naked capitalism

Anonymous says:

I’m just a residential landlord type guy who loves this site and generally can understand. However, this one needs explaning to me.

Can someone put this in plain english for me?

Oil is so far above historical norms that it is bound to crash???
or
Oil is so far above historical norms that it won’t come back down???

and what the heck is a standard deviation?

Thank you,

Mitch says:

Ack! Stock prices are not gaussian! Their actual distribution has significant skewness (toward the upside) and kurtosis (fat tails).

Point being, the probability of that SPDR movement is way, way higher than Kass calculates.

Tom Lindmark says:

Maybe it’s just the result of the mother of all short squeezes.

Anonymous says:

Mitch is right that it’s not 11 standard deviations … probably more like 4 or 5, with a suitable “fat tails” adjustment for non-normally distributed market moves. But it’s a big pop.

And illustrating the principle that volatility is bidirectional, we now have a sharp afterhours selloff, after Merrill Lynch, Google and Microsoft all crapped the bed with their earnings reports, and got slammed for 7% apiece.

Nevertheless, a near 30% pop in the BKX bank index in two days is not mere noise. It doesn’t quality as a “new bull market blastoff” (A/D ratios are too low), but it may well be a “bear market rally” blastoff. Me long (for now).

Anonymous says:

“what the heck is a standard deviation?”

A standard deviation is a measure of how far away from average something is. The bigger the standard deviation, the more unlikely the event.

A person who is more than one standard deviation more intelligent than average is considered borderline gifted. A person who is three standard deviations more intelligent than average is entering the genius range.

Albert Einstein was probably 7 or 7 and a half standard deviations above average.

So an eleven standard deviation event is MUCH MUCH less likely than running into someone as smart as Albert Einstein at the local Starbucks.

CathyG

Michael McKinlay says:

The phenomena is systemic, not individual …

We are moving into a systemic crisis not a crisis of individuals … though it surely does effect individuals.

And these latest moves look to be, as previously mentioned a classic short covering with the market setting up for another “Bear Trap” somewhere down the line.

Yves Smith says:

We’ve discussed Gaussian distributions, skewness, and kurtosis before……but even with the much greater propensity to fat tails that idealized distributions suggest, Jeremy Grantham’s observation is an interesting one.

My favorite statistical blooper came last year:

On August 12, in a post titled, “The Subprime Meltdown Hits Quant Hedge Funds,” DeLong summed up the quant attitude:

And investors trust these guys with their money….

Anonymous says:

Either:

a) Everybody’s forgetting about using the square root of time

or:

b) Doug Kass is having a bit of fun

S says:

The move to halt naked shorts on the “19″ special companies has everthing to do with it. The proposed legislation to give a balnk check to the Treasury is nothing more than un american. This congrss has a 12% approval rating and it is handing out taxpayer money all in an effort to save people like Dick Fuld. A telling referendum that everything is a systemic risk these days. Bunning has it absolutely right, these people are the systemic risk. Ironic to hear the SEC, absent during the decade long pump monkey routine, now the house of ethics. This entire bank stock rally was orchestrated beginning with Wells Fargo, who will be rewarded like JP MOrgan with a “merger.” Note that the Treasury is being given the power to buy FHLB debt as well. Not mtoo much discussion of this $800B plus dumping ground for the banks. Roubini mentioned it, but there has been a mention since Countrywide drew down $60B. If ever there was a microcosm of the new “ethic,” this is it.

Yves Smith says:

I assume Kass got his eleven deviation factoid from someone else and was making fun of that sort of statement.

But the more serious point per the second point is that really extreme moves, at least in asset classes, tend to revert. Since these financial stocks aren’t an asset class, that observation may apply to them. However, this sort of move was still pretty extreme. As the comments about short covering attest, there is reason to think that it won’t hold at that level.

But we’ll find out in due course, regardless.

Observer says:

I predict Benoit Mandelbrot will soon be regarded as the genius of finance mathematics that he actually has been for 40 years already.

Note the year of this review, by the way. Not yesterday but 10 years ago. plus ça change … indeed.

————-

http://guava.physics.uiuc.edu/~nigel/articles/mandelbrot.html

Last Year in Mandelbrot

Fractals and Scaling in Finance by Benoit B. Mandelbrot Reviewed by Nigel Goldenfeld
Physics Today, October 1998

Department of Physics
University of Illinois at Urbana-Champaign
1110 W. Green St.
Urbana
IL 61801

On October 19, 1987 the Dow-Jones Industrial Average, the widely-followed proxy for the US stock market, declined by 23%, a move that some observers noted was a 20 standard deviation event. This drop, which was almost twice as large as the famous stock market crash of 1929, is not an isolated incident, but one of a number of large drawdowns and bear markets this century alone, the most recent of which, the October 1997 crash, was only a “modest” 8% drop. Faced with these statistics, most of us would probably be prepared to agree that price changes are not Gaussian or examples of random walk behavior. However, events such as the 1987 crash, World War 1 and the crash of 1929 are extreme and properly regarded as outliers. What about business as usual?

The answer, of course, depends on who you ask. On one hand, the well-regarded semi-popular book on finance, “A Random Walk Down Wall Street” (W.W. Norton, New York, 6th edition 1996) by Burton Malkiel, takes its title and its theme from the notion that stock price changes follow a Brownian motion. Virtually every textbook on advanced finance takes the Brownian motion description as its starting point, and the celebrated Black-Scholes formula for option prices is based upon this description.

And on the other hand, there is Benoit Mandelbrot. No reader of this journal can be unaware of the enormous impact made by Mandelbrot’s earlier book “The Fractal Geometry of Nature” (Freeman, New York, 1982), which has introduced many to the notions of fractal dimensions, scaling and self-similarity, and which spawned a host of coffee-table imitations. What is perhaps less well-known, however, is that some of Mandelbrot’s earliest forays into fractals involved a detailed analysis of the time series for cotton prices in New York. Mandelbrot’s shocking conclusion, published in 1963, was that the time series was in no way Gaussian: in fact, he argued that the departures from normality could be accounted for by using distribution functions with infinite variance, which are termed L-stable. Mandelbrot examined the convergence in sample number of the variance of the logarithm of the daily price changes and found erratic variation rather than convergence. Subsequently, his student Eugene Fama (who has himself enjoyed a distinguished career in finance) examined the time series for the thirty stocks in the Dow-Jones Industrial Average, finding no exceptions to the long-tailed nature of the distributions observed.

The implications of these and subsequent findings are profound, yet it is fair to say that the work was practically ignored by economists and practitioners of finance. Even today, the problem of “fat tails” is swept under the rug by the vast majority of financial risk managers, even though the phenomenon is sufficiently widespread and well-recognized as to have earned its whimsical name. Mandelbrot’s heirs are primarily physicists entering the field of finance, who recognize the fundamental importance of fat tails and are able to elaborate and extend Mandelbrot’s suggestive results. This is something of an ironic development, as Mandelbrot takes pains to emphasise, and reflects the close intellectual relationship between finance and physics. The discovery of Brownian motion, usually attributed to Einstein’s famous 1905 paper, was in fact anticipated by Louis Bachelier five years earlier in his Ph.D dissertation on finance “Theorie de la speculation”, which remained largely ignored by economists until the 1950’s and 60’s. Elements of Mandelbrot’s work in the early 1960’s, which superseded Bachelier’s analysis just as it was becoming widely accepted, arguably anticipate some of the concepts of scaling and renormalization which were a focal point of physics during the 1970’s. The concepts of fractional Brownian motion and multifractals which are still frontier topics of research in physics and academic finance (as practiced by physicists) were introduced by Mandelbrot in the late 1960’s and 1970’s. And most recently, legions of physicists have found gainful employment on Wall Street as “quants”, performing intricate calculations of price and risk of derivative securities, using sophisticated detailed models whose underlying premises remain those of Bachelier—Brownian motion (more accurately logBrownian motion).

Richard Kline says:

Mandelbrot’s study on cotton prices is actually a fairly approachable piece of work for those who have a taste for order distributions in timeseries. Check it out, sez Joe Bob.

And the bank stock bounce, at eleven standard deviations, not so much, but it’s still fundmentally nonesense, and don’t bet a nickle that it’ll stick, neither. What it does indicated to me, though, is that the public authorities will stop at nothing to keep equity prices from quitting. And that’s not only irrational but likely to inflict substantial collateral damage on the real economy in due course. . . . Sold to the system, and paralyzed in the headlights, they clutch their carpetbags full o’ bonds to their bosoms and cry, “Stop, thief!” At whom, precisely?

anewc2 says:

For those who wonder what it all means, here is my take. Statistics is not designed to tell you what it all means. Statistics describes the numbers you see. If you really believe that price changes are random in the coin-flipping sense, then no, you would not expect to see mean reversion. Each new day starts a new reality, and the past is forgotten.

My own view is that price changes are not random in this sense, that there is a underlying fundamental reality that prices will always reflect, one way or another (and that maybe this is why they have fat tails). Then yes, you would expect mean reversion because that mean is anchored in reality.

And in the case of the financials, I do expect it, and more, with a vengeance. These things tend to overshoot. (The statistics can estimate how much, but don’t ask me: I haven’t researched it.) But if you want to know what it means, read the papers and the blogs with large doses of salt on hand, and come up with your own conclusions. Read the history books too, especially about “buy when blood is running in the streets”. We’re not there yet.

I’m no expert — note that “experts” are dropping like flies — but at least my explanation is not being sold to you. (Except by friggin’ Amazon. Jeez.)

Juan says:

mock turtle,

Veneroso’s 2007 presentation to the World Bank had to do with commodities in general and in particular, metals.

Bottom line:

I make the case that, in real terms, we have had an unprecedented commodity bubble in this decade. This bubble has occurred because of unprecedented investment and speculation in commodities, largely by way of derivatives. The far more important engine of this bubble has been leveraged speculation by hedge funds. Over the last two years prices have climbed even though the microeconomic fundamentals of commodities have deteriorated. There lies ahead a bursting of this commodity bubble. It is now being triggered by deteriorating fundamentals and it will be exacerbated by eventual investor revulsion which will reverse the extraordinary fund flows that have created this bubble.
(Frank Veneroso, 2007)

His complete argument can be downloaded at: http://www.venerosoassociates.net/

I will only add that the notional value of OTC commodity derivatives held by U.S. and foreign banks, which one of his charts indicates to have risen from $1 trillion at end 2004 to $5 trillion at end 2005 has, according to the BIS, increased to $9 trillion (Dec 2007).

Along with Frank, I certainly do not believe the New Era commodity supercycle theme provided by so many commentators.

Bottom line 2: ongoing financial crisis will deflate this bubble.