Predictability and Panic

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Predictability and Panic

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Uncertainty and irrationality

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Uncertainty and irrationality

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Predictability and Panic

Prepare for more frequent and extreme volatility. New and powerful influences, ranging from social media and financial technology to algorithmic trading and esoteric valuation models, will increasingly upset market stability and bring unprecedented rewards and unpredictable disaster.

Predictable market conditions will be upset by sudden unpredictable movements.

Financial markets can be predicted reliably only when the world does not change. Even during periods of stability, judgment based on expectations and assumptions as much as hard facts and economic analysis, form the basis for buying and selling decisions. Market crashes and financial crises are a continuing and breathtaking reminder that markets are irrational and uncertain. Taken to an extreme, the combustible combination disrupts global markets and societies. New analytical tools and technologies appear to make worrying about unforeseen risks obsolete. But this naïve belief in technology’s ability to understand and predict catastrophic risk is a fundamental cause of that very catastrophe.

Stability is illusory because in an uncertain world, unforeseen changes can have seismic effects. The pandemic is only the latest example, but there are always greater risks inherent in markets than is acknowledged, and most investment strategies do not accurately reflect the risk that certain investments are assuming for a given return. Safety can be an illusion if the risks are not well understood, both systemic and undiversified.

As we have seen, oversight, regulation, or any sort of self-imposed moderation will continue to be ineffective or nonexistent, and always trail behind the most dangerous and detrimental market developments. Financial weapons of mass destruction continue to multiply and are now available via smart phone in everyone’s pocket. Expect more and greater turbulence.

Uncertainty and Irrationality

Clear and coherent markets, free from political agenda, bad compromises, and ineffective regulation is almost nonexistent. The consequences are usually pyrotechnic. It is not as if the world hadn’t provided ample warnings about the risks associated with irresponsible finance. History has centuries worth of such examples, but even looking at recent events over the last 25 years is illuminating.

In spite of Alan Greenspan acknowledging the “irrational exuberance” of the markets in 1996, stock market valuations continued to rise. The warning signs of unstable economies were believed to be localized and the broader markets decoupled from this turbulence. This was naïve thinking then and outright irresponsible now.

The idea that markets are uncertain, and consistent prediction is essentially impossible, is not new. John Maynard Keynes published a book on probability and uncertainty in 1921, with this concept of uncertain and irrational markets forming the basis of his general theory of financial markets. So, years before the stock market crash of 1929, and almost every 10 to 15 years afterward, the cycle of financial crashes and panics was predicted by a well-publicized thinker, and then, as is typical, ignored. The lesson is simple, and Keynes laid it out 100 years ago: markets seem rational but only during periods of stability. Markets are uncertain. Predictive models work most of the time, and that is their fundamental flaw. They will fail. Investment models that account for uncertainty and failure succeed in the long term.

Abundant Cash Is Not Cash Available Abundantly

The pandemic, Fed interest rate policy and bond purchases, restrictive banking regulations, and banks’ swelling cash balances will have a lingering impact on liquidity and produce some mind-bending policies to deal with this uncharted territory. As the pandemic emerged in March 2020, strange things happened: Bond markets seized up and investors panicked. Bond yields spiked causing severe price declines. Credit default swap prices (debt protection derivatives) rose 100x in less than a month. The dollar rose and liquidity dropped for U.S. Treasuries, usually the world’s most liquid security. There was substantially lower demand at U.S. Treasury auctions. The Federal Reserve responded with an almost never-ending pile of cash, buying vast quantities of bonds with newly created cash. It has continued its purchases, at a pace of at least $120 billion a month. But this has not resulted in “happy days are here again.” This mountain of dollars is limiting liquidity and constraining markets. That’s right, read that again if you must – too much cash can constrain the economy.

More volatility. Less predictability

S&P 500 stock market values are experiencing the same volatility as the first half of 2020, the start of the Covid-19 pandemic (based on the 50 largest value movements as a percentage of the index’s total market value).

Heightened volatility has grown more common across the stock market even as major indexes are approaching record highs. The volatility is not limited to specific circumstances of craziness, such as GameStop (rising more than 2,000% and then cratering), or Viacom (losing more than half its value as Achegos imploded). Apple gained $265 billion in market value during only five trading sessions in January – more than the total worth of Coca-Cola. In March, NVIDIA and PayPal each lost over $50 billion in market value in just a couple of days.

These dramatic movements show that market volatility leads to big price movements in stocks, both up and down. There are a couple of factors combining to enhance this turbulence:

The popularity of the momentum trade (buying stocks that are rising quickly and dump the relative losers quickly).
Decreasing liquidity (fewer buyers and sellers for the other side of trades).

Both factors magnify the market’s moves in either direction.