Horse Sense

The writer has recently become enamored of the concept best expressed as 'the beating of dead horses' - that is, diminishing marginal returns. Describing a situation in which money or energy expended in extracting more out of a given known set of circumstances fails to be rewarded at the same rate as it did in the past, some examples would be:

1). The reciprocity failure of photographic films - which is a measure of the degree to which, above or below certain limits of light intensity, silver emulsions fail to respond in the expected fashion to changes in aperture or shutter speed. Simply, in very dark situations, cranking open the f-stop and holding the shutter button down for half an hour at a time might not produce you a picture;

2). The technical analysis indicator known as the RSI. Admittedly reversing the order of the cart and the beaten nag, it is nonetheless true that a series of prices that take the indicator from 50 to 70 will not, if repeated, get it from 70 to 90. Worse, eventually the RSI will reach a maximum for that input that no number of repetitions can violate. Hence, the absolute certainty of receiving 'non-confirmation' signals (or, better said, non-confirmation noises - seeing as they are mostly generated by the formula itself);

3). Nortel Networks. Now bankrupt, this company (much as the yet breathing Alcatel-Lucent), never really recovered from the diminishing returns that came on the heels of the religiously-held, and funded, belief that the limitless possibilities of the information highway would require equally untethered amounts of bandwidth - forever;

4). Overcrowded trades resulting from the simultaneous moves of too many practitioners of similar trading methods.

This last item merits its own bit of blather.

In the case of a company that takes on too much debt to invest in a line of business that suddenly becomes subject to diminishing marginal returns, the wrong move is paid for in the stock price and the correct procedure is to take one's lumps by downsizing and paying off creditors. However, a hedge fund manager, when faced with the same prospect - as slippage, for example, makes a mess of returns - actively looks to get fatter by borrowing money in order to goose the cash profits from which he gets his reputation and his cut, and was usually rewarded with people sending in more loot.

But in the case of long/short equity funds (which got beaten up early during the margin call phase of the present malaise) which might have depended heavily on certain corporate debt ratios to separate the wheat from the chaff, this raises the interesting possibility that they themselves, were they publicly traded entities, would be found on the short side of their own spread bets. Funny, isn't it? That investors seldom thought to look on them as functioning businesses before mailing in their cheques and money orders.

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