The crash is coming!
Complexity and chaos science can help shed light on why booms and busts occur.
Complex systems affect nearly every field of human knowledge or endeavor, from astronomy and biology to the arts, the humanities and finance. These systems are natural, man-made, or combinations of the two. A hurricane is a natural complex system. So is an avalanche. A stock market is a man-made complex system. All exhibit a large number of interacting components (agents, processes, tipping points, etc.) whose aggregate activity is nonlinear/exponential (not derivable from the sum of the parts) and typically exhibits hierarchical self-organization and chaotic tendencies.
Imagine you’re on a mountainside and there’s snow building up and it’s still snowing and an avalanche forms…it’s windswept, frigid, and highly precarious. You’re watching the snowpack, and if you’re perceptive, you realize it’s going to collapse and could bury some skiers or wipe out the community below.
Well, here comes a critical snowflake, it disturbs a few other snowflakes, that spreads, it starts to shoot, it starts to slide, it gains momentum, it comes loose and the whole mountain comes down and buries Aspen or Gstaad. Who do you blame? Do you blame the snowflake or do you blame the unstable pack of snow?
BLAME THE SYSTEM
The accumulation of snow on a mountain top and an impending avalanche is an example of a complex system — but really, such systems can be found everywhere: weather is a complex system, the ebb and flow of populations is another example, the volatility inherent in stocks markets, and even Jackson Pollock’s drip paintings contain qualities of complexity and chaos (peep this vid and read this and this). Essentially, Pollock’s manic, chaotic paint splatters embody fractal patterns that somehow reflect the ‘fingerprint of nature.’ Financial markets, too, are said to be underpinned by fractals (calculated this way: zn+1 = zn2 + c), and are far riskier than we want to believe.
Just like in the avalanche example, where various factors at the top of a mountain (accumulating volumes of snow, weather, temperature, geology, gravity, etc.) make up a complex system that is difficult to predict, the global economy and capital markets are similarly complex. Let’s focus on the current state of the global economy and the potential properties/catalysts that could trigger a ‘financial avalanche’, which we think will come in October.
Markets possess all the properties of complex and chaotic systems, as outlined by the literature:
System actors have different points of view. (i.e. bullish, bearish, long, short, leveraged, non-leveraged, etc.)
Capital markets are over-connected, and information spreads fast. (i.e. chat rooms, phone calls, emails, Thomson Reuters, Dow Jones, Bloomberg, trading systems, order entry systems, etc.)
Trillions of dollars of securities are exchanged in transactions every day (i.e. stocks, bonds, currencies, derivatives, etc.)
4. Adaptive Behavior
Actors change their behavior based on the signals they are getting (i.e. making or losing money, etc.)
And like the avalanche example, where a single snowflake can trigger a much bigger event, there are increasing signs that the complexity behind the stock market has also reached a critical state.
5. Random Events
MARKETS IN A CRITICAL STATE
Here are just some examples that show how the market has entered into an increasingly critical state:
The VIX, an index that aims to measure the volatility of the market, hit all-time lows this summer.
Bull Market Length
Meanwhile, the current bull market (2009-present) is the second-longest bull market in modern history at 3,109 days. The only bull market that was longer went from the 1987 crash to the Dot-com bust.
Valuations at Highs
Stock valuations, based on Robert Schiller’s CAPE ratio (which looks at cyclically-adjusted price-to-earnings), are approaching all-time highs as well. Right now, it sits 83.3% higher than the historical mean of 16.8. It was only higher in 1929 and 2000, right before big crashes occurred.
Market Goes Up
Investor overconfidence leads investors to believe the market only goes up, and never goes down. Indeed, in this bull market, markets have gone up 67 of the months (an average gain of 3.3%), and have gone down only 34 months (average drop of -2.6%).
Here are some additional signs of systemic risk that make complex markets less stable:
- A densely connected network of bank obligations and liabilities
- Over $70 trillion in debt added since Financial Crisis
- Over $1 quadrillion in notional value of derivatives
- Non-bank shadow finance through hedge funds and securitization make risk impossible to measure
- Increased leverage of banks in some markets
- Greater concentration of financial assets in fewer companies
In other words, there are legitimate reasons to be concerned about “snow” accumulation – and any such “snowflake” could trigger the avalanche.
In complex dynamic systems that reach the critical state, the most catastrophic event that can occur is an exponential function of scale. This means that if you double the system, you do not double the risk; you increase it by a factor of five or 10!
THE NEXT SNOWFLAKE
What could trigger the next avalanche? It could be anything, including the failure of a major bank, a natural disaster, war, a cyber-financial attack, or any other significant event.
Such “snowflakes” come around every few years:
1987: Black Monday
The Dow fell 508 points (-22.6%) in one day.
1994-95: The Mexican peso crisis
Systemic collapse narrowly avoided when the U.S. government bailed out Mexico using the controversial $20 billion “Exchange Stabilization Fund”.
1997: Asian financial crisis
East Asian currencies fell in value by as much as -38%, and international stocks by as much as -60%.
1998: Long Term Capital Management
Hedge fund LTCM was in extreme distress, and within hours of shutting down every market in the world.
2000: The Dotcom crash
Nasdaq fell -78% in 30 months after early Dotcom companies crashed and burned.
2008: Lehman Brothers bankruptcy
Morgan Stanley, Goldman Sachs, Bank of America, and J.P. Morgan were days away from same fate until government stepped in.
SHELTER FROM THE AVALANCHE
The Fed and mainstream economists use equilibrium theory, regressions, and correlations to quantify the markets. And while they pay lip-service to black swans, they don’t have a good way of forecasting them or predicting them.
Markets are complex – and only complexity theory and predictive analytics can help to shed light on their next move.
Alternatively, investors can seek shelter from the storm by investing in assets that cannot be digitally frozen (bank accounts, brokerage accounts, etc.) or have their value inflated away (cash, fixed-income). Such assets include land, precious metals, fine art, and private equity.
The warning signs of this next crash have now manifested, and VIVISXN is calling for a 5-10% correction to the downside on October 10-ish. We also believe that war with North Korea is inevitable due to the underestimations and misapprehensions of the hazards inherent in the US-DPRK relationship, and current dynamics will trigger a conflict on the Korean peninsula. Markets will be roiled and crisis will ensue, but trading opportunities will be rife. Get hedged asap!
VIVISXN MEDIA – Finance + Economics + Art