The PPT is the Only Thing Stopping an Outright Crash

The markets have changed and many are going to get "taken to the cleaners."

Last year, 2017, was a not a normal year for stocks. Stocks as an asset class are not meant to go straight up without even a 1% pullback. But that is precisely what happened for nearly an entire year.

Now that massive market rig is over. And anyone who continues to invest as though it's 2017 is going to get annihilated in the coming weeks. The only thing that stop an all out crash in stocks was clear and obvious intervention in the markets by Central Banks.

Take Friday's action for example. The S&P 500 briefly broke its 200-DMA. At that point the Plunge Protection Team stepped in and ramped stocks over 3% in the span of an hour.

This was intervention, plain and simple. NO real investors "panic buy" stocks in this kind of rapid frenzy.

This raises the question…

What would have happened if the PPT had not stepped in? Where would stocks fall to?

Buckle up, it's about to get nasty. The PPT can trigger bounces, but it requires REAL buyers for stocks to enter a prolonged rally.

Put another way, we're still going to that circle in the next few weeks.

BIll Blain: "The Unintended Consequences Are Finally Coming Back To Bite Us"

Fundamentals ok, Technicals corrected, so why we should still be nervous on what comes next for markets...

"If the apocalypse comes, tweet me.."

That was an interesting week that was.... but what a hangover we face! What happened to the global bull stock market? Just as the party was looking likely to carry on forever, the music stopped... Reading through market the scribblers this morning, the consensus seems to be it was just a correction, and we should be buying the dips. I'm always a big supporter of buying dips.... I'm not so keen on buying into a more secular decline.

Thing is, it feels there is nothing particular we can put the finger on as responsible for last week's stock market ructions. Bond yields rose a bit, inflation has gathered a bit of momentum, and economic fundamentals remain generally positive and are expected to improve in line with rising growth estimates. There is little threat of an oil-shock. Folk have pointed out that with so much money likely to be invested in share-buybacks and special dividends by US companies repatriating cash, the stock fundamentals look positive.

Central banks remain hawkish re normalisation and higher interest rates - but modestly so. A world with moderate on-trend inflation, still low interest rates, and solid growth prospects should be positive. A screaming buy signal.  

Others say last week's pain was technically driven – on the back of a massive sudden and shocking unwind of "short-vol" trades. Others say if was due to AI driven algorithmic traders, while the FT carries a story about insurance companies dumping massive amounts of stocks, triggered by rising volatility, linked to "managed volatility" variable annuities.

These two views, i) that fundamentals haven't fundamentally changed, and ii) that it was technical driving the sudden sell off, suggest we should be doing what we always do at times like this – wonder when to buy the dips! And that's what the bulk of market commentary is about this morning – when to BUY THE DIP.

Look at that table I sent round last week. Most crashes reverse quite quickly - the really bad long ones require a very significant element of economic destruction or fundamental reassessment. Aside from catching a few foolish levered Vol players, there hasn't been a fundamental product or sector destruction this time.

There are clues in trading patterns – Lower highs and lower lows. Or the CNN Fear and Greed index spinning round 180 degrees over a few days into Extreme Fear Zone. My stock pickers say the last bear phase in Feb 2016 was a far more negative market phase than what we've just seen. Anyone that bot then has seen massive gains! Steve Previs comments this morning: "sure the market has dropped 10%, but its not that big a deal. If the SPX breaks and closes below 2500, then something different may be taking place." However, he expects the market will remain highly volatile for at least the next few weeks.

But.. But and But again. I'm not convinced…

What drives the kind of fear we saw last week? There are the risks we can plan for and hedge against, and there are the Cygnus Atratus events we can't. But, the biggest threats of all might just be things so blindingly obvious they are hidden in plain sight for no one to notice. A few years ago it was the silly notion that bundling up risk into mortgage pools or CLOs made the risks go away. My first ever market crash was when buyers of perpetual bank bonds suddenly realised they were buying equity not credit. This time it might be the passive/docile cash tied up in ETFs.. or something else completely.

10-years ago central banks started playing with "extraordinary momentary policy" in their efforts to stabilise markets. Economists warned that printing so much money - which is what it was - would result in catastrophic inflation as money was transferred from the financial markets to the real economy – the convoluted theory behind QE.

Of course, that is not what happened. Inflation never occurred. In fact Deflation became the threat. What if it is lurking elsewhere? The money central banks spent on bond purchases caused investors to arbitrage the buy programmes. It created massive distortion across financial assets and if you are looking for inflation - there it is. In stock markets and bond markets. QE is why bonds are so tight and stocks so high. And its over.

While it made little rational sense to invest in European peripheral sovereign credits because of their credit outlook, it made enormous sense to buy them on the basis the ECB was buying them (or giving banks free money from LTROs to buy them)! Smart investors rode prices higher. What was their to worry about? Same is true across bonds and into equity.

The unintended consequences are now coming back to bite us. Yield tourists find themselves sitting on financial assets they barely understand, except to worry they look.... overpriced. Now that QE is over - or soon to be over – they are wondering where we go next, and that's fuelling the current fear and uncertainty!

I reckon I've warned about the unintended consequences of QE and financial asset inflation over 500 times in last 10-yrs. Maybe I'm finally right? There is a great article by Bloomberg Gadfly Marcus Ashworth this morning on ECB corporate purchases – read it and tremble.

Anyway… it's a fantastic morning here in London. My train ride in from Hamble was perfect (for second week in a row), and Scotland beat France y'day. Life is perfect, except for fact I've got the dentist this afternoon after breaking a tooth. It's going to hurt.

Just like market.

Goldman's Shocking Capitulation: The Buy-The-Dip Era Is Dead, "This Is A Genuine Regime Change"

Earlier today, we were delighted to report that after the biggest vol explosion in history, the world's largest hedge fund Bridgewater, went from urging traders to go all in as recently as January 23, to warning that a "bigger shakeout is coming."

It turns out that Ray Dalio wasn't the only fund to urge its broader client universe - and anyone else who cared to listen - to do one thing, while telling a select group of clients to do the opposite. As we noted on Saturday, in his latest Weekly Kickstat published on Friday, Goldman's chief equity strategist David Kostin essentially told clients to BTFD, suggesting that the correction was likely almost over, based on historical patterns.

Meanwhile, on the very same Friday, Brian Levine - co-head of global equity trading at Goldman Sachs - sent out an email to the investment bank's bigger clients, in which he made a stunning prediction: the Buy the Dip Regime is now over.

In the email, first reported by the Financial Times, Levine writes that "Historically shocks of this magnitude find their troughs in panicky selling" and yet "I've been amazed at how little 'capitulation selling' we've seen on the desk . . . The 'buy on the dip' mentality needs to be thoroughly punished before we find the bottom."

And, more shockingly, the person in charge of the most important trading desk also said that "longer term, I do believe this is a genuine regime change, one where you sell-the-rallies rather than buy-the-dips."

Brian Levine's full shocking letter is below:

Thought I'd consolidate a bunch of thoughts and themes gathered throughout the week and try to make some sense out of the 10% correction we've seen the past two weeks from a market that had gone a record period of time without even a 5% drawdown!

• Trigger? I've heard many "write-off' this correction as being technical in nature. Well, yes, that was the trigger, but if you're hanging your hat on that, you're missing the bigger picture. The market had effectively quadrupled over the past 9 years. Why? Obviously numerous variables contribute, but it would be hard to dispute that unprecedented, globally coordinated easy monetary policy was your primary driver to force investors out on the risk curve. Sure, rates have been gradually rising the past few years, which the stock market has easily digested, but there's always a threshold that sparks a seminal change. And I don't think it was a coincidence that the S&P topped out on the very same day 10-year yields made 4-year highs (a week ago Monday the 29th)....and rates have backed up a further 15 bps to 2.8% currently. The fact that bonds couldn't rally in the equity selloff is evidence of a regime change in the multi-year equity bull market.
• "Bulletproof Psychology" is punctured — It's generally a late-stage bull market when the greatest justification for buying equities is "there's nowhere else to put my money" and conformist performance-chasing. Hence, we've recently witnessed countless red-flashing warning signals about positional complacency — just in the past few weeks, we saw:
  • GS Risk Appetite indicator hit record highs
  • Both the Conference Board AND the University of Michigan surveys showed a record percentage of investors expected the stock market to be up this year
  • Investors Intelligence weekly survey of 130 market newsletters showed bullishness hit 32-year highs(that's over 1000 datapoints)
  • AAII Sentiment weekly survey of investors' bullishness hit 8-year highs
  • Historically, a high Sharpe return in S&P (steady rises with minimal vol) often presages a major correction,and two weeks ago the 1-month trailing Sharpe of the S&P 500 was over 6!

My response to common justifications for a rebound back:

• "It's been a non-panicky selloff' — True, but historically shocks of this magnitude find their troughs in panicky selling. I've been amazed at how little "capitulation selling" we've seen on the desk, despite outsized market share. The "buy on the dip" mentality needs to be thoroughly punished before we find the bottom.
• "The corporate bid will stabilize the market" — corporates make up —8% of market volume, and —2/3 of buybacks are now bought systematically via 10b5-1 programs. Historically they were far more discretionary in buying sharp declines (not that down 5-10% from all-time highs would really qualify), so although we are seeing increased volumes in corporates this week, generally they haven't matched the increase in market volume. Longer-term, I believe buybacks increase significantly over the course of the year, but don't think that's a major factor over next week or two's action.
• "This is technical to equities — credit is hanging in" — Well, that was earlier in the week. High yield is really starting to break down vs. equities today (not to mention that HY didn't participate in the equity rally last month to begin with).
• VIX E'TN post-mortem — Well, it worked as structured.....obviously a +100% daily move drives a short fund to zero — was unfortunate how many didn't seem to understand that risk (as $3B+ of assets virtually disappeared on Monday)......but it also serves as a cautionary anecdote for market tops. Any short or levered product can go to zero in a day. Ironically, the strategy of selling vol can ALSO work for a long period of time until it knocks you out.....both ultimately proved true. In regards to the stock market, the vol-selling strategy has provided quite a bid to the equity market in recent years —remains to be seen what happens to this trend, but I would expect VIX to ultimately settle back closer to its historical range in the high teens.
• Systematic Flows: per our resident expert Paul Leyzerovich (who has nailed this, btw), the supply baton is currently being passed from Vol-control funds to Risk Parity, and CTA supply has been heavier in EMEA and moving to the US. Overall, he believes we are in the "sweet spot" of supply over the next 1-2 weeks, with about $20b/day of supply
• expected globally. About 3/4 of this supply you should see via futures. It is also important to note that the longer we've stayed at these levels, the more supply becomes "irrevocable" — ie. the supply will come even if we rally back.
• Fundamental Flows: Just two weeks after the largest Global Equities INFLOWS ever (+$33B), we get the largest weekly OUTFLOWS ever (- $30B....over half was SPY). Again, this appears to be a flashing sentiment shift, but a week doesn't make a trend. That said, the above does make a mean sound bite though.
• Client positioning: As of yesterday, client gross positioning ROSE 5% to new highs (and we heard similar at a top competitor). Nets came down, but to find a floor in a 10% 2-week-long correction, you need to see some real portfolio reduction ie adhering to the words of Colonel William Prescott, don't fire until you see the whites of their eyes.

Other datapoints that are relevant:

• SPY call open interest at all-time high (bearish)
• Are you glass half-full or half-empty? I've heard bearish arguments driven by "the S&P still trades at 21 times earnings!" and bullish arguments driven by "the S&P is trading at only 16 times NEXT YEAR'S earnings!"
• Technically, the 100-day moving average has proved critical support for the past couple of years, but we sliced through it yesterday. SPX 2540 is the 200-day, which we haven't breached in 20 months.
• SPX currently down 3% YTD. Through yesterday client performance is hanging in, with both Equity Long/Short and Quant performance in range of flat to down 1%.

Bottom line, we haven't reached the short-term bottom, but you'll know it when you see it (or at least 5 minutes later!). But longer-term, I do believe this is a genuine regime change, one where you sell-he-rallies rather than buy-the-dips.

SocGen: "Fundamentals Are Always Strong When Sell-Offs Begin"

When warning over the weekend that there has been a regime change in equity markets and that instead of buying the dip investors should sell the rip, Goldman's co-head of equity trading Brian Levine countered  the traditional response that despite the "technical selloff", investor psychology remains intact with the following:

I've heard many "write-off' this correction as being technical in nature. Well, yes, that was the trigger, but if you're hanging your hat on that, you're missing the bigger picture. The market had effectively quadrupled over the past 9 years. Why? Obviously numerous variables contribute, but it would be hard to dispute that unprecedented, globally coordinated easy monetary policy was your primary driver to force investors out on the risk curve. Sure, rates have been gradually rising the past few years, which the stock market has easily digested, but there's always a threshold that sparks a seminal change. And I don't think it was a coincidence that the S&P topped out on the very same day 10-year yields made 4-year highs (a week ago Monday the 29th)....and rates have backed up a further 15 bps to 2.8% currently. The fact that bonds couldn't rally in the equity selloff is evidence of a regime change in the multi-year equity bull market.

In other words, Goldman no longer believes that one should "ignore the selloff because fundamentals remain strong."

Adding to this overnight, SocGen's Andrew Lapthorne writes that "fundamentals are nearly always strong when the market starts to sell-off." And, as the strategist adds "when markets correct, the standard retort is that in the long-term it pays to stay invested and that the fundamentals remain strong and supportive."

To determine the validity of this statement, SocGen looked at prior corrections in the S&P 500 to see how fundamentals looked at the point when the market turned. What Lapthorne found using data since 1985, is that at the point when the S&P 500 dropped 10% or more, on average the US ISM index was at 51.6 (indicating economic expansion), trailing EPS growth was on average running at 7% and forward growth expectations were at 11%.

The point being that at the top, economic fundamentals always look strong and this is why interest rates are going up. It is interest rates, not growth, that is the concern.

Lapthorne then shifts focus, and echoes an analysis conducted by Goldman's David Kostin last Friday...

... namely how long it takes to recover from your index price loss.

Here, the mild corrections in 1998 and 1999 took under 90 trading days to get back to the initial index level. This compares to the 2000 and 2007 corrections which took over 1800 and 1400 days respectively to recover the prior price level.

In such long draw down periods, the compounding dividend takes on added performance, as in total return terms although you made no money in price terms from 2000 to 2007, at least you made 12.5% via the dividend. Another good reason to avoid dividend cuts.

Finally, looking at the composition of the selloff, SocGen notes that so far we have seen very little in the way of fundamental stock price discrimination. Specifically, during the worst day of selling, we saw some of the lowest ever cross sectional stock dispersion for a down market of such magnitude.

"In brief it looks like investors were selling markets, not stocks, a fact also reflected in the initial outperformance of small-caps versus large-caps."

To Lapthorne, the next market phase is key: do markets simply shrug off the sell-off and resume business as usual, or do they start differentiating?

We've clearly been arguing for a while now that holding balance sheet risk in an era of rising interest rates and higher market volatility has limited upside but significant downside. That view has only become reinforced by the recent market turbulence.

So far today, they are once again "simply shrugging it off", and judging by the wholesale rip in stocks just as fundamentals were ignored on the downside, so they will be forgotten on the rebound.

What Just Changed?

The illusion that risk can be limited delivered three asset bubbles in less than 20 years.

Has anything actually changed in the past two weeks? The conventional bullish answer is no, nothing's changed; the global economy is growing virtually everywhere, inflation is near-zero, credit is abundant, commodities will remain cheap for the foreseeable future, assets are not in bubbles, and the global financial system is in a state of sustainable wonderfulness.

As for that spot of bother, the recent 10% decline in stocks: ho-hum, nothing to see here, just a typical "healthy correction" in a never-ending bull market, the result of flawed volatility instruments and too many punters picking up dimes in front of the steamroller.

Now that's winding up, we can get back to "creating wealth" by buying assets--$2 million homes in Seattle that were $500,000 homes a few years ago, stocks, bonds, private islands, offshore wealth funds, bat guano, you name it. Just borrow whatever you need to borrow to buy more.

(But don't buy bitcoin. No no no, a thousand times no. It is going to zero, Goldman Sachs guaranteed it.)

Ahem. And then there's reality: something has changed, something important. What changed? The endlessly compelling notion that risk has magically vanished as the result of financial sorcery is now in doubt. If risk hasn't been made to disappear, and even worse, can't be corralled into a shortable instrument like VIX, then--gasp--every asset and instrument might actually be exposed to some risk.

As I've noted many times here, risk cannot be made to disappear; it can only be transferred onto others or off-loaded into the financial system itself. Risk can be cloaked or masked, and indeed, that is the beating heart of financial alchemy: we can eliminate risk by hedging via exotic instruments.

Once risk has been vanquished, then we can safely invest in all sorts of high-yield ventures that were once risky: junk bonds, emerging market debt, private wealth funds and so on.

But if risk cannot be destroyed, then where is it? If we can locate and isolate it, then we can hedge it, right?

But what if risk has been pushed into the vast machinery of the global financial system itself? This was the unwelcome (and as yet unlearned) lesson of the 2007-08 Global Financial Meltdown: risk, we were told, was confined to the subprime mortgage corral, and if you avoided that corral, your exposure to risk was near-zero.

That turned out to be false. The belief that risk exposure is near-zero generates an irresistable desire to load up on high-yield riskier assets because, hey, why not? If risk is near-zero, why leave all that low-hanging fruit on the tree?

This is a self-reinforcing feedback loop: the higher the yields available on risk assets, and the lower the perceived risk exposure, the greater the incentives to move more borrowed money into ever-riskier assets, which then pushes systemic risk ever higher.

The end-game of this self-reinforcing feedback loop is collapse, as risk inevitably emerges where it is least expected. Home mortgages were safe and boring. Well, not quite, after financial alchemy was applied to vanquish risk and thus unleash enormously profitable financialization.

Nobody knows where systemic risk might emerge, or how much risk exposure is lurking in assets. What was once safe is now less certainly safe. So where do you earn those fat returns without risk, the returns the world has come to see as entitlements due capital everywhere, at all times?

The illusion that risk can be limited delivered three asset bubbles in less than 20 years.Each bubble collapse caused more structural damage, and each central bank "save" introduced higher levels of systemic fragility, which is another way of saying systemic risk.

Though no one in the financial sector dares say this in public, the possibility that central banks can no longer sustain the illusion that risk has been vanquished is now front and center. If risk can't be corralled and quantified, then it can't be offset with any degree of confidence. If risk can't be corralled and quantified, it can't be offloaded onto unsuspecting others without the possibility that the system itself will collapse once the risk that's been piling up in the global machinery manifests.

Something has changed, but nobody dares talk about it. That tells those who listen to what's not being said something of great value.

"We Are Living In A Reality Distortion, This Is Not Over Yet"

Just a week before the biggest spike in US equity market volatility ever - something 'no one' in the mainstream even thought possible - Universa's Mark Spitznagel warned "a reckoning always follows...something really big is coming"

This is an age of massive artificial economic imbalances and systemic risks.

Repress change, and you repress all that it means. Repressing it is sheer hubris and, in Dylan's words, "beyond your command." You can only defer it, not stop it. (Juxtapose this view with outgoing U.S. Federal Reserve Chair Janet Yellen's ambitious claim that there will not be another financial crisis "in our lifetimes.") When we try enforcing stability by decree, a reckoning always follows. An unsustainable boom leads headlong to an inevitable bust. A hard rain falls.

Rather than fear it, we should "tell it and think it and speak it and breathe it." This is Dylan's resolve. Something really big is coming. Let the central bankers try to keep standing in its way, but as investors we need to recognize and accept its logical consequence of a return to the meaning of volatility. Change and volatility are good. "There is nothing perpetual but change"—according to Mises, who surely must have loved Dylan just as much as I do.

While this is a common theme from the guru of tail risks, his timing could not have been better. As some might say "nailed it," and Spitznagel was asked to explain how to spot market crashes coming on Bloomberg TV this week...

Spitznagel begins by pointing out the obvious, and crushing the business models of 99% of the mainstream media's guests:

"My job is not picking the top. My job has always been risk mitigation. Picking crashes is impossible... timing crashes is impossible. If you require a forecast in order for your investment thesis to do well, then I think you're doing it wrong."

The Universa CIO then reminds viewers that this is not over yet, explaining that markets do not crash in one big move but in an oscillatory drop and pop manner that "is meant to shake out the weak hands and get you short at the bottom.. really it's an impressive thing what the market can do."

"We are living in a reality distortion," Spitznagel continues, "when it comes to what happened this week, and what will happen ahead, all roads lead to the central bankers at The Fed."

"People feel we are in a benign investing environment... we are not!"

"We have been here before. Let's remember The Great Moderation of the mid-2000s - we have seen this play out before and it will do the same thing again... It is so naive that people think they can put on trades like the short-volatility trade - I think people don't really believe it but in the low-rate world, they are forced to chase and do crazy things..."

"It's easy to snicker at how naive the short-volatility-trade was, but it is a short-gamma trade - which means there is feedback process where selling begets selling... There is no difference between that and people who are long the market - they are long the market because it went up; when it goes down people are not going to want to be long."

And they are doing it again already!!

Bob Dylan put it best, Spitznagel said, "people don't do what they believe, they do what is convenient.. and then they repent... I think what we saw in the last few days was repenting, and there is more to come."

The bubble in passive investing is "a big problem," warns the hedge fund manager, but there are bigger problems:

"...think of the landscape of problems we have - think of the over-valuations we have, look at where rates are, there's no room for more monetary-easing... for us to focus on the derivatoive tail wagging the dog here is losing sight of the big picture - It's easy not to worry about that but everything is distorted today - this is what happens when we have the type of historic monetary interventionism that we have had."

Then Spitznagel dives into the uncomfortable reality for the Bloomberg TV anchor:

"The S&P is a risky thing to hold. It does not feel that way, but it is... I expect in the coming years we will take back a decade..."

"Everyone has this dogma of 'diversification'," he explains "they think it is the answer to the markets we are in today (and to risk in general)."

It's not - "the reality is that diversification has not been a good risk strategy, because correlations tend to spike just when you least want them to..."

"After the fact they realize that when correlations spike, people who think they are diversified - the extreme case being risk-parity - get it wrong and it is too late at that point... we are going to see this negative feedback happen again - but it will not be driven by a small area of the derivatives market, it will be driven by actual sellers of stocks."

Bloomberg's Alix Steel finally asks for some advice for her viewers: "Is there a magic-hedge that would help you if you owned the S&P 500?"

Spitznagel simplifies things perfectly: "own less of it! ... it's a bad idea for the public to be looking at derivatives hedges in general... that was one of the problems of these VIX products. There are people in these things that have no business being in them in the first place (and frankly I would put some professionals in that category too)."

CROLLO - impresa e strumenti

Avrei potuto comprarmi la casetta al mare e stare tranquillo in panciolle seguendo le mode dei conformisti e dei pecoroni, ho preferito fare l'imprenditore finanziario, si perchè di impresa si tratta di organizzione di uomini e mezzi, peraltro mezzi assai avanzati, oltre al blog ed alla fabbrica consistente in una struttura assai articolarta di sistemi decisionali che si fondano sulla teoria ed analisi dei sistemi complessi, sui sistemi decisionali in ambito stocastico ed inferenziale che prendono a prestito tecniche dalla fisica delle particelle oltre che dall'econometria, dall'analisi tecnica e quantitativa, sto predisponendo una serie di tool di scanning & screening dei mercati a livello globale. 

Nassim Taleb On XIV: "Why People Who Make Money Are Usually Wrong"

Echoing Mark Spitznagel's insights into how 'naiveté' led to the epic losses experienced by many 'nickel-picker-uppers' this week in the short-vol game, Nassim Taleb takes to YouTube to provide some more color on the fallacy of forecasting and what destroyed XIV traders.

Taleb begins by noting that "many people attempted to profit by forecasting volatility [would drop] and from the fact that the contract [in this case XIV] was poorly constructed... they were right, until they were destroyed."

Academics cannot get the idea that you don't have to be right about the world to make money.

"Antifragile explains why understanding x is different from f(x) the payoff or exposure from x.Most of the harm/gains come from f(x) being convex or concave, not from understanding x.

Forecasting is off an average, and average is for academics and other morons."

As Jacob Wolinsky writes, this video illustrates the point with XIV that went bust while being correct about volatility --and why people who make money are usually wrong.

Transcript:

Friends. Let's discuss the problem forecasting one same time explaining the XIV/VIX trade. A bunch of people constructed the contract saying the VIX is overpriced, mis-prices volatility, how over-forecast the variation in the market is; the contract is poorly designed, so let's make money off of that... And they were right but they were destroyed and lost all of this money.

Why?

Because they didn't realize that forecasting has nothing to do with P&L, nothing to do with real-life; what matters is you payoff function.

So these people were right. If you invested say $25 you would have made some money. I think a high of $146 overtime. And in one day they lost everything.

It's now at $5 and probably shopuld be lower.

So what what did they do that was wrong.

What they did is not understand that being right on a random variable X doesn't mean making money out of it. Your payoff f(x) needs to be aligned with what you're forecasting. And in fact the payoff function f(x) is never X; and f(x) can be very complicated. In real-life, most people think you've got to focus on X or academics or other idiots.

f(x) is what you focus on when you make the decision. It's much easier to understand your function of a random variable than the variable itself. That's what I said throughout 'Antifragile', and very few people are getting it.

[00:01:57] Academics cannot get the idea that you don't have to be right about the world.You have to make decisions that are convex, in other words, decisions that make sense and in fact you don't have to be right about the world. And this also explains why paranoia is entirely justified, if you're f(x) is concave.

So your overpricing and underpricing of probabilities is not what matters; what matters is your payoff function.

So let's see what happened here... Let's take your payoff function. Remember you have a payoff function that's a polynomial - you know pretty much everything in life is some nonlinear function that can be expressed through splined polynomials (and of course you can do it a more sophisticated way, but that's pretty much what it is).

This is a way for us to understand first-order non-linearity.

When you plot (1-x^2), you see what happens here (below) and so I build a forecasting function that is the mean of (1-x^2). So what does it do here

[Taleb shows the function's attempts to 'forecast' the 1-x^2 using its historical mean to that point]

[00:03:45] Although you're right on X you're wrong in your payoff function you're going to be harmed big time.

Now let's take an extreme case.

This is why I often say, "I've never seen a rich forecaster; good forecasters are always poor because they don't forget that the average forecast is not what matters. What matters is not to be harmed by these concavities."