For Investors, 'New Normal' Means 'Getting the Tails Right'

In a world where the unusual has become usual and abnormal has become normal, tried-and-true investment strategies are becoming tried and untrue.


Such is the thinking from a growing class of investors who are veering farther away from traditional portfolio theory and more toward "Black Swan" mentalities espoused by author Nassim Taleb.

Pimco bond fund mangers, who have coined "New Normal" as their outlookfor the next several years, have become the latest to warn investors away from playing the percentages.

In an essay from Pimco's Richard H. Clarida, the firm's executive vice president and global strategic advisor, investors are cautioned that "we are in a world in which average outcomes for growth, inflation, corporate and sovereign defaults, and the investment returns driven by these outcomes will matter less and less for investors and policymakers."

"This is because we are in a New Normal world in which the distribution of outcomes is flatter and the tails are fatter," Clarida continues. "As such, the mean of the distribution becomes an observation that is very rarely realized, creating at least three fundamental consequences for investment strategy."

The "fatter tails" of which Clarida speaks relate to outcomes along a traditional bell curve, in which results are expected to be distributed in a uniform manner with extremes at either end and a large "bell" shape in the middle. Fatter tails, or ends of the curve, would mean that less probable events are occurring more often.

Pimco sees the consequences of this trend being:

  • A requirement for investors to be "getting the tails right," or more accurately predicting and reacting to unusual events.
  • Suffering through more "risk on, risk off" days. Clarida borrows a popular expression of late for analyzing daily events and deciding whether they are supportive of riskier trades, such as stocks, or safer moves, like bonds. He sees "frequent flips" in these types of days, with risk largely dependent on Asian equity markets.
  • Using less debt, or leverage, when making trades. The more predictable years of 1987-2007—the "Great Moderation" as he calls it—allowed and in fact required more leverage for investors. But with the cost to borrow going up, investors will have to change their approach.

"Investors had 25 years to get comfortable with the Great Moderation," Clarida says. "The sooner they recognize those days are over, the better."

Data bear out that the market has changed—in the past year and since the onset of the credit crisis three summers ago.

New York Stock Exchange Traders
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New York Stock Exchange Traders

In more than one out of three (37%) trading days this year, the market either has gained or lost more than 1 percent. Those events were even more common in 2008 and 2009, at 53 percent and 47 percent respectively, compared to just 11 percent in 2006.

Such trends don't always show up in market gauges such as the CBOE Volatility Index , which is often referred to as the market's favorite fear gauge but is not as often a measure of volatility as felt on trading floors. The index generally runs inversely to the direction of the markets, turning lower on up days even if the move is dramatic.

"Investors had 25 years to get comfortable with the Great Moderation. The sooner they recognize those days are over, the better." -Pimco advisor, Richard H. Clarida

The VIX has remained relatively tame even as the market has gone through a correction phase off the most recent highs of April 23.

These fast gyrations, though, are felt by investors who struggle to keep up with the whipsaw market.

"You're seeing a lot of day-to-day volatility, but when you map it out there's very little overall volatility," says Uri Landesman, president of the Platinum Management hedge fund in New York. "One of the reasons for a lot of the day-to-day volatility is there's been pretty low volumes in the market. The lower the volume, the greater the volatility. Some (low volume) is seasonal and some of it is that people don't know what's going on."

Landesman has his own strategy to play outliers on the bell curve, using plays that go out two standard deviations, a measure that computes the dispersion of data from the mean, or center point.

The strategy centers on option plays that come at low cost because they are so far from normal expectations.

"In a number of our strategies we try to create the tails for free. I suspect that other people may be thinking about this as well," Landesman says. "What we're trying to do is make a decent return likely within a two standard-deviation outcome of whatever we're playing. We're looking for upside or alpha to come from greater than two standard deviation-events, which we're not paying very much for."

For retail investors whose strategy may be less sophisticated, the trend away from the mean could simply translate into hedge strategies to protect portfolios against unusual events, such as the collapse of the subprime market that triggered the financial crisis.

"We call it a barbell market in a workout phase—hedge against deflationary risk with Treasuries yet long equities to maintain exposure to economic and earnings growth that persists," John Stoltzfus, strategist at Ticonderoga Securities in New York, advised clients Friday. "At the end of the day, it's a workout market, and the bifurcation makes sense based on where we have been and what has been done to take us out of the crisis."