Predicting The Unthinkable In Financial Markets

The nuclear strategist Herman Kahn coined the phrase ‘thinking about the unthinkable’ in a series of black comic Air Force briefings that became On Thermonuclear War (Princeton University Press, 1960).  Faced with a year-long crisis in US credit markets analysts have embraced similar imagery in their forecasts of catastrophic risk.

Several different players in the financial ecosystem rely on the forecasts for multiple payoffs, one for their target audience and the other for themselves:

  • Research Analysts: (1) Provide clients with guidance and metrics to the market turbulence; (2) stand out in the pecking order of research firms and competing industry/sectoral analysts to remain relevant.
  • Investment Media: (1) Catastrophes as the source of drama and headlines to keep consumers engaged; (2) Financial and operational synergies of convergent media production.
  • Fund Managers: (1) An external input to valuation models for visiting potential firms to invest in; (2) A parameter for deciding on the asset classes, diversification and hedging for investment portfolios.

Some questions to ask in evaluating any catastrophic forecasts that predict the unthinkable:

  • What is the source, type and timeframe of the evidence presented?  The source may be company interviews, earnings calls, investment calls and trade seminars.  The type may be firsthand observation, market rumour, financial model, computer simulation or analyst conjecture.  The timeframe may be historical simulation of past data, quarterly forecasts or a longer time horizon for capital financing, global market entry, innovation pipelines or sustainability projects.  The source enables you to filter any possible agendas, the type refers to the information structure, whilst the timeframe often has embedded assumptions about cause-effect relationships, impacts, and the actions of others.
  • Why is the analyst making this forecast and could there be other agendas? Analysts have biases and personal theories that an attention economy might amplify.  At a group level this becomes self-reinforcing collective wisdom that may turn out to be flawed.  In embracing a current meme in a true believer stance analysts create a cognitive frame prevents them from considering alternative outcomes, options and possibilities.  At its most cynical this question is a reminder that forecasts are not objective or value-neutral, especially if the analyst is under pressure to generate earnings revenue or has a different private opinion to their public view.
  • What is the analyst’s track record in accurate forecasting?  This focuses on the analyst’s patterns of thinking and rhetoric in forecasts; how their performance compares to an industry, market or sectoral baseline; and the margin of error in their past forecasts.  This can be used to construct a brains syndicate, to filter out media reports and noise, to surface hidden assumptions and how they affect performance, and as a quality assurance check.
  • How might the catastrophic forecast be hedged? This shifts the focus from optimistic versus pessimistic views to the risk management focus on mitigative strategies and action planning.  To be effective, this requires an understanding of your risk profile and risk-return needs (risk averse, neutral or seeking), your time horizon, and the nature of the financial instruments, investment portfolio and markets to be used.

Are Financialistas Over Hedge Fund Chic?

You can blame George Soros for making hedge funds the dark horse of the irrationally exuberant 1990s.

As the public face of the Quantum Group of Funds, Soros gained notoriety for short selling the English pound in September 1992 and allegedly making $1 billion in profits.  Adam Curtis observes in his riveting documentary The Mayfair Set (BBC, 1999) that Soros’ victory signalled the first time that market speculators had beaten a country’s central bank.  In the aftermath Soros cultivated a master trader persona based on his personal ‘theory of reflexivity’ or how ‘participant’s bias’ can shape our actions in and perceptions of market events.  Hedge fund chic arose in Wall Street as investment banks rushed to found hedge funds, which use leverage and pooled capital to manage assets, derivatives and securities for an investor group.

Financialistas however are showing signs of buyers’ remorse as subprime turbulence brings an end to Soros-inspired hedge fund chic.  The high-profile collapse of Bear Stearns‘ two hedge funds in mid 2007 was only a precursor, Hedge Fund Research notes, of 170 liquidated in early 2008.  The survivors have adopted Soros’ global macro strategy which relies on computational finance and dynamical models of currencies, interest rates and other macroeconomic factors to achieve returns.

Global macro is a risky strategy for several reasons: it requires forecasting models of complex interactions, computing power and fund mangers with impeccable judgment for asset allocation.  In fact global macro deals with a specific risk class known as systemic risk that results from business cycles and macroeconomic movements, thus it cannot be diversified away.  Add funds’ massive leverage of pooled securities, industry secrecy, little government regulation and hypercompetition between different funds and managers, and an accurate calculation of risk-return is difficult.  These challenges overshadow the potential of applied research solutions, such as Fritz Zwicky‘s morphological analysis, a problem-solving method which deals with ‘multi-dimensional, non-quantifiable problems’ – relevant to the macroeconomic factors and systemic risk in global macro strategies.

Hedge fund chic faces several other problems.  As an investment category hedge funds have matured and their combination of high leverage and high management fees are unsuitable for many non-institutional investors.  Subprime fallout is triggering change in US financial and regulatory institutions which will inevitably lead to more rules and regulatory oversight of edge funds and managers.  Internally, hedge funds also need to separate managerial processes (principal management, portfolio execution) from financial reporting (mark to market book) and governance (board, corporate and policies & procedures).

Which means despite Soros’ alchemical touch hedge fund chic may now be a fad.