Bill Miller is using earthquake forecasting to predict the stock market’s next Big One
He’s using earthquake modeling tools to forecast market risk “I’m surprised somebody is still messing with that stuff”
When pitching investors, you normally don’t want “hedge fund” and “earthquake” in the same sentence. But Bill Miller, a once-dominant money manager known for quirky thinking, is starting a fund that will make bets based in part on a computer model designed to predict natural disasters.
Called Seismic Value Partners 1, the fund marks Miller’s first foray into hedge funds after decades managing mutual funds at Legg Mason. He won approval last month from the Securities and Exchange Commission to open Miller Value Partners, a money management firm that will oversee his hedge funds. As of a December SEC filing, no money had been raised for the initial Seismic fund.
Miller has licensed a computer model from OpenHazards Group, a Davis, Calif., company run by engineers, mathematicians, scientists, and business executives. The idea is to apply the mathematics of forecasting the probability of seismic activity to the chances of a stock market crash.
Like severe drops in the exchanges, “earthquakes are extreme events,” says Lisa Rapuano, who helped Miller run the Legg Mason Special Investment Trust mutual fund during the 1990s. “This has the potential to help Bill avoid big mistakes, which is one of the downsides of his investment style.”
Miller declined to comment. A decade ago, he was among the bestknown and most-admired stock fund managers in the world, thanks to an astonishing winning streak. His Legg Mason Value Trust fund beat the Standard & Poor’s 500-stock index for 15 consecutive years, from 1991 through 2005. By 2008, when the crisis hit, the fund was heavily invested in financials. It lost 55 percent that year, vs. a 37 percent loss for the S&P 500.
The notion of sidestepping a big loss like that holds an obvious appeal. But some scholars dismiss the idea of applying an earthquake model to stockpicking. “I don’t think it has diddly to do with financial markets,” says Joseph McCauley, a physics professor at the University of Houston and author of Dynamics of Markets: Econophysics and Finance. “I’m surprised somebody is still messing with that stuff.”
OpenHazards Chairman John Rundle, a well-known seismologist who teaches physics and geology at the University of California at Davis, has been adapting his theories on natural disasters and financial markets with help from members of the Santa Fe Institute, a nonprofit research organization where Miller is chairman emeritus and the largest donor.
Miller’s fund will use signals from the model to make daily determinations on whether to purchase or sell short securities that mirror the performance of the U.S. stock market, such as the SPDR S&P 500 exchange-traded fund, according to regulatory documents. The goal is to outperform the S&P 500 over periods of a year or more
with less volatility. Miller will likely employ the model as an “overlay” to individual stock picks, Rapuano says.
The concept that seemingly unrelated catastrophes, from extinctions to avalanches to market crashes, might follow similar underlying patterns dates to the 1980s, when the late Danish physicist Per Bak began writing on the subject. “It’s something everyone would like to do, but it is inherently close to impossible,” Gene Stanley, a physics professor at Boston University, says about trading stocks based on such models. Knowing the probability of a crash is not the same as knowing the timing.
Miller has long been known for his unusual approach to investing. At Value Trust he looked for stocks trading at a discount to their intrinsic worth, a classic value investment approach. But he merged that with other ideas. He was an investor in Amazon.com at a time when most value managers thought the company was overpriced using standard growth expectations. But he and Rapuano developed a model for how Internet businesses might grow based on ideas they had picked up via the Santa Fe Institute, Rapuano says.
After 2008, the Value Trust fund trailed the index in two of the three ensuing years. Miller stepped down as its manager in April 2012.
He rebounded running the $1.3 billion Legg Mason Opportunity
Trust, generating average annual returns of 26 percent from 2012 through 2015. In 2016, however, he’s suffered, losing more than 18 percent so far, compared with a 5.3 percent loss for the S&P 500.
Miller runs Opportunity Trust through LMM, a Baltimore-based investment adviser he owns with his son and Legg Mason. A Legg Mason spokeswoman says Miller’s arrangement with LMM is unchanged.
John Seo, co-founder of Fermat Capital Management, which buys insurance company bonds with payoffs linked to catastrophes, says he can see a broader use of earthquake modeling. While traders often have extensive data on how their portfolios would perform in a market crash, they seldom know how likely such a downdraft would be. “That’s where the earthquake guys come in,” Seo says. “They’re good at assigning probabilities.”
The bottom line A fund manager famous for big wins and a huge loss has a complicated idea for trying to take crashes out of the equation.