“A ‘Black’ Anniversary for a ‘Black Swan’”
by Brian Maher
“Happy anniversary!” Jim Rickards tweeted this morning, giving our old friend Mr. Market a good razzing. Happy anniversary to what? “Black Monday.”
On this date in 1987- 29 years ago- the Dow plunged 22.6%. 508 jolly points in one day. The Dow’s biggest one-day percentage drop ever. “The equivalent today,” Jim noted, “would be a one-day 4,106 point drop to 14,055.” The big question: 29 years later, is history planning a sequel? Consider…
Citibank’s tea leaf and bird entrails readers recently cooked up a chart. It compared this month’s S&P with October 1987’s. Not the Dow, mind you. And it’s only through the 7th. But still. Here it is:
A perfect match? No. But close enough to arch an eyebrow or three on Wall Street. Some argue the chart’s phantom. Stocks blasted higher in almost vertical fashion to start 1987. The S&P was up about 40% by the end of September, leaving stocks “extremely stretched.” Too much. Too fast. Due for a wallop. This year, in contrast, stocks tripped out of the gate for their worst start in history. The S&P is only up about 6% for the year in light of January’s swoon. Stocks have a firmer toehold on the ladder this time.
So… Is another Black Monday lurking? We don’t know. And analysts see a face in every cloud if they look hard enough. But there’s something odd about Black Monday we just can’t shake out of our hair…
The strange thing about Black Monday, as we first noted in July, is it never should have happened. Not just in the sense that regulators were snoozing on the job or some gasket blew somewhere. No. It literally never should have happened… It was almost statistically impossible. Charlie Bilello is director of research at Pension Partners LLC. He studied Black Monday. And his research shows Black Monday was such a freak of nature, such a purple unicorn, it was “simply not ever supposed to happen, in the history of the universe.”
It has to do with what statisticians call “standard deviations from the average.” The lower the standard deviation, the more common the event. The higher the standard deviation, the rarer the event. Take your typical bell curve. As Scientific American puts it, “In a perfect bell curve, 68% of the data is within one standard deviation of the mean, 95% is within two, and so on.” Three sigmas would include 99.7% of the data. And Bilello says the likelihood of a five standard deviation event is “essentially zero” on any given day.
So… if the chance of a five standard deviation event is “essentially zero” on any given day… what on Earth do we make of a 17 standard deviation event? That was Black Monday. A 17 standard deviation event.
Seventeen standard deviations means it never should have happened. Not in the history of the universe. But it did… 29 years ago… today.
Did God pull a joke on the market that day? Was it just some bizarre midnight collaboration of chance? Or are markets somehow more prone to “black swans” than the laws of chance suggest? Maybe the latter. Bilello: “Markets operate in the world of fat tails, exhibiting large skewness. This is a fancy way of saying extreme events (high standard or ‘sigma’ moves) are much more likely to occur than a normal distribution would predict.” The market is a whirling delirium of complexity. Even more so now than 1987. And that’s the thing…
Jim Rickards pioneered the study of complexity theory and its applications to markets. His conclusion? Markets are increasingly susceptible to “black swan” events as their complexity grows: “One formal property of complex systems is that the size of the worst event that can happen is an exponential function of the system scale. This means that when a complex system’s scale is doubled, the systemic risk does not double; it may increase by a factor of 10 or more. This kind of sudden, unexpected crash that seems to emerge from nowhere is entirely consistent with the predictions of complexity theory. Increasing market scale correlates with exponentially larger market collapses.”
In case you glided past it: “When a complex system’s scale is doubled, the systemic risk does not double; it may increase by a factor of 10 or more.” Then Jim brings the ax down on the root: “As systemic scale is increased by derivatives, systemic risk grows exponentially.” The derivatives market in 1987 was a pimple compared with today’s. And today’s derivatives market dwarfs that of 2008. With Jim’s “complexity multiplier,” could it be that today’s market risk is not just higher, but exponentially higher than 1987? Something to ponder of a fair October evening…
“Globalization… creates interlocking fragility,” says author and statistician Nassim Nicholas Taleb, “while reducing volatility and giving the appearance of stability. In other words, it creates devastating Black Swans. We have never lived before under the threat of a global collapse.” Now we do.
Below, Jim Rickards shows you the three threats converging on the markets all at once. Could they lead to another Black Monday-type event? Read on.”
“The Three Threats Converging Now”
By Jim Rickards
“After covering the three risks converging on us right now: excessive debt, lower productivity, and the absence of central bank policy options, there’s more to the story. Let’s consider specific threats to your wealth that emanate from these risks: systemic collapse, asset bubbles, and lost confidence in the ability of central banks to respond to crises.
Threat 1: Systemic Collapse. The prospect of systemic collapse or economic instability is being driven by a global dollar shortage. This sounds strange at first. How can there be a dollar “shortage” when the Fed has printed trillions of fresh new dollars in the past eight years? The answer is that dollar debt has expanded even faster than dollar printing. Every dollar printed by the Fed has been leveraged into twenty dollars of new debt by global markets.
The Fed put new money printing on hold with the end of QE3 in November 2014. Since then the dollar has grown stronger partly because of the end of new money printing. But, the dollar-denominated debt is still growing in the oil patch and emerging markets, and in U.S. student loans, car loans, credit cards and other obligations. A stronger dollar and disinflation make this debt more onerous and harder to repay.
We’re already seeing periodic earthquakes resulting from this dollar shortage, including the October 2014 “flash crash” in Treasury yields, and the August 2015 shock devaluation by China. It won’t be long before an even bigger earthquake is unleashed.The Fed could address this with more money printing. In fact, I expect to see a program of QE4 sometime in 2017. But, of course, that just feeds the asset bubbles, which are a separate source of systemic risk.
Threat 2: Asset Bubbles. When investors ask, “Where’s the inflation after all this money printing?” my answer is, “Don’t look at the supermarket shelf; look at the stock market.” In other words, we have not had much consumer price inflation, but we have had huge asset price inflation. The printed money has to go somewhere. Instead of chasing goods, investors have been chasing yield.
Part of this asset bubble inflation has to do with a flawed theory of bond/equity “parity.” The theory says that once you adjust for credit risk and term premium, bonds and stocks should yield about the same. Right now, safe ten-year Treasury notes yield about 1.65%. Many stocks have dividend yields of 3% to 5%. Investors know that stocks are riskier than safe bonds, but how much riskier? Under the parity theory, investors can keep bidding up the price of stocks until their dividend yields get closer to 2%, leaving a small margin over bond yields to cover “risk.”
There are many flaws in this theory (including the fact that companies go bankrupt all the time, and boards of directors can and do cut dividends in recessions). But one of the biggest flaws is the complete disconnect between what’s driving bond yields in the first place. If bond yields are falling because deflation is ruining the Fed’s plans to reflate the economy, is that a reason for stocks to go up? If bond yields are signaling recession, should you really be bidding up stock prices to extreme levels based on a theory of yield “parity?” This behavior defies common sense and economic history, but it’s exactly what we’re seeing in the markets today.
At some point, probably sooner than later, the reality of central bank impotence and looming recession will sink in and stock valuations will collapse. The drop will be violent, perhaps 30% or more in a few months. You don’t want to be over-allocated to stocks when that happens. This analysis applies to more than just stocks. It applies to a long list of risky assets including residential real estate, commercial real estate, emerging markets securities, junk bonds and more. It only takes a crash in one market to spread contagion to all of the others.
Threat 3: Lost Confidence. Finally we come to the greatest threat of all- the inability of central banks to deal with crisis and the complete loss of confidence by investors in the efficacy of central bank policy. The last two global liquidity panics were 1998 (caused by emerging markets currencies, Russia, and Long-Term Capital Management) and 2008 (caused by sub-prime mortgages, Lehman Brothers and AIG).
Another smaller liquidity panic arose in 2010 due to problems in Middle Eastern and European sovereign debt (caused by Dubai, Greece, Cyprus and the European periphery). In all three cases, central bank money printing combined with government and IMF bail-outs were enough to restore calm. But these bailouts came at a high cost. Central banks have no room to cut rates or print money in a future crisis. Taxpayers are in full revolt against more bailouts. Governments are experiencing political polarization and there’s political gridlock around the world. There is simply no will and no ability to deal with the next panic or recession when it hits.
Consumer inflation expectations have fallen to the lowest level since late 2010 (not long after the last crisis) and the trend is down, toward levels not seen since the depths of the panic in 2008. With central banks around the world doing everything possible to cause inflation (QE, ZIRP, NIRP, helicopter money, currency wars, forward guidance, etc.), what does it say about confidence in central banks that inflation expectations are falling, not rising?
The world is moving toward a sovereign debt crisis because of too much debt and not enough growth. Declining productivity is the last nail in the coffin in terms of countries’ ability to deal with the debt. Inflation would help diminish the real value of the debt, but central banks have proved impotent at generating inflation. Now central banks face the prospect of recession and more deflation without any policy options to fight it.
The impact of deflation and the strong dollar have caused a shortage of liquidity around the world. Since private debt has expanded faster than central bank balance sheets, a dollar shortage has arisen as debtors scramble for dollars to pay back debts. This raises the prospect of a new liquidity crisis and financial panic worse than 2008.
Persistent low rates have not caused inflation, but they have caused asset bubbles, which threaten to pop and unleash a financial panic on their own- independent of tight financial conditions. When this new panic hits (either from a liquidity shortage or bursting asset bubbles), investors will have no confidence in the ability of central banks to limit the panic.”