A certain
former Secretary of Defense once famously commented that "there are known knowns... there are known unknowns... but there are also unknown unknowns." This
impromptu rhyme was the winner of the 2003 Foot in Mouth award and the subject of many lampoons. The competence of the much maligned former secretary aside, the comment struck a rather poetic accord with this blogger's view on much of life, especially in the context of speculation. Hence the name of this blog, "The Unknown Unknown."
"The Unknown Unknown" is particularly appropriate for describing unfolding current events. As of the writing of this commentary, the fixed income market is essentially non-functional. Many taken for granted assumptions no longer hold. Any collateral save AAA government bonds seems to be treated with suspect; everyone is suddenly (ir?)rationally paranoid about counter party risk. The covered bond market in Europe has essentially
shutdown -- an early winter holiday for that market perhaps. US municipal bonds are rumored to be in an awful mess. Freddie Mac, an institution implicitly guaranteed by Uncle Sam -- some say with only a wink of an eye -- is
exploring recapitalization. Fannie Mae the other GSE of similar stripes, is perhaps in the same boat. Citigroup, Merill Lynch, UBS and countless others have taken a bloodbath due to write downs on CDOs held on their balance sheets. All is certainly not well in fixed income land.
In addition to the problems in fixed income, the buck seems to be no longer a hard currency. Perhaps the most telling,
Jay-Z's latest music video depicts him with €500 notes rather than "da Benjamin," the traditional rappers' note of choice -- the founder of UU's alma mater must be rolling over in his grave. The buck's seeming demise is new and strangely twisted to this blogger -- his native tongue practically equates the USD with gold, literally calling it "American gold." As it stands, it seems the buck is devaluing against virtually everything on the planet except toxic subprime mortgages.
Things are slightly calmer in equity land. Though the VIX is hovering around 25, the S&P 500 currently stands at where it started at the beginning of 2007 -- not great but not a complete disaster. The big story of this year is the
massive quant fund deleveraging that occurred in August of this year. At the time, one of UU's friends in the industry remarked, "there is a great disturbance in the force." It seemed that the more Barra beta neutral optimized and previously profitable your portfolio was the more you disastrous your PnL was during the unwind. Though all seemed well to your average index punter, the dispersion of the index underlyers was moving in accordance to
Murphy's Law against the long/short market neutral players. Matthew Rothman of Lehman Brothers commented to the Wall St. Journal that "events that models only predicted would happen once in 10,000 years happened every day for three days." The tempest seems not completely dissipated just yet; AQR and Goldman Sach's GEOs are
rumored to be liquidating.
Yet all in all, this blogger believes that the overall sentiment in equity land so far looks to be somewhat less pessimistic than in fixed income land. That said, it appears that equity players are on edge. Going into year end they seem to have sold off quite a bit of their big winners to lock in the gains for the year. Emerging markets for one looks like such a case. Everyone is looking for tea leaf readings from the helicopter riding Federal Reserve chairman before getting back in it seems.
We are certainly experiencing interesting times and it is UU's belief that many profitable opportunities will arise. As a part of this blogger's exercise to document his continuing education in financial market speculation, he will maintain two paper portfolios and post updates of them regularly in the fashion of
Macro Man, who's blogging inspired UU's foray into the same.
The first portfolio will be a naively simplistic relative value portfolio employing traditional CTA and black box macro techniques. It will essentially be a collection of systematic trend following and mean reversion strategies with dabbles of short volatility and short correlation plays, all quantitative in nature. The main exercise for this portfolio is risk management. Since all the aforementioned strategies are essentially the equivalent of driving by looking into a rear view mirror, they will be particularly susceptible to fail quite spectacularly in the face of an unknown unknown or what a recently published book calls a
"Black Swan." Mitigating that risk will be essential to its profitability and long run survival.
The second portfolio will be geared towards adhoc contrarian views and attempts to capture the unknown unknown in a profitable manner. By the nature of its stated mission, this portfolio will be discretionary and highly subject to the whims of this blogger who confesses that there may be many trades in this hypothetical portfolio that will be very unscientific and utterly random -- this portfolio will be UU's hypothetical "punt" book.
The two portfolios will be components of a fictional $100 million AUM hedge fund where risk capital will be allocated between the two different schools of speculation. Since UU has not found time to back test some simple models, the initial trades will be in the "punt" portfolio.
