Felix Salmon

What do you call a market which rises on bad news and panics — as it’s doing today — on no news at all? The 10-year Treasury is now yielding less than 3%, the Dow’s back below 10,000, the VIX is over 30, and the Nasdaq is down 2.4% in a matter of minutes; French stocks have fallen more than 3% today, and in general the global risk-aversion trade seems to be back on.

Interestingly, gold is down a little today: maybe at these levels it’s more of a risk asset than a safe haven. But more generally I think we’re seeing what happens to markets which are much more global, complex, and interconnected than they’ve ever been in the past: correlations can appear out of nowhere, and it’s silly to even attempt to explain significant intraday market movements by recourse to anything in the news.

Our brains are hard-wired to look for causality wherever we can, so if news isn’t causing this volatility then naturally we look for other explanations instead: is there something churning hard below the surface? Did a large number of hedge funds all have very similar trades, and now they’re all trying to exit their positions at the same time? It’s impossible to know for sure, but I do wonder how and whether the phenomenon of high volatility on no news correlates with the rise of hedge funds.

If you’re invested in these kind of markets, only the two extremes make any sense, it seems to me. Either you’re a buy-and-hold type who’s convinced about the existence of the equity premium over the long term and who happily ignores all intraday volatility, or else you’re a high-frequency trader who loves to make money on a tick-by-tick basis. Everybody else is liable to get stopped out, or otherwise crushed. And in many ways, the only winning move is not to play.

Jim Surowiecki today looks at the flipside of the moral hazard trade: if you can’t count on governments to bail you out in extremis, then you’re likely to have volatile and unpredictable markets.

Political risk is hard to manage because so much comes down to the personal choices of policymakers, whether prime ministers or heads of central banks. And those choices aren’t always going to be economically rational—witness Merkel’s recent tergiversations. Similarly, the U.S. government’s failure to bail out Lehman Brothers in 2008 seems to have been in part the result of Treasury Secretary Henry Paulson’s desire not to be seen as Mr. Bailout. Investors, then, are being forced to read the minds of policymakers—not something they’re good at. Markets work best when there’s lots of information available and a historical track record to go on; they excel at predicting things like horse races, election outcomes, and box-office results. But they’re bad at predicting things like who will be the next Supreme Court nominee, as that depends on the whim of the President.

Surowiecki is saying not only that Merkel should have bailed out Greece with alacrity and that Paulson should have bailed out Lehman: he goes on to praise successful interventions in the markets such as the Clinton/Rubin bailout of Mexico, Hong Kong’s successful 1998 intervention in its own stock market, and the Obama Administration’s decision to preserve as much equity and debt value of the banking system as it could.

In all these cases, government intervention was used to prop up market prices — of Mexico’s bonds, of Hong Kong equities, and of US bank stocks and preferred debt. And yes, when there’s a government put, volatility goes down. But that doesn’t mean that government puts are a good idea: after all, it’s not the job of government to reduce market volatility.

What’s clear is that governments — and I’m including central banks here — have much less ammunition now than they did pre-crisis, even if they still have the willpower to intervene to save markets from themselves. And the willpower is evaporating rapidly, to boot. The result is that the moral-hazard play is becoming increasingly dangerous, and that volatility is sure to stay high.

The only thing keeping markets from plunging on worries surrounding European finances is faith in the political credibility of the European Union and the ECB. And on that front, there’s a lot more downside than there is upside, since we’re leaving a world of very high European cohesiveness and entering a world of much greater uncertainty. It’s already clear that the UK is going to be absent from the European project for the foreseeable future; the big risk is that the Germans will follow suit.

A lot of investors have made a lot of money from the moral-hazard trade over the past 15 years or so. When that trade comes to an end, expect the losses to be just as big, if not bigger.

Many thanks to the guys at HuffPo, who splashed my video from Friday all over their front page this weekend: the resulting post has now received well over 2,500 comments, and there’s even now a “Felix Salmon Investment Advice” tag over at HuffPo, which is scary.

Naturally, the video being less than 80 seconds long, there wasn’t room for a lot of background and exegesis. But the message I was trying to send is not that I think stocks are going to fall. Rather, it’s that volatility has risen, and that it makes sense to sell stocks in periods of high volatility.

I had a very interesting conversation with Barry Nalebuff today, co-author of Lifecycle Investing: he’s the guy with the idea that young people should lever up their stock-market investments, and that pretty much everybody under the age of 40 should have 100% of their retirement funds invested in stocks. I wrote about his idea a couple of years ago, and I found it intriguing; my main issue with it is that it’s very hard to implement in practice, and that someone trying to do so might well fail miserably. Basically, it’s far too complicated for a typical young investor to even try to follow.

Barry made one thing very clear to me today: if you don’t believe in the existence of the equity premium — if you don’t believe that stocks are going to outperform bonds over the long term — then you shouldn’t invest in stocks at all. Even if you’re completely agnostic on the issue — if you have no idea whether the equity premium exists — you should still have no money in stocks.

The advice in Barry’s book is entirely for people who are invested in the stock market, and who will invest even more in the stock market. They are likely to put in far too much money towards the end of their lives, when they’re at the peak of their earning power, and far too little at the beginning; Barry’s idea is to even things out a bit so that they’re less likely to get wiped out by a freak stock-market fall just before they retire. If you can follow his strategy — and that’s a very big if — then it’s actually safer than most retirement-fund strategies.

So let’s say that you’re a long-term investor, and you believe in the equity premium, and so you want to invest a chunk of your money in stocks. What percentage of your money should that be? Ayers and Nalebuff helpfully provide a downloadable “Samuelson Share Calculator” to come up with a number for that.

The Samuelson Share is named after Paul Samuelson, and basically says that the percentage of your retirement funds that you should have in stocks is found by a pretty simple formula:

Samuelson Share = Return / (Risk^2 x RRA)

Here, Return is the expected equity premium: the degree to which stocks will outperform bonds, on an annualized basis. Risk is the VIX, and RRA is your own Relative Risk Aversion.

On the downloadable spreadsheet, you can fill in whatever numbers you like for the different variables. Ayres and Nalebuff plug in a pretty high equity premium of 5.04%: that doesn’t mean that they expect stocks to rise by 5.04% a year, remember, that means that they think stocks will outperform Treasuries by 5.04% a year. I find that very optimistic, but fine, let’s leave it there. They also assume an RRA of 2, which means your risk appetite is greater than that of about 76% of the population. Given the expected audience for their book, maybe that’s reasonable. And finally, they plug in a value of 18% for the VIX. With all those inputs, the Samuelson Share output is 78%: you should have 78% of your investments in stocks, on average, over the course of your investing life.

But now what happens if you change the 18% value for the VIX to its actual closing level on Friday, which is 40.95%? Suddenly, the Samuelson Share plunges to just 15%.

And if you go from a portfolio with 78% stocks to a portfolio with 15% stocks, then that means you have to sell more than 80% of your stocks, pretty much overnight.

Meanwhile, if you think that the equity premium is just 1% rather than 5%, your Samuelson Share falls even further, to just 3%. And if your risk aversion is a pretty typical 4, rather than a relatively aggressive 2, then your Samuelson Share becomes a barely-visible 1.5%. At that point, you basically have to sell all your stocks.

And remember, none of these calculations are based on the expectation that stocks will fall — in fact, they’re all based on the expectation that stocks will rise!

The point here is that volatility alone is reason enough to exit the stock market. If you want your lifetime investments to have an average 78% exposure to the stock market, then it makes sense to have 100% or even 200% exposure when you’re young. But that’s no longer the case if the VIX is somewhere over 40. (And remember, it hit 80 at the height of the market chaos at the end of 2008.)

I feel I ought to have some money in the stock market. But if I take the spreadsheet and plug in an equity premium of 2.5%, a VIX of 30%, and an RRA of 2, then my Samuelson Share comes out at a decidedly modest 14%. And that’s being very generous, in my view, when it comes to the equity premium.

You don’t need to have a very long memory to remember how loss-averse people turn out to be when the stock market plunges. They hate it when that happens — even if their stock-market investments are long-term savings which they have no need to liquidate. That kind of risk aversion is — or should be, in any case — an incredibly important driver of asset-allocation decisions. And in a time of great uncertainty and stock-market volatility, the lesson to be drawn is that most of us will be able to sleep much better at night if we’re not invested in the stock market.

Just ask Barry Nalebuff. His net worth isn’t in stocks: it’s tied up in a company he co-founded, Honest Tea. Which has surely provided a much better return than any index fund, no matter how leveraged: ten years after he founded it, Coca-Cola bought a 40% stake for $43 million.

I always knew that Nouriel Roubini was quite volatile. I just never thought to chart it.