The Problems for Recovery: The Declining US Trade Gap

The US trade gap fell by 28% in November 2008. While this is a backward looking number, it is still horrifying. It means that the export economies of the world are under terrible stress. The US trade gap is the milk that sustains the infant economies that rely almost entirely on exports. Not that the US economy is supreme: it is an adult who is addicted to heroin. Our economy must get its fix of foreign credit or else the whole system will collapse.

This leaves the financial markets perilously close to the edge. The Chinese-American symbiotic liquidity cycle had analogues in Japan, South Korea, India, and all over Asia. This drove trade and cash flows between the US and many countries. Once US trading partners reached a certain level of economic sophistication, complex import-export linkages developed within the Asian ecnomies themselves.

This macroeconomic process drove the markets on the way up because it perpetuated rising asset prices. Higher prices meant more producers could profitably enter business. This led to increases in jobs, bank lending, and general economic activity. That in turn led to higher asset prices and so on.

The problem is that prices are falling, largely due to an acute global financial panic. This has thrown the feedback cycle in reverse. Falling prices put companies out of business. As firms consume less materials and labor (layoffs) money fails to reach places it used to. Retail firms fail and economies throw large amounts of workers into idleness. Ripples of failure perpetuate through the economy.

The only thing that can stop this cycle (maybe) are the governments of the world. Their actions are powerful, but take a long time to manifest. In the short term, a cycle of economic pain and destruction is unavoidable. 2009 may turn out to be a bad year.

But the rationale for an eventual recovery is compelling. The Federal reserve has engaged in stimulus policies that are unprecedented in the post WWII era. Ben Bernanke's rhetoric leaves no room for interpretation: he will do anything, including printing money, to avoid long term deflation.

This means that at some point the fed will go too far. Perhaps they already have. Prices will stabilize sometime in the next year or two. When that happens zero borrowing costs will inflate bubbles just by necessity. Someone will borrow for zero percent and lend for two percent, and the whole system will reflate.

What the Data Can't Tell You: Plucking the string of the market

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So much time and effort has been placed in the pursuit of analyzing past stock market data sets to mine for statistically significant anomalies. This is a great process for determining what would have made you money in the past, but is lousy for predicting how the strategy will perform when large amounts of money are employed to capture the discovered anomaly. Oftentimes, especially in statistical arbitrage, the presence of one or two more large players can tip a once profitable strategy into a money pit.

The key to arbitrage is being the first or second to find it... and staying small. Scaling up a strategy is hard, but making small amounts of sure money is easy for those patient enough. Perfecting a stable of small but consistently profitable arbitrage strategies is the key to long term income.

A successful arbitrageur should be able to be both statistician and wildcatter. We must pluck the string of whatever market instrument we have assembled and listen to what sound results. We must model the interaction of our strategies with the market as judiciously as we derive the theoretical arbitrage itself. Otherwise, taking a strategy from theory to practice is impractical and useless.

This financial crisis has taught that even the most statistically inclined of us must have a sense of just going with the flow. Make a decision. See what happens. Go from there. Use the tools that have worked before but with new assumptions.