Watching with interest the weakness unfolding in the “high beta” space which we warned about given the return of higher inflation expectations and the continuation of the “higher for longer” narrative, when it came to selecting our title analogy we decided to embrace “Structured criticality”. In our March conversation “The Arrow theorem”, we mentioned the growing “avalanche” risk or grain of sand also called “structured criticality” based on “stock concentration” being at “Great Depression Level” according to Goldman Sachs. The top 10% of US stocks in the US now reflect around 75% of the entire market. “Structured criticality” is a property of complex systems in which small events may trigger larger events due to subtle interdependencies between elements. The aggregate behavior of avalanches can be modeled statistically with some accuracy. For example, you can reasonably predict the frequency of avalanche events of different sizes or rogue waves as popularized by Didier Sornette in his book “Why Stock Market Crash”. Research firm Variant Perception uses LPPL model when it comes to trying to understand “Structured criticality which we find of great interest given our numerous musings relating to rogue waves such as our 2016 post “The Disappearance of MS München”. One of our astute reader “ghiblinewt” commented at the time:
“You certainly give pause for thought with your writing, I would suggest there is enough here for several articles but some comments spring to mind.
Rising correlations and the failure of VaR:
A long, long time ago I recall reading a book called "Iceberg Risk", it challenged the assumptions of normality and homoscedasticity behind the VaR modelling. One of the profoundest books I've ever read, I think the gist was Gaussian PDFs (Probability Density Functions) required additively independent risk factors whereas the cross-correlations ruined this assumption, hence the non-Normalcy and the leptokurtosis. So, using just the first and second moments to describe the risk distribution- and praying that they were going to be stationary- was giving nothing but false (Fool's) confidence. And this book was written long before the GFC. It’s too bad none was listening.” – “ghiblinewt” – February 2016.
The book our reader is referring to is 2002 “Iceberg Risk: An Adventure in Portfolio Theory” by Kent Osband for the inquisitive minds wiling to delve more into the deficiencies of standard risk assumptions for portfolio management:
"The mainstream seems less interested in managing risk than the appearance of risk." – Kent Osband
Indeed, in our day and age it seems to us that Mark Twain was right when he said:
“It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”
As such, understanding “structured criticality”, “Iceberg risk”, ”Rogue Waves” and “concentration risk” and using LPPL models in some instances can be very useful we think in these days and ages of “irrational exuberance” to paraphrase Robert J. Shiller 2000 book. Irrational exuberance being defined as widespread and undue economic optimism, “optimism bias”, positive feedback loop and the dangers of “positive correlations” but, our behavioral mind is rambling again.
In this conversation we would like to continue to look at the recent price action in “high beta” space in general and US High Yield in particular. As well we want to look at “70s stagflationary vibes given our recurring theme of “Fiscal dominance” issues and budget deficit trajectory.
Our long monthly musings are now for paid subscribers only. Don’t hesitate to subscribe and share our work and if you like our musings.
As well, don’t hesitate to reach out if you have any questions or suggestions.
Keep reading with a 7-day free trial
Subscribe to Macronomics Newsletter to keep reading this post and get 7 days of free access to the full post archives.