Fama's Monkey

The random walk theory of equity prices (and everything else that trades in a so-called "efficient market") has been a perennial favorite of financial academics since it was pronounced by Eugene Fama in his doctoral dissertation in 1965. But it has also been the target of just about everyone else involved in markets. After all, how can you possibly justify mega-million bonuses if your job can be relegated to a monkey throwing darts at stock tables?

Despite reams of analytical data supporting Fama's theory during the last four decades, the finance industry has raked in trillions of dollars in research, management and performance fees. It seems thatit is not so difficult, after all, to continuously convince the gullible that the financial profession is always in possession of a better mousetrap. As for the suspicious, there is the ultimate weapon: no-load, low-fee index funds and other passive products: the industry's lucrative version of a (well-paid) monkey.

Despite the above, there are stellar exceptions to Fama's "you can't beat the averages" rule: Warren Buffet has been doing so consistently for nearly half a century. (Rumor has it that he is an alien in possession of time travel technology. I mean, c'mon... what sort of billionaire prefers Omaha over the Bahamas?) But, seriously, assuming that consistent market outperformers are not from a galaxy far, far away, how can their success be explained given Fama's theory?

As usual, the devil is in the fine print: Fama said that his theory holds for "...randomly selected securit(ies) of the same general riskiness". And within these last three words there is enough room to hold an ocean of water. When John Templeton was making a name for himself by investing in foreign and emerging markets, a Japanese automobile stock was considered so exotic as to constitute a whole different class of risk vs. GM. Likewise, when Buffet was buying small private companies at huge discounts to market multiples (See's Candy, anyone?), no one would include them with regular equities.

The secret of the game is to be early, patient and possess enough staying power so that properly selected "exotic" investments eventually become re-classified as "regular" risks and get re-priced accordingly (notice the word "properly": not applicable to monkeys). But this is a blog about the pernicious dangers of excessive debt - what is Fama and his monkey doing here? Hang on...

The connection between debt and risk assessment has always been there, of course. But until the emergence of Credit Default Swaps there were no pure-play instruments in existence to trade business risk (i.e. default risk). They were either connected to interest-rate risk (bonds) or equity market risk (stocks). The latent hunger for such pure plays was so huge that CDS's went from $1 trillion to $32.5 trillion in just 5 years. Now, that's what I call a growth business.

And this development, dear reader, has collapsed all risk categories into one: a bubbling stew of exotic and regular risks, all thrown together into the same pot. All of a sudden, a zero coupon bond issued by a private equity fund to finance the takeover of a listed company at 10+ times EBITDA is considered to be in the same general risk category as a bond issued by General Electric. Or, how about a synthetic CDO - a "bond" made up from CDS's? Or a curve steepener, a bet on the shape of the yield curve, also dressed up as a "bond"? All are considered bonds, so into the same pot they go. And since Fama's efficient markets are supposed to immediately and perfectly discount all available information, all that is needed is a monkey and a set of darts. Result? Down went all risk premiums, willy-nilly...

It gets more interesting: because of CDS's, the connection between credit instruments and equities has become very tight. It is a sort of self-perpetuating, self-reinforcing loop, with equity traders looking at CDS's for risk assessments and CDS traders looking at stock performance to price CDS's. As long as business prospects look bright the system keeps chugging upwards, pressuring risk premiums and volatilities to record lows. All are happy.

But it seems logical that when prospects dim, the process will work in reverse: we may experience a grinding, remorseless and long-lasting drop in financial asset prices as risk premiums and volatilities go higher, churning inside the loop. The current system is so new that it has never been tested during a bear cycle, so no one really knows what will happen.

Where does this leave us today? The defining characteristic of all markets right now is exactly that collapse of all risk premiums, i.e. the convergence of just about every investment instrument into one hyper-category, connected through the CDS market. In other words, Fama's monkey is throwing darts onto one huge board containing everything from Brazil ethanol producers and Zimbabwean gold miners, to US Treasurys and CDO bonds made up of Polish mortgages priced in yen. The proof lies in the way risk, volatility and equity markets now trade in tandem all over the world. Nothing seems to diverge - everything goes up or down together.

But, as the success of Buffet, Templeton et. al. make abundantly clear, the secret for superior investment returns is to predict which kinds of seemingly dissimilar risk categories are going to converge and be re-priced upwards - or seemingly similar ones diverge and be marked down. For example, back in 1999-2000 most dotcom stocks were not equities per se, but enormously overpriced lotto tickets. Once it was made clear, dotcoms got a massive haircut.

I believe the emergence of this global hyper-category of investment instruments is an important contrarian signal and we should be paying close attention for any signs of (a) its working in reverse and/or (b) sharp divergences within it.