Tuesday, July 31, 2007

Credit worries in context

The financial world is coming to an end! Not yet. Some analysts have switched their rosy views to one of gloom in a relatively short period, so it is important to focus on the facts and then determine what the markets are telling us.

The best way to look at the credit worries is through spreads. The spread is the added premium above the risk free rate that buyers need to be properly compensated for the risk that they take on. The spread can also be used to infer the probability of default. Two spreads that provide good insight on the markets are long-dated (10-year maturity) BBB-rated corporate and swaps spreads. BBB-rated corporate bonds provide information which is on the cusp between investment grade and high grade. They will be highly sensitive to changes in risk perception for investors who may think there is a change in the credit environment. A decline in these credit ratings may push it into high yield which in some cases cannot be held by some funds. The swap spreads provide information on banks and other financial institutions which are highly sensitive to changes in liquidity and credit risk.

Corporate credit and swaps spreads with 10-year maturities for the period 1990 to the present serve as a good historical review. It is noticeable that spreads will move with the business cycle. When there is a business slowdown, the credit worthiness of companies will decline. Hence, spreads widen. The spreads will also change with specific event risks such as the LTCM crisis and the 9/11. These uncertain events will increase the credit risk of companies.

An examination of the spreads shows that there has been an increase credit risk, but we are not near the highs for the last seventeen years. The top figure shows 10-year swap spreads since the 1990. The second figure shows 10-year BBB corporate yields relative to 10-year Treasury rates as well as the difference in rates, the spread. It could be we have just started the crisis, although the sub-prime credit problems were obvious for the last six months. Nevertheless, it is early to say that this will be a larger credit risk event that what we have seen in the past. It is natural for spreads to increase and they may have been low by historical standards in the case of swaps. A spread increase seems to be a normal part of the changing credit horizon. Slowdown in economic growth as well as specific credit event problems are the cause of these changes. The problem is always with the perception of investors. If the expectation was that credit spreads were stable and would not see large changes, more leverage could be employed. If this stable scenario proves wrong, there are problems.

But what is the key issue for many companies borrowing in the debt market? The overall level of rates, the combination of the risk free rate and the spread is what borrowers have to pay. When looked at from this perspective, the credit spread issue is not yet a problem. The decline in treasury rates has actually offset a large portion of the spread increases so the cost of borrowing on an absolute basis has not changed. Nevertheless, the response in the credit markets has been swift. The amount of new bond issues has fallen like a rock this month. While this is expected with spread widening, it also suggests that investors do not want to lock in debt at current spreads.

Investors must be expecting higher spreads in the future, so they are waiting for something better before committing funds. This is the most relevant information. The spreads will continue to widen until the market perceives that they will not. The pain will be felt by those who anticipated a stable market. This is not a novel prediction but suggests that expectations are still the driver for most financial markets. We are only at the beginning of this credit event.

Thursday, July 26, 2007

Reading about personality trading


Out of the Pits: Traders and Technology from Chicago to London by Caitlin Zaloom provides a good description of the transition from pit trading to electronic trading. It is a crafted story of what I called in my last passage personality trading. You get a true feeling for how many of the firms that have sponsored traders are run and how these individual went about their day. While it brought to life many of the details of trading in Chicago and London, the book was less than satisfactory in providing the details of how decisions are made and how traders dealt with the risk of their positions. It is one thing to tell the reader that traders faced risk and adjusted their personality to deal with it. It is another to describe the sick feeling of holding a position that is going against you and you are at a loss for what to do.

Zaloom, who is a cultural anthropologist, presents this material from the perspective of an academic who was studying a special subculture no different than someone who may have been living with a tribe in Africa. This framework gets in the way of telling the story of traders. Even though she worked in the pits and traded, her lack of finance knowledge or her unwillingness to provide details from this perspective hinders the study. I have always been looking for that combination of insight on the decision process with a description of trader behavior. You have these how-to books that give advice and may provide some stories of trading, all generally positive, yet there is not a book that describes the feeling of trading and what you have to do to get along with the culture of trading. Making generalizations about family ties in Chicago and the Essex man of London does not allow for the variety of personalities that have been supported by the pits and futures markets. There are traits and commonality to traders, but we are still left wondering what motivates some to take these risks. Saying that they are no different than the daredevils of extreme sports seems simplistic.

We will have to wait for another book on the topic to provide us the insight of how decisions were made and how personalities drove the profits for this business. This better be done soon because more of the traders in the pits are scattering in different directional soon we will only have a class of electronic traders.

The end of personality trading

The purchase of the CBOT by the CME ends an era of Chicago trading. 2007 marks the near final end of personality trading, the conduct of trading face-to-face. Of course, the end of personality trading for most markets ended years ago and there is still pit trading in Chicago, but the combination of these two institutions ends the personal dynamics of two venerable institutions. These two institutions fought for supremacy and bragging rights in the futures business for decades. This competition was not always directly with the product offerings, but through their personality and strategic vision. Going to research conferences in the early 1980’s told me that there was a difference in the behavior of the exchanges. The CBOT had the confidence of a leader and took the lead of spreading the word on futures trading. Working for the CME during part of the 1980’s, you lived the rivalry. The CME wanted to be more innovative faster with technology and find new markets for success. Of course, most of firms traded products on both, but the local traders were wed to one exchange.

Personality trading was defined by the people who worked a market. While you could not see this personality within the data through analysis of the time series, you felt that the color on the market from the traders in the pit who provided information. Of course the color you received on order flow about what was going on could also come and haunt you, but you could sense the rhythm of the markets from those who traded it.

The death of personality trading was slow and not apparent to most. The introduction of electronic trading was the biggest body blow, but the demutualization of the exchanges meant that professional managers beholding to shareholders would run the exchanges. Exchanges would no longer be the vision of exchange committee members. The governance turned the world upside down. Personality could not govern the responsibility of the managers to their shareholders. Efficiency and scale became more important than ego.

The professional managers of the CME group will move to the CBOT building at the end of LaSalle Street. This is progress. The markets have become more prices transparent since the age of electronics. The exchanges are better managed because of the focus from shareholders and the over growth of trading has made this period special in the history of futures markets, yet there is the feeling that we have lost something in his process. The yelling and screaming was a part of the exchanges. The muscular trading of the pits defined Chicago in the same vein as Carl Sandburg described Chicago as the city of broad shoulders.

What does Chicago trading mean now? It has been years since I have lived in Chicago and there is often as ensue of nostalgia for the past when you age. The markets are better served and more efficient, but trading the markets will be different. You are trading the price on a screen and not the additional personality of the pit. These are probably not the first comments that will write glowingly of the Chicago past; nevertheless, with the merger of the CBOT with CME we are coming closer to the finality of personality trading.

Tuesday, July 24, 2007

$100 per barrel oil on the horizon

Surprisingly, there has been little clamor about the chance for $100 per barrel oil. It is more surprising that there have not been the gloomy stories about the high price of crude oil as a tax on consumers. In fact, if you look at the stock market, you would think that oil prices have been hitting the lows for the year. The stock market is less sensitive to oil because energy intensive industries are a lower percentage of the key market indices. However, the story of oil has always been about the consumer’s ability to pay for energy relative to other demands on their pocket book. It is likely that we have adjusted to high oil only to the extent that we are will to make other sacrifices. Real income is growing but that does not mean that consumers are saving more. Behavior, under this current environment, requires a “grin and bear it” mentality. The current increase has not been sustained long enough to get a significant change in behavior.

Is $100 per barrel oil in reach? Absolutely. You can buy a September ‘08 call struck at $100 for about a dollar. If you just follow the numbers based on current prices and volatility in the market, you will find $100 oil within two standard deviations. You add a drift term to prices and you are within easy reach of $100 per barrel in the next year.

The cause of this increase is a combination of both short and long-term effects. OPEC production is down as part of an attempt to hold prices steady. They forecasted slower growth in the US. What happened was a surprise increase in global demand. Coupled with this lower production is the fact that we have had isolated short-term declines in production in some key countries as well as some large production fields reaching maturity. Nigeria has seen more rebel activity. Iraq has still not got its production numbers up. Recent reports suggest that Venezuela has not been able to meet production quotas. Iran has been embroiled in the uranium enrichment problems with the UN. All lead to a tight crude oil market.

We are not predicting $100 oil but it is within grasp. There has not see major changes in response to the latest increases. The $17 move since the beginning of the year has been viewed as temporary; nevertheless, we may have to wake up to a continued oil tax.


Monday, July 23, 2007

Popping corn prices

The recent behavior in the corn market suggests that the long-run view has to be tempered with short-term dynamics. Corn like other grain markets will be affected by the weather. There can be strong demand for a market, but if supply grows faster with better weather conditions, it will drive the price in the short-run.

The key story driving the corn market in the last year has been ethanol. This story hit a fever pitch just before Spring planting. The price of unleaded gas has increased more than expected which had further stoked demand for corn, although the price has declined in tandem with corn since mid-June. The amount of production from new ethanol plants is strong with capital expenditures responding to government subsidies. Corn demand for ethanol is now greater than the amount for exports.This demand story may have taken on the dimensions of a bubble in some parts of the Midwest. One agricultural economist suggests that 40% of the increase in corn prices in the last year has been due to ethanol demand.

This strong expected demand provided an opportunity for corn farmers to make extra income through crop switching to corn production. The result was the largest corn planting on record and exploding prices. From a year ago corn prices increased over $1.30 per bushel for the front-month futures contract, a 33% change in prices to their highs in mid-June of $4.32 per bushel.

Yet, in less than a month the price has fallen by over a $1 per bushel on weather patterns which have been almost perfect for growing. The strong plantings with favorable weather conditions which increase yields mean that we may see a bumper corn crop. The logistics of producing ethanol to take on this extra supply may prove harder than originally thought. Regardless of what some may think about the long-term demand, grain prices are still driven by short-term weather.

Carry and equity markets

A recent argument from a major bank suggests that currency carry trades are tied to the performance of equity markets. The line of transmission between carry and equity markets is an interesting one and more complex than what some may think. Establishing a link may be harder than what one would expect.

How can carry trades be best described? It is actually a combination of two trades. First, it is a pure financing trade. Borrow the low yield and buy the high yielding instrument. This is no different than bond financing trades where you borrow short and lend long, but instead of trading maturity differences, you are trading differences in rate location. Now this is unlikely to be profitable if it was not for the second trade which is the currency component. The second part of the trade is based on the assumption that currency markets are not fully linked to interest rate markets. If there was a strong link, uncovered interest rate parity would hold. We will not go into all of the details for why link is not perfect other than to say that the currency markets are driven by a different set of investors than those in the bond markets. There are not enough cross-over investors to get uncovered interest rate parity to hold.

Given the description of carry trades, there should not be a direct link between carry type trades and equity markets, so you have to dig deeper into this story to find a meaningful relationship. Nevertheless, there may be a relationship through three sets of factors.

One is a risk aversion factor which may be the most creditable. The risk aversion story is based on the idea that if there is an increase in volatility, then there will be a market reaction tied to the fact that market participants are risk averse. There will be a desire to cut positions in high yielding risky currencies. A corollary to this story is that those countries which are lenders and have a balance of payments surplus will bring capital back to their home markets. These countries also happen to be those which have lower yields. Carry trades are tied through risk aversion to higher volatility. Higher volatility will cause both markets to demand a higher risk premium to hold these securities.

The other potential link between carry trades and equity markets is through macroeconomic transmissions which affect nominal interest. Here the analysis gets a little murky because the impact of the business cycle, monetary policy, and inflation may cause equity markets to move at times in opposite directions with carry and at other times in tandem. Look at the simplest case of tighter monetary policy. A central bank placing restrictions on credit will cause short-term interest rates to increase. This may be good for the carry trade but may have a negative impact on equity markets. There can also be situations with interest rates rising from stronger business conditions which will be good for the carry trade and may also lead to strong equity markets. The relationship is more ambiguous.

The third link may be through international equity flows. Under this scenario, relative equity returns between two countries may lead to financial flows which affect exchange rates. These exchange rate changes from financial flows may reinforce carry trades or disrupt the direction of exchange rates associated with carry. Some argue that especially for emerging markets equity flows have a strong impact on exchange rates which could be greater than fixed income flows.

Generalizations of what may happen with carry trade based on equity markets should be looked at with healthy degree skepticism. There has to be an understanding of the root cause of each market move to make a judgment on the relative impact.

Sunday, July 22, 2007

Diagnosis and investments


Reading work outside the usual investment topics can provide a different perspective on some of the age old problems of trading. I just finished How Doctors Think by Jerome Groopman which is a must read before you get sick. Understanding how doctors think will help you get the best medical care possible. Understanding how doctors think will make you a better investor.

I was amazed at how closely the problems of diagnosis are associated with problems of investment decision-making. Doctors are not gods but human beings who have to make difficult decisions under tight time constraints and limited information. The stakes are life or death but not dissimilar to what any traders has to face. Traders and investment professionals have to take information from a wide set of sources and try to develop a story for a forecast. If you are wrong, the costs are high.

The issue for both doctors and investment professionals is determining what can be done to become a better decision-maker. The chance of developing good expert systems has been discredited in both fields. There are no set of rules that can be applied to each discipline when faced with a high level of uncertainty. Of course, there are general rules that will work in most cases, but when models are routinely employed, problems will arise. There is the growing view that being a good diagnostician requires not following set rules but looking for the unusual in past facts and trying to fit a story for what may be out of the ordinary. A base model may be a starting point but not the solution.

Medical doctors are not dissimilar from traders. A patient comes in and describes some facts concerning their current circumstances. What hurts? They describe the context of their current situation through their medical history. The doctor has to assess the situation and make a decision on what is the best course of action. For most cases, this is relatively easy and follows the usual format. You follow the textbook symptoms and prescribe a solution. The problem arises when someone comes in who has symptoms that are out of the ordinary. What do you do now? These are the situations of maximum risk. This is when falling back on our usual behavior is dangerous. Doctors will fall into well-know decision traps as they try and fit the current situation into a box of what is consistent and wrong.

This sounds all too familiar with many trading decisions. You look at a trade. Where is the value? you may start with the usual analysis and then move to what may be out of the ordinary to find a solution. While behavior finance provides investors with a plethora of potential problems, there has been little work at describing what managers and traders go through to make a diagnosis of a trade. The how-to-do-it books focus on specific rules and prescriptions but do not discuss failure and how traders learn from mistakes. It is from our mistakes that we learn the most, but these are events we discuss least.

Groopman does not have a broad array of prescriptive solutions to the diagnostic problems, but causes the reader to focus on thinking outside of the box. The best doctors are those who have the characteristics of Sherlock Holmes, the power of observation, questioning and deductions. The next time someone says that it is obvious that prices should go up be wary. Start asking questions why and think why this case may be special.

Wednesday, July 18, 2007

Inflation and capacity utilization


Inflation is a general increase in the price level of goods and services. It is also thought of as a monetary issue. It used to be taught that inflation is always and everywhere a monetary phenomenon. Sounds easy enough, but it is relatively hard to separate general price changes from relative price changes. For example, the price of food and energy is going up, but this could be related to the demand for these specific products or to problems in supply and not inflation. This is why food and energy are excluded from the core inflation rate.

The signs of inflation are complex, but one that should be closely watched is capacity utilization. This provides a measure of the slack in the economy for production. It is not a good measure of slack for the service sector which is the majority of economy, but does provide information on where there will be supply congestion. The capacity number may also be offset by excess capacity abroad, but it has generally been a good guide of potential inflation. If the economy is growing but the capacity utilization is below its peak, there will be a low probability that inflation will come from production constraints.

The current capacity utilization is near its all time highs since the last recession. There is the potential for greater price pressure as to moves closer to highs. It is currently at 81.7 with the high since the last recession being last year at 82.3. The average since 1972 has been 81. The mid-1990's numbers are generally higher than 82. It is not a good stand alone indicator, but it does provide added insight for where inflation may be heading. Given this number is high and growth has been good in the US, there is little likelihood that core inflation will ease in the near-term.

Tuesday, July 17, 2007

Natural gas marches to a different drummer

While crude oil prices have surged higher on stronger demand from sustained economic growth, natural gas has moved lower. The front month contract is now at levels not seen since March 2004. This was unexpected by many market forecasters.

Part of this decline is associated with a decrease in the hurricane risk premium. After the difficult 2005 season, 2006 saw a seasonal effect based on the expectation that there would again be disruptions in the key Gulf of Mexico producing region. This was supposed to happen again given the forecasts for a number of major storms. The hurricane season lasts from June 1st until the end of October, so we are still early into the season, but there is no activity that would suggest a supply disruption at this point.

Nevertheless, these disruptive events can come up unexpectedly. The height of the season is in August and early September but there are still hurricanes that can hit key Gulf areas near the end of the season. Hurricane Wilma, for example, hit Florida near the end of October. Nevertheless, natural gas inventories for 2007 are above the give year averages albeit slightly lower than last year. Given inventories have had a chance to build, the impact of a supply disruption is reduced. This has been coupled with a relatively mild summer. This weather pattern has led to the low natural gas prices even though crude has moved well past the $70/barrel level.

The correlation between crude oil and natural gas is surprisingly low given they are both classified as energy commodities. Any expectations that they should follow the same pattern should be put to rest. Each should be viewed within their own supply and demand characteristics.

Tuesday, July 10, 2007

Avoiding the tough questions concerning Amaranth

There is nothing like providing a good roadmap of a problem and then doing nothing. A clear case for regulatory action can be made from reading the testimony of the Acting CFTC Chairman. The Senate investigation found evidence that when Amaranth could no longer take positions in the NYMEX natural gas futures, they just switched there business to ICE. ICE does not have any position limits, so a trader who wants to control large positions can do it with impunity on the ICE after his position limits have been used up at the NYMEX.


The problem is that these two markets are closely linked. Switching trades from NYMEX to ICE is not trading separate markets but trading essentially the same contracts. This can lead to the potential for manipulation. The following quote states that a link between the markets for potential manipulation is clear, but the Acting Chairman concludes that they do not have the ability to analyze a potential manipulation problem. Nonetheless, he is able to conclude that the ability to manipulate prices has been reduced by having these two markets - one with limits and the other without. Someone will have to help me understand how that conclusion could be reached

“Given that price discovery may be conducted at both ICE and NYMEX, successful manipulation of the ICE price would be reflected in the NYMEX price. Arbitrage between ICE and NYMEX makes it possible for ICE prices to influence NYMEX prices. Since the Commission has not conducted a review of surveillance practices at ICE, our response cannot be as soundly based as would be the case were we asked about manipulation possibilities at NYMEX. However, the ability to manipulate prices on either has likely been reduced, given that ICE has broadened participation in contracts for natural gas.”

Testimony of the Acting Chairman of the CFTC Walter Lukken before the Permanent Subcommittee on Investigations Committee on Homeland Security and Governmental Affairs United States Senate on July 9, 2007. See the full testimony for some light reading. http://www.cftc.gov/files/opa/speeches07/opalukken-26.pdf

This type of poor analysis and attempts to avoid the difficult issues associated with Amaranth will make for an environment where more regulation is forced on the futures markets. Regulatory overkill in response to extreme cases and poor oversight will have far-reaching effects on many of the traders who have always played by the rules.

Tuesday, July 3, 2007

Going back to basics in the FX market

The FX market is still an areas of finance that is not well understood by many. Along with arcane terminology, the models often employed in the FX market have a spotty history of forecasting. They have a history of not working, yet are trotted out on a regular basis with a confidence that they can provide useful information.

That being said, all is not lost. There is strong research that suggests that even if models have a spotty history as measured by a low R-squared, they can have value within a portfolio. There are optimization approaches that can take into account model uncertainty and reduce the risk of a wrong forecast. We have found these techniques useful. Even with a poor history, going back to simple models help isolate what may be important factors driving the FX market.

Purchasing power parity is a one of the key concepts that is supposed to drive the FX markets in the long-run, yet it often fails as an effective tool in the short-run. It can only be used for long-term valuation and even then it should be considered with suspicion. Nevertheless, PPP can also give useful information on one of the key relationships in the currency markets. We have recently looked at PPP and found some interesting non-linear relationships which do make sense. While PPP seems to hold well when there is relatively high inflation or more importantly when there is a high differential in inflation between two countries, it fails when there is little differential in inflation. This should not be unexpected. When the noise of the market is greater than the differential signal that could come from inflation differs, there is little explanatory power or relationship between these variables. The real exchange rate is relatively unchanged and factors such as financial flows or interest rates will be the drivers. While there has been a little more movement in exchange rates that can be explained by the recent differentials in inflation, the spread in these are still not enough to make PPP a useful indicator except at the extremes.

More importantly, we have found that looking at the relationship of short-term changes in inflation relative to exchange rates actually shows some of the wrong expected signs. We found this very unusual given that the expected signs were in place in the 80's and early half of the 90's. However, a close inspection suggests that inflation targeting may be associated with these unexpected relationships. If there is higher than expected inflation in a country and they target a lower inflation, there is the expectation that the central bank will increase interest rates which may lead to a currency appreciation, Investors will be driven by the financial rates and not by the pure inflation. Put differently, inflation above the traget is not expected to last and is dicounted. This could provide us with the wrong regression signs for monthly inflation.

In a era of inflation targeting some of the old approaches to exchange rates may have to be adjusted to account for expected central bank action. It is not that PPP does not hold, but that the basic equations may be signaling something else.

Good economy, bad dollar

The US stock market has been a strong ride since February and has come off its lows since the middle of June. The latest gains have been a response to the economic data that shows a more robust manufacturing sector and controlled inflation. Given this information, the expectation would be that the dollar should strengthen. The higher equity prices should lead to larger capital flows into the United States. The higher growth and lower inflation also should be good for the dollar.

Currently, that is not the case. While limited value should be taken in any one days activity, the dollar is at lows versus a number of currencies. This may have made more sense during a period of slower growth and rising inflation, but not as much during a periods of rising economic activity. Granted the reversal of gloom in February lead to some dollar strengthening but we are now at a point that the Euro is near highs.

Currency markets at this time are driven by carry and what monetary authorities may do. A good growth scenario with limited inflation means the Fed may be on hold for a long-time. This means there will be no gain from holding US fixed income. With other central banks increasing rates, the carry demand is still strong for holding money assets in other countries. This style bias will have to change before we see dollar strengthening

Sunday, July 1, 2007

Changing growth expectations and asset markets

The most telling investment story for asset classes is the continued increase in the stock market and the changing expectation in the bond market. These stories are closely tied together and show the difficulties of adjusting to a swiftly changing economic landscape in the first half of 2007.

The stock market can be characterized by three phases. Phase one, the gains until the China sell-off. Market expectations changed with the perception that assets were actually riskier than expected and that growth may be slowing. Phase two was the the recovery of the equity markets based on the idea that assets were not looking at a change in risk and that fact that housing problems may not spillover to the rest of the economy. The third phase is the period of consolidation during June. Growth may be positive but moderate. The risk of inflation may be diminished.

Bond markets have sold off on the economic rally. With the probability of a recession diminished and the chance for higher inflation and no reduction of interest rates by the Fed. the market saw some of the worst performance in years. The last half of June, however, saw a bond rally. The surprise has been a decline in inflation and moderate growth.

Learning European economic history

Most American investors do not understand the European economic landscape, or we think we know it as a bureaucratic socialist leaning system which has been in a state of continued stagnation relative to the United States and Asia. This view of relative stagnant growth opportunities is a falsehood and a misunderstanding of what has been accomplished since WWII. The more recent history is a legacy of the earlier miracle but cannot be characterized with a simple view of just state domination.

The European economic model and history is well explained in The European Economy since 1945: Coordinated Capitalism and Beyond by Barry Eichengreen, a leading scholar of international finance and hisory. It is detailed review of the dynamic changes that have been seen in the European economic landscape. It is a comprehensive analysis of economic development over the last half century which dispels many of the myths of European development.

The economic story of Europe is actually a development miracle during the first half of this period. Part of this growth was the catch-up from the war, but it has also been a comprehensive approach of how to integrate ecnomics between different groups. Not all of the the countries took the same path but there was a common goal to get growth on track. It has been a useful set of policies driven by cooperation between labor, government, and business as well as a willingness to meld Europe into a single market.

The European miracle according to Eichengreen was possible because of the cooperative legacy between the three major economic players that existed before the war. Strong government intervention to promote growth was backed by labor and business to make Europe a success. This cooperative structure worked well during the period of reconstructive growth or catch-up. This structure of state directed cooperation did not do as well over the last 30 years when new technology and innovation were the hallmark of growth. The coordinated capitalism, however, led to European integration, a single currency, and strong improvement in standards of living.

The question is whether this historical model of coordination can be recast for a changing world economy. Prof Eeichengreen does not have an answer, but reading the history can give us a model and context for how Europe may behave in the future.

The Black Swan - Fooled by Randomness Redux




The Black Swan -The Impact of the Improbable is the expanded philosophical extension of Nassim Taleb's earlier book, Fooled by Randomness. "Fooled" was a great book for exposing the impact of chance extreme events and the problems that occur with any empiricism. No matter how many white swans we may count, there is no proof that black swans do not exist. While Fooled by Randomness was written for a trader audience, it received a wide following from all professions. The Black Swan can be viewed as the more extensive deeper discussion of the main thesis of his earlier book.

Taleb deliveries a wide ranging discussion on the core topic with extensive discussion on the historical antecedents for Black Swan thinking. Taleb can be insufferable, bombastic, erudite, brilliant, petulant, and single-minded in a single paragraph. You may not fully agree with his arguments, but he is a masterful debater and can poke holes in all of the prevailing views on forecasting. Taleb is a man on a mission to get us out of conventional thinking. His relevant lessons have and should influence all disciplines who are not focused on the potential for Black Swan events.

This extension of his earlier thinking has the same basic arguments. The short list of his theses are as follows. We do not live in a Gaussian world. Expect the unexpected. Our ability to predict the future is poor. Our knowledge is limited about what may happen in the future. Our history has not been smooth but is subject to jumps. While we think we can live in as stable world, we actually are in a environment of extremes. We use narrative to wave stories and find causality when it may not exist. We look for confirmation of what we are already thinking. Of course, these short statements of what Taleb is trying to explain does not do the topic justice. He is a masterful story-teller.

The key criticism for this work is not what he says but what to do next. He is like the party out of favor in government. Good at criticism but short on solutions. Taleb is burning down the house of Gaussian Platonic conventionalism, bu there is not an alternative to dealing with the unknown risks. Maybe awareness is enough. We may have to await another book from Taleb for those answers.