I have no crystal ball with which to predict the Future, a confession that comes as a surprise to some journalists who interview me. Still less do I think I have the ability to out-predict markets. On every occasion when I've considered betting against a prediction market - most recently, betting against Barack Obama as President - I've been glad that I didn't. I admit that I was concerned in advance about the recent complexity crash, but then I've been concerned about it since 1994, which isn't very good market timing.
I say all this so that no one panics when I ask:
Suppose that the whole global economy goes the way of Japan (which, by the Nikkei 225, has now lost two decades).
Suppose the global economy is still in the Long Slump in 2039.
Most market participants seem to think this scenario is extremely implausible. Is there a simple way to bet on it at a very low price?
If most traders act as if this scenario has a probability of 1%, is there a simple bet, executable using an ordinary brokerage account, that pays off 100 to 1?
Why do I ask? Well... in general, it seems to me that other people are not pessimistic enough; they prefer not to stare overlong or overhard into the dark; and they attach too little probability to things operating in a mode outside their past experience.
But in this particular case, the question is motivated by my thinking, "Conditioning on the proposition that the Earth as we know it is still here in 2040, what might have happened during the preceding thirty years?"
There are many possible answers to this question, but one answer might take the form of significantly diminished investment in research and development, which in turn might result from a Long Slump.
So - given the way in which the question arises - I know nothing about this hypothetical Long Slump, except that it diminished investment in R&D in general, and computing hardware and computer science in particular.
The Long Slump might happen for roughly Japanese reasons. It might happen because the global financial sector stays screwed up forever. It might happen due to a gentle version of Peak Oil (a total crash would require a rather different "investment strategy"). It might happen due to deglobalization. Given the way in which the question arises, the only thing I want to assume is global stagnation for thirty years, saying nothing burdensome about the particular causes.
What would be the most efficient way to bet on that, requiring the least initial investment for the highest and earliest payoff under the broadest Slump conditions?
Eliezer: The problem is not finding a 100-1 bet. The problem is finding a counterparty offering such a bet that is highly probably to be solvent and willing to pay up, after a 30 year depression/recession.
In fact, if anything, it makes more sense to be on the 'cash in hand now' side of such bets. As Warren Buffett is.
Yeah, so, no potential martingales, no exposure to negative black swans, no unlimited downside risk. Thought that'd be obvious, but I guess in this financial system it's anything but.
Personally I believe in the long slump. However I believe in human optimisim that will make people rally the market every so often. The very fact that most people believe the stock market will rise, will make it rise at least once or twice before people start to get the message that we are in the long slump.
It's worse than you think. You have to find a counterparty that will never, or seldom, engage in '100-1' type bets to other people that might threaten your chances of getting future money. Yet who is offering 100-1 odds right now.
As Buffett says: it's not who you sleep with, it's who THEY're sleeping with, that is the problem.
It makes no sense to use Nikkei 225 or Dow Jones performance as indicators of economy performance, standard PPP GDP per capita is better than that in every imaginable way.
Japanese growth rates of 1-2% a year are historically still among the best performing human societies ever, even during industrial revolution we didn't get that much, and estimates for earlier times are of order of magnitude of 1% a decade or less.
You should refine the question:
Most assets are priced off expectations. And as you suggest, not many people expect a 30 year slump. Suppose an asset paid off relatively well for a 30 year slump, but not otherwise. It wouldn't cost much because most people would believe it isn't worth much, and you could buy it at, say, 1/10000th of the payoff. If the world came to unanimous expectation a 30 year slump, then the price would increase towards the payoff value and you would be much richer from the capital gain.
Or do you want something that pays off well after 30 years of slump, irrespective of other people's beliefs, say from generating a high yield each year? In this case, a good investment strategy might be to buy shares in companies with lots of intellectual capital like Intel and Pharmaceutical makers. Without the need to invest in R&D and innovate, and without the threat of others innovating, those kinds of companies could provide a nice income each year from exploiting their existing intellectual capital, simply selling the same old stuff at the same prices.
I don't think your second example is very good; in fact, I think investing in pharmacorps would be implicitly a bet against a long stagnation, simply because drug patents have very specific expiration dates, and a stagnation implies that existing and near-future drug patents will not be replaced with new patents, and their lunches will be eaten by commoditizing generic-makers (who themselves will profit little). The ultimate "patent cliff".
The safest investment is Treasury Inflation Protected Securities (TIPS). Ordinary investors should avoid investing in derivative securities such as options. If you are rationally pessimistic go with TIPS.
Also, you would never get the 1/100 odds because in a sense money is more valuable in the state in which the economy is doing poorly. So say there are two bonds, each in 30 years have a 99% chance of paying 0 and a 1% chance of paying $1,000. The first bond pays off in a state in which the economy has done very poorly, the second in a state in which the economy has done OK. The first bond will cost a lot more than the second.
If you do want to play with derivative securities just maintain a short position in the S&P 500. If you think the decline will be gradual rather then all at once you could just keep buying short term put options on the S&P 500. As the market declines you will gain wealth which you could use to increase your short position.
If you are really, really pessimistic spend your money stocking up on canned goods and guns.
People who answer survey questions seem to consistently display a pessimism bias about these large scale trends, and the equity premium puzzle also can be interpreted as people being unreasonably pessimistic about such things. So I find it hard to believe that people tend to be too optimistic about such things. If you really want to bet on the low tail of the global distribution, I guess you should listen to survivalists. If you think the US will be more down, why invest in foreign places you don't think will be so down.
Writing call options for many years in the future wouldn't pay 100 to 1, but would put money in your hand now. The big problem is that YOU can end up having to pay 1000 to 1 or 100 to 1 or whatever, essentially unlimited amounts of money, if your bet is wrong.
You can buy put options for X years into the future. That has limited downside (you can only lose your initial investment, no more) and can appreciate 50 times (I don't know about 100...). However, I don't know how the market for these would react to a "long slump," ie, they may not appreciate much just by virtue of the market sitting still. It may need to fall in order for these to appreciate. But I don't know.
I think put options are the closest to what you're looking for: limited downside, theoretically massive upside, far away expiration, etc. But I'm not certain they'll perform as you want.
Could you expand on "complexity crisis"? My impression is that the crisis is Scott Adams' confusocracy writ large.
I won't comment on the bet-ability that Mr. Yudkowsky discusses, but I'd like to ask a question. Quite a few people suggest various "Mad Max" scenarios as a result of the global financial cataclysm. An awful lot of them go on to discuss how they'll protect their families with their personal arsenals. To me, Mad Maxing or Hunker in a Bunker scenarios are a failure of imagination, falling back on old images without really thinking too deeply. I would love to come across some fresh thinking about what outcomes may be in store for us, and then I'd like to bet on them.
It does not meet your criteria but I like S&P 500 Covered Call Fund for the long slump.
Also any house hold item that lasts a long time and has a payback e.g. insulation, perhaps greenhouse etc.
To concur with some others: write covered calls, preferably long ones to minimize your exposure to short rallies. This will give you a steady stream of income. If reinvested, it might yield 100 : 1. 128:1 would be 7 dblings, so in 30 years, that requires dbling every 4 years, so 18%/yr. Writing covered calls in a flat environment can easily generate that.
My brother might know the answer to this. I'll ask him and get back to you.
Slightly off-topic, here's a "fun" financial puzzle for you:
John Smith is in trouble. You see, he has liquid assets worth $500,000. Normally, that wouldn't be a bad thing, but John Smith owes Tony Soprano $1,000,000, and the loan comes due in exactly one year from today. If he doesn't pay up, and in full, Tony is going to have him whacked.
John Smith figures that, in a worst case scenario, he could take his $500,000 to Vegas, bet it all on red on a single roulette wheel spin, and have a nearly 50% chance of paying off his debt. (He'll worry about the IRS after he pays off Tony.)
You're John Smith's broker. Can you come up with a better investment strategy for John Smith and his $500,000?
You can use a binary option and probably do better than the 3% spread at the roulette table. Having said that, I don't know of any exchanges with the instrument you're looking for, so you'd probably have to go OTC for the instrument and maybe pay a broker's commission + prop desk spread, so you wouldn't save too much. Bear in mind you don't need the full $1mm - you only need $1m/annual interest rate.
Given your actual reasons for wondering about the world economy in 2040 conditioned on there not having been an extinction/Singularity yet, the survivalist option is actually worth a small hedge bet. If you can go (or convince someone else to go) live in a very remote area, with sufficient skills and resources to continue working quietly on building an FAI if there's a non-existential global catastrophe, that looks like it has a strongly positive expectation (since in those circumstances, the number of competing AI attempts will probably be few if any).
Now considering the Slump scenarios in which civilization stagnates but survives, it looks like there's not much prospect of winding up with extra capital in that situation, relative to others; but the capital you acquire might go relatively farther.
I have to say that the fact you're strongly considering these matters is a bit chilling. I'd be relieved if the reason were that you ascribed probability significantly greater than 1% to a Long Slump, but I suspect it's because you worry humanity will run out of time in many of the other scenarios before FAI work is finished- reducing you to looking at the Black Swan possibilities within which the world might just be saved.
If the broker believes some investment has a positive expectation this year (and is not very likely to crash terribly), he could advise John Smith to invest in it for a year minus a day, take the proceeds and go to Vegas. If he arrives with $550,000 instead of $500,000, there's a betting strategy more likely to wind up with $1,000,000 than the original plan.
The balance of risk and reward between the investment part and the Vegas part should have an optimal solution; but since anything over $1,000,000 doesn't factor nearly as much in John's utility function, I'd expect he's not going to bother with investment schemes that have small chances of paying off much more than $1,000,000, and he'd rather look for ones that have significant chances of paying off something in between.
Yes, when people blithely say, 'Oh it'll be over by 2010 you bet', I have this exact thought. How do -you- know? How do you know it won't be -worse- than the GD, which after all took a giant war to fix?
As for, "Conditioning on the proposition that the Earth as we know it is still here in 2040, what might have happened during the preceding thirty years?" I think warming and wars and no epochal advances in technology.
There is no magic bullet now, more than any other time. If there is, people all jump on it, and it stops becoming a magic bullet. Gold is the perfect example: it's being pumped up so high by speculation and 'safety' investors that it's intrinsic worth is no longer relevant - it's in a bubble.
I believe that the effect of this downturn on technology research will be tempered somewhat by this fact: if 'safe' investments are more risky, more speculative endeavours become >relatively< less risky. Furthermore, human resources become more plentiful (half of silicon valley will be sitting around with nothing to do, and willing to work for cheap). Of course, this put much of dent into the problem - no money to invest means no money to invest, but some calculations of comparative ROIs and risk would be useful to bring up in any investment pitch these days :>
I'm also not convinced that we will have a Japan style downturn. Why? Certainly not because anyone is doing anything to stop it, but because emergent technologies have such potential for wealth creation in the medium term. For instance (just one instance from many): how long until we get GM biofuels online? 5 years? Certainly less than ten.
In regards to investment, there are several strategies that might make sense that have been suggested to me. Here are a couple, off the top of my head:
Half of these companies will go to zero. The other half (or less, in all likelihood) will, just by the nature of surviving the downturn, pick up other business and increase in value and make up the loss. This worked well during the dot-com crash, as long as you did a good job of identifying the companies that would survive.
At some point RE will become attractive again: quite likely obscenely attractive - so attractive that no one will go near it. You would need to be prepared to sit on them for a good long while though, and be very careful where you buy - entire cities are in danger of going down the tubes, which will postpone their real estate recovery into post-singularity era, whatever millennia that happens to occur in.
Of course, neither of these are investment strategies for before the slow down occurs. At this point, if you aren't trading, you are best keeping your money out of the market. Buy and hold is dead.
Naturally, this is just my two cents, and is opinion, not investment advice.
Ouch. The optimism in this 6 year old post hurts.
2009, January 22: Above comment made
2009, July 10: GM files for chapter 11 bankruptcy. It received a $51 Billion government bailout.
2010: GM has ~6 million "Flexible-Fuel" vehicles on the road, which can run on normal gas or E85 Ethenol.
I guess if the Flex Fuel was what Johnathan meant by "GM biofuels", then they came about much quicker than expected. If not, then it's been 5 years and we haven't seen much outside of DIY bio-fuels.
Biofuels understood as ethanol from corn are basically a disaster that no one is enthusiastic about any more. Biofuels understood as running diesels on used McDonalds frying oil do not scale.
Eliezer, there was rapid scientific progress in late-1600s Western Europe even though wealth per capita was vastly lower than current levels. Ditto scientific and technological progress in Victorian England. Could it be that the reason you believe that an economic slump would stall R & D is that the global public-opinion apparatus has fooled you and those you have trusted on this issue? "But it is necessary for scientific progress," might have been a convenient false argument to convince certain sectors of public opinion whose are sceptical about other arguments about the need for pro-growth policies.
Richard, that's a good point and Japan's technology hasn't exactly been standing still during its slump, either - but then what should I believe about markets and investments, conditioned on scientific and technological progress having been slower than expected?
Eliezer: the economic foo-far-raw has drained away minds and resources, made genuine progress and productivity less attractive, and distracted world leaders and opinion. Why invest in a start up venture when Maddof and his pals can offer you 28% every year?
Patri, that only works for the first few years, until other people start thinking that the environment is flat. Then the selling price of calls goes down.
You could put some of your capital in a well managed hedge fund, that way you can profit even if the market falls further. N. Taleb most probably made some good money lately using his investment strategy but does it hold in the long run and are black swans more common these days as a result from markets being more connected globally ? (no decoupling etc).
Re: Doug -
Get a loan from a bank or set of banks for as much as you can. With $500k in hand and a reasonable financial situation, it should be possible to convince them that you can pay off a loan of $500k! Pay off the mafia with that; this is a near-guaranteed way of paying off the debt.
Then Smith's bankrupt and just defrauded a bank for $500k and will face the consequences of that, but he's still alive, with much higher probability than 50%.
Given that Munroe has solved the problem of Friendly AI in today's xkcd, I think we can rest assured that concepts like "economy" have a near 100% chance of being moot by 2039.
So you don't need to hunt around (xkcd doesn't make searching by date perfectly easy):
Steve, I came here precisely to post that comment. XKCD, hilarious as usual.
Eliezer: I'm glad you're finally willing to at least consider the possibility that the world can end up someplace that is neither paperclips nor singulariparadise. A few years back a friend of mine asked you on the #sl4 IRC channel "what do you need to continue your work in the event of collapse" and your response bordered on dismissive. What got you to take long-term economic slump seriously as an existential threat?
Jonathan El-Bizri: on what grounds do you assume we will have GM biofuels online in less than ten years? How much per gallon in 2009 dollars do you expect such a fuel to cost? Why?
Jes: Mad Max scenarios happen all the time. Daily life in much of sub-Saharan Africa is one big Mad Max scenario. Afghanistan is a Mad Max scenario (and was before the US invaded, and still was before the Soviets invaded). What the hunker-in-a-bunker crowd gets wrong is the transition phase: they neglect to think about what needs to happen BETWEEN now and the final descent into chaos and barbarism. What are the upper and lower bounds on how long this transition phase takes? What might be some indicators that the transition is occurring and how far along it is? Guns and canned food only become valuable asset in the late stages. Nobody seems to even ask what's a good investment in the early and middle stages of descent. If only they did, they might end up with more spending power to use on said guns and canned food in the later stages. Thoughts?
As for me, I've been paying attention to some bearish index-tracking ETFs, whose value is inversely related to the performance of the target index (e.g. SRS, SKF). Certain alternative energy companies might also be good investments, as might be railroads and their suppliers. Coal and "green" coal processing. But of course investing in individual companies or even sector tracking ETFs requires a lot more research, caveat emptor.
Here's an odd bias I notice among the AI and singularity crowd: a lot of us seem to only plan for science-fictional emergencies, and not for mundane ones like economic collapse. Why is that? Anybody else notice this?
Buy some long-dated S&P puts from Warren Buffett. There is no additional capital risk beyond the initial purchase price.
"Here's an odd bias I notice among the AI and singularity crowd: a lot of us seem to only plan for science-fictional emergencies, and not for mundane ones like economic collapse. Why is that?"
One hypothesis: because the value in the planning (and this may be rational, if nontransparent) is primarily for entertainment purposes.
Defy the data, assume the market is wrong. If people are unemployed, it's probably not because they can't do anything useful, but because the market hasn't found a way to use them yet. Their labor is undervalued, so buy their labor. At a severe slump, it will be economical for well off people to hire others to shine their shoes (or whatever the styles of 2025 dictate) just because they need the money. In your scenario, you know that R&D is underfunded, which likely means bright young people scavenging for less demanding jobs. Hire them to work on your AI or something with a faster/more likely payoff, or invest in an R&D company.
Dr. Commonsense: I have always been highly interested in the possibility of economic collapse and have spent substantial effort to plan for it while ignoring most futuristic disasters, most of which can't practically be planned for.
Michael Vassar: I agree about nano-goo and papercip scenarios having too many unknowns to be planned for at this time except in very broad terms. Regarding economic collapse, what do you think of the following statements...
Put attention on phisical gold. If finansial system would collapse, its price could grew several times (and I read somewhere that on current price gold is covering only 1 per cent of fiat monney - so it could grow 100 times if it will replace paper monney). And phisacal gold don't depend of any finansial institutions (except nationalisation in style of Roosevelt).
Also Long Slump would lead to wars, and supertechnologies will continue to develop quikly in military research hubs. So you could join military research institution and get good finansing until 2040.During GD was made key innovation which leads to creation of nuclear bomb - 1932 was opened neutron and so on.
Also you could say that only FAI could resolve complexty crisis, which is true - and get long term funding.
Deliberately worsening an economic slump carries with it the moral burden of possibly slowing down technological advances that would otherwise save the lives of millions of people currently doomed to die of old age.
Also, a sufficiently bad economic slump will diminish hope of successful cryopreservation for those still alive and permanently eliminate hope of revival for those already cryosuspended by causing either cryonics facilities or their suppliers to go out of business.
Doesn't come remotely close to the expected benefit of reducing existential risk.
Still, it sounds like a terrible idea.
Well, if you have been misled into believing that scientific progress having been slower than expected entails economic production falling or stagnating, then you will tend to have assigned too high a value to investment strategies or hedging strategies that bet on the performance of the economy as a whole (e.g., shorting index funds). So, perhaps look for more specific bets. E.g., sell short shares in companies that produce "emergence engines" or "consciousness capacitors" or some other output demand for which will fall if progress stagnates in the area of science under discussion.
Look at stocks as temporary trades based on specific catalysts jumping in and out of cash. Convert cash into physical assets, second home on your property, farm and ranch land.
Lottery Tickets? Life Insurance?
Eliezer, isn't the answer to the question "no." By definition, in the Long Slump, no asset classes will do well and no bubbles will form.
The Long Slump will entail prolonged government intervention in the markets, people hunkering down, being scared of taking risks.
The only asset that might do well is the one that is in most demand: dollars. People will hoard money; it will be the only thing in demand. Debt will be paid down. People will stop spending. The yen has done well during Japan's long slump.
It won't payoff quickly and it won't pay off 100:1, but it will payoff.
Otherwise, stay as diversified as possible and hope that at least one of your asset picks is right.
I think to answer you question you need to be able to define the meaning of the term "long slump" scenario more specifically. The Japan example suggests a low deflation, low but slight growth scenario, steadily decreasing asset prices. This would suggest buying longer dated puts on indexes and rolling these over when they come due. Alternatively longer dated puts on stocks which maybe vulnerable (e.g. those with significant debt).
The difference in the next 30 years to the Japan situation is that presumably under this type of scanario the situation would be a global one - which you would expect to significantly change dynamics. E.g. possible tension between countries with increasing protectionism etc. In this case you would be short exporters, especially those with some local competition in their export markets.
Another scenario would be loss of faith in faith money due to high inflation and/or loss of faith in US dollars as reserve currency due to high gov adn private debt etc. Gold is the obvious way to go. For small money you'd probably at risk buying longer dated calls on gold and roll them over.
This is stuff off the top of my head. To get into it more deeply I think you need to think about what the self reinforcing dynamics would be and why these dynamics wouldn't be inevitably self defeating. I discuss this in terms of George Soros ideas on reflexivity at http://reflexivityfinance.blogspot.com/
Cheers Steve van Emmerik
Simple Answer: Don't Invest...Trade.
Originally, I typed up a version of this and sent it directly to Eliezer. This was mostly because I wanted to check a bit closer before I made the stuff available to "peer review."
Having watched the market a bit, and being content with the results, I have retooled it and posted it here. Eliezer, being busy, I'm certain, with other matters, hasn't yet given me any feedback, so some of my assumptions about the requirements are likely wrong, but I figure he (or someone) will correct me eventually.
Getting The Slump To Pay 100:1 (Or At Least 10:1).
The investment thesis originally stated is "global stagnation for 30 years."
There is a conflict in the way the thesis is worded here: "What would be the most efficient way to bet on that, requiring the least initial investment for the highest and earliest payoff under the broadest Slump conditions?" But I will get to that later.
We are looking for an investment strategy to capitalize on the thesis.
We, like most investors, want to get the most "bang for the buck." We would like to enjoy as much leverage as possible, even (especially) if that doesn't come from borrowed funds.
I suspect, based on all of this, that we want an options strategy. It provides "organic" leverage, that is, it doesn't require literally borrowing, and it has the flexibility you are looking for.
In particular, I think we want to do something like the reverse of what Warren Buffett recently did. He sold European puts on major indexes with 15-20 year expiration. "European" puts (options) meaning that they can ONLY be exercised on the expiration date not "American" options which can be exercised by the holder at any time UP TO the expiration.
-Short Options Writing Course (With "Why We Are Not Buffet" Goodness):
When you "Sell Puts" or "Write Puts" you are promising a third party or third parties that you will buy the underlying asset for a particular price at a particular time (or time-frame in American options) IF they exercise the option. They are buying the option, and pay cash for it (usually) when the contract is written or traded. Their option is to sell you (to "put") the underlying asset at the agreed upon price. As you can see, if things get really dire, and you have sold someone put options, they might want to ask for collateral to be sure they will be paid. Your downside is unlimited. You might have to sell someone a bunch of shares worth $86,000 a share (Berkshire for instance) for $30 per share. You might go insolvent, after all. Your "counterparty" will seek to reduce her "counterparty risk." This is particular to options writers, or those who SELL PUTS. Or SELL CALLS. Options buyers (who have the option) don't put up collateral unless they borrowed to buy options.
Obviously, if the underlying asset is higher (lower) than the "strike price" of a put (call) option (the price which will be paid at expiration) the option will go unexercised, or "expire worthless." The premiums (what the seller was paid for the option on day one) are the seller's to keep.
It looks like Warren Buffett sold put options that permit the counterparty (Goldman Sachs is expected, but no one knows) to sell him several billion dollars worth of interests in four different global stock indexes in 15-20 years at a price which was set at the then market rate, or near it. Buffett was paid $4.5 billion for the options. One presumes his thesis was to invest that money for a healthy return for 15-20 years and (he hopes) have the options expire worthless. Essentially, this was a bet on long-term global non-stagnation. Sort of the opposite of our bet.
What Buffett managed to negotiate, because he's Buffett, is NO COLLATERAL CALLS on the options. That is, even if things sink into the ground, he does not have to put up collateral for the options (except in some very exceptional circumstances involving the finances of Berkshire and not the current mark of the options). Otherwise, he might have had a brutal capital call in the billions of dollars with the recent disaster.
Though it looks like it might be good to just sell calls (the technical opposite of Buffet's trade) you can't do what Buffett did. Writing calls in any large quantity, which would be betting on stagnation or deteriorating prices (as suggested by some comment authors), is a bad idea for this collateral reason. If you are wrong you are going to have to come up with cash before the options expire, or you will have to "cover" the calls up front by buying the Index (the "covered call" strategy).
So, we need something else.
An interesting bit of contrary data to Eliezer's statement: "in general, it seems to me that other people are not pessimistic enough; they prefer not to stare overlong or overhard into the dark; and they attach too little probability to things operating in a mode outside their past experience."
Actually, the options market is almost exactly the opposite usually. There are a number of reasons, but primarily as a consequence of the crash of 1987, put options got quite popular as protection and a hedging tool. These tend to be very expensive. (Certainly, Loss Aversion plays a role here, and there are many option traders who look to take advantage of mispriced puts). Warren Buffett is one of these, particularly in his demonstrated love of selling "catastrophe insurance," which is essentially his way of saying "people are too pessimistic."
"What would be the most efficient way to bet on that, requiring the least initial investment for the highest and earliest payoff under the broadest Slump conditions?"
Well, the "highest" payoff I'm with. The "earliest" payoff is a problem. You either are betting on 30 years of slump, are you are betting on 1 year of slump for 30 years in a row. Or 5 years of slump 6 times in a row. If you want periodic payments, that's different than wanting a lump sum after 30 years. I will assume you really want a 30 year slump with payments every year or couple of years in the slump.
You also say "slump" not "crash." I took this to mean stagnated, but not continually deteriorating prices. This helps us because it makes our option strategy cheaper. Covering prices from $1000 - 0 (buying a put option) is expensive, particularly since I doubt your counterparty is going to make good if the market is really at "0". (This is like buying dollar denominated insurance on Treasuries. If the Treasury defaults the last thing you will be interested in getting is a big pile of U.S. Dollars).
I suppose we would best measure economic "stagnation" with stock indexes or the like. We are, I think, really making a bet on volatility. We are betting that for 30 years we won't see big swings up or down. 30 years of... just "blah." We are also betting on "anchored volatility." That is volatility from a particular price with an extending time frame, not 30 day volatility averages, and not average daily volatility or some scrolling time window measure.
Return Models for Options:
What we really want is an options return model that looks like this (where x-axis is price of the underlying asset and y-axis is returns to us).
Profit when the asset price just sits there. "There" being some price we think represents the "settle point" for "the 30 year slump." This is a "sideways strategy." The two options strategies we are looking for here are a Long Call Condor and a Long Put Condor.
Basically, we buy a call at the low end of the range you want to cover. Then we sell two middle strike calls that represent the ends of our top level, buy a call at the top of our expected price range for the underlying.
I decided to take a look at what this might cost and what the market might return for this strategy. I did this with S&P 500 options because they tend to have good liquidity and therefore we could (one imagines) get good prices. Also, the S&P 500 index changes with the economy. Its components are rotated in and out. It tends to be a good representative slice of general economic progress (or lack thereof) and not stuck on any particular sector or company. Really, the index is linked to the future expected earnings of a decently representative slice of the economy.
Obviously, options prices depend on expected volatility so the actual returns on the play will vary year to year as your cost to put on the strategy varies. If anyone is really interested I will check into this.
As I write this, the S&P 500 index is sitting at 827.50. Let's assume that we want a strategy that will pay us every year that it ends in the same place it started +/- around 10%. So, something that will pay us off if the price falls between 750 and 910 in December. Or something.
Using S&P 500 options it's not hard to construct a scenario that will pay up to 1000%+ on an investment like this in December 2010 if the S&P 500 closes at 827.50 (its closing price today) on 12/17/2010, and pays at least SOMETHING if we end up anywhere between 750 and 900 or so.
Basically, for $4,300 in investment you will see the maximum return of $45,700 anywhere between 800.15 and 849.50.
Of course, the reason this pays off so well is because the market thinks you are fool for betting it. But, then the line between genius and fool is fine and judged in hindsight.
If you consider it an insurance policy, $4,300 as insurance from stagnation (but NOT a catastrophic crash) with a 10x payoff is pretty good. But you are insuring for a VERY thin slice of possible worlds in December 2010-- especially if our dataset is near infinite! ;) Obviously, if we widen the middle, our returns diminish.
In addition, you have American options here. That means if mid-way through the year you are in your profit band, you can take the profits whenever you like. For example:
If in June of 2010 the S&P 500 was at 827.50, your options would be worth 131% of what you paid. You could sell them right there. (Or wait). By September, with no change in price, you are looking at 231% returns.
Of course, you could renew the bet each year, resetting to the current price. And you could bet more. $10,000 pays out over 100,000, obviously, in the right circumstances.
I would be VERY curious to hear if this is anything like Eliezer intended.
Equity Private, I take it you didn't get my second email either, then. I got both of yours.
WOW! Equity Private, this is the most lucid and useful analysis of a stagnation investment strategy I've seen. Thank you so much for posting.
How would your strategy be different if the goal was to get a modest return in a stagnating market, a larger return in a market crash, and a loss in the event of sustained growth? Do you think there is a way to guard against transient bubbles?
"How would your strategy be different if the goal was to get a modest return in a stagnating market, a larger return in a market crash, and a loss in the event of sustained growth? Do you think there is a way to guard against transient bubbles?"
Well, you could supplement the strategy with out of the money puts, that would pay more farther down to the downside, but you'd be really limiting your return with that. In fact, puts are so expensive right now that adding options that give you just a 200% return on this position when the S&P 500 hits 300 (this would be amazingly bad) drops your original stagnation position's returns to -20%.
I'll do a more detailed strategy and see what kind of returns we can create to cover the "way down" side.
Come to think of it, perhaps I should explain why I think there will be a long-term downward trend.
Given that every large, complex civilization before ours has eventually collapsed, the burden of proof should be on those who claim that ours is exceptional and will not collapse. If I'm wrong and our civilization outlives me, I don't mind losing some money on my investments. I'd rather be a poor guy in a rich civilization if this insures me against being a poor guy in a poor civilization. If I'm right, I want to at least use the fact that I'm right to extract some wealth as a consolation prize and use that wealth to help myself and other techno-geeks survive and perhaps somehow hasten the next civilizational cycle.
If I had to guess, the most likely cause of collapse would be dwindling oil and gas supply combined with a growing demand caused by population growth and increasing industrialization. It's true that this creates incentives to develop alternative energy sources, but there are organizational, informational, and physical limitations on how quickly our infrastructure can be retooled to such alternatives. It is prudent to hedge one's bets that engineers and entreprneurs will win this race. Furthermore, every single alternative has a higher per-kilojoule cost than oil. Therefore, even if liquified coal, or biodiesel, or fuel cells become commercially viable, we will still be spending a larger fraction of our wealth just keeping the lights on than we do now, and I would expect the effect on the economy to be similar to a tax corresponding to the same amount.
But that's just my guess. I don't claim to know why our civilization will collapse, nor when this will happen. I do know that this collapse will not happen overnight, and there may be a long time window during which to exploit it before "the market is at 0".
Probably commodities, especially non-renewable resources, and companies that produce them.
If we were to go into a long slump with slow technological growth and minimal infrastructure development, then that would probably mean we would continue to use fossil fuels for a long time, which would have to mean steadily increasing prices over the long haul as supplies slowly get smaller and more expensive to produce.
The downside is that if the long slump doesn't happen, if technology does continue to advance and infrastructure investments in better technology are made (electric cars, high-speed rail, renewable, third generation nuclear plants, maybe even fusion if we're lucky), then the value of those may suddenly drop at some point. But I think your "long slump" scenario is assuming that doesn't happen; significant technology change and re-building our whole infrastructure would almost certainly mean economic growth.
I'm not sure if it pays off 100 to 1, but it should give a good rate of return over time in a long slump scenario.
I don't think the long slump scenario is very likely, but that's a different issue.