Monday, March 24, 2008

On the uselessness of describing "booms and busts"

Quantification is useful, even essential for investing.

However, with computing power so cheap, it is no wonder that arb-type trades and investment strategies CANNOT continue to do well. Profits attract competition, competition squeezes what is one to do?

Answer: Leverage. Gear up your pairs trades and arb strategies until profits regain expected levels. Regrettably, this process (repeated many, many times by participants) guarantees an entirely different volatility regime. The economist Minksy has been quoted much lately. As the "Minsky moment" is bantered around by everyone seeking some explanation for the events of the past year. But ex-post explanations to me are so unsatisfying, and arguments based on "boom and busts" only tell half the story.

The other half concerns Super Levered Operating Businesses, or "SLOBS".

The SLOB explanation is more ecological and organic. The opportunity cost of firms NOT to invest in SLOBS becomes high. More capital floods into SLOBS. More leverage is required to increase returns. Then, suddenly some heroic participants begin to question the sustainability of the SLOBS profits, and decide to squeeze them into submission.

It has nothing to do with abstract notions of what "should" happen in economic cycles - it has EVERYTHING to do with opportunistic firms sensing a weak hand at the poker table. Booms and busts do not simply "happen". Capital is misallocated by chasing historical returns that can never be sustained in a competitive business environment.

SLOBS become the low hanging fruit of the financial ecosystem - their leverage screams at more nimble and astute firms: "pressure me to will not take much, and once you do, your returns (properly annualized as the gains one receives from shorting these firms comes very, very quickly) will be massive."

So, for me there are no "booms and busts", only opportunistic people and firms taking advantage of herd-following money.

No comments: