Profiting on Chaos
These hot, lazy days of summer have investors lulled to a comfortable slumber with a foot firmly on the gas pedal. The July 25th Almost Daily Grant’s reported that BofA strategists, going all the way back to 2008, determined that “it has never cost less to protect against an S&P 500 drawdown of 5% or more over the next 12 months, as higher rates and low implied volatility and correlations have presented ‘a historic entry point for hedges.’” The folks at BofA also emphasized that market doomsday insurance is even cheaper than in 2017, when “several records for complacency, including the lowest VIX in history,” were established.
Mark Spitznagel and his crew of traders at Universa Investments are likely buying this cheap insurance with both hands, with the intent to cash in with the stock market’s next cratering. Spitznagel and his collaborator, the much more public Nassim Nicholas Taleb are the subjects of Scott Patterson’s Chaos Kings: How Wall Street Traders Make Billions In The New Age Of Crisis.
Spitznagel is well known in Austrian economics circles as a fan of the free market school and critic of central bank intervention. His 2009 piece in the Wall Street Journal, began “Ludwig von Mises was snubbed by economists world-wide as he warned of a credit crisis in the 1920s. We ignore the great Austrian at our peril today.” Also, his book The Dao of Capital contained plenty of what Patterson calls “Austrian diversions.”
Taleb is a best selling author of books such as The Black Swan and AntiFragile. He recently appeared on CNBC’s Squawk Box predicting a crash. Although he did say and never claims he knows exactly when the crash is coming. He did recommend avoiding real estate and AI-related stocks.
Patterson weaves together a very readable story of how Taleb and Spitznagel met and the frustrations of selling tail-risk hedging to a Wall Street that held the collective belief of Modern Portfolio Theory, diversification of high and low risk investments in a portfolio provides protection from an unknown market calamity. Buying deep out-of-the-money puts (right to sell at a certain price before a certain date) on exchanges is frustration drawn out for years in most cases. The puts expire worthless and Spitznagel must have the fortitude to continue implementing what is the vast majority of the time a money-losing strategy. But, when the crashes come, the returns are enormous. Meanwhile, “Universa traders found the job hard and often tedious. Coming in every day–and losing money–for years.” (emphasis original)
There are exciting episodes in the book chronicling Spitznagel’s group trading in a frenzy to cash on, for instance the 2010 Flash Crash. Universa booked a $1 billion gain on the crash which lasted a half an hour. The story of pension behemoth CalPERS terminating Universa’s tail-risk hedge in January 2020, just prior to the COVID market meltdown in March, which would have provided the California pension fund a 4,144 percent return will make CalPERS members pull their hair out.
But while the theme of the book is the future is unknowable and becoming more so, Patterson’s story wanders into Taleb’s pandemic, environmental and future of democracy predictions for a good share of the book. For Taleb fans, Patterson provides plenty of the iconclast’s views. An epidemic is the greatest risk to mankind according to Taleb. And forecasting the future is the biggest mistake people make in managing risk. Exposure and sensitivity to extreme events are what matters.
Taleb points out that the human brain craves order and “so we impose patterns, structures, fragile frameworks onto a world constantly roiled in chaos,” writes Patterson. Taleb wrote in The Black Swan, “The more you summarize the more order you put in, the less randomness. Hence the same condition that makes us simplify pushes us to think that the world is less random than it actually is.” (emphasis original)
Sure to annoy some liberty-loving readers is a quote of Taleb’s from twitter about the government’s response to COVID. “Libertarians’ are…incoherent,” Taleb wrote in May 2020, “they deny stores the right to require masks & constrain their freedom yet ask for freedom… Nothing to do with libertarianism: rather a collection of marshmallowbrained psychopaths and misfits taking their hatred of humanity too far.” Whoa.
Near the conclusion Patterson writes that by late 2022 Universa was providing crash protection for $20 billion in assets. The highest in its history. With the markets screaming higher this year more protection is needed, but there are those like the gentleman running CalPERS in 2020 who must learn the hard way.