Mises Daily
Wednesday, October 08, 2014
by Peter St. Onge

 A panel discussion at the 2014 Mises University addressed the question of whether Austrian economics can improve financial predictions.

We first want to distinguish between a colloquial meaning of prediction — improving the accuracy of one’s expectations — and the more rigorous sense of actually knowing the future. Austrians emphasize that the belief that one actually knows the future can be very dangerous, especially when central planners start to think their statistics and charts constitute crystal balls.

On the other hand, Austrian economists certainly predict in the more colloquial sense of improving accuracy of expectations. Indeed, Austrian economists even look both ways before crossing the street.

A secondary discussion has focused on the prediction failures of particular financial commentators who try to use an Austrian approach. This is a valid point; anybody who predicts for a living deserves to have their record examined. But in the process we want to be careful to assign blame correctly; was the theory to blame, or did the practitioner either misuse theory or combine that theory with bad data.

So, first, we want to be specific about what economic theory itself can and cannot do. Critics seem to think theory should be a map, when theory itself is more like a compass: a compass that tells you where to go, not how to get there. Just as there are good and bad compasses, there are good and bad theories.

In the real world, prediction is a spectrum: we might predict the sun will rise tomorrow, that winter will be colder than summer, that money-creation leads to inflation. All of these predictions are subject to outside factors, therefore they all run on different probabilities and different magnitudes.

Reading astronomy alone won't tell you if winter will be mild. And it certainly won't tell you if a given day will be cold. Similarly, economic theory will not give you precise magnitudes nor will it give you precise timing. For that we need to supplement the theory with data. This proposition, that theory alone does not give you all the answers, is a part of "radical uncertainty" in Austrian economics, a concept admirably popularized by Nassim Taleb's best-seller The Black Swan.

To actually predict using an economic theory — any theory — you need data. A good theory will tell you what data you need. If you choose well, that data informs your magnitudes, and it's the magnitudes that give you your best timing.

To see why, consider walking backward on an eastbound train. The train is pointed east, and you walk west. Which direction is your body moving? Well, are you walking fast? Is the train moving slow? Newtonian physics or human anatomy will only get you part-way. Closer than Aristotelian physics and octopus anatomy, to be sure. But you'll need to supplement the theory with data. The theory is necessary but insufficient.

The question becomes, then, whether Austrian economics is better theory. Does it give better answers about fundamental trends. After that, no matter what theory got you there, you'll have to plunge into the data.

One of my favorite examples is the role of consumption in economic growth. Consumption is taken by most non-Austrian economists as a positive indicator of economic health. Like a doctor's thermometer, consumption tells you the economy is "healthy" and likely to grow. Non-Austrians make this prediction largely via correlations: higher consumption is correlated with future growth.

An Austrian, on the other hand, starts with logical causation. And, logically, when an extra resource is consumed that means it was not invested and it was not saved. After all, you can only do three things with a resource — consume it, invest it, or set it aside for the future. So raise consumption of resources and you necessarily lower either physical investment or you run down the stock of saved resources.

So an Austrian doesn't naïvely celebrate consumption. Rather, our theory tells us which data to use next. Was the extra consumption siphoned out of investment? Or was it siphoned out of savings?

If it came out of savings, then consumption may well grow tomorrow's GDP, albeit "stolen" from the future by running down saved resources. If, on the other hand, it came from investment, then the mainstreamers ..are completely wrong — siphoning from investment to consumption will have no impact on current growth and will actually harm future growth. Simply because investment makes stuff in the future, while consumption does not.

The point here is that data alone doesn't tell you the whole story, which is a core proposition of the Austrian approach. Instead, you need to start with good theory that tells you which data you need and where to look next. Guiding that process is the fundamental proposition of Austrian prediction, and to ask for more is to fundamentally misunderstand what theory can do. Just as Newton alone won't tell you who's walking west on a train, Austrian theory alone won't do all the work in investing.

by Lawrence Delevingne
October 5, 2014

Stocks have gone virtually straight up for more than five years. Interest rates are poised to rise. Volatility—a gauge of fear in the marketplace—barely registers. Every time the market swoons, like it did as October began, it snap backs as bullish traders "buy the dip," as Wall Street calls it.

Some say investors are following former Citigroup CEO Chuck Prince's ill-fated advice from 2007. "As long as the music is playing," he said at the time, "you've got to get up and dance."

Prognosticators like Mark Spitznagel think that music is about to end.

"History and logic show that this Fed-manipulated stock market is unsustainable," said Spitznagel, president of $6 billion Universa Investments.

Spitznagel may be talking his book—Universa's core strategy is to make money when the market drops—but he has precedent. The Miami-based hedge fund firm is advised by Nassim Taleb, author of the 2007 book "The Black Swan: The Impact of the Highly Improbable."

Many clients in Universa's "tail hedging" strategy made returns of about 120 percent in October 2008 alone when the stock market plummeted (a tail-hedge refers to the unlikely-to-occur tails of a bell curve-shaped probability graph).

Despite that, the big money isn't rushing to buy insurance—like options on the CBOE Volatility Index—against a crash. Advisors to the largest investors—ultra-high net worth families and institutions like pensions and endowments—have seen a slight up-tick in interest in protective strategies, but not a lot of action.

"Some clients are showing interest in hedging, but it's mostly just conversations at this point," said Justin Sheperd, chief investment officer at $9 billion fund of hedge funds Aurora Investment Management.

Data from investment firm tracker eVestment shows that the assets of funds that should perform best when markets drop and volatility spikes are still far below peak assets.

 So why can't investors protect themselves? Managers of protective funds say simple psychological habits make people forget the past.

"Tail hedging is by definition a very contrarian trade. To be effective, it requires that most people think it is nonsensical," said Universa's Spitznagel. "Then they change their minds after a crash and the cycle begins anew."

Anthony Limbrick, a portfolio manager at 36 South Capital Advisors, a $750 million London-based hedge fund firm focused on tail risk products, gave a seasonal analogy. "Turkey life insurance," he said, "is always cheapest right before Thanksgiving."

A small group of hedge fund managers promise investors protection.

There are the tail-risk funds run by Universa and 36 South, or similar offerings from Pine River Capital Management, Saba Capital Management, Ionic Capital Management and Capula Investment Management.

There are also volatility-focused strategies that perform best when asset prices move up and down quickly. They include Capstone Investment Advisors and Parallax Volatility Advisers.

And there are so-called short-biased or short-only funds that specialize in betting against stocks. Their numbers have dwindled since the crisis, but notable players include Jim Chanos' Kynikos Associates, Dialectic Capital Management, Gotham Asset Management and Kingsford Capital Management.

 Such funds often perform poorly in up markets, making the business difficult to run between corrections and forcing some out of business. That can make it more challenging for investors in hedge funds to choose managers they like.

"The number of institutional-quality, actively managed tail-risk hedging or portfolio protection strategies is relatively small," said Kevin Lenaghan, a director at investment consulting firm Cliffwater "If clients want to allocate to these, there's not like hundreds of them we can get comfortable with…it's a challenge."

 Some consultants advise skipping most protective hedge funds.

"Given the underlying risks and recent performance of tail-risk funds…we shy away from them," Rob Christian, head of Research at K2 Advisors and Franklin Templeton Solutions, said in an email. "They don't necessarily pay off during periods of increased market volatility."

Christian noted that the funds were relatively expensive and haven't performed well recently. He said his firms prefer to manage portfolios using hedge funds that can quickly increase or decrease risk.

 Some say simple diversification is better.

"Most clients feel that as long as they focus on diversification, they're OK," John Anderson, president of JPMorgan Alternative Asset Management, said. "They are looking for diversifying strategies that can provide positive returns over paying for hedges which can be costly."

Besides hedge funds, some investors use options to hedge. For example, they could buy a contract that costs pennies on the dollar that would pay off big if the stock market declines by 25 percent in one year, for example.

"Today it's particularly cheap to buy protection—those strategies could add a lot of alpha when the market corrects," Aurora's Sheperd said.

"If market patterns of recent months prevail, there may be a good opportunity to hedge at even lower costs again," added Steven Wieting, chief investment strategist for Citi Private Bank.

Wieting, whose wealthy clients have at least $25 million, said he prefers using derivatives strategies to reduce portfolio risk, not dramatically altering the mix of investments for rare events.

"When the pricing is right, it can help reduce portfolio turnover and improve long-term returns by keeping clients invested," he said.