FM: It is no huge revelation that a lot of our recent economic problems can be blamed on short-term thinking; never looking beyond the next quarter. You take a circuitous route in your book to describe this. Is that on purpose?
MS: It is on purpose. The whole point is there is a lot you have to build up along the way. There is a path you have to follow to get somewhere and it is not the direct path. For instance, it is not enough to give someone an investment strategy, the key is what is underlying that investment strategy, why these things should work, what the thinking behind it is. It is very easy to say this is a strategy that works and it will continue to work. There are data mining issues with that. You need to approach trading in a much more deductive way. It was the point to build up the necessary tools to code to the strategy.
FM: It seems that we intuitively know some of these things but often don’t act on it.
MS: People say it is a long term thing. It is almost a cliché to say that. They use it as an excuse for what is not working at the moment. What I am talking about is not just about waiting, it is about working in the present to gain an advantage in the future as opposed to just putting something on and twiddling your thumbs and watching it work. Yes, we are all very short-term minded. Corporate managers are thinking about the next quarter. This is all very rational for them to do. There is the [Stanford professor Walter] Mischel study (an experiment to determine whether kids would be willing to wait to get more marshmallows or take one immediately). It turns out that the reason they don’t wait is not because of impatience, it is that they don’t believe you are going to come back with more. Any investment manager is right to think that if I don’t get my marshmallow now, do well now, you are not going to give me an opportunity to do better later. And they are right about that. It is a structural problem. These people are acting very rationally based on the structure of these industries. I firmly believe the big problem here is one of being trapped in the present and all that matters is that next slice of time. It is both a structural problem in history and our psychology.
FM: You successfully called the market turns of 2000 and 2008. Was your tail hedging strategy perfected or was it just forming?
MS: I was on the floor from 1993-97. In ’98 I was a swaption trader at Credit bank primary dealer arm. In 1999 I started a hedge fund with Nassim Taleb, who was at the [Chicago Mercantile Exchange] when I was at the CBOT; 2000 was our big play there. In 2005 I went to Morgan Stanley within its stat arb group. In 2007 I left to start Universa [Investments] and we all know what happened in 2008.
FM: A lot of people saw the 2000 crash coming as the market appeared overbought throughout the late 1990s but lost money by being wrong on the timing. Is your strategy a fix for that problem?
MS: Absolutely. You can’t short markets that are running like that. You are going to blow yourself up. It goes back to Everett. That’s the reason I approach market this way: the idea of taking a one tick loss. If you want to trade that market with S&Ps you would short it, but when you are wrong you will have a tight stop. And throughout the ’90s you would have taken a lot of losses. Eventually you would have been right, whether you would make up all your losses, I can’t say.
What I do with options is nothing more than a fancier way to do that. Right now I would say the market is massively distorted, we are going to see a huge sell-off but I would never advise someone to be short this market. You would blow yourself up. The market will balance itself; as it has in all the other bull moves caused by distortions in the last 100 years. It managed to right itself but the path there is difficult and there is no telling how far it can go.
In the late ’90s clearly [Fed Chair Alan] Greenspan was the driver of that boom. There was a nice believable theme behind it that we were in a new economy. The market went further than it ever had in recorded history. Here we are again on the cusp. If the market rallies much from here, now we are back in this territory like 1999. It is possible the market could double from here or triple from here. I happen to think it is not the likely path.
FM: Isn’t it different now. In the ’90s we had a booming economy. No one would confuse the last six years with a booming economy, we know it is struggling and the Fed is trying to keep us above water waiting for stronger growth to happen.
MS: Agreed. But I would argue in both situations ultimately there were delusions. The booming economy of the ’90s was happening but it was not based on anything real. At some point monetary distortion can easily lift asset prices but it also could make it look like there is activity in the economy that is artificial. They both had similar sources. The late ’90s look very different than today and for that reason it will probably be very difficult for us to go too much higher.