There’s an interesting passage in Michael Lewis’ The Big Short, in which he describes how a couple of amateur wanna-be hedge-fund managers made their fortune by identifying (what they saw as) an anomaly in options pricing. Basically, they observed that companies suffering from cataclysmic events (ex: a serious SEC investigation into company leadership) tended to see their option prices drop by a significant amount, often by 30% or more.
But in the long-term, that’s peculiar for many cases: the decreased option price is building in an estimate of the short-term volatility, but the situation isn’t a bell curve; the true value of the stock is probably discrete, either zero if the company crashes, or not fundamentally affected if it survives. Therefore, there is a lot of money to be made in identifying whether companies will survive their exogenous shock.
I feel like this same thing is playing out with the debt limit.
(First, a sidebar.)
I don’t think it’s surprising at all that negotiations have failed to achieve agreement prior to market movement in reaction to the possibility of default. This is all very reminiscent of the TARP votes in Fall 2008. The underlying structure of the negotiations seem to be about leverage, for both sides. Leverage which won’t appear until it becomes more than cheap talk. For instance, ex ante , it’s tempting to answer yes to both of these positions/questions:
Position #1: We are about to suffer a major economic catastrophe, completely of our own making, unless we raise the debt ceiling in the coming days. All other considerations need to be set aside, and we need to indicate to the markets that U.S. Treasury holdings are, and will continue to be, for all intents and purposes, zero-risk investments. Given that, isn’t it imperative that we pass a clean bill that raises the debt-ceiling enough to cover a substantial length of time?
Position #2: We’ve been trying to reign in the debt/GDP ratio in this country for over a generation, and we’ve gotten nowhere. There’s plenty of blame to go around for that. But now it’s more serious; if we don’t suppress the ratio in the coming quarter, U.S. Treasuries are in danger of losing their AAA credit rating, regardless of whether we raise the debt ceiling. It’s quite difficult to cut entitlements or raise taxes in any political environment, and it will be impossible once the debt ceiling issue is resolved. Given that, isn’t coming to a grand bargain right now the only responsible thing to do?
The only point I make here is that both of these positions — which, if you read carefully aren’t the partisan positions — require leverage that is not based on cheap talk. And until the markets react, it’s all cheap talk.
(Ok, back to my original point.)
Well, the markets are reacting now. The Asia openings put S&P 500 futures down about 1%, and also had investors moving away from the dollar. And that brings us back to the issue of options volatility.
Here’s the issue: the S&P futures are unlikely to be correctly priced at some miniscule or minor discount off of what they were yesterday. There was no value lost in the market, just an increased amount of volatility. But that risk is, as described above, basically a discrete variable in the long-run: we’re talking about either serious global economic problems or, well, nothing. That’s unlikely to create a long-term 1% or 3% or even 10% drop in the broad market indexes. The only possible results are much worse than that, or much better.
Which means, I think, that the smart money right now should be pouring into any equities that are marked down due to the possibility of default. This is in part because I think the political risk is poorly priced and that a debt deal will follow shortly from serious market reaction, but more so for the Pascal’s Wager aspect of all this: if we drop into a depression, your 401(k) holdings are going to be the least of your concerns. So you might as well bet long the market, no?
