Death by Comet Revisited, “a story about how much is enough”

By Bruce L. Raphael       November 6, 2007

Hunt Taylor was a star in the hedge fund world in New York City up until his tragic death in Arizona on February 4, 2006 in the mountains outside of Phoenix on a large motorcycle.  He lead conferences in Vegas, kept high ranking experts in finance glued to his every word when he spoke during those steak dinners.  He didn’t believe in UFO’s but he had an uncanny knack of combining wisdoms to let anyone willing to listen that he was not penny-wise and pound foolish about monetary policies.

What I recalled during the growing popular viewing of Comet 17P/Holmes this month from October 23, 2007 to now November 4, 2007, is the current instability in the over rational world of financial markets that was lead by a downfall of hedge funds followed by sub-prime fires in the mortgage and lending markets.   I sat in Hunt Taylor’s office on Madison Avenue on  September 21  2004 discussing all the turn of events of the last two years, while cnn.com was creating some concern for Hunt that particular day.

He spoke clearly in the boardroom. His bulging girth at the time was held together by some very nifty suspenders, making him look like a cross between Daddy-Warbucks and Billy Joel. I had not seen him for a few years; upon my return from Australia we got together and caught up. In the hour that he gave me he revealed that his luncheon with the Assistant Secretary of Treasury revealed some very nasty plans coming forth for the United States economy.  “Bruce …” he said with careful meter to his tones, “ you had better buy gold and consider some impending changes to the world as we know it”. “You mean a financial collapse of the markets?” I asked with some feeling of confidence.

“Well, in so many words, I have learned that from all my years of studying markets and movements of credit, there are some forces that will implode upon the overextended nature of our credit system here in America.   From my meeting with  John Hammond I learned some distressing terms for the future of the United States economy.  Let it be known that his aggressive anti-Bush sentiments will undo him, yet he is perfectly transparent in the wake of O’Neill’s dismissal.

“Secretary O’Neill was an outspoken critic on the complexity of our nation’s tax code. He believed the code’s complexity was inhibiting personal as well as corporate growth in America and became one of the administration’s leading advocates for change. It will get very bad, and I would hate to see you on the streets when the US Dollar would be no more.” “Be no more!?  How can that happen?” I insisted.  On the oversized plasma TV in the boardroom President Bush was addressing an audience.  “It is part of the crazy apparent leadership of our current President. That is all I can tell you now.” Hunt concluded and gave me a tour of the office.

Hunt and I went way back to the days of prep school in New England he and his sister Patti were actually my oldest friends I had.   So as my oldest friend and wisest intellect in our New York City aging circle of  colleagues, when he spoke I listened.   In the week to come I sent him current updated news and science on cometary theory as posted by Professor  James McCanney, scientist and astronomer in the days when his Millenium Group was aggressively setting up new scientific arguments on the behavior of cometary activity in our solar system.   A week or so later, Hunt had written the consummate prophetic piece that would haunt me to this day.  Something that he learned at that luncheon with Hammond, changed his way of thinking on what to prepare for in the immediate future.  And something about comets made it crystal clear that his story would have more impact than we knew then.

His story published in Lipper HedgeWorld Limited on October 4, 2007 begins here:

”You never know what is enough, until you know how much is more than enough” – William Blake Someone once told me Myron Scholes said the folks at Long-Term Capital Management thought they had their risk buttoned down. In their minds, they were walking down Madison Avenue, eyes trained on the tops of the buildings, looking for falling safes, when they were suddenly struck at an oblique angle by a comet.

To understand what Dr. Scholes meant by a comet, I think one first has to understand the difference between risk and uncertainty. Risk is the chance that some unwanted but quite conceivable outcome occurs.  You’re in the casino. You bet on black. It comes up red. Uncertainty, on the other hand, is the chance you’re affected by some unwanted outcome you’ve never even considered.

{Author’s note: It is the following words that brings us to the point of the story, that genius and deep set feelings for the economies and policies that were put in place by the helmsmen of the Fed, were perhaps a well scripted deception, focusing on stealth and subterfuge.}

You’re leaving the casino with your winnings when suddenly you’re hit by  a …comet.  We’ll leave history to decide whether Long Term Capitol Management was hit by a comet or whether LTCM was the comet.

I’m not here to pick on Myron Scholes. He is a brilliant and literate man, Whose new fund, Oak Hill, seems to have addressed the risk issues From every angle.  But the thing is, sooner or later, there’s always a Comet.  I’ve learned to keep on eye trained on the night sky looking for Them while I sleep.  They are wired into the DNA of the free market system. As Eugene Fama, father of efficient market theory and Dr. Scholes’ thesis  adviser many years ago, told Roger Lowenstein in When GeniusFailed, “life always has fat tails” .  The extreme end of the left tail of the distribution is where the ‘comets’ live.  That this tail is “fat” simply means there are more comets out there than investors care to suppose.

The markets—in fact, societies—have a long and infamous history of ‘death by comet’ . 

The year 2004 ended on a similarly sour note with the second Mexican peso Crisis.  This one, interestingly, was aggravated by the assassination of a Mexican finance minister, leading foreign investors to conclude that the Political situation was out of control and causing them to pulltheir money out of the country at an accelerated rate.  Only later did it come out that the murder was the result of a family conflict.

Taking a quick tour back through the years:  we had 911 in 01’, the bursting of the dot.com bubblein ’00, LTCM in ’98, the Asian Contagion in /97, the cary trade and the Peso crisis in ’94—and that is just 10 years.  We had The Hunt brothers in ’91, the LDC crisis in ’82, the crash of ’87, the S & L crisis in ’89.  Anyone see a pattern here?

Market shocks are roughly as predicatable as the buses on Madison Avenue.  More so, according to most New Yorkers.

Life always has fat tails.

But why do they recur?  Given all we’ve learned about risk, wouldn’t it seem We could sidestep a debacle or two? It’s worth trying to understand the ground-state conditions that set the stage.

One thing all those past debacles had in common was a sudden, mass liquidation.  No one ever went broke trying to get into a position, Pets.com notwithstanding.

The incomparable Edward O.Wilson noted in his wonderful book Consilience, that Immanuel Kant, in 1784, had observed that “man’s rational dispositions are destined to express themselves in the species as a whole, not in the individual.”   I find this largely to be true, unless of course, mankind is using leverage.  Leverage is like an echo chamber to the emotions of the investor, and leverage has been a culprit in more than one of the bloodlettings.

Perhaps more to the point is the herd-like behavior of crowds.  Investors have shown, time and again, that they prefer the company of others.  It’s reassuring, particularly when we are invested in markets we might not understand as well as we should.  The company of others, expressed in a chosen security, tends to make the price go up, creating profits for the investors, who are too often use them to buy more of the aforementioned security, extending the cycle.  And because this feels good, we tend to keep doing it.  We tend to climb the proverbial ‘wall of worry’ in packs, then herds.  The stampedes come on the way out.

Steve Waite, in his book Quantum Investing, distinguishes between exogenous risk, which is risk that comes from outside events, and endogenous risk, which is risk that has built up internally.  The terrible events of 9/11 were exogenous.  The crash of ’87 was endogenous.  I find most market shocks are from endogenous risk. No one yells fire in the movie theater. It just gets too crowded. The tipping point tips. Someone moves toward the door, and suddenly it’s too late.

The final dynamic is the almost unanimous opinion that exists prior to the Event.  Even when most of us know better, we tend not to act.  Stocks in ’87 and ’99, the carry trade in ’94—we knew these markets weren’t going to go forever, but lemming-like, we marched steadfastly cliff-ward. George Ellliot, the English novelist, saw through to the essence of why we overstay our welcome when both history and common sense argue for a prudent departure:

“The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm.  The lapse of time during which a given event has not happened is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.”

Put simply, the fact that it’s been a long time since the last market shock now convinces us that there will not be another one, all evidence to the contrary.

Life always has fat tails.

A pretty big statement.  Notice that Fama said “life” and not “markets”. In fact, cataclysmic events can be found throughout nature. Seismic stresses create earthquakes rather than a gentle shifting of tectonic plates.  Snowfalls create avalanches, storm clouds turn into tornados; we see the process everywhere. The same thing happensin societies.  The Enlightenment ends in the French Revolution. The Assassination of Archduke Ferdinand of Austria by a secret Serbian nationalist group called the Black Hand sets in motion a mindless series of events that culminates in the First World War. On and on.

Finally I think this is about camels and straws. A straw can’t break a camel’s back any more than a snowflake can cause an avalanche or one sell order can cause a market to crash---yet ultimately, they do. And then, as William Blake  said, you know how much is more than enough.

So, what conditions exist tody? Which markets could be setting themselves up for a dislocation?

If I am coldly rational, I am actually more sanguine about prospects when I apply the criteria mentioned above.  Some friends had an interesting dinner conversation recently.  They asked whether the markets were currently being driven by fear, greed or uncertainty.  The decision was uncertainty.  Iraq and the election were enough to keep most investors on the fences.

Uncertainty does not create unanimity of opinion.  Are we so comfortably long with either stocks or bonds that they are now prone to sudden mass liquidation? Probably not. At least not here and now (October 4, 2004).

How about leverage? No really. Margins debt is not extreme in equities relative to where it has been , and bonds have had two years of sideways action.  Greenspan has raised the short end  0.75% while the long end has traded back down to a 4% yield,  gently deflating the carry trade.

There are areas that concern me though.  The first is credit. I can’t find anyone who’s worried about it.  Even I can’t find a good reason to worry about it, and that’s got me nervous.  Spreads are as tight as they have been in years, and complacency is rampant.  I know corporate blance sheets are in great shape, but I’ve seen credit sliced and diced and repackaged in more ways than Oscar Meyer has meat products and there would be hell to pay if spreads went south.

Then there is the consumer. I’ve seen all the new metrics about hosehold net worth relative to debt service. I also know that the U.S. consumer has not entrenched in 12 years.  That’s a long time. And no one is really looking for it. And they are levered.

Housing also meets my checklist. Everybody’s long (including me), everybody’s levered (including me), and if housing ever turns down, The Wall Street Journal will read like a Stephen King novel.

Finally , there are hedge funds. I’ve written about that in the past. I believe there are structural and leverage issues that could become problems under the wrong circumstances.  And the thing about hedge funds is that they don’t tolerate outflows very well.

Am I predicting a market shock in one of these areas? Not necessarily, but I’ll make book we’ll see a systematic shock someplace, and I’ll give odds it will be in the next 18 months.  By then, we’ll be well into the first term of the new presidential cycle and lots of bad stuff tends to happen then.  And while I’m not smart enough to tell you what asset or investment class is going to get hit, my strong suspicion is that it will be one we are not focused on.  That’s the part of the night sky my telescope is trained on.

{Authors’ Note: It is quite the parable when a friend’s inky hand rises from the grave and speaks.  It is another thing to know that what we conceive is what we believe in.  I think the cometary mystery remains one that Hunt himself felt under the right conditions compelled to share milliseconds in universal time before Holmes became a sentinel in the night sky.}