Fortune - Waiting for the next stock market crash

Waiting for the next stock market crash
By Scott Cendrowski
Fortune Magazine
25 September, 2013

The author of the new Dao of Capital -- a hedge fund manager and former top trader for Nassim Taleb -- sees a 40% drop looming in the S&P 500.

"You know what I mean?" Mark Spitznagel has just finished explaining one of the paradoxes of today's business world. Spitznagel, 42, is the hedge fund manager who returned more than 100% during 2008. He was Black Swan author Nassim Taleb's head trader for years, and he's the author of a new book entitled, The Dao of Capital. Spitznagel adheres to the Austrian School of economics, which, in simplest form, says government has no business meddling in monetary policy -- the Fed's moves only cause distortions that will later be corrected by markets. We spent the better part of a recent lunch discussing how his life has been shaped by the Austrians.

Were he anyone else, that would be a tedious experience. But Spitznagel has a special draw. He is not the type of investor you and I think about when we think of professional investors. He sometimes spends years steadily losing money as he waits for stock markets to return to normalcy following, say, the late '90s run-up in tech shares, or the housing boom that followed it. But when Spitznagel makes money, he really makes money. The options he buys on the S&P 500 (SPX) and other indexes, which have large payouts during crashes, cost little when he buys them because sharp stock losses seem unthinkable until they happen.

Spitznagel is smarter than most of us, but he doesn't parade it. He likes to argue his position, but he listens to what you have to say. He talks at a fast clip, but he wants to know you're following along. Which is why after he explains how odd it is that today's ultra-low interest rates are driving businesses to hoard cash and pay out more dividends to shareholders instead of doing the rational thing and using that cheap financing to grow their businesses, he asks me, "You know what I mean?"

I do, sort of, mostly because I read The Dao of Capital before our lunch. After Spitznagel got some press in 2008, a publisher approached him with the opportunity to write about the philosophical underpinnings of his investing. Dao of Capital is not something I would give to my mother. But it is a fascinating and radical break from the investment dogma of the past several decades, which basically amounts to this: Buy stocks, and you'll be all right. Spitznagel argues that those stocks have been heavily distorted by the likes of fed chairmen Alan Greenspan and Ben Bernanke, who will stop at nothing to keep them rising, and the pain that follows those run-ups -- the market plunges in 2000 and 2008, for instance -- can be avoided by patient investors who recognize the situation.

He likens his process to life's roundabout road to success, as opposed to the direct. (Dao is the ancient Chinese word for a path or a process.) The direct way is easy but ultimately unrewarding. The roundabout way takes longer but leads to a better strategic advantage. Take a wartime example: The mighty Soviet army invaded Finland in World War II, but half a million Red soldiers eventually lost to the crafty Finns who strapped on skis in the snowy landscape and were able to attack the rows of marching Russians in quick bursts. Or another example: Jeff Bezos of Amazon (AMZN)  has continually reinvested profits into his business to the delight of patient investors, despite sometimes strong opposition from Wall Street, which calls for better profits today. Amazon is successful because of Bezos's roundabout way to success.

Here's what Spitznagel's roundabout strategy looks like in action. His hedge fund, Universa, is often said to profit from Black Swans, the term, popularized by his former boss Taleb, for unforeseeable events. Except Spitznagel disagrees with the premise of black swans in finance. The tech bubble and 2008 crisis were not Black Swans, he says, "because they were seeable!" He and others saw the makings of bubbles from a host of indicators. He often expects large stock market losses following the Fed's accommodative policies over the past three decades, so he invests as such. Here's how Spitznagel's firm profited during the 2010 Flash Crash, from a 2011 Bloomberg profile:

"In April 2010, Universa paid about $2 each for S&P 500 put options expiring that May that would pay off if the index fell below 1,100. At the time, the index was around 1,200. The firm sold the puts as they soared to more than $60 each during the one-day crash on May 6, when the S&P fell as low as 1,066, erasing $862 billion in U.S. equity values in 20 minutes."

Neither I nor anyone I call a friend has the patience to invest like that. To endure months and years of steadily climbing stocks -- and therefore losses as option after option expires worthless -- before being vindicated. It goes against the human need for immediacy. We are programmed to demand one apple today instead of two tomorrow because for hundreds of thousands of years one apple today was more important than any number tomorrow because tomorrow wasn't a sure thing.

I asked Spitznagel if his DNA is different from the rest of us. "I was lucky," he says. When he was a teenager, a family friend named Everett Klipp brought Spitznagel on as a clerk at his Chicago options firm. Klipp, who has since passed away, taught Spitznagel about roundabout investing and taking small losses in order to cash in on the big opportunity. Spitznagel could have first been exposed to the short-term thinking of a hedge fund or bank. Instead, he found a great mentor.

So what is he expecting in stocks markets today? It's not pretty. Spitznagel tracks something called the Misesian Stationarity Index, so named for one of the Austrian School's greatest thinkers. The index follows the monetary interventions of governments. When the Fed is goosing the economy with rock bottom interest rates, the index tends to rise. When the index is very high, as it is today, large stock market losses are expected. "We have no right to be surprised by a severe and imminent stock market crash," he writes in his book. "In fact, we must absolutely expect it." Potential losses could reach well over 40% in the S&P 500, he says.

"We're the bad guys," Spitznagel says, smiling. It can seem like that. Not many other investors talk about the dire consequences of the Fed's moves with same frankness or want to discuss potential large stock losses. But then again, not many have reaped so many rewards from them either.

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