While Wall Street’s long-only mindset might consider him as some sort of an anachronism, setting himself apart by considering a diversification method using bonds and clearly claiming the emperor has no clothes. That’s not boring. Challenging the prevailing thought process on a little island of thought, opening up new avenues for risk management, is exhilarating to Spitznagel. But once the nuanced dichotomy of what some consider revolutionary is understood – looking at the stock market opportunity lost by investing 40% of a portfolio into low returning bonds – then the importance of end-point investing becomes apparent to volatility conscious investors near the end of an economic cycle. The dichotomies in today’s absurd world are clear to those who actually seek real answers.
How can Spitznagel be best known for predicting the 2001 and 2008 market crashes but such brilliant analysis didn’t play any role in why his hedge fund delivered strong returns during such weak markets? Forecasting markets is fruitless, says the man who predicted the previous two.
The dichotomy exists for the same reason the fund manager known deep in alternative investment circles for using a “long volatility” strategy also revealed that short volatility is no stranger to the portfolio. Market soothsaying has no impact on Universa’s day-to-day investment strategy, Spitznagel said with an important caveat.
The 47-year-old fund manager pointed to his next prediction of a forthcoming markets crash, reiterating a theme. The man who predicted the previous two says he can’t predict exactly when the market will get it, but that market price adjustment will happen, leading to a question.
Can Spitznagel see core market causation for three market crashes in a row, something yet to be accomplished by any major hedge fund manager?
In this three-part series, we first take a look at Spitznagel’s economic theory to understand why he thinks the market will crash, then we explain how Universa’s strategy works and finally explore how his investment mind was shaped, leading to an uncommon approach that comes from a little-known sect deep inside what is generally considered “Wall Street.”
Spitznagel doesn’t have the look of a radical. His placid if almost “boring” Midwestern face belies a man with a strong spine and deep convictions to an investment philosophy that largely shuns the weak consensus. His current market view, that another market price adjustment is inevitable, coalesces with other voices that think excessive central bank interventionism will collapse under its own weight. The “systematic mispricing of risk,” as author William Cohan recently called it in Vanity Fair, is documentable on several levels: sovereign bonds trade at negative real interest rates while stocks and junk bond values approach historic high valuations being among several concerns.
While the opinion that the market is overvalued is not as novel as it was in 2008 or leading up to the 2001 “Tech Wreck,” understanding Spitznagel requires understanding not one but two distinct philosophies. There is a market outlook that, in part, has Chinese roots. And then there is a very different investment philosophy that is guided by separate principles that have derivatives at their root. And then there has been his time spent in the global derivatives industry, where he learned from a very particular “Chicago school” of thinking that is very different from “Wall Street.”
The Austrian School of Economics has different definitions
Former US Fed Chair Alan Greenspan is credited with having his economic thinking rooted in an Austrian School of “free market” thinking to which Spitznagel outwardly subscribes. This concept was taken to an extreme when Greenspan declared to then crusading CFTC Chair Brooksley Born that there wasn’t “a need for a law against fraud” because the market would take care of white-collar criminality. This thinking didn’t wear well nearly two decades later as the largest and most influential banks have racked up historic levels of fines for illegal mischief and have not been punished by markets, delivering among their biggest profits in their history. Spitznagel, like Greenspan, has faith in free markets, but he is also rooted in dogged realism.
“Governments can play a role in enforcing contracts, and keeping markets honest, and enforcing torts, etc.,” he pointed out, while also muttering that “markets do that better, of course.”
His pressing concern isn’t bankers engaging in repeated acts of market manipulation for profit but central bankers tipping those same scales of free markets to keep interest rates low. In his mind, the Alan Greenspan era, which stated in 1987, was also a time of unprecedented central bank intervention that has created a pattern of markets overheating and resetting ad nauseum.
He said its “a pretty dependable rule of thumb that governments have a way of screwing up virtually everything that they touch” when entering free markets. “They try to make some aspect of the economy or markets or the world better and they end up getting the opposite. It’s almost a cliché.”
What is odd, however, is that seldom do the “official” market manipulators get challenged in a respectful format.
While many economists disagree with Greenspan – some sharply – there is mostly agreement in the derivatives markets in which Spitznagel trades that markets are a tool for price discovery. Markets are designed to measure economic supply and demand. When demand exceeds supply the price goes up and vice versa. These are core performance drivers that are first understood as a frame to evaluate more complex issues. So what happens when a central bank puts its hand on the market scale too harshly?
“The next market crash will be greater than any in human history,” Spitznagel told ValueWalk. “The monetary intervention we’ve seen since 2008 is unprecedented. Something destructive always happens when a government sets prices.”
Spitznagel’s warnings come at an odd time, as what is rapidly becoming the failed state of Venezuela learns the lessons of market repression. Kids have been reported in the streets throwing bolivars, the nation’s currency, into the air as rampant inflation makes them worth nothing more than the paper they are printed on.
Spitznagel doesn’t want this to be the future, which is one reason he raises the issues, particularly in regards to market manipulation.
While extreme, such central economic planning has a history of ending badly in places such as the former USSR and other communist regions. While the US has been considered to be a “free market system,” he sees a strategy drift with an invisible hand coming into play.
“We have this strategy creep by central banks since the 1980s,” he said, pointing to a general lack of concern regarding the impact of central bank interference on free markets. “We get desensitized. It is hard to question something that is working for you.” But that is part of the problem. Central bank monetary intervention can provide a tranquil look to the markets when interest rates are low. But the longer the free market repression, the worse the consequences.
Spitznagel’s worst fear is that monetary repression will lead to inflation, which many business models can’t handle, a point he made:
It would be painful for a lot of people in the short run and that is a really bad thing. At the same time, it would allow capital to be deployed in a much more rational and effective way. Right now we have companies alive today that should not be alive today. And that capital should go to other, more productive places. The progress of civilization slows down when capital is allocated as irrationally as it is today when interest rates are artificially set.