Redstate

Of course, I'm talking about the returns to public equity. When equity markets do finally recover, the action will shift to privately-owned equity. Sidestepping government interference is part of the reason, but not all of it. And I've believed this for years now, not just since the current problems started. I hate to leave it there, but it's too big a subject for a small comment.

If we are in the middle of a systemic repricing of risk (a phrase I first started using early last year, before it became evident that a global financial crisis was underway), I don't think it's like any of the earlier periods that you mention.

I think rather that it comes from the nature of today's financial markets. Over the last two decades or so, equity markets have become more and more like the dog being wagged by the tail. And the tail is the derivatives markets, which are all driven by the sophisticated mathematical modeling sometimes called "neoclassical finance."

We've had at least four major wakeup calls that there is something rotten in the world of mathematical risk modeling: the 1987 crash; the 1997 Asian Flu; the 1998 Long-Term crisis; and the 2007 Subprime Crisis. All of these events were believed to be about as mathematically unlikely as a shattered windowpane jumping back together by itself.

If we've finally had the wakeup call that people listen to, then that could be the basis for a widespread and prolonged slowdown.

There will always be a place for publicly owned equity shares, however with SarbOx, that place probably isn't going to be the place... Relative to the past, few small companies see going public as the end game - now the route to monetize a business one has built is either private equity via an LBO or otherwise or acquisition by a larger company. The companies going public now seem to have exhausted the preferred options available. This leads to not only unhealthy equity markets but an unhealthy political environment - big companies grow by acquisition, lobby the government to regulate their industries, effectively keeping competition out. This all conspires to screw consumers and small business.

True that the derivatives market has become much larger than the equities market, and a couple of big factors in that have been execution and market impact costs and the shift towards mathematical modeling. However, derivatives have to have something underlying to derive their value from, the tail can only wag the dog for so long, and in all the crises you named(although not so much the '87 crash), that has been forgotten. People need to realize that mathematically modeling risk based on a Gaussian distribution(bell curve) will never work over any length of time. You may be able to model the market somewhat using a Mandelbrotian(fractal) distribution, but even that is fraught with peril.

There will probably always be suckers(represented heavily in the so-called professional investor class) who will fall for the Gaussian distribution BS because they have a financial incentive to do so. Just do it anyway, knowing it's wrong, have a few good years and watch the money come rolling in to your fund with its "proprietary investment model that takes everything into account" and take your big paychecks out until it blows up in your face. Hell, you've screwed your investors, but so what, you've got your money!

There's an interesting anecdote in Taleb's "The Black Swan" about casinos, where risk on table games, slots, etc rightfully should be modeled with a Gaussian distribution. He lays out 5 times where casinos have lost big money. Interestingly, none of them had anything to do with risk from "whales" or cheating. One was when Siegfried and Roy's tiger attacked one of them, despite being trained by them from a pup and sleeping with them every night. They had insured against the tiger jumping into the audience and other such plausible scenarios, but the one they didn't insure against was the tiger attacking the trainer, causing the casino to lose something like $100 million.

There will always be a place for publicly owned equity shares, however with SarbOx, that place probably isn't going to be here...

As I was reading through your comment, I kept saying "boy, this sounds like someone who just read The Black Swan." Sure enough... :-) The first clue was the Mandelbrot line.

I liked Taleb's book but it was frustratingly lightweight and unsystematic. And if you examine what's happened to imputed volatility in derivatives markets, Taleb's insights provide no particularly tradeable advantage.

If indeed it turns out that scientific risk management has a fatal flaw built into it (namely, the tails of the S-curves aren't fat enough), then it's possible to imagine a world in which risk doesn't get allocated by the market with nearly as much efficiency as it does today. That could happen because people will no longer be able to use as much leverage. In turn, that would happen because there won't be any more instruments that make complex assets mathematically impersonate garden-variety corporate bonds.

If, as you say, the tail must someday stop wagging the dog, then it's not a forgone conclusion that such an outcome would be bad for the global economy. It might mean that traditional banking ("making money the old-fashioned way") might make a comeback.

Who would be hurt? Certainly the large sector of the financial world that makes most of its money from liquidity and volatility. I've long had the intuition that this entire sector is not a positive value-added in the global economy in the first place. And I'm not the only Wall Streeter who privately thinks so.

For what it's worth, Sarbox isn't the only, or even the most important reason why public equity will become a permanently-underperforming asset class.

Yep, read the Black Swan a while back, but that casino story really stuck with me. I've also read a lot of Mandelbrot's stuff.

Taleb's book was definitely interesting, he certainly has a unique perspective if his writing style is a little weird. I think it's a relatively good book, makes one think, but I agree that it's unsystematic.

I agree that the way a lot of people bill liquidity as a justification for their existence is pretty lame, as a certain amount of liquidity would exist without them(for instance if everyone just did online trading). However, I don't think liquidity in general is overbilled - there is certainly a liquidity discount involved in private equity that can be quite significant and a not insignificant one involved with thinly traded equities. As a reformed Wall Streeter myself, my opinion is that investment firms in general add little value in the ways they perceive they add value, and not a whole lot of value in general.

Also, and maybe this is too broad of question for a quick response, but how do you see public equity becoming a permanantly-underperforming asset class? I agree they'll underperform for at least a few more years, but my ears perk up when I hear the "it's different this time" sentiment. In my view, there has to be a solid public equity market to sustain a vibrant economy, or, absent that, there has to be another widely available asset class that serves to provide the equity capital to business. I just can't see private equity being able to provide that - not enough people can invest in it thanks to sophisticated investor laws and the lack of liquidity would lead to subpar valuations, hurting the incentive to start a business.

I'll take a very quick shot at what you correctly say is too big a subject for a short post.

The nut of it is that people do what they get paid to do. And the people who pay corporate managers are the guys who run the large pension funds and university endowments.

They don't pay managers to deliver alpha. They pay them to deliver consistency. Over time, management has no incentive to take the kind of risk that will result in performance that beats the market.

On the private-equity side, broadly speaking, the incentives run the other way around. (This will change somewhat in the current credit-challenged environment, and private companies will be under more pressure to generate enough cash to cover debt service.)

When you talk of not paying managers to deliver alpha, I take it you mean corporate managers, correct?

If I'm reading you correctly, you're saying that the public equity market's doesn't deliver the proper incentives to the corporate managers(ie CEOs, CFOs, COOs, etc of everyday companies) and that the large pension funds and endowments along with private equity more properly align the incentives of various stakeholders(whether they be employees, customers, shareholders or whomever)?