Fat Tails, But Which Way? Up or Down?

Alpine Macro has an interesting article on risk. They provide two extremes, melt up and melt down.

Melt Up or Melt Down?

Please consider some snips from Fat Tails.

Everyone on Wall Street is freaking out over the 2/10-year yield curve inversion, with recession being the most feared outcome. I am fully aware of the fact that the expression of “consensus view” is often biased and very influenced by a subjective assessment of the outlook. But it seems clear that the risk perception of the investment world has migrated to the darker side.

With more investors believing that a recession could be just around the corner, there could be only two extreme cases — things turn out to be either a lot better than feared or much worse than what is currently discounted. Which is it?

I had a conversation recently with a very shrewd and smart investor whom I have known for nearly 30 years. Let’s call him Joe. Joe is seriously concerned that things could turn out to be much worse than most anticipate. His bearish case starts with Trump being highly unpredictable, and no one seems to know his game plan for his trade war with China. This is very bad for the economy in general and harmful for business investment in particular.

Besides, Joe is worried that the trade war could easily degenerate into a full-scale Sino-U.S. confrontation that leads to military skirmishes in the South China Sea, an invasion of Taiwan by the PLA and China cracking down on Hong Kong demonstrations, all of which could lead to economic sanctions, trade embargos or financial blockage. These aredepression shocks that can inflict huge financial losses.

Besides, even if Trump is defeated by any of the leading Democrat candidates today, Joe thinks that the U.S. stock market would get destroyed, along with the dollar. In his view, all Democrat presidential hopefuls are racing to the left and their policy agendas are best described as extremist. As a result, Joe has completely shunned risk assets, but he does not like bonds either. To him, European bonds are rip-offs and long-dated U.S. Treasurys are too expensive, offering no investment value.

“Where do you put your money?” I asked. “Gold. Period.” replied Joe.

The Other Tail

I understand Joe’s concerns and don’t think he is irrational. China-U.S. relations are obviously front and center of the stock market fluctuations, and policy in both Beijing and Washington has been hijacked by hawks. Nevertheless, I think Joe is too pessimistic and that we should not ignore the other side of the tail risk: that things could turn out much better than what is feared.

Both Trump and Xi are not only rational, but highly calculating. With U.S. elections fast approaching, Trump’s pain threshold has been lowered. He will do whatever it takes to get re-elected, and this means that he will have to tread very carefully not to push the stock market over the edge.

Xi is dealing with a slowing economy and, of course, he hopes to stabilize trade relations with the U.S. China’s decision to not go for tit-for-tat retaliation on Trump’s latest set of tariffs is a smart move, allowing Trump to “save face” and could pave the way for some sort of a deal. In other words, Trump’s outburst over China’s retaliation two weeks ago might have been the peak of the trade tensions leading to the U.S. presidential elections.

Besides, neither Xi nor Trump want to have a “hot war”, as both know the impact of any shooting war between the two countries would be devastating for the world. Besides, it is extremely unlikely that Beijing will send troops into Hong Kong to squash the protests.

Why Any Fat Tail?

I think that was an excellent discussion but why does there have to be any fat tail?

Yes, consumers are still holding up and yes there is a heck of a lot of recession talk, me included. But that does not imply an extreme move.

I side with those who do not expect a crash. By crash I mean a 25% decline in a calendar year or short stretch in adjoining years.

But I also side with those who find investing at these lofty heights a bad idea.

Most Frustrating Move

The most frustrating and damaging move would be a very long, very slow decline coupled with fake breakdowns and fake breakouts. Why not -15%, +5%, -10%, +3%, -15%, +8%, -18% etc etc and at the end of it all stocks are down 50%or more over 7-10 years.

The bulls and bears would get chewed up.

I do not think a "crash" is likely simply because credit conditions are not the same as in 2008 and 2009.

On the other hand, valuations are stretched as much as 2007, 2000, and 1929.

Admittedly, this is the scenario I felt likely for several years and it has not played out that way, yet. Perhaps it never does.

My point now is think about something besides an either this or that setup.

I still favor a brutal neither but I do side with "Joe" on gold.

Mike "Mish" Shedlock

Comments (28)
No. 1-11
Country Bob
Country Bob

Mish "Fat Tails, But Which Way? Up or Down?" .... Neither. Sideways, and for a very long time.

The entire G7 is "going Japanese". Decades of ineffective QE and negative short term interest rates. It means endless barrage of fiscal stimulus that accomplishes very little initially, and less and less over time. It means every year the Bank of Japan / Fed / ECB lowers interest rates to negative, and it has no material effect. No one even bothers to report when the Japanese announce another round of fiscal stimulus or central bank buying, because who cares?

It means the political class can't even save a nuclear power plant from widely expected tsunami after effects. It means all the G7 governments become increasingly irrelevant. It means all the G7 governments get bogged down in gridlock and quagmire.

I am sure the US congress will do studies and pass legislation to make themselves look busy. I am sure the Fed will have FOMC announcements to make themselves look busy. I am sure none of if will actually matter. The debt matters, and it will essentially neuter the G7.

I am not worried. I agree with Mish that a stock market crash is highly unlikely, sideways is my default scenario. Mom and pop businesses (outside of retail) will also do OK. Banks and pension funds will buy Treasuries because they are legally required to, same reason the Japanese post office buys JGBs.

Many Japanese people are quite happy, in spite of their government's impotence. I have been studying how they adjusted, because I suspect that will be very relevant throughout the G7.


The 10 year US bond yield bounced sharply this week after a couple months to the downside. All the headlines of negative interest rates was contrarian.


"A brutal neither" - a well-turned phrase. And, from a trader's perspective, the most brutal scenario.


My personal view:

  • there is excessive "cash" released for the last 10 years.
  • this "cash" release did not work to increase the inflation as intended (as much as)
  • this "cash" needs to be invested somewhere, so it went into stocks/bonds/property
  • but with time, 1) property has got saturated and detached from proper valuation based on rents 2) interest rates ( inverted bond prices) went so low that reached negaives, or it got saturated too
  • this leaves Gold and Stocks only. So, 1) capital preservation will go into Gold until it is saturated... probably a couple of years... 2) anything else will have to go into stocks, probably income stocks would be a priority
Tony Bennett
Tony Bennett

'Joe' is clueless re Treasury market