Sunday, 8 November 2009

History: It Ain't Just Bunk

Human beings are good at interpolation, passable at extrapolation, bad at identifying inflexion points, and downright terrible at processing one-off events. It’s no coincidence that these skills are, sequentially, associated with increasing investment success: the harder it is to do something, the more money one makes for doing it.

This particular progression from easy to difficult is not merely the artifact of some deep-seated behavioral tendency or evolutionary bias. Deterministic and presumably unbiased algorithms, faced with unprecedented events, perform just as badly as humans. This is only to be expected: the very word ‘unprecedented’ implies that there is no baseline to build from or compare with, a circumstance under which most algorithmic approaches tend to flounder.

Unfortunately for all concerned, real life is full of one-off events. What we call history is, as Rudge memorably puts it, just one bloody thing after another. And that’s precisely why I’m suspicious of attempts to mindlessly trawl through past data for aggregate patterns. Every episode is different; every episode is new.

This does not mean that history should be discounted entirely. Quite the contrary. A deep and broad knowledge of history (and not just the history of the markets!) is essential to becoming a successful trader. Events may not repeat themselves exactly, but they certainly rhyme; the trick is to find out what they rhyme with.

So how does one accomplish this trick? Regular readers will know the answer: by asking ‘why’. Questions such as ‘what’ or ‘when’ or ‘which’ or ‘how much’ are no doubt useful when it comes to short-term, tactical trading, but they are limited in their ability to throw light on long-term, strategic trends. Asking ‘why’ a particular historical event turned out the way it did, on the other hand, is the first step towards recognizing its kinship (or lack thereof!) with seemingly similar events developing today. Understanding the past is the key to understanding the present, to say nothing of predicting the future.

This sounds overly abstract but in truth it is anything but; the technique of asking ‘why’ at all times can (and should!) be used to analyze not just big-picture historical movements, but also individual trades. Indeed, finding out why a particular trade worked while others failed is a key component of the trader’s art.

Here’s an example from my own career trading bonds. My portfolio was, in general, designed to capture or monetize excessively rich risk premiums (curve, liquidity, capital structure, you name it). Risk premiums of course tend to widen in times of market stress, so my portfolio behaved as if it were short event risk. To hedge against this I invariably had a long position in Fed Funds futures and the first few Eurodollar contracts, confident in the knowledge that any ‘flight-to-quality’ would send these assets higher. (Also, in truly extreme cases the Fed could be counted on to step in and cut rates, helping the front of the yield curve.)

I was not alone in this practice. Here’s an excerpt from an interview with Christian Siva-Jothy, former head of prop trading at Goldman Sachs:
Being long fixed income is like a synthetic long gamma trade. More than 90 per cent of the time, if there is a major dislocation to the economy, fixed income will rally. I sleep better at night doing that.
Insurance is not the only reason to be long bonds. There’s also the widely-held belief that rallies tend to be slow grinding affairs while selloffs tend to be sudden sharp shocks1; it’s a lot easier to ride the former than it is to time the latter. Here’s Siva-Jothy again:
Bear markets in fixed income are very short with powerful rallies. You can make money during a bear market but you have to time your trades perfectly.

As a matter of fact, most successful bond traders of the recent past, like Siva-Jothy, have had a perpetual long bias, and have justified it on similar grounds.

Looking back though, I wonder if this is not just post facto rationalization. After all, the Treasury market has been rallying more ore less continuously for the last quarter of a century; long bond yields have gone from 15.5% in 1981 to 2.5% in 2008. You would have had to be a spectacularly incompetent long-biased trader not to make money over this period. Conversely, no matter how good you were at trading from the short side, you’d have been hard pressed to make big returns in such a strong bull market. And that’s why most bond traders, through experience or by selection, tend to have a bullish stance2.

All very well, but so what? So this: what if bonds turn? What if the 30-year bull market was a one-off event that will not be repeated, rather than a trend that will continue3? What if 2008 marked the low in bond yields? What if rates stay steady or trend higher over the next decade or two? Will the front of the yield curve still serve as an event hedge? Will rallies continue to be protracted and selloffs continue to be compressed? Right now, nobody knows for sure, but these are questions worth keeping in mind. A trader who does otherwise – who merely trades from the long side without asking why being long Treasuries worked in the past – risks being blindsided.

Footnotes

# 1Here’s a cherry-picked illustration:



# 2Of course, this explanation merely pushes the question back one level. Why did the bond market rally for 25 years? That’s a question that deserves a full-length post in answer.

# 330 years is, admittedly, a long timeframe for a ‘one-off’ event, but note that the current bull market was preceded by the greatest bear market in US Treasury history. Perhaps the entire rally in rates since 1981 is merely reversion to the long-run (pre-bear) mean.

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