Financial markets are, in reality, complex adaptive systems exhibiting behavior which can oscillate between calm and chaotic, efficient and inefficient. After any type of crisis, there is a new attitude to risk that will be present for a number of years – the span of possible outcomes in any given system has expanded and the extremes have heavier weight, making investors more cautious. The caution means tails are fatter. Thus, risk premium is where the money is. Simply put, buy chaos and sell order.
As for the financial system itself, it is perhaps overdone to call it a ‘system.’ It is rather a collection of procedures still growing in number and undergoing change. Subcomponents of the system explore a landscape that is changing at an ever faster pace. The landscape is complicated indeed, comprised of communication bits, capital flows, the number of bits for moving around the Internet, pieces of memory, or the number of bits of data we’re downloading and putting in our brains.
So the world of highly complex adaptive systems—those systems whose components and interrelationships interact and learn and change everything about themselves and their world—are inescapably overreactive and at times counter-intuitive. Instead of a deterministic and tractible world, the world is intrinsically intractable.
Those that live in a complex adaptive system grope about trying to find their way, often unaware that there is no such thing as an absolute discerable reality. In financial markets, this implies a mistaken belief that there is a unique fair value. The arc of human evolution bends toward barely controlled chaos and continuously explodes everything you thought you knew.
Now there is a degree to which prediction is possible. If the Federal Reserve buys trillions of securities, it is clear that, barring some offset, risk is going to have a run. Even then, the directionality is clear. But there is no precision as to levels or even precise assets that benefit. So positioning needs to be based on prevailing beliefs, not a given forcast model or its predictions. When the other side of the prevailing belief (a pure subjectivity) is cheap, the stage is set for a big change in valuation. Trading is about defeating human over-reaction and the fear, constriction, and paranoia that comes with it.
There are plenty of ways to position counter the prevailing view. Note the chart on this page. Realized volatility is less than option volatility. That is to say, option premium undergirds the viability of investing in extremes. More often than not, selling vol picks up option vol premium in excess of realized loss. This is because of the fearful over-reactive nature of complex adaptive systems.
Capital assets occur as one of two kinds: real or fiat. Real assets are constrained by a limited rate of increase in amounts outstanding. Fiat assets have a potentially unlimited rate of increase. Fiat assets involve the very human aspect of contracting between debtor and creditor, between owner and lender, given irreducible uncertainty about the future.
The world is awash in fiat assets, but that is no rationale for investing in real assets. fiat assets are investments in human ingenuity and capability. This beats gold or silver or other real assets any day.
Credit, the top of the capital structure, is a good place to be in a world saturated with debt. Unlike equity, credit has limited potential upside to compensate the lender for the possibility of loss in a hold to maturity framework: the best that can happen is that it is repaid as promised. Consequently, the focus with debt is on preventing loss-on security and on a reliable cash flow that can ensure repayment.
The risk is that you catch a train wreck. We’ve all heard the Yiddish proverb מענטש טראַכט, גאָט לאַכט - "Man schemes and God laughs."