I may be a dumb southerner who limped through advanced calculus like a wounded animal, but I spent a fair amount of time in college studying math and applied statistics. (I think it is amazing you can graduate from many institutions with a degree in finance, having memorized a bunch of formulas with absolutely no clue how the underlying math works--or doesn't).
Seth Klarman (prospective monkey tip: you should know who he & Baupost are) wrote in his annual letter about his fears that Trump will create volatility and uncertainty. (NYT Article)
This got me thinking back to my days in data mining, regression modeling, and other topics. As well as Klarman's earlier observation:
When the markets reverse, everything investors thought they knew will be turned upside down and inside out. 'Buy the dips' will be replaced with 'what was I thinking?' Just when investors become convinced that it can't get any worse, it will. They will be painfully reminded of why it's always a good time to be risk-averse, and that the pain of investment loss is considerably more unpleasant than the pleasure from any gain.... ...Correlations of otherwise uncorrelated investments will temporarily be extremely high.
Considering that correlations are the bedrock of pretty much everything in predictive analytics, and the fact that 70%(?) of market volume is algorithmic trading based on predictive analytics, wouldn't this create a problem? It seems to me that there is a potential that the old models stop working, at least temporarily.... Who will provide the liquidity and volume? Will HFT firms be forced to take the hit or be allowed to just turn the machines off? Remember (or read about) when that happened in 2010? I heard that as a risk management proposal recently: here. <--- Pure stupidity IMHO
Furthermore, for strategies that rely on models built on more historical data, if they dynamics of the market change for whatever reason, geopolitical, financial or otherwise (thus changing the correlations).. wouldn't this render them useless? To my understanding, they have all been built and tuned in the last ~decade, where markets have steadily climbed, volatility (correct me if I am wrong) has been pretty low, and everything has been skewed by QE 'forever'. As every value disciple knows, that can all change, and when it does.. it usually changes pretty quickly. Didn't LTCM blow up for similar reasons? And aren't most of the quants too young (or any of us for that matter) to remember Scholes ran a hedge fund that blew up anyway?
I was hoping some of you young Haim Bodeks could climb out of the dark pools and throw some color on this.
On a side note I was a double major, one of which was in econ, where my econometrics professors thought the analytics department were a bunch of quacks and we were always cautioned by the analytics department about relying on models, "ALL ARE WRONG, SOME ARE USEFUL, SOMETIMES."
PS if you have the full text of the Klarman letter (and I know some of you are going to go find it now). Fucking post it. Don't be a jackass.
Throwback Thursday - this post originally went up a year ago and is pretty relevant to what's going on these days in the market.
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