"The Tripwire on the Next 'Black Monday'”
Monday, September 24, 2018 16:17
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“The Tripwire on the Next ‘Black Monday’”
by Brian Maher
“‘Black Monday’ – “Oct. 19, 1987- remains the bloodiest one-day carnage in market history. 508 points the Dow Jones plunged that hell-sent day – an impossible 22%. A similar stock market event today would translate to a 5,843-point cataclysm.
We compare that October day to the ancient Battle of Cannae, when invincible Rome lost as many as 70,000 legionnaires to Hannibal’s armies, in a single day. Or to the first day of the Battle of the Somme, July 1, 1916, when nearly 20,000 British soldiers fell flat under the German guns and never got up. What could lead today’s market to its own Cannae, its own Somme – its own Black Monday?
Today we consider one harrowing possibility. Harley Bassman is a world-class expert in derivatives – what Warren Buffett has termed “weapons of mass destruction.” ($2.2 quadrillion - CP) Not long ago Bassman set out with one question in mind: The only question one cares about, identifying the tripwire that would tip our system into disequilibrium. That is, what could turn a bad day on Wall Street into another Black Monday? And is there a specific percentage decline that could start the dominoes going over? Bassman’s researches indicate there is.
But what? Before revealing that (black) magic number, let us identify the villain of this tale, a possible trigger for the next horror picture: Passive investing. After the 2008 near-collapse, the emergency responders at the Federal Reserve inundated markets with oceans of liquidity. The biblical-level flooding knocked down existing financial signposts, and “fundamentals” no longer seemed to matter. The tide was rising, and all boats with it.
“Active” asset managers on the hunt for market inefficiencies could no longer separate winner from loser. Some 86% of all actively managed stock funds have underperformed their index during the last 10 years. Explains Larry Swedroe, director of research at Buckingham Strategic Wealth: “While it is possible to win that game, the odds of doing so are so poor that it’s simply not a prudent choice to play.”
“Passively” managed funds – on the other hand – make no effort to pinpoint winners. “Passive” because they sit back on their oars, and let the flowing tide lift their boat. They track an overall index or asset category – not the individual components.
It is a strategy that has yielded handsome dividends this past decade of rising waters, as Tim Decker, president and CEO of ISI Financial Group, explains: “Passive management came into its own during the long bull market that started in late 2009, after the market had collapsed amid the financial crisis in 2007–2008. Money had been flowing from active to passive vehicles in the preceding years, and investors -disillusioned by their losses in the crisis and the high fees they had paid – started turning to passive vehicles even more. That trend has continued to this day.”
Passive investing has increased from 15% in 2007 to perhaps 35% by the end of 2017. It is a percentage that is only rising. All is swell as long as rainbows appear in the skies over Wall Street and the tide continues to rise. But the risk is this: When the tide recedes… it recedes. As Jim Rickards explains: “In a bull market, the effect is to amplify the upside as indexers pile into hot stocks like Google and Apple. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock.”
But comes the central question: How far might stocks have to sink before unleashing the hounds — and another Black Monday? The aforesaid Bassman’s investigations have yielded an answer: A 4% single-day drop could prove sufficient: It seems possible that as little as a 4% decline in a single day could be enough to create critical mass. From today’s stratospheric Dow reading of 26,555, a 4% single-day swoon translates to an 1,062-point loss. A thumping drop, yes – but not beyond imagining.
The Dow Jones plunged nearly 3% just this March after the Trump administration announced tariffs on China. Must we stretch our minds far to conceive a 4% loss? Not much, we dare say. And then what happens, Jim Rickards? Passive investors will be looking for active investors to “step up” and buy. The problem is there won’t be any active investors left or at least not enough to make a difference. The market crash will be like a runaway train with no brakes.
Consequently: “This is one more reason why the next stock market crash will be the greatest in history.” Let the record reflect… that history includes 1929, 1987, 2000 and 2008. Perhaps passive investing will write the next harrowing chapter… Below, Jim Rickards shows you why passive investing is setting up markets for a “major collapse.” How is passive investing like a parasite draining life from the market? Read on.”
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“Free-Riding Investors Set up Markets for a Major Collapse”
By Jim Rickards
“Free riding is one of the oldest problems in economics and in society in general. Simply put, free riding describes a situation where one party takes the benefits of an economic condition without contributing anything to sustain that condition. The best example is a parasite on an elephant. The parasite sucks the elephant’s blood to survive but contributes nothing to the elephant’s well-being.
A few parasites on an elephant are a harmless annoyance. But sooner or later the word spreads and more parasites arrive. After a while, the parasites begin to weaken the host elephant’s stamina, but the elephant carries on. Eventually a tipping point arrives when there are so many parasites that the elephant dies. At that point, the parasites die too. It’s a question of short-run benefit versus long-run sustainability. Parasites only think about the short run.
A driver who uses a highway without paying tolls or taxes is a free rider. An investor who snaps up brokerage research without opening an account or paying advisory fees is another example. Actually, free-riding problems appear in almost every form of human endeavor. The trick is to keep the free riders to a minimum so they do not overwhelm the service being provided and ruin that service for those paying their fair share.
The biggest free riders in the financial system are bank executives such as Jamie Dimon, the CEO of J.P. Morgan. Bank liabilities are guaranteed by the FDIC up to $250,000 per account. Liabilities in excess of that are implicitly guaranteed by the “too big to fail” policy of the Federal Reserve. The big banks can engage in swap and other derivative contracts “off the books” without providing adequate capital for the market risk involved. Interest rates were held near zero for years by the Fed to help the banks earn profits by not passing the benefits of low rates along to their borrowers.
Put all of this (and more) together and it’s a recipe for billions of dollars in bank profits and huge paychecks and bonuses for the top executives like Dimon. What is the executives’ contribution to the system? Nothing. They just sit there like parasites and collect the benefits while offering nothing in return. Given all of these federal subsidies to the banks, a trained pet could be CEO of J.P. Morgan and the profits would be the same. This is the essence of parasitic behavior.
Yet there’s another parasite problem affecting markets that is harder to see and may be even more dangerous that the bank CEO free riders. This is the problem of “active” versus “passive” investors. An active investor is one who does original research and due diligence on her investments or who relies on an investment adviser or mutual fund that does its own research. The active investor makes bets, takes risks and is the lifeblood of price discovery in securities markets. The active investor may make money or lose money (usually it’s a bit of both) but in all cases earns her money by thoughtful investment. The active investor contributes to markets while trying to make money in them.
A passive investor is a parasite. The passive investor simply buys an index fund, sits back and enjoys the show. Since markets mostly go up, the passive investor mostly makes money but contributes nothing to price discovery. The benefits of passive investing have been trumpeted by Jack Bogle of the Vanguard Group. Bogle insists that passive investing is superior to active investing because of lower fees and because active managers can’t “beat the market.” Bogle urges investors to buy and hold passive funds and ignore market ups and downs. The problem with Bogle’s advice is that it’s a parasitic strategy. It works until it doesn’t.
In a world in which most mutual funds and wealth managers are active investors, the passive investor can do just fine. Passive investors pay lower fees while they get to enjoy the price discovery, liquidity and directional impetus provided by the active investors. Passive investors are free riding on the hard work of active investors the same way a parasite lives off the strength of the elephant.
What happens when the passive investors outnumber the active investors? The elephant starts to die. The following chart shows that this is exactly what is happening. Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while $2.0 trillion has been withdrawn from active-strategy funds.
The active investors who do their homework and add to market liquidity and price discovery are shrinking in number. The passive investors who free ride on the system and add nothing to price discovery are expanding rapidly. The parasites are starting to overwhelm the elephant.
This chart reveals the most dangerous trend in investing today. Since the last financial crisis, $2.5 trillion has been added to “passive” equity strategies and $2.0 trillion has been withdrawn from “active” investment strategies. This means more investors are free riding on the research of fewer investors. When sentiment turns, the passive crowd will find there are few buyers left in the market.
There’s much more to this analysis than mere opinion or observation. The danger of this situation lies in the fact that active investors are the ones who prop up the market when it’s under stress. If markets are declining rapidly, the active investors see value and may step up to buy.
If markets are soaring in a bubble fashion, active investors may take profits and step to the sidelines. Either way, it’s the active investors who act as a brake on runaway behavior to the upside or downside.
Active investors perform a role akin to the old New York Stock Exchange specialist who was expected to sell when the crowd wanted to buy and to buy when the crowd wanted to sell in order to maintain a balanced order book and keep markets on an even keel.
Passive investors may be enjoying the free ride for now but they’re in for a shock the next time the market breaks, as it did in 2008, 2000, 1998, 1994 and 1987. When the market goes down, passive fund managers will be forced to sell stocks in order to track the index. This selling will force the market down further and force more selling by the passive managers. This dynamic will feed on itself and accelerate the market crash. Passive investors will be looking for active investors to “step up” and buy. The problem is there won’t be any active investors left or at least not enough to make a difference. The market crash will be like a runaway train with no brakes.
The elephant will die.”
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Of course, there’s nothing we can do to stop or change what’s coming. But I for one
want to at least try to understand it, and if you’re reading this, you do too. Good!
- CP
Source: http://coyoteprime-runningcauseicantfly.blogspot.com/2018/09/the-tripwire-on-next-black-monday.html
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