What we don’t know

September 30, 2014 07:00 PM

Throughout this long strange recovery from what was truly a historic crisis in 2008 there has been a feeling of unease. While no one likes a black cloud, it is impossible not to feel that there is another shoe waiting to drop in the evolution of the credit crisis that struck in September 2008 and which has led to extraordinary central bank interventions and an unprecedented six-year period of a zero interest rate policy. 

October is often a fearful month for markets. Perhaps doubly so this October as we are in the sixth year of a recovery very few people have felt the benefits of. It also is expected to mark the end of open-ended quantitative easing, or QE3. It is a time that many have dreaded as the market is expected to stand on its own two feet without the extraordinary stimulus from the Federal Reserve. 

We thought it would be a good time to look at risk on a larger scale. 

A recurring theme of past market panics is that traders had miscalculated the amount of risk they had in their portfolios and of certain products. Some of it was due to mislabeling —products rated as AAA that lost 90% of their value should not have been labeled as such — and sometimes it was due to flawed risk measures. 

In the last 30 years equity markets have had several “so called” five sigma (standard deviation) moves that are only supposed to happen about once in a hundred years based on normal distribution measures. In “Deeply flawed risk benchmark,” Scot Billington and Rob Matthews report on the results of a study into using standard deviation as a measure of risk. In it they point out how this measure tends to miss the mark at the most important times, failing to predict the chance of large downward moves accurately. 

We reached out to James Rogers, an old friend of Futures, to get his take on what comes next after this extraordinary period of Fed intervention. 

Not surprisingly, Rogers would have liked to see the Federal Reserve and U.S. government use more restraint and deal with spending issues rather than to have flooded the world with “artificial liquidity.” 

He doesn’t believe there is imminent risk of a market collapse—though added he is terrible at market timing—but says there is a day of reckoning coming and the next economic downturn will be worse than the last because of the level of debt we are carrying (see “Rogers on the Fed and global economics”). 

What was surprising is that Rogers, who recently visited North Korea, is bullish on the prospects of free market reforms in that Communist country, and has predicted that the two Koreas will unify within five years. This is truly a bold prediction and one we had no inkling of. “Where China was in 1980, where Myanmar was in 2011, is happening [now in North Korea],” Rogers said. He tells us what he discovered on his trip in, “Off Topic.” 

Rogers’ observations are startling and exciting but also raise many questions regarding human rights, personal freedoms and the long history of abuses in North Korea. We would not presume that these issues have gone away but what seems clear is that something new is going on in North Korea and it is strange that very few of us in the West know about it. If a North Korea that is truly an open society, not in a constant state of war with South Korea and the United States emerges, that would certainly be welcome news. 

Rogers also said there will still be a leg up in the commodity bull market he forecasted more than a decade ago. While many commodity markets have receded recently, Rogers’ long-term track record is pretty strong so we wouldn’t doubt him. 

Speaking of commodity investments, George Rahal challenges the notion that there is an inherent roll yield in passive commodity investments (see “The truth about the GSCI roll yield,”). For years there has been a belief that passive commodity investments benefited from the tendency of certain markets to be in backwardation and were punished when markets where in contango. The so-called roll yield was used in marketing some of these passive investments. Rahal’s research shows this may not be the case and should be the start of a healthy and interesting discussion. Of course roll yield and the contango effect represent another form of risk and this issue discusses risk and opportunities. 

Speaking of risk, it is a little odd that geopolitical risk hasn’t created a spike in the crude oil (NYMEX:CLV14) market. In the past, relatively minor threats of conflict in the Middle East have been know to create spikes in crude, but this summer with multiple conflicts in the region and ISIS threatening the stability of two states — not to mention the Russian/Ukrainian situation — crude oil is dropping. Dominick Chirichella explains how North American production has truly changed the nature of this market (see “The world of oil is changing, again,”). 

As noted above, the month of October has often been scary for traders and markes. We certainly aren’t predicting a major market event this month but considering where we are now (and what has happened throughout history) it is a good time for traders and managers to make sure all of their risk management ducks are in a row. 

 

E-mail me at dcollins@futuresmag.com@Futureswriter

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.