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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
“One must have a mind of winter/To regard the frost and the boughs/Of the pine-trees crusted with snow;//And have been cold a long time/To behold the junipers shagged with ice,/The spruces rough in the distant glitter//Of the January sun; and not to think/Of any misery in the sound of the wind,/In the sound of a few leaves,//Which is the sound of the land/Full of the same wind/That is blowing in the same bare place//For the listener, who listens in the snow,/And nothing himself, beholds/Nothing that is not there and the nothing that is.”
Wallace Stevens, “The Snow Man” (1921)1
Wallace Stevens (1879-1955) is remembered as an important American modernist poet, but he spent his days (when he was not scribbling poems in his notebooks) drafting legal contracts as an insurance company attorney. In “The Snow Man,” he dramatizes human consciousness confronting the external world in language that is deceptively simple. There is nothing simple, however, about Stevens’ portrayal of human consciousness.2 His description of the world as “Nothing that is not there and the nothing that is” serves as a vivid emblem, not only of what men see when they look outside themselves, but of what they see when they look at the modern global financial system. This system is one in which value is wholly dependent on policy that is obviously unsustainable and financial instruments are little more than electronic bytes. Moreover, the survival of the system is wholly reliant on these bytes freely circulating around the world. The fragility of the external world and the complexity of human consciousness are overwhelming characteristics of the systems on which human life depends.
Virtually every conversation with a conscientious investor today includes an acknowledgement that central banks’ massive stimulus efforts will end in tears. Unfortunately, nobody can specify
when the tears will start flowing. In his new book, Antifragile, Nassim Nicholas Taleb argues that “it is much easier to understand if something is harmed by volatility – hence fragile – than try to forecast harmful events, such as these oversized Black Swans.”
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1. Wallace Stevens, The Palm at the End of the Mind: Selected Poems and a Play (New York: Vintage Books, 1972), p. 54. Double hash marks (//) denote stanza breaks and single hash marks (/) denote line breaks.
2. The poem moves from seeing (“regard the frost,” “behold the junipers”) to thought (“not to think/Of any misery”) to hearing (“the sound of the wind,” “the sound of a few leaves”) and then to a conflation of seeing and hearing (“the listener, who listens in the snow,/And nothing himself, beholds/Nothing that is not there…”). Using all of the tools of consciousness, man is “nothing himself” left beholding “Nothing that is not there and the nothing that is.” I have read this haunting poem hundreds of times since I first discovered it as a student at Brown in the late 1970s. Like other great works of art, its meaning grows with each successive encounter.
3. Nassim Nicholas Taleb, Antifragile: Things That Gain from Disorder (New York: Random House, 2012), pp. 12-13. I would urge everyone to read this important book, which is filled with valuable insights on virtually every page.
For that reason, he argues that we should focus on preventing such unpredictable events from inflicting harm. “Since detecting (anti)fragility…is easier, much easier, than prediction and understanding the dynamics of events, the entire mission reduces to the central principle of what to do to minimize harm (and maximize gain) from forecasting errors, that is, to have things that don’t fall apart, or even benefit, when we make a mistake.”4 The ghost of Hyman Minsky hovers over Mr. Taleb’s work. Professor Minsky taught us that stability breeds instability, and Mr. Taleb builds on that insight by arguing that systems that are not subject to any stress are poorly designed to withstand volatility. The lesson for portfolio managers is that we should stop worrying about things we can’t predict (such as the timing of the inevitable market dislocations to which current monetary and fiscal policy failures will lead) and instead focus on structuring our portfolios to be strong enough not only to withstand such events but even to profit from them.
Portfolio managers, however, must know how to read the signs of stress that are likely to precede any market dislocation. That will allow them to further buffer their assets from losses. In my portfolio management, I focus on a series of data points developed over many years that served me well in predicting both the 2001-2 and 2008 credit crises. As soon as the data started signaling trouble ahead, I took steps to reduce my portfolios’ vulnerability to losses caused by a large market sell-off (and avoided those massive losses). But that doesn’t mean that these signs will serve me well the next time the system experiences stress. Like everything else involved in managing a portfolio of financial assets, these warning signs must be constantly reevaluated for efficacy. Both financial markets and the global economy are changing before our eyes.
“Nothing that is not there and the nothing that is” can be read in many different ways. One interpretation is that it describes the difficulties of determining what man sees when he looks outside himself to a world whose meaning is based as much on perception as objective reality (the “facts”). “The Snow Man” strikes me as a particularly vivid rendering of a world where economic value is increasingly intangible. As the world learned to its dismay during the crisis, financial assets are “there” and “not there” (another way of describing them is to quote Gertrude Stein: “There is no there there.”) Many financial instruments reference other assets, while even direct obligations are distorted in value by unprecedented and relentless central bank easing. Technology, regulation and policy are currently buffeting markets with forces whose consequences are likely to be different than what most people expect. The likelihood of unintended consequences emphasizes the need to build portfolios that are robust to volatility and instability.
Dead sharks
The world is awash in money. But money isn’t what it used to be. I would point to two characteristics of modern money that should be keeping portfolio managers up at night (they certainly keep me up at night).
The first characteristic is that only 20% or so of total money today is “base money,” which is defined as currency in circulation plus bank reserves held at the Federal Reserve (M0). The other 80% is debt - claims on the stock of base money that cannot be satisfied unless more base money is created (M1, M2, M3).5 Debt is a promise (or contractual obligation) to pay. It is increasingly obvious that many of these promises are not going to be kept. The global economy is incapable of generating sufficient economic growth to fulfill these promises.
The second characteristic is that a large percentage of money is in the form of derivatives rather than direct obligations. A derivative is a contract in which repayment is based on the ability of the contractual counterparty to perform. The value of a derivative is therefore subject to two contingencies: the value of the underlying instrument and the ability of the counterparty to pay. Pundits debate whether the proper measure of outstanding derivatives is the “net” or “gross” amount of outstanding contracts.
This debate hinges on the contractual nature of these contracts. Optimists argue that only the “net”6 should be considered since most (about 90%) of derivative contracts involve offsetting positions. Pessimists counter that the “gross” amount should be the focus since in a crisis many counterparties will be unable to perform, leaving many obligations unpaid. Who is correct? The optimist is correct as long as there isn’t a crisis, and the pessimist proves that even paranoids have enemies when there is a crisis. Even if we use the “net” exposure, we are still talking about a multi-trillion number that could cause serious (if not fatal) damage in the event of a severe crisis. The outstanding volume of OTC derivatives was estimated to be $25.4 trillion (gross) and $3.7 trillion (net) at June 30, 2012 by the International Monetary Fund (IMF).7
These characteristics have created a system that is wholly dependent on the ability of money to keep circulating through the global financial system. What happened in 2008-9 – and truly terrified Ben Bernanke and others – was the fact that money stopped circulating. In order for the global financial system to persist, money must continue to circulate freely. If that makes the system sound like a Ponzi scheme, that is because that is exactly what it is. Another way to describe this situation is by reference to a scene in the movie Annie Hall. Alvy Singer (played by Woody Allen) and Annie are flying back to New York from Los Angeles. Alvy tells Annie: “A relationship, I think, is like a shark. You know? It has to constantly move forward or it dies. And I think what we got on our hands is a dead shark.” That is how I think about the global financial system: if money stops circulating (as it almost did in 2008), the system will die. In 2008, we almost had a dead shark on our hands.
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Michael E. Lewitt
[email protected]
5. Thanks to Paul Brodsky and Lee Quaintance of QB Asset Management (www.qbamco.com) for their great work on base money and related topics.
6. “Net” exposure measures the amount of outstanding contracts after offsetting positions are removed from the calculation.
7. Stign Claessens, Zoltan Pozsar, Lev Ratnovski, and Manmohan Singh, “Shadow Banking: Economics and Policy,” December 4, 2012, International Monetary Fund Staff Discussion Note.
Disclaimer
All opinions and investment recommendations expressed by Michael E. Lewitt in The Credit Strategist as well as on Twitter under the Twitter name @credstrategist are solely the opinions of Mr. Lewitt and do not reflect the opinions of Cumberland Advisors or its affiliates or employees, managing directors, owners or principals.
Disclosure Appendix
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The Credit Strategist
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This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist
