Excerpts
"The global financial markets walk on the razors edge of empiricism and what you see is not what you think, and what you think may very well be impossible anyway. The impossible object in art is an illustration that highlights the limitations of human perception and is an appropriate construct for our modern capitalist dystopia."
"The fundamental characteristic of the impossible object is uncertainty of perception. Is it feasible for a real waterfall to flow into itself; or for a triangle to complete itself in both directions? The figures are subject to multiple forms of interpretation challenging whether our naïve perception is relevant to understanding the truth. The impossible object is of vast importance to mathematics, art, philosophy and as I will argue... modern pricing of risk.
Modern financial markets are a game of impossible objects. In a world where global central banks manipulate the cost of risk the mechanics of price discovery have disengaged from reality resulting in paradoxical expressions of value that should not exist according to efficient market theory. Fear and safety are now interchangeable in a speculative and high stakes game of perception. The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant."...
"Likewise how certain are we that the elevated two-dimensional prices of risk assets and low spot volatility have anything to do with fundamental three-dimensional reality? In this brave new world volatility is an important dimension of risk because it can measure investor trust in the market depiction of the future economy. The problem is that the abstraction of the market has become an economic reality unto itself. You can no longer play by the old rules since those rules no longer apply."...
"I know what you are thinking. You didn’t get your MBA to be an amateur philosopher - your job is to make cold-hard decisions about real money - not read Plato. You are out of luck. For the next decade this market is going to reward philosophers over students of business. Why? Because the modern investor must hold several contradictory ideas in his or her head at the same time and none of them really make any sense according to business school case studies.
Welcome to the impossible market wherw kkowledge is not what you know but certainty in what you do not Volatility is cheap and expensive at the same time Fear is a better reason to buy than fundamentals Risk-free assets are risky Common sense says do not trust your common sense."...
"Global central banking is the architect of the modern impossible object."
"To appreciate the cumulative effects of this stimulus consider a research report released by the Federal Reserve in 2011 that concluded since 1984 a staggering 80% of the premium earned from domestic equity was achieved in the periods leading up to FOMC announcements. How ironic.
As expressed in past letters, in the mind of this volatility trader the current paradigm of monetary stimulus may best be understood as the greatest leveraged volatility short in economic history (“The Great Vega Short” Artemis Q4 2010). The monetary policy of asset purchases is analogous to continuously rolling “naked” put options on the global economy and reinvesting the premium to collateralize the system with the goal of short-term growth at the expense of long-term systemic risk. In the case of QE3 this policy action is quite literally a volatility short because the purchase of MBS is also a simultaneous sale of pre-payment optionality. The stimulus regime socializes "tail risk" to generate short-term prosperity."...
"The defense of quantitative easing rests largely on an assessment of what would have happened to the economy absent its support. Nonetheless we should fear the law of unintended consequences because it takes a very small shift in perception to result in uncontrollable socio-economic change. We may get higher asset prices today but at the expense of inflation, class warfare, social unrest or something even worse tomorrow."...
"Either way the fate of markets rests largely on the psychological fight between the credibility of global central banks to defend an optical illusion against the will of risk markets to test the fragile boundaries of human perception.
We are now in the middle of a bull market in equities, commodities, bonds, and fear all at the same time. How can these conflicting visions of reality co-exist in the same multi-dimensional space? Welcome to the postmodern economy."...
"The perfectly efficient market is by nature random. When the market has too much influence over the economic reality it was designed to mimic, the flow of information becomes increasingly less efficient with powerful consequences."...
"Information becomes trapped in a self-reflexive cycle whereby the market is a mirror unto itself. Lack of randomness ironically leads to chaos. I believe this is what George Soros refers to as "reflexivity". The impossible object is a visual example of reflexivity."...
"If financial markets are the mirror reflecting a vision of our economy third dimension markets measure the distortion in the reflection."...
"The market is no longer an expression of the economy… it is the economy."...
"In the postmodern economy market expectations are more important to fundamental growth than the reality of supply and demand the market was designed to mimic. Our fiscal well being is now prisoner to financial and monetary engineering of our own design."...
"In the postmodern financial system markets are a self-fulfilling projection unto themselves while trending toward inevitable disequilibrium. While it may be natural to conclude that the real economy is slave to the shadow banking system this is not a correct interpretation of the Baudrillard philosophy."...
"The higher concept is that our economy is the shadow banking system… the Empire is gone and we are living ignorantly within the abstraction. The Fed must support the shadow banking oligarchy because without it the abstraction would fail."...
"The price discovery mechanism of markets is held together by fragile psychology that is increasingly dependent on money creation to sustain itself rather than economic growth. When systems become abstractions upon themselves they contain less and less information, are less random, and hence more susceptible to extremes in either direction. This is a source of tremendous opportunity and shocking systemic risk."...
"The fact that tail risk and volatility-of-volatility markets are historically expensive only shows that investors have never been more certain of their own uncertainty."...
"What are the “unknown unknowns”? Ask a psychic… I have no idea (that is the point) but if someone put a gun to my head and forced me to guess I would answer volof-vol itself. The more traders use ‘uncertainty’ as a market timing indicator the more unstable and cross-correlated markets will become. "...
"If you extend that concept to high frequency market microstructure and take it to the logical extreme you may see the problem. Today everyone is afraid of the next 2008 but I am afraid of the next 1987 (in equity or bonds)."...
"Today volatility is its own impossible object. Volatility markets are simultaneously calm on the surface and fearful underneath. Look at volatility one way and you see nothing but complacency with five year lows in the VIX index, but look at it from a slightly different angle you will see a furious bull market in fear."...
"The post-financial crash options market is marked by the transfer of risk premium from the center of the return distribution to the left tail in what I refer to as a ‘bull market in fear."...
"The worst crashes usually occur when investors are not prepared or excessively leveraged. Very rarely are you ambushed when you are totally ready for it. Widespread hedging provides an unseen floor to equity prices. In a hedged market the majority of investors are 1) not forced to sell in a decline or; 2) have the ability to buy on the dip.
Even when markets are hedged self-reinforcing crashes often occur in phases with the first wave wiping out weak portfolio insurance defenses and the second wiping out portfolio equity (see September 2008). It may be counterintuitive but you shouldn’t be afraid to climb the wall of worry when there is a mosh pit of hedged investors below you and below them a central bank financed mound of pillows stuffed with fiat currency. When the Fed is scared they expand their balance sheet to support the economy. When investors are scared they buy portfolio insurance putting a floor underneath stock prices. Ironically markets are at their very best when everyone is scared out of their minds."
Risk-free assets are risky...
"In a highly correlated world alpha generation is often a closeted volatility short. There is also the problem of hedge funds crowding into the same trades. I remember at some emerging manager conference where a woman said that her definition of “emerging” was a fund with only $1 billion and anything less was not worth consideration. That’s a little like saying you heard the cupcakes are really good at your neighborhood bakery but you won’t shop there until it is listed on the NASDAQ. Today 49% of hedge fund assets are controlled by the top 3% of the largest institutions. If everyone is chasing the same investments a lot of that “alpha” begins to look like “beta” with leverage or liquidity premium."...
"When the market is an impossible object the price of risk can change radically as perception shifts. Hence what may be sound judgment one minute may be completely foolish the next. If two contradictory ideas can exist simultaneously then there is no such thing as “simple perception” anymore. How is it possible for safety to be risky and for otherwise calm markets to be rich in fear?"...
"Paradox is now fundamental. The investor who can adapt to shifting perspectives will endure the volatility of an
impossible object. Common sense says do not trust your common sense anymore. Don’t live in a box or walk a flight of stairs that leads back from whence you came."...
"Today’s market is the most infinitely complex impossible object ever imagined and for the investor to thrive in it he or she must think creatively and be adaptable to the changing modes of acuity. You must be able to imagine different realistic states of the world and think as both the mathematician and the artist. Ironically he or she who plays it safe may be assuming the greatest risk of all."
Source: www.artemiscm.com
