“The first principle is that you must not fool yourself—and you are the easiest person to fool.”
― Pippa Malmgren
This morning risk assets sold off and volatility spiked on building US-Russia tensions over President Biden’s decision to allow our Ukrainian allies to use US long-range weapons inside Russian territory.
Ukraine quickly attacked a Russian base using US-made missiles.
Russia responded by updating the threshold for a nuclear response to include large-scale conventional attacks within its territory.
Nuclear war is among the scariest and most severe risks facing humans. That does not mean it is a risk that is easily perceived by markets, indeed, since it is low probability, sometimes markets completely disregard it. It is also an issue that many humans misunderstand. And with issues that we misunderstand we often miscalculate, and we mis categorize—we over consider impertinent information and underweight the important stuff. Emotions and experience and fear grip us. But the stock market is rarely shaken by geopolitical events, even nuclear ones.
The stock market, for instance, only fell about 5% during the Cuban Missile Crisis at the tail end of the Kennedy Slide. It is important to consider that the public facing side of the nuclear question is often quite incorrect. For example, Kennedy partially won the presidency by promising to close the missile gap with the Soviet Union.
It was supposed that the Soviets had many more missiles than they did. Indeed, US intelligence at the time indicated there was a missile gap in the other direction—that indeed the Soviet capability was far inferior to what was presented. In other words, the US probably could have conducted a first strike in the early 1960s with little direct consequences to the US mainland since the Russians had such an inferiority in ballistic missiles at the time.
Like the public didn’t understand the true dynamics at play in the Cold War standoff of the early 1960s we are likely missing much in the current exchange between the West and Russia. But overall, the change to nuclear doctrine didn’t even promise a nuclear response unless there was “large-scale” use of American long-range weapons inside Russian territory. This effort may be more to ensure Ukraine doesn’t push too hard before a peace can be negotiated. Because of all the emotions swirling around when nuclear war is brought into the mix, we can use an unbiased method to analyze conflicts: power laws.
Of course, Russia’s capability has changed and been greatly augmented since the missile gap days. There is no doubt now that Russia could cause nuclear mayhem if it wanted to. But today’s developments fall short of that becoming likely. Instead, this is a fairly predictable Russian response to President Biden allowing the Ukrainians to use their long-range weapons inside Ukrainian territory.
Ultimately though, the power laws suggest the conflict in Ukraine could be winding down. And despite this morning’s VIX spike, oil markets are still down—which wouldn’t likely be the case if escalation was a real prospect. Indeed, this lowering of the nuclear threshold for Russia may have the effect of cooling the conflict. It may be a strategy in what will likely be emerging peace negotiations.
For instance, like Benford's law and other power laws, a researcher named Lewis Richardson found that the same applies to war casualties. In other words, wars in which 1 million people were killed were ten times less likely than wars in which 10,000 people were killed and a hundred times less likely than violent conflicts in which 100 people were killed in action.
This means that the more people die in a war, the sooner it is likely to end. When you get specific information about the regional histories of the conflicts, you can also extrapolate a qualitative element to complement this insight. The scale and scope of the conflict between Ukraine and Russia means that both sides are bumping against the limiting factors that make wars subject to power laws. The other thing is that Russia’s action seems escalatory—when actually it is made from a position of weakness. It is trying to use nuclear threats where the conventional might of its military is insufficient. And given the conventional might of the US military, Russia’s updated doctrine makes sense from their perspective.
The same ill-fated logic that led to the US public believing their worst fears and thinking there was a missile gap when there was not is always at play in markets. The variance premium itself, a fixture of volatility we often take advantage of in this column, is the same principle. Reality is often not as bad as the worst we can imagine. I think Khruschev’s logic below illustrates why decisionmakers often feel an allegiance to greater humanity that we do not necessarily perceive from our perspective. I think despite efforts to perhaps show the opposite for military gain, this logic still holds in Russia. The nuclear arsenal of Russia is being used right now, in the same way a robber uses a gun. But the objective is to keep military attacks outside of Russia, not to actually escalate. Given the scale of Russia’s losses, we think they will be looking for a way out of the conflict in a Trump administration.
“Khrushchev told Norman Cousins, a few months after the crisis, his reaction at the time: When I asked the military advisors if they could assure me137 that holding fast would not result in the death of five hundred million human beings, they looked at me as though I was out of my mind, or what was worse, a traitor. The biggest tragedy, as they saw it, was not that our country might be devastated and everything lost, but that the Chinese or the Albanians might accuse us of appeasement or weakness. So I said to myself, “To hell with these maniacs. If I can get the United States to assure me that it will not attempt to overthrow the Cuban government, I will remove the missiles.” That is what happened, and now I am reviled by the Chinese and the Albanians.… They say I was afraid to stand up to a paper tiger. It is all such nonsense. What good would it have done me in the last hour of my life to know that though our great nation and the United States were in complete ruins, the national honor of the Soviet Union was intact?”
― Daniel Ellsberg, The Doomsday Machine: Confessions of a Nuclear War Planner
So, let’s make a trade of it. It’s going to be very high-risk like our last VIX trade. We are betting that the temporary spike on fears of escalation over Ukraine will quickly revert and that we will rally into Thanksgiving. The historical probabilities certainly support this assertion.
Buy the December 11th, 2024, $16 put on the $VIX. These opened at around $1.25 (ask/bid average)
This is a highly risky trade where you could lose your entire potential investment.
