Tuesday, December 06, 2005

That surreal feeling

There are some events in life that must be experienced from a certain perspective to be even remotely understood. For example, you don't know what it is to have a child until you have one of your own. Some, most of whom don't have children, might argue otherwise. Yet it is an argument that can only be settled one way, by having a child, the effect of which almost always leads to a changed view.

In that class of events having to be experienced to be understood I place a breakdown in civil society, which I saw in Asia during their financial crisis of 97-98 and, the focus of this post, the breakdown of normal market function when prices cannot be found and when you have a position or stake in the outcome.

Ask any parent if they have ever had a moment of terror when they couldn't find their child, thought they ran out in the road, or even, after months of crying every two hours to be fed, slept soundly for 6 hours (Oh my God! I've been sleeping for 6 hours, is the baby still breathing?!), and they will likely say yes. It is a strange feeling, as if the universe isn't working right, which can only be assuaged by confirmation that, yes, the baby or child is fine.

Far less shocking, at least to me, but evoking a similar surreal feeling have been those moments which stretch into minutes when your brokers shout market out, looking for a price. Back when I was trading FX and FX options I used to sit on a trading floor which looked somewhat like this, rows of computer terminals and price screens manned by rows of people. Little speakers carried the voices of brokers into the room continually updating foreign exchange rates:
25-8 on 121 for 10 dollar Yen (which means the broker has a client(s) who will buy 10 million US$ in exchange for Yen at 121.25 and sell 10 million US$ in exchange for Yen at 121.28). After a while the clamor from the little speakers fades into the background of the mind, although, like a parent listening to a sleeping child, you always have an ear out.

Once that clamor has become normal to a person, that sense of always being able to get into and out of a position quickly grows. You might make a bad trade but, you think to yourself, at least you can always get out. Indeed, the idea that one can always get out or hedge is, to a greater or lesser degree built into most option pricing and derivative portfolio risk management models-yes a great portion of the mountain of dervatives whose notional value exceeds many multiples of world GDP are using a flawed model. The Black Scholes model, which won the "inventors" a Nobel Prize in 1997 is one such model that assumes continuous pricing. Ironically Myron Scholes, of Black-Scholes option pricing model fame, was a partner of
LTCM, the hedge fund that collapsed in 1998, in part because they bet on continuous markets and learned their lesson, the hard way.

I have witnessed quite a few times when that assumption is wrong, very wrong. It's funny, even when I've been on the right side of the move, the absence of prices, the panic in voices has evoked that surreal feeling in me, as if water were flowing uphill. With the benefit of hindsight I think the surreal element comes as the veneer of civilization, which I believe is only as deep as our sense of the world is true, is peeled off and the animal panic is exposed. One of the articles of faith among those, whether they are aware of this or not, who believe in the variations of the efficient market theory, is that on some level, markets are run by reasonable, deliberative people who might miss a few things but will surely see the big picture. Yet the history of man is filled with just such mass revelatory events.

Have you ever lost a million $ in a few minutes? I have, fortunately it was the bank's money. It evokes a feeling of impotence. You want to get out, you are screaming at the brokers and colleagues to get you a price but they can't ..... and on that silly screen you can see the price going against you faster and faster.

I've watched the same feelings manifest on the faces of fellow traders. The initial anger quickly switches over to panic and finally the color drains from the face and the jaw goes slack as the inherent risks of the game are brought home in a profound way. Perhaps crude language expresses the crude feeling best, it hits you in the gut. It is a humbling moment, and one I hope to never forget, although I'm stupid enough to have needed a few refreshers.

Yet, even though I can print graphs and describe the action and feelings to people it is often like explaining those moments of terror as a parent to the childless. There is, I believe, a rotten little secret at the core of the Religion of Finance of which many players are aware on some level but not in their guts, if you will. The markets, as with all human endeavors, are prone to error and in some of those cases of error, only those who get out before it is obvious get out at all. The rest then learn a valuable lesson. The more I think about the line from a recent post by Stephen Roach; We all know these imbalances you speak of are unsustainable -- we just can’t afford to focus on the endgame, and my own communications with the professional investing community, many of whom seem to be searching for the elusive moment right before everyone else is going to put on the defensive trade, the more I realize that sooner rather than later I'll be experiencing that surreal feeling once more.