By Mark Spitznagel
What is a black
swan event, or tail
event, in the stock market?
✓ It depends on who’s asking.
✓ To those familiar with Austrian
capital theory, the impending U.S. stock market plunge (of even
well over 40%)—like pretty much all that came before in the past century—will
certainly not be a Black
Swan, nor even a tail event.
✓ Nonetheless, the black
swan notion is
paramount—in perception: Market participants’ failure to expect a perfectly expected event—that
is, they price in only Anglo swans despite the Viennese bird lurking
conspicuously in the weeds—much like what is happening today, brings tremendous
opportunity.
I. On Induction: If
it looks like a swan, swims like a swan, …
By now, everyone knows what a tail is. The
concept has become rather ubiquitous, even to many for whom tails were
considered inconsequential just over a few years ago. But do we really know one
when we see one?
To review, a tail event—or, as it has come to be known, a black swan event—is an extreme event that happens with extreme infrequency (or, better yet, has never yet happened at all). The word “tail” refers to the outermost and relatively thin tail-like appendage of a frequency distribution (or probability density function). Stock market returns offer perhaps the best example:
Over the past century-plus there have clearly been sizeable annual losses (of let’s say 20% or more) in the aggregate U.S. stock market, and they have occurred with exceedingly low frequency (in fact only a couple of times). So, by definition, we should be able to call such extreme stock market losses “tail events.”
But can we say this, just because of their
visible depiction in an unconditional historical return distribution? Here is a
twist on the induction problem (a.k.a. the black swan problem): one of vantage point, which
Bertrand Russell famously described exactly one-hundred years ago with his
wonderful parable (of yet another bird) [1]:
"The man who has fed the chicken every day throughout its life at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken … The mere fact that something has happened a certain number of times causes animals and men to expect that it will happen again."
Bertrand Russell, The Problems of Philosophy (1912)
My friend and colleague Nassim Taleb
incorporates Russell’s chicken parable as the “turkey problem” very nicely in
his important book The Black Swan [2]. The other side of the coin, which
Nassim also significantly points out, is that we tend to explain away black
swans a posteriori,1 and our task in this paper is to avoid
both sides of that coin.
The common epistemological problem is
failing to account for a tail until we see it. But the problem at hand is
something of the reverse: We account for visible tails unconditionally, and
thus fail to account for when such a tail is not even a tail at all. Sometimes,
like from the chicken’s less “refined views as to the uniformity of nature,”
what is unexpected to us was, in fact, to be expected.
II. Not Just Bad
Luck: The Austrian Case
Perhaps more refined views would be useful
to us, as well.
This notion of a “uniform nature” is
reminiscent of the neoclassical general equilibrium concept of economics, a static
conception of the world devoid of capital and entrepreneurial competition. As
also with theories of market efficiency, there
is a definite cachet and envy of science and mathematics within economics and
finance. The profound failure of this approach—of neoclassical economics in
general and Keynesianism in particular—should need no argument here. But
perhaps this methodology is also the very source of perceiving stock market
tails as just “bad luck.”
Despite the tremendous uncertainty in
stock returns, they are most certainly not randomly-generated numbers. Tails
would be tricky matters even if they were, as we know from the small
sample bias, made worse by the very non-
Gaussian distributions
which replicate historical return distributions so well.2 But stock markets are so much richer,
grittier, and more complex than that.
The Austrian School of economics gave and
still gives us the chief counterpoint to this naïve view. This is the school of
economic thought so-named for the Austrians who first created its principles3,
starting with Carl Menger in the late 19th century and most fully
developed by Ludwig von Mises4 in
the early 20th century,
whose students Friedrich von Hayek and Murray Rothbard continued to make
great strides for the school.
To Mises, “What distinguishes the Austrian
School and will lend it immortal fame is precisely the fact that it created a
theory of economic action and not of economic equilibrium or non-action.” [5]
The Austrian approach to the market process is just that: “The market is a
process.” [4] Moreover, the epistemological and methodological foundations
of the Austrians are based on a priori, logic-based
postulates about this process.5 Economics
loses its position as a positivist, experimental science, as “economic
statistics is a method of economic history, and not a method from which
theoretical insight can be won.” Economic is distinct from noneconomic action—“here
there are no constant relationships between quantities.”6 [5]
This approach of course cannot necessarily provide for precise predictions, but rather gives us a universal logical structure with which to understand the market process. Inductive knowledge takes a back seat to deductive knowledge, where general principles lead to specific conclusions (as opposed to specific instances leading to general principles), which are logically ensured by the validity of the principles. What matters most is distinguishing systematic propensities in the entrepreneurial-competitive market process, a structure which would be difficult to impossible to discern by a statistician or historian.
This approach of course cannot necessarily provide for precise predictions, but rather gives us a universal logical structure with which to understand the market process. Inductive knowledge takes a back seat to deductive knowledge, where general principles lead to specific conclusions (as opposed to specific instances leading to general principles), which are logically ensured by the validity of the principles. What matters most is distinguishing systematic propensities in the entrepreneurial-competitive market process, a structure which would be difficult to impossible to discern by a statistician or historian.
To the Austrians, the process is decidedly
non-random, but operates (though in a non-deterministic way, of course7)
under the incentives of entrepreneurial8 “error-correction” in the economy.9 In a never ending series of steps,
entrepreneurs homeostatically correct natural market “maladjustments” (as well
as distinctly unnatural ones) back to what the Austrians call the evenly
rotating economy (henceforth
the ERE). This is the same idea as equilibrium, but,
importantly, it is never considered reality, but rather merely an imaginary gedanken experiment through which we can
understand the market process; it is actually a static point within the process
itself, a state that we will never really see. Entrepreneurs continuously move
the markets back to the ERE—though it never gets (or at least stays) there.
Rothbard called the ERE “a static situation, outside of time,” and “the goal
toward which the market moves. But the point at issue is that it is
not observable, or real, as are actual market prices.”10[7]
Moreover, “a firm earns entrepreneurial profits when its return is more than interest,
suffers entrepreneurial losses when its return is less … there are no
entrepreneurial profits or losses in the ERE.” So “there is always competitive
pressure, then, driving toward a uniform rate of interest in the economy.” [7]
Rents, as they are called, are driven by output prices11 and are capitalized in the price of
capital—enforcing a tendency toward a mere interest return on invested capital.
We must keep in mind that capitalists purchase capital goods in exchange for
expected future goods, “the capital goods for which he
pays are way stations on the route to the final product—the consumers’ good.”
[7] From initial investment to completion, production (including of higher
order factors) requires time.
By about one hundred years ago, the
Austrians gave us an a priori script for the process of boom and
bust that would repeatedly follow from repeated inflationary credit expansions.
Without this artificial credit, entrepreneurial profit and loss (“errors”)
would remain a natural part of the process, except that, for the most part,
they would naturally happen quite independently of one-another.
Central to the process is the “price of
time” [7]: the interest rate market. This market conveys tremendous information
to entrepreneurs due to the aggregate time preference (or the degree to which people prefer
present versus future satisfaction) which determines it and is reflected in it.12 Interest rates are indeed the
coordinating mechanism for capital investment in factors of production.
Non-Austrian economists typically depict
capital as homogeneous, as opposed to the Austrians’ temporally heterogeneous
and complex view of the capital structure. We see this in the impact of
interest rate changes. Low rates entice entrepreneurs to engage in otherwise
insufficiently profitable longer production periods, as consumers’ lower time
preference means they prefer to wait for later consumption in the future, and
thus their additional savings are what move rates lower; high rates tell entrepreneurs
that consumers want to consume more now, and the dearth of savings and
accompanying higher rates make longer-term production projects unattractive and
should be ignored in order to attend to the consumers’ current wants. The
present value of marginal higher order (longer production) goods is
disproportionately impacted by changes in their discount rates, as more of
their present value is due to their value further in the future.
Variability in time preferences changes
interest and capital formation. If lower time preference and higher savings and
lower interest rates created higher valuations in earlier-stage capital
(factors of production) which initiates a capital investment boom, this
newfound excess profitability would be neutralized by lower demand for present
consumption goods and lower valuations in that later-stage capital. (John
Maynard Keynes’ favored paradox of thrift is completely wrong, as it ignores the
effect on capital investment of increased savings, and resulting
productivity—and ignores the destructiveness of inflation, as well.)
But there is an enormous difference
between changes in aggregate time preference and central bank interest rate
manipulation. Where this is all heading: The Austrian theory of capital and
interest leads to the logical explication of the boom and bust cycle. To the
logic of the Austrians, extreme stock market loss, or busts—correlated
entrepreneurial errors, as we say—are not a feature of natural free markets.
Rather, it is entirely a result of central bank intervention. When a central
bank lowers interest rates, what essentially happens is a dislocation in the
market’s ability to coordinate production. The lower rates make otherwise
marginal capital (having marginal return on capital) suddenly profitable, resulting
in net capital investment in higher-order capital goods, and persistent market
maladjustments.
Despite the signals given off by the lower
interest rates, the balance between consumption and savings hasn’t changed, and
the result is an across-the-board expansion—rather than just capital goods at
the expense of consumption goods. What the new owners of capital will find is
that savings are unavailable later in the production process. These economic
cross currents—more hunger for investment by entrepreneurs seizing perceived
capital investment opportunities, and consumers not feeding that hunger with
savings, but rather actually consuming more— creates a situation of extreme
unsustainable malinvestment that ultimately must be liquidated.
The only way out of the misallocated,
malinvestment of capital, is a buildup of actual resources (wealth) in the
economy in order to support it. This could result from lower time preferences
(but as we know compressed interest rates actually inhibit savings)—or of course
by accumulated reinvested profits over time (but of course time will not
be on the side of marginal malinvested capital earning economic losses).
Credit expansion raises capital investment
in the short run, only to see the broad inevitable collapse of the capital
structure. Eventually the economic profit from capital investment and the
lengthening of the production structure are disrupted, as the low interest
rates that made such otherwise unprofitable, longer term investment attractive
disappear. As reality sets in, and as time preferences dominate the interest
rates again (even central banks cannot keep asset valuations rising forever),
projects become untenable and must be abandoned. Despite the illusory signs
from the interest rate market, the economy cannot support all of the central
bank-distorted capital structure, and the boom becomes visibly unsustainable.
“In short,” wrote Rothbard, “and this is a
highly important point to grasp, the depression is the ‘recovery’ process, and the end of
the depression heralds the return to normal, and to optimum efficiency. The
depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy
to normal after the distortions imposed by the boom. The boom, then, requires a ‘bust.’”[8]
Aggregate, correlated economic loss—the
correlated entrepreneurial errors in the eyes of the Austrians—is not a random
event, not bad luck, and not a tail. Rather, it is the result of distortions
and imbalances in the aggregate capital structure which are untenable. When it
comes to an end, by necessity, it does so ferociously due to the surprise by
entrepreneurs across the economy as they discover that they have all committed
investment errors. Rather than serving their homeostatic function of correcting
market maladjustments back to the ERE, the market adjusts itself abruptly when
they all liquidate.
What follows—to those who see only the
“uniformity of nature”—is a dreaded tail event.
III. The
Stock Market as “Title to Capital”: Austrian Investing
In order for the Austrian School’s logical
market process to help reframe an otherwise surprising negative event in the
stock market, we need to somehow understand and track where we are in that
process. Our limitations are underscored by a very important tenet of the
Austrians themselves: controlled experiments simply aren’t possible in
economics, and empirically isolating cause-and-effect is impossible. But
perhaps, staying close to the principle of parsimony, the systemic distortions
that we are seeking can still be rigorously and robustly recognized.
So if we want to distinguish periods of
vulnerability to correlated entrepreneurial errors—the busts of the Austrian
boom-bust cycle and the losses of the stock market, and thus recognize ex
ante when such loss
is no longer a tail event—we just need to recognize the periods of monetary
credit expansion and resulting malinvestment. This isn’t necessarily all that
easy, which the Austrians know well.
The natural approach should be to use the
earlier gedanken tool of the fictional ERE and identify
clear deviations from it. Recall the homeostatic entrepreneurial mechanism
always at work which “smooths fluctuations and facilitates movement toward
equilibrium,” [8] the aggregate entrepreneurial “goal” [7] of a mere interest
return on invested capital. But we cannot observe an ERE, since it doesn’t even
exist. Instead, we can observe what I’ll call the “aggregate ERE”—where “there
are no entrepreneurial profits or losses” [7] in aggregate. In aggregate, it
will look the same, and what it will tell us is functionally the same: What
entrepreneurs (on aggregate) are doing and where they are heading.
We need a robust indication of when
aggregate capital productivity, or aggregate return on invested capital—as
capitalized in the price of capital—suddenly and persistently and inordinately
exceeds or is below the cost of that capital: interest rates. As we know from
the previous section, this is unique to a monetary credit expansion. Changing
time preference won’t widen or narrow this spread from the noise of the ERE
(recall that, in the case of higher savings, lower demand for consumption goods
would ultimately offset higher demand and valuations in capital goods);
innovations or productivity gains shouldn’t either (at least not very much, as
“the sovereign consumer” [9] will ultimately steal those gains). Only
central bank interventionism will accomplish this. All maladjustments, however,
require an eventual return.
So a robust indicator of this spread will
offer us information on where we stand in any central bank-induced boom- bust
market process, or more specifically where entrepreneurs are most vulnerable to
sudden and inevitable correlated errors.
Conveniently, as Rothbard noted, “the
stock market is the market in the prices of titles to capital,”13 [8] and “at any point in time the
capital value of a firm’s assets will be the appraised value of all the
productive assets, including cash, land, capital goods, and finished
products.” [7] As the expected productivity of capital is immediately
capitalized in those title prices, and as the net tangible capital in place is
part of a complex temporal capital structure with drawn- out production
processes that adjust very slowly, how those aggregate prices of title to
capital compare to the aggregate current net tangible replacement value of that
capital in place must tell us something about the anticipation of aggregate
profit. When the ratio is high, titles to the factors of production are being
bid up by entrepreneurs as capital investments in higher-order goods grow and
malinvestment accumulates; when the ratio is low, of course, the reverse is
happening.
Conveniently, this ratio exists in the
equity Q ratio14:
I have covered this measure in some detail
(from a corporate finance as well as empirical standpoint) in a previous paper
titled The Dao of Corporate Finance, Q
Ratios, and Stock Market Crashes (see
link here) [10], so I’ll spare you the gory
details. But it should be obvious that Q indicates in a very robust way the
implied spread between aggregate return on invested capital and the
aggregate cost of that capital.15
So what becomes of the tails when we
condition on Q? Despite the Austrians’ warning that the path back to the ERE is
inherently unpredictable, we should nonetheless expect to see regularities
which reflect the extreme entrepreneurial vulnerabilities with higher Q:
Without a doubt (or at least with over 99% confidence16), bad things happen with increasing expectation when conditioning on higher Q ratios ex ante. That is, when Q is high, large stock market losses are no longer a tail event, but become an expected event.17
Without a doubt (or at least with over 99% confidence16), bad things happen with increasing expectation when conditioning on higher Q ratios ex ante. That is, when Q is high, large stock market losses are no longer a tail event, but become an expected event.17
Basic corporate finance principles are
enough to explain the entrepreneurial forces at work to drive the convergence
(and empirical mean reversion) of the Q.18 But it is very difficult to
rationalize the intermittent divergence without monetary arguments and the
temporal complexities of the capital structure.
Clearly, time is required before “the end
of inflation could reveal the widespread malinvestments in the economy, before
the capital goods industries showed themselves to be overextended, etc.” [8]
Again, the path back to the ERE—including the time it will take—will always
involve uncertainties. But, again, there are regularities in this “stopping
time” to liquidation:
Again I use the non-parametric bootstrap
methodology of [13].
The question is not if, but when.19 And, in fact, though not surprisingly,
the majority of the losses tend to happen in a rather concentrated plunge at
the tail end of the path down to minus 20%; for instance, in just the last two
months before the market passes through our 20% drawdown trigger, it typically
(on average) has experienced a loss of nearly the entire 20%.
I see in these studies—in the deviations
from the ERE, and in the violent shifting of capital back and forth into higher
and lower stages of production with assumed changes in time preference, and
with the surprising empirical regularities thereof—a tremendous century-long
out-of-sample test20 of
the deductive a priori Austrian capital and interest
theory; and we must certainly fail to reject the theory’s validity.
What would the assumption of the validity
of these ideas and the reframing of tails have done for someone starting
in 1913 (at the birth of the Federal Reserve) in the U.S.?21 There would have been moments of time
when, with an understanding of the recovery process and the purging of
distortions, aggressive investing would have been much easier to stomach.22 At other times, as the ticking
time bomb is
anticipated,23 stepping
aside during the entrepreneurial scramble for capital investment (though
hopefully avoiding shorting that investment, a most hazardous act indeed24)
would have been perhaps somewhat easier—despite the frequent extreme
opportunity cost (though longer term advantage) of doing so.
Austrian economics, with a little bit of
data sprinkled in, makes the case clear: There haven’t been black swan events
of significance in the aggregate U.S. stock market over the past century; more
alarmingly—due to the evident monetary credit expansion today—we would be hard
pressed to be surprised by severe stock market losses now.
Fortunately, most people (at least in the
equity derivatives markets) disagree.
IV. Blackbirds
Baked in the Pie
To me, this apparent intellectual
nitpicking over the distinction between what is a tail and what isn’t a tail is
rather important. In fact the black swan notion is paramount—in perception. If
the market perceives (or rather prices) a large loss in the stock market as a
tail event even when such perception (and pricing) is unwarranted, obviously
tremendous opportunity exists—even if only to protect a portfolio against such
deleterious losses.
One would think that the ubiquity of black
swan consciousness (among the press and pundits, but presumably also among
investors) would bring with it a heightened cost of “tail insurance.”
Furthermore, aren’t Austrian economists overrunning the derivatives markets in
a panic over their anticipation of sudden and rampant liquidations?
The answer is clear from the below chart
of the S&P 500 variance swap market (a pretty good proxy for the price of
tail hedging,25 by
duration of the tail hedge), both current and an arguably similar if not more
benign environment five years ago:
Clearly, though inexplicably, there is little fear in the pricing of 1 to 3 month options,26 which are cheaper than five years ago and even beyond.27 (There is, however, great fear in the typically suboptimal long-dated protection space.28)
Clearly, though inexplicably, there is little fear in the pricing of 1 to 3 month options,26 which are cheaper than five years ago and even beyond.27 (There is, however, great fear in the typically suboptimal long-dated protection space.28)
But if the derivatives markets were
showing much fear, wouldn’t this be perfectly inconsistent with the illusion of
lowered aggregate time preference and thus greater attractiveness of
longer-term capital investment in the first place? Monetary credit expansion is
ultimately based on this fundamental illusion, and for the illusion to
end—which would include an acceptance of most of the content of this paper by
the marketplace—it would mean the recognition of accumulated malinvestment and
its necessary liquidation. For the potential failure of the illusion to be
perceived — including in the equity derivatives markets—as anything other than
a black swan event would mean the collapse of the very illusion in the
first place.29
An extreme loss in the stock market is
indeed priced in much (though not necessarily all) of the equity derivatives
markets as an extreme tail. I cannot explain why this is—why a tail is still a
tail—just as I cannot explain why the Austrian School remains (despite a
century of evidence) the “somewhat reluctantly tolerated outsider.” [3] But, as
the two are in fact one in the same, here too we should not be surprised.
V. The Eagle Has
Landed
The epistemological problems of black
swans and tails are significant; from the face of it, it is impossible to come
close to predicting or even understanding the properties of the most severe and
rare events by extrapolating what we have already seen. There is a fundamental
illusion at the heart of this problem, a distributional illusion which can be shattered
in an instant.
To me, “tail hedging” mainly addresses a
very different (and even more severe) epistemological problem: the economic
illusion created by monetary policy, which often takes long periods of time to
wear off but, when it does, suddenly reveals the extreme entrepreneurial errors
of malinvestment which lead to sudden rampant liquidation of capital.
This monetary illusion addresses the tail
illusion, as disregarding the former in fact causes the latter.
Some may find this paradoxical coming from
me: From my view, empirically and from an a prioriAustrian interpretation,
black swan events have been largely insignificant in at least the last century
of capital investment in the U.S., including the current crisis.30 Investors have indeed encountered
surprising and pernicious events, but the fact is those who were surprised have
essentially been those (in the extreme majority) with a brazen disregard for
the central concepts of Austrian capital theory and monetary credit expansions;
that is, capital goods and the time structure of production.
To the relentless willingness by most
investors (as witnessed through my career, and indeed for at least the past
century) to repeatedly price in the almost certain success of inflationary
credit expansion, I owe my past and future success in betting against them;
that is, betting on their assumptions about what are rare events.
Mises’ great insight was that the
foundation of material civilization is the entrepreneurs’ patience in
refraining from consuming a portion of their produced goods and returning it to
the drawn-out production process. Only savings—that is, foregone
consumption—creates capital goods and wealth. “Those saving—that is consuming
less than their share of the goods produced—inaugurate progress toward general
prosperity. The seed they have sown enriches not only themselves but also all
other strata of society.” [14]
Don’t let Bernanke tell you otherwise. The
Fed has in fact made this process much harder and much more treacherous,
as we have seen, as capital structure profitability becomes highly illusory.
The great Austrian tradition and the
market forces it elucidates in its a priori methodology for economic understanding
provides an equally important, though unappreciated, methodology for investing.
It seems to me that “tail hedging”, as
I’ve been practicing it for about 15 years now (and I dare not speak for
any others who are so new to the game), could be called “central bank
hedging”—or, better yet, “Austrian investing.”31
Indeed, this activity over my career
likely would have been much less interesting without the insights of Dr. Mises
and the actions of Drs. Greenspan and Bernanke.
Danke schön, meine Herren. Wir sind jetzt
alle Österreicher.*
[*"... We are all Austrians now." — JH]
[*"... We are all Austrians now." — JH]
_________________________________________
Notes:
Notes:
1 Nassim’s healthy skepticism of data—both
forward looking (extrapolation) as well as backward looking (hindsight
bias)—is, to this author’s thinking, his greatest contribution.
2 Measured tail magnitude and thickness tend
to grow with sample size under many power law distributions, for instance.
3 Ironically, the country of its namesake is
decidedly non-Austrian. According to Mises, “Those whom the world
called ‘Austrian economists’ were, in the Austrian universities, somewhat
reluctantly tolerated outsiders.” [3]
4 Most notably in his monumental tome Human
Action [4]
5 Mises named this praxeology,
or the deductive science of human action striving to meet its ends. [4]
6 Interestingly, despite this skepticism of
inductivist methods, observation does play a role in praxeology; as Mises said,
“Only experience makes it possible for us to know the particular conditions of
action. Only experience can teach us that there are lions and microbes. And if
we pursue definite plans, only experience can teach us how we must act
vis-à-vis the external world in concrete situations”. [6]
7 Mises spends much time on probability,
bifurcating the subject into what he calls “class probability” and “case
probability” (similar to Frank Knight’s “risk” and “uncertainty” distinctions,
respectively), assigning insurance or pooling risks to the former (“We know or
assume to know, with regard to the problem concerned, everything about
the behavior of a whole class of events or phenomena; but about the actual
singular events or phenomena we know nothing but that they are elements of
this class.”) and economic action to the latter (unrepeatable and
lacking quantifiability). [4]
8 Mises calls entrepreneurs (and suggests the more specific term promoters)
“those who are especially eager to profit from adjusting production to the
expected changes in conditions, …, the pushing and promoting pioneers of
economic improvement.” [4] I combine this function with that ofcapitalists (whom Mises defines as those who own
and risk capital) in my use.
9 What Mises called catallactic competition [4]
10 But our analysis “cannot describe the path
by which the economy approaches the final equilibrium position.” [7] (Later
we’ll take a peek nonetheless.)
11 As per Carl Menger’s theory
of imputation.
12 Time preferences are “psychologically
determined by each person and must therefore be taken, in the final analysis,
as data by economists.”
13 And of course “real estate is the other
large market in titles to capital.” [8]
14 This is related to Tobin’s Q ratio of
James Tobin [11], which is the ratio of aggregate enterprise value (equity plus
debt) to the aggregate corporate assets or invested capital; I am using the
equity Q ratio in this paper, which is just total equity over the net worth of
the firm—where total assets are netted against total debt, so with no debt the
net worth is the invested capital.
15 See [12].
16 This is the same study I showed in [10],
and for more detail on the data and methodology—the distribution-free,
non-parametric bootstrap methodology used in [13]—I refer the reader there.
17 In options speak, if a 20% down strike is
a “50 delta” (that is, it has a 50% likelihood of expiring in-the-money), it
is the at-the-money strike—certainly not a tail. (In fact what is
happening is the whole distribution of returns is shifted downward, as well as
increasingly skewed.)
18 Tobin’s presumption that Q would drive
capital investment was backwards, as title to that capital drives the Q; Q
levels have only a mild pull on the slow process of production goods
accumulation, but Tobin’s understanding of the error correcting nature of the
entrepreneur was correct.
19 The current age of upper quartile
valuation for the U.S. stock market is just above the median of 30.
20 Truly free of hindsight bias.
21 In Vienna in mid-1929, for instance, we
know that Mises decline a position with Kreditanstalt, declaring, “A great
crash is coming, and I don’t want my name in any way connected with it.”
22 Let us remember, this is not simply a doom
and gloom approach. It is just as likely to be a tremendously opportunistic
optimistic approach—specifically when malinvestment is being liquidated and the
Q becomes lower. Capital is not destroyed, but rather title just changes hands
at more advantageous prices to the buyer.
23 And there is much noise around these
median stopping time estimates
24 The beauty of options
25 In terms of put premiums, think of this as
tracking the implied volatility of very roughly a 25 delta put.
26 Where heightened valuations would be
expected, for reasons of the ticking time bomb of Figure 4, among others
27 Clearly, one needn’t agree with the Austrians
in order for tail insurance to make sense. This is especially the case at
this pricing. As the previous section makes clear, the prices of titles to
capital tend to climb with monetary credit expansions, until they don’t.
Many see tail hedging as a way to remain long, perhaps even in a levered way,
despite otherwise unacceptable uncertainties.
28 If there is a blatant trade idea in this
paper, it might just be to sell five year variance (or better yet a five
year butterfly).
29 This consistency in pricing explains the
tendency for premiums in the options markets to generally diminish with rising
Q ratios. The Austrian case simply does not get “baked in the cake,” at least
not before it is imminently obvious and too late. The Krugman/neo-classical case
(for monetary credit expansion), despite a perfect record of failure,
apparently does.
30 Of course this does not mean that
catastrophic, free market capitalism-destroying events—either manmade or
not—couldn’t have happened (and the manmade variety has historically been
entirely related to the interventionism explored in this paper). We are dealing
with the realm of entrepreneurial action within a competitive economic system
and the monetary distortions which affect it. But note that during the one-hundred-plus
years of this study there was much devastating unprecedented world conflict,
which managed to still be subsumed by Austrian praxeological principles.
31 I have yet to have read about aggregate
equity valuations vis-à-vis aggregate corporate net worth as the telltale sign
of the Austrian business cycle at work, as well as an indication of location in
that process, and I hope it becomes an investing offshoot of this great
tradition.
______________________________________
Appendix: References
Appendix: References
[1] Russell, Bertrand, The
Problems of Philosophy (1912).
[2] Taleb, Nassim, The Black Swan (2007).
[3] Greaves, Bettina Bien, Austrian
Economics: An Anthology (1996).
[4] Mises, Ludwig von, Human
Action (1949).
[5] Mises, Ludwig von, Notes
and Recollections / Memoirs (1978).
[6] Mises, Ludwig von, Epistemological
Problems of Economics (1933).
[7] Rothbard, Murray,
Man, Economy, and State (1962).
[8] Rothbard, Murray, America’s
Great Depression (1963).
[9] Mises, Ludwig von, The
Anti-Capitalistic Mentality, Freeman
(1956).
[10] Spitznagel, Mark, “The Dao of
Corporate Finance, Q Ratios, and Stock Market Crashes” (2011).
[11] Tobin, J., “A General Equilibrium
Approach to Monetary Theory”, Journal of Money Credit and Banking,
1, 15–29, (1969).
[12] Koller, T., M. Goedhart, D. Wessels,
and McKinsey & Company, Valuation: Measuring and Managing
the Value of Companies, 5th ed. (2010).
[13] Pandey, M.D., P.H.A.J.M. Van Gelder,
and J.K. Vrijling, “Bootstrap simulations for evaluating the
uncertainty associated with peaks-over-threshold estimates of extreme wind
velocity”, Environmetrics, 27-43 (2003).
[14] Mises, Ludwig von, The Freeman
(1963).
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