rising among risky assets toward the end of a bull market?  Not at all.  I have even written about it on occasion.

But if few understand this, then only a few will take shelter when correlations get high.  The rest will continue the disorderly party until the “market cops” show up in the bear market.

If it becomes a widespread idea, a market rule, etc., it may constrain behavior for some time, leading to no large crashes, but after a long while with no crashes some will assume that such crashes are not possible, and the rule is out-of-date.  Four  examples:

  • Stocks should yield more than Treasury bonds.
  • Stocks should yield more than 3%.
  • Q-ratio
  • CAPE10

Many items that have intermediate-term wisdom, and are known to have that wisdom, eventually get ignored.  The first two I listed were common market nostrums in their day.  The second seem to have more long-term validity, but get ignored by many who say, “It’s different this time!”

But even if everyone agrees that a certain risk measure is a correct risk measure, and it becomes a part of the market’s furniture, that doesn’t mean risk ceases.  It does mean risk takes a different form.  I think of all of the people decided not to take equity risk during 2000-2007, and decided to invest in residential real estate, or take risk through CDOs, subprime RMBS, etc.

Yes, they avoided risk in the stock market.  They ran into something far more fundamental.  The risk from all risky assets, public, private, leveraged, unleveraged, is everywhere, and it is very difficult to hide while taking risk.

The markets incorporate a lot of rules that have partial validity.  They are known variably, and apply variably.  At some points these rules seem sharp and prescient.  At other times they seem weak and outmoded.

This brings me back to my view that the market is an ecosystem where no strategy has permanent validity.  Strategies ebb and flow as many parties search for scarce returns.  There are well-known limits to markets, like the Q-ratio and CAPE10.  If the markets come up with another one, like risky asset correlations, it will have validity, restraining speculative behavior, until people overwhelm it, and a new bust happens.

The boom-bust cycle cannot be repealed.  But it takes many forms.

By: David Merkel, CFA of alephblog