FM: Many experts suggested that regulations and policy needs to be countercyclical. Do you agree?
MS: They look the other way when everything is going well. I totally agree. But it shouldn’t be so much about them in the first place.
FM: Discuss your trading philosophy and how it can be used.
MS: You simply step aside when markets get distorted. What does that mean? You have to watch all your friends making money when you are sitting aside making nothing. You are no longer focusing on your returns today but the return opportunities you will have later when markets reset. I am thinking about the advantage that you will have with dry powder when the markets crash and not about return today. By doing nothing I am doing something real big. I am allowing myself opportunities later.
A higher level example of that is what I do, which is instead of doing nothing you actually have positions that will [create] a tremendous amount of cash. What is the hardest position to have right now? It is cash. The Fed knows what it is doing. It is pushing you out of something it doesn’t want you in. It is not an accident. If your focus is only on that next slice of time like all the professionals, then it is not an option. If you can plan for those other slices of time, they should be far more important to you than the current one.
If you had followed the strategy you would be far ahead of the market. You would have been out of the market since 1996, which is a very hard thing to do.
FM: In your strategy do you constantly have the same hedge on or do you increase and decrease it based on the MS Index?
MS: You can increase it or decrease it. I showed an example in the book that it is the most affective when there is a high MS index; when it is low there is not a lot of room for a systemic crash. When that is low a tail hedge is not critical. The great thing about what I do is that the more distorted the market gets, the cheaper my trade is and the better the risk/reward looks. It is a very convenient property. For instance the VIX tends to go down when the S&P rallies.
FM: How much do you underperform the market when things go well?
MS: It is complicated because I do some complex hedges and spreads. What I talk about in the book is a very simplistic naïve representation where you are just buying out-of-the-money puts. But it costs you a low single digit percentage a year—in that naïve case. I could be short premium meaning if the market shuts down I am earning premium but if the market crashes I am long gamma.
FM: There has been a lot of criticism of alternatives. Is this dangerous given that it will push people to long equity strategies?
MS: All bets are interconnected. There is one big systemic bet that everyone is taking right now. Diversification is hard to come by. It is a shame. We are very good extrapolators.
FM: How will the current distorted market be resolved?
MS: At some point whether it is quickly or not [there is so much leverage a system can take] markets will crash. In classical economic perspective they say that when interest rate get lower we have higher liquidity preferences, people don’t want to lend anymore, they don’t want to borrow anymore. That is why balance sheets at banks get so bloated. It will probably happen quickly when it happens but at the end of the day when markets are this distorted you will find your way back.
FM: What is your goal with the book? It includes concepts that are very easy to understand but difficult to execute in investing and in life.
MS: That’s kind of my thinking. It sounds like a cliché. These are the tools of what got us here in the first place. The idea of a roundabout. Focusing on the means and not the ends. It is so obvious but it helps to understand the role it has played. You can’t just focus on outcomes, you have to have something else to lean on. It is not empiricism that you should lean on because it can guide you down the wrong way so you need these concepts and in order to understand them and believe them [you have to see how they came about].
Half of it was good introspection for me. It is a travesty what the smaller investors go through so to me it was important to try and get people to understand this perspective. So much of Austrian theory is difficult to get through. Though I went about it in a roundabout way, my goal was to make it somewhat approachable.
FM: For people to adopt this is it just going to take pain? Another crash or event to reorganize ourselves?
MS: I think it will. And capitalism will be blamed again when it happens. All the scary stories that we heard when they jammed through TARP, a lot of it was overstated. I can’t prove it and I don’t think others can prove the other side of it. But this idea of the end of the world scenario is entirely wrong. We should look at this as a healthy process, as a cleansing process. We would be on the road to very healthy real growth today if we just let it cleanse itself. My ultimate message is one of great optimism. Seeing optimism in a crisis or a tragedy. It is a means to a much greater end. We need to recognize that. Politicians can’t because politicians will not get reelected during a crisis. They are rational to try and stop all pain. …We should have had more banks fail.