Monday, July 10, 2017

"Icarus Trades" - Are these something to worry about?

We have heard the term "Icarus Trade" recently popping up in market discussions a number of times. Icarus, in Greek mythology, creates wings to fly but his overconfidence took him too close to the sun where his wings burned and he fell back to earth.  In investment terms, the overconfidence of some investors will take them to market extremes only to suffer a fatal fall as the market normalizes. As markets go to extremes, a position can turn into an Icarus Trade. Call it a variation of a crowded trade. As the market moves to valuation extremes, investors are more likely to get burned and sent back to earth. This is a nice story, but is it true? Narratives should not beat reality. 

I can argue that this is testable. In equity space, as markets move to more extreme valuations, the downside risk may get larger, so high valuation may see more negative skew in the future distribution relative to non-extreme periods. High valuations should be associated with a change in the distribution with potentially more downside risk. Of course, we could form a test for this except there is a simple problem. What is a high valuation? We need to know this ex ante and we need to be able to set some bounds on the test period. Finally, we need a sample of potential Icarus trades which could be anyone's guess.  

Icarus got burned because he was not able to measure being too close to the sun. At what point does being too close to the sun occur? For equity holders, did it occur yesterday or will to be tomorrow? Has it occurred for tech investors? What about bond investors? This problem can be closely related to two approaches to trade management. For those that can measure value, you get out when the market moves to overvaluation. For those that cannot measure value or believe it is too uncertain, the simple rule is to hold onto winners and only reverse after the price direction changes.  Rules for behavior can be engaged. However, be aware of the false narrative that sounds illustrative but has no foundation in the solid number.

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