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

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Tony Bennett
Tony Bennett

'Joe' is clueless re Treasury market

Tony Bennett
Tony Bennett

"Most Frustrating Move"


Anything possible, but put me down for CRASH when the time comes.


Crash allows Shock Doctrine. Again. Massive taxpayer bailout. ARRA.2. TARP.2. Sometime after the fact Hank Paulson admitted TARP was written months earlier. Just waiting for the right moment to spring on Congress.

Wall Street would prefer a CRASH over long drawn out affair. One or two bad years (with bailout, of course) then back to Big Bonuses as everyone piles back into market.

CFOs desperately want a kitchen sink quarter ... or year. A period when everyone comes clean together. No one will be singled out for extra punishment.

For now bias is to the upside, right up to Lehman Moment (where someone big can't pay [Deutsche Bank?] or China devalues bigly? Something Big will happen).


Seems like no one wants to live under the communists.

Kinda like New York State and Chicago.

"skirmishes in the South China Sea, an invasion of Taiwan by the PLA and China cracking down on Hong Kong demonstrations,..."


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

It is difficult to make a timely read on a manipulated market.

"Meanwhile, as Credit Suisse notes, one of the major features of the US equity market since the low in 2009 is that the US corporate sector has bought over 20% of market cap, while institutions have sold 7% of market cap." BofA CIO Michael Hartnett: "the sole buyer of US stocks remain corporate buybacks, not institutions"

With some 250 trillion in global debt, we are in the midst of the greatest financial fraud in the history of the world. Interest rates are the lowest in 5,000 years, which is how long civilization has existed. Negative rates are an ultimate fraud.

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The real question is how not to play that game.

And how governments will, more and more, force you to play that game.

"Negative rates are an ultimate fraud."


Trump is rational? Do rational people really still believe this?

The cultists, sure.... he could set one on fire and it would expend its last fiery breaths declaiming how this was part of Trump/God's master plan, and how it was stigginit to those snowflake libs who turn pail at the scent of burning meat.

Anybody rational that has been paying attention know's he's a stumbling demented child-king, who's only thought is the prosecutions waiting for him when he's kicked out of office. He will destroy the world to save himself if he can. Luckily the folks around him give him a hamburder and let him rant when he tips over, and only let him out when he's calmed down.