There's quite a bit of commentary out about the "10,000 year" bloodbath the quants have been experiencing for the past few weeks. I'll summarize some of it, then add my own thoughts, and then getting back to the point of this blog, summarize what it means for CASTrader.
What blogs I read think. First, Abnormal Returns consistently has a roundup of the current market pulse and regularly expands on a current theme of the day, such as the bloodbath in more detail. Zero Beta previously warned about the dangers of the hedge fund "black box" quant models, and in an aftermath post, points the finger at leverage, finding a source that indicates these funds typically run 3 to 10 times leverage. Paul Kedrosky thinks fat tails and "10,000 year" events are the wrong way to look at things. Kedrosky believes there is a mode of the markets that conforms to the statistical distribution model, but also one that is distributionless. He makes the analogy of regime change in the markets being like schools of fish responding to a predator. The Epicurean Dealmaker makes a similar analogy to Kedrosky's distributionless mode by describing the markets as being similar to and avalanche or failure of grains in a sandpile. David Merkel at The Aleph Blog thinks the carnage is not over. 1440 Wall Street locates a defiant, "damn the torpedoes, full speed ahead" quant.
Updates: Is the fingerprint of Barclay's evident?
Commentary from Lehman on what happened. (PDF) (via World Beta). More analysis at DealBreaker.
Update II: Rick Bookstaber, author of Demon of our own Design, has analysis. (via Felix Salmon)
What I think. Andrew Lo's Adaptive Market Hypothesis (AMH) gives an explanation for all of this, and confirms many of the above analyses, but uses a different analogy. An excerpt from a post on the AMH I wrote last October:
Yes, you can make excess profits in the financial markets. Opportunities for arbitrage exist (Grossman-Stiglitz Paradox), and may appear and disappear. Rather than a trend toward ever increasing efficiency as EMH implies, efficiency ebbs and flows with market euphoria, panics and crashes.
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Another point that Lo talks about, but really doesn't drive home as an implication of AMH is how dominant agents can implode suddenly, being too "adapted" for their own good. Dinosaurs grow too big for their own good and when the environment changes, they go extinct. Hedge funds like LTCM can become highly leveraged, making a lot of money until they implode. Ditto for Amaranth.
On related note, I've become much more convinced by this episode that predator-prey relationships exist in the markets and that backtests are dangerous. An excerpt from that post:
Conventional backtesting systems that I am aware of do not attempt to measure how your system alters the market. Prey-type backtests are based on the assumption of infinite liquidity, which isn't a bad assumption for small traders. In fact, a perfect backtest could not possibly be performed on a predator system because you cannot possibly know apriori the exact consequences of your actions.
The "45-year lookback models" that don't account for liquidity and other key ingredients of the AMH are of limited value, especially when running billions. There's only so much alpha for a given model or strategy (and your fellow trader's models) to exploit. If you're trading like everyone else - you're prey.
What it means for CASTrader. It's pretty simple: adapt or die. As I also wrote in the AMH post:
In my opinion, the Kelly Formula is the "secret sauce" that can optimize the chance for survival. Get greedier than indicated by the Kelly Formula, and you'll eventually blow up; bet less than the Kelly Formula, and you'll be outcompeted by people who do. The Kelly Criterion is the equilibrium survival state of the AMH.
Kelly can only be applied when you know the odds and your edge, and it must be applied with great care, otherwise it can be hazardous to your wealth. In an adaptive marketplace, the odds and your edge change - they are by no means static.
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