Tsunami Time

January 2005 Dr. Hans Black

At the risk of sounding like Bill Murray in Lost in Translation, we are wondering if this is “tsunami time”. The tragedy of the events of December 26th is that while they were so totally unexpected by those in the tsunami’s path, there were scientists who saw the impending disaster unfolding and tried to warn the governments of Indian Ocean countries and their targeted inhabitants — in vain. There were simply no direct links available to warn government leaders much less so on the day after Christmas. By the time word finally did reach countries such as Kenya, where the waves hit only many hours later, preparations were disorganized at best or non-existent at worst. Pacific nations have marvelous technology based in Hawaii to warn them of tsunamis in the Pacific Ocean but no such technology exists off the coast of Indonesia or in any other Indian Ocean location. Even I, a money manager whose predilection for worry is enhanced by a Reuters news headlines beeper at all times, was able to read the very earliest headlines from the U.S. Geological Survey based in the Indian Ocean that a Richter 9 event had taken place early on Sunday morning, December 26th.

While there has, over the past few days, been pervasive evidence of the destructive nature of tsunamis in the natural world, the term ‘tsunami’ has also been applied as a metaphor for financial events over the last 25 years. The stock market meltdown of 1987 comes to mind as, of course, does the bond market collapse of 1994 and the fiasco of LTCM (Long Term Capital Management) in August/September 1998, which paralyzed certain portions of the bond market. The warning signs were evident in all these cases, for those who were able to discern them, but common to all these events was that the vast majority of market participants did not heed the warnings in front of their eyes and continued to enjoy themselves at the party, oblivious to the dangers looming.

I came across a book published this year by the famous mathematician, Benoit Mandelbrot, The Misbehavior of Markets, which he co-authored with Richard Hudson, which may lead to an overhaul of our early warning system for financial tsunamis. Mr. Mandelbrot is one of the most famous mathematicians alive today and is known as the inventor of fractal geometry. Together with Mr. Hudson, who is an editor at the Wall Street Journal, Mr. Mandelbrot proposes that the current theory of risk in the markets is hopelessly benign in that it severely downplays actual risks in the live marketplace. The vast majority of financial risk models used today are based on Bachelier distributions, which Mr. Mandelbrot dismisses as far too simplistic: a model that measures odds in casinos, where the previous winning number has no influence on any subsequent number, is completely impractical for financial markets. In practical terms, he is arguing that market upsets or periods where markets dramatically misbehave according to older models may indeed be occurring more frequently than many believe. By attacking not only the mean-variance approach or even more such advanced thinking as the capital asset pricing model, Mr. Mandelbrot essentially challenges most modern portfolio analysis and many economists by asserting that most commodities, stock and other market price movements are not normally distributed. This, of course, also flies in the face of current optimization models as well as those who currently sell basic risk management tools. The impact of Mr. Mandelbrot’s work may prove to be revolutionary in the financial world.

The timing of Mr. Mandelbrot’s book is not accidental. We are seeing such an enormous appetite for risk right now although we are barely two years beyond the bear market lows of October 2002, which proved to be a culminating point for the great wave of declines that started in March of 2000 and resulted in an almost 50 percent decline in the S&P Index. Market participants today have clearly forgotten what happened in the early years of this decade. Increasingly, we are seeing stocks go up on flimsy news, and whole lists of new names in the mini-cap area show good percentage gains with little or no fundamental backing. Indeed, even discount brokers such as Schwab have made statements to the effect that small customers are back in droves. These observations are not limited to equities and may indeed be even more appropriate in many areas of the fixed income market where speculation is, frankly, rampant. Bond spreads, i.e. the spread between Treasuries and other kinds of bonds, have narrowed considerably from the levels of just two years ago. This has powered many bond portfolios invested in various kinds of mortgages, high yield securities, collateralized debt obligations and also, of course, collateralized loan obligations. In addition, the thousands of new hedge funds that have sprung up in the last few years are all looking for ways to make money and many of them have found a comfortable home in these very high-risk areas of the fixed income market. It is noteworthy also that the Federal Reserve, which has just published its minutes to its last meeting as this is being written, is clearly making noises about these increased risks in the markets. The message could not be clearer from the Fed that they will continue to raise interest rates in an environment they evidently consider susceptible to the destructive force of a financial tsunami.

If only the people of South Asia could have been so clearly forewarned.