Monday, January 25, 2021

It's A Volat(oil) World - Tail Events

I touched on tail events on the previous post and how they can precipitate entirely unforeseen consequences.  Let’s look at this in more detail.

First, a recent example.

Last April WTI crude oil front month futures traded at an unprecedented -$35 per barrel, ie. sellers had to pay buyers (Fig. 1).  The  sudden collapse in demand due to COVID lockdowns created a physical oil glut which filled all available storage tanks at the authorized delivery locations. No one wanted to take delivery of oil, at any price, simply because there was nowhere to store it.  

No one ever imagined negative oil prices, but they happened and  that’s the very definition of a “black swan” or, in more mathematical terms, a “tail” event (ie at the tail end of a probability curve).

Figure 1

Switch to today. As financial markets soar to ever higher highs they predict an ever rosier future for the US economy, and the risk/reward balance overextends heavily towards risk (Figure 2).  It is therefore more probable that a “normal” negative event will produce a proportionately bigger drop than otherwise, something like a reversal to mean, while a totally unexpected “tail” event may have entirely unexpected consequences, something analogous to negative oil prices.

Figure 2

Let’s let our imagination run wild..

What’s the most unthinkable scenario for stocks if a true tail event happens?  Well, I can’t see how negative stock prices could occur, but... how about zero?  Or thereabouts? What if no one wanted to part with cash all of a sudden, no matter how attractive the offered price?  What if margin money disappeared, or became so expensive as to be practically unavailable? 

What if some or many CFD counterparties could not honor their contractual commitments and failed, creating a domino effect? CFDs work on razor thin margins and the brokers as a matter of standard routine immediately close out losing client positions once the margin money put up as collateral evaporates.

Imagine a day that opens with a gap down of 10%, creating a tsunami of automatic closing out sell orders which avalanche through the system. Will “real money” institutional investors step in? No way, they’re not stupid to catch a falling knife and, anyhow, they already know this is a bubble. Margin calls to cover the excess losses will be automatically executed since these days trading accounts are linked to speculators’ bank or credit card accounts. Remember, with margins as low as 2%, a 10% move generates losses 50 times greater, ie 500%. If XYZ stock is down $10 the loss on the account will be $500.

What could lenders do? Well, exactly what they did in October 1929: quickly shut down the margin lending window, creating even more selling pressure to raise needed liquidity. Even if most brokers run a square book, even a few counter-party failures will quickly spread and force everyone to hoard cash. Ergo, no buyers at any (reasonable) price.

But that’s what the Fed is there for, right? Lender of last resort and all that jazz? Ok, but lender to who? Joe Bloe plunger from London? Or Stavro Bloefeld credit manager of the AlphaBet CFD platform in Cyprus? Oh, maybe their prime brokers will act as intermediaries? Yeah, right, like they won’t  remember what happened to Lehman and many more back in 2007-08.  Remember, it was not the Fed who saved the likes of AIG, Citi, Merrill, et al.  It was the Treasury Secretary who blackmailed financial industry leaders into saving their failing brethren by threatening a complete government takeover.  (Paulson could do it because he was the ex CEO of Goldman and knew exactly how to do it, he was one of them and could stare them down.  You think Janet Yellen could do it? Not in your, or her, dreams.)

From my own experience I tell you that when panic rages it’s every man for himself. You sell first and ask questions later. I was there in October 1987 when credit managers were going around from desk to desk screaming at brokers “your customer has 30 minutes to bring in a check/wire or I’m selling him out”.  With e-banking, today that 30 minute window is now more likely 30 seconds. And 1987 may be considered a hiccup today, but it was a bigger single day drop than even Black Monday in 1929.

Index tracker funds are very likely another potential accelerator, particularly “short” ones that promise 2 and 3X performance.  I won’t go into detail, but you can see how they would be forced to sell into a down market.

Now, compound all of the above with algo and flash trading which make up as much as 80% of daily volume, creating a false sense of market depth and breadth. Such systems have “circuit breakers” which will shut them down immediately.  This leaves only “real money” traditional investors, people exactly like Buffett, Munger, Dalit, Grantham, et al.  Most all of them are already on record saying we are in a bubble, so they won’t buy until the blood flows...

In summary: this is a very thin and very narrow market masquerading as a real, structural bull market. It is highly susceptible to some kind of black swan event which will produce very, very high volatility.

What could that tail event be? I have no idea.  By its very definition, a black swan is an unknown-unknown.  But we know they exist, even though the market is behaving as if they don’t...


  1. Excellent post! What's the source for the figure 2 chart? Thanks.

  2. Could Bitcoin's rally be a misplaced hedge agaisnt those unknowns you're mentioning here?