Alpha - Will Mark Spitznagel’s Doomsday Bet Pan Out in 2014?

Will Mark Spitznagel’s Doomsday Bet Pan Out in 2014?
By David Graubard
Institutional Invester's Alpha
January 07, 2014  

The Universa Investments founder stands to gain if his predicted 40 percent market correction comes true. But so far, few others are sounding alarms.
       
The U.S. stock market finished 2013 with a nearly 30 percent gain, and many hedge fund managers think 2014 will probably be a pretty good year as well.

Mark Spitznagel, however, is not one of them. The founder and CIO of Santa Monica-based hedge fund firm Universa Investments recently sounded a dire warning that the Standard & Poor’s 500 Index will suffer a draconian 40 percent correction some time within the next three years, most likely within a year. (As it happens, stocks finished the first few trading days of the year with losses.)

Spitznagel has made something of a business out of such doomsday calls. He made similar predictions against the market in 1998, 2000 and in 2008, the last of which propelled him to fame. That’s because by that time, he had already founded Universa and was running a so-called tail-risk fund. These funds are designed to perform well in the worst market conditions, and like insurance policies, require investors to pay into a losing strategy until something bad happens.

It turned out that 2008, with the S&P 500’s bruising loss of 38.5 percent, was the perfect time to be running such a fund. Universa earned 120 percent that year, while the median hedge fundlost 6.85 percent, according to HedgeFund Intelligence Global Index. So why listen to Spitznagel this time? For one thing, his was the first tail-risk hedge fund to make a huge amount of money from a stock market crash. And while famed hedge fund managers like David Tepper of Appaloosa Management and Leon Cooperman of Omega Advisors think fears of a major correction are overblown, Spitznagel is not the only famously smart person sounding the alarm on equity markets. Nobel Prize winner Robert Shiller concurs that the market is near an unsustainable level, although he does not think it’s in for quite such a drastic decline as does Spitznagel.

Still, it’s probably worth bearing in mind that Spitznagel made his latest doomsday call at the same time that he released his first book. The Dao of Capital: Austrian Investing in a Distorted World is a 368-page tome blending the memoirs of a philosophic option trader with a heated critique of the Fed and an explanation of how Austrian economics applies to tail-risk hedging.

Spitznagel borders on the fanatical in his belief that the Federal Reserve is bringing the next market crash closer each day through what he calls monetary distortions, or the effect that its so-called quantitative easing measures, such as its monthly Treasury bond purchases, are having on the markets. One such distortion: inflated equity valuations fuelled by the Fed’s zero interest rate policy, Spitznagel argues. Also, the Fed’s habit of injecting liquidity into the financial system to solve problems creates asset bubbles that his fund benefits from when they eventually burst, he says. Spitznagel says he wrote his book in part to help investors understand, and then exploit, market crashes caused by these monetary distortions.

In writing a book, Spitznagel is following in the footsteps of Nassim Taleb, his former partner at Empirica Capital — the first tail-risk investment firm and a precursor to Universa — and the best-selling author of The Black Swan: The Impact of the Highly Improbable. “The two went down different paths. Taleb is an academic, and Spitznagel will always be a full-time trader,” says one investor close to the two friends. Taleb has no ownership or decision making role at Universa, although he serves as an advisor. The team speaks with him a few times each month, typically on research and marketing issues.
“Since I was a partner at Empirica, the first tail-risk hedge fund, one could say Universa is a continuation of that platform that ran between 1999 and 2005 that we founded,” Spitznagel explains. “But a lot has been learned and tweaked along the way.”

Spitznagel says that writing the book was “good introspection” for him and helped sharpen his ideas. “Also, I wanted to get out the message on how destructive the Fed is to people,” he adds. “The best way to protect ourselves is to understand that.”

The firm’s flagship Black Swan Protection Protocol equity tail-risk fund seeks to make an extraordinary amount of money in a stock market crash and lose nothing when the market does very well. By having such a hedge in place, Universa’s clients say they have the confidence to expand their equity allocations and stay invested through turbulent markets under the premise that they would reinvest a significant amount of cash into a discounted stock market from income generated by the BSPP fund in a crash.

A tail-risk hedge can act like a double-edged sword for some investors, however, as they lose money until a stock market crash occurs. “I don’t think there’s enough data available or standardization out there to say a tail-risk hedge is right for a portfolio,” says Damian Handzy, CEO of New York-based Investor Analytics, a risk management consulting firm.

There’s also an abnormally high behavioral risk that investors will pull out of the hedge too early. “An investment committee at some point will question what is this doing for us” as losses accumulate, adds Handzy. Another critique of tail-hedge strategies is that there is no way to know which of the various products in the growing market for these funds will hold up during the next systemic market crash.

For the many who aren’t ready for a tail-hedge, Spitznagel has a strategy for them too. “Investors should simply step aside in cash, and doing so in such distorted environments has historically beaten pretty much everyone long term, with far less risk,” says Spitznagel, who calls this his “mom-and-pop strategy” in his book. “Doing this, earning zero returns, is perhaps the most difficult investment to stomach today. Then the investor can buy after the rout that inevitably follows and be rewarded for having stepped aside.”