Seeing the Black Swans coming

Nassim Nicholas Taleb is about to address the massed ranks of the CFA Institute, but it seems plenty of them already know that the market is not totally efficient.

Jeremy Armitage of State Street Associates gave a morning presentation which gave evidence that returns for currencies, bond yields, and the S&P 500 are not “normally” distributed - a key assumption of many risk models which Taleb has gone out of his way to attack. For all three asset classes, the chance of a daily event which is more than 2 standard deviations away from the mean is about 4 per cent, he said. That is significantly higher than you would find under a “normal” bell curve distribution, where this would only happen 2.5 per cent of the time.

In Taleb’s honour, State Street has also gone on a “black swan hunt”. [Taleb’s best-selling book refers to events that could not have been predicted from past behaviour, and which lead to severe market turbulence, as black swans.]

According to Armitage, watching the flows in and out of institutional fund managers can give a clue that a black swan is flying your way. “Black swans migrate,” he says, “when liquidity is at riot point.” This is State Street’s definition of moments when investment flows dry up, showing extreme risk aversion.

Historically, such conditions rarely last long, because they provoke a policy response - generally, the Federal Reserve and other central banks cut interest rates.

But last year, the markets stayed at “riot point” for four months, unprecedented in State Street’s back-tested models. This was a sign that the rally in emerging markets at the end of this year was not to be trusted, and that some black swans may be on their way. With hindsight, we now know this was a good signal.

Other findings from State Street’s research? The foreign exchange carry trade is more or less dead, and will not revive for a while. Using Value-at-Risk models - even though Taleb would disapprove - there is more value at risk now from selling short low-yielding currencies and putting money into high-yielding currencies than at any time in the last eight years.

And the huge divergence between energy and financial stocks does not seem to be driven by liquidity. Indeed, institutions seem to be bullish about financials and bearish about energy, despite the results from the first quarter. That could, according to Armitage, be a signal that the gap is ready to narrow, with financials ready to stage a recovery.