"The Odds of Another 'Black Monday'”
Friday, October 19, 2018 17:09
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“The Odds of Another ‘Black Monday’”
by Brian Maher
“We lower our head… and pause in silent memory. For the black crepe went up on Wall Street 31 years ago today – Oct. 19, 1987. The Dow Jones plummeted 22.6% that distant “Black Monday”… its largest one-day fall ever. A comparable blood-spilling today would plunge the index some 5,700 points. How likely is an encore? Answer shortly.
Meantime, the ghosts of October 1987 have the stock market spooked rather hard this month. The Dow Jones closed another 327 points lower yesterday. As of yesterday’s close, the index has sunk 1,500 points since peaking Oct. 3. Both the S&P and Nasdaq also took good hard soakings yesterday.
We turn to the mainstream financial media for answers – likely weak answers – but answers. Reuters, for example, spoons us this apple sauce: “U.S. stocks fell more than 1% on Thursday as the European Commission issued a warning regarding Italy’s budget and concerns mounted over the possibility of strained relations between the United States and Saudi Arabia.”
Neither explanation passes our inspection. The market his digested tougher stuff. MarketWatch supplies its own answer: “Investors continued to weigh minutes of the Federal Reserve’s September meeting, which were viewed as hawkish. The reference is to Wednesday’s release of the minutes from the Fed’s September meeting. But the Fed’s hawkishness is news to whom precisely?
Markets were already factoring in additional rate hikes. Yields on the 10-year Treasury were higher, it is true. But the move was a relatively orderly affair. Markets have by now digested the recent spike that sent stocks careening nearly two weeks ago. The Dow Jones was up 64 points today. But both the SP and Nasdaq closed in red numbers.
Maybe stocks are simply out of steam. Liquidity is running dry. This quarter may represent “peak earnings” for corporations as tax cuts lose their punch. Buybacks too will likely wither for the same essential reason. Perhaps the worst is yet to come. Or perhaps cheery earnings reports will keep the show going for a space – the answer eludes us.
But on this black anniversary of Oct. 19, 1987, what are the odds of another 22% one-day hemorrhaging? We have previously noted that Black Monday was such a miracle of chance, it never should have occurred – in the history of the universe. Can we therefore exclude the possibility of a sequel? We cannot expect a once-in-a-4.6-billion-year event to recur within decades or even centuries – or millennia.
But today’s hyperconnected markets are staggeringly complex. Jim Rickards argues that complexity leaves markets far more naked to “black swans” than odds alone suggest: “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… “
But when can you expect another Black Monday? With three mathematical men in tow, Harvard finance professor Xavier Gabaix conducted a study – “Institutional Investors and Stock Market Volatility.”* They ransacked decades of stock market history, both home and abroad, to rig a formula figuring the frequency of these events.
The results? They conclude you can expect a Black Monday-level event… once every 104 years. Does that mean you can safely snooze until 2091? It does not. As financial writer and analyst Mark Hulbert explains: “Note carefully that this doesn’t mean a crash this big will occur every 104 years. This instead will be their average frequency over long periods. So it’s possible that we will not experience another 1987-magnitude crash in our lifetimes – or that another will occur today.”
Still, you are confident in the odds. But how about a 10% one-day drop? The study concludes one should occur eight days of the next 100 years – roughly once every 13 years. But as Hulbert reminds, 30 years have lapsed since the last 10% slip. Overdue, we are. A 10% one-day fall from today’s heights would represent a 2,500-point hammering.
Only a handful of stocks are pulling the wagon forward today – some one-third of the S&P trades in bear market country. Institutional investors are loaded up with the draft horses. If they unload them en masse, who will take up the slack? Meantime, computers make far more trading decisions today than 30 years prior. If they go amok once the selling begins… maybe you will have your 10% rout. And who can say it stops there? All the while, Old Man Time has his eye on the clock… counting away…
Below, Jim Rickards shows you how the threat of market contagion is greater than ever. How does Jim recommend you prepare for the worst? Read on.”
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“The Threat of Contagion”
By Jim Rickards
“Each crisis is bigger than the one before. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses. This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008. Today, systemic risk is more dangerous than ever. Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.
To understand the risk of contagion, you can think of the marlin in Hemingway’s “Old Man and the Sea.” The marlin started out as a prize catch lashed to the side of the fisherman Santiago’s boat. But, once there was blood in the water, every shark within miles descended on the marlin and devoured it. By the time Santiago got to shore, there was nothing left of the marlin but the bill, the tail and some bones.
An even greater danger for markets is when these two kinds of contagion converge. This happens when market losses spillover into broader markets, then those losses give rise to systematic trading against a particular instrument or hedge fund. When the targeted instrument or fund is driven under, credit losses spread to a wider group of fund counterparts who then fall under suspicion themselves. Soon a market-wide liquidity panic emerges in which, “everybody wants his money back.”
This is exactly what happened during the Russia-Long Term Capital Management (LTCM) crisis in 1998. The month of August 1998 was a liquidity crisis involving broad classes of instruments. But, the month of September was systematically aimed at LTCM. I was right in the middle of that crash. It was an international monetary crisis that started in Thailand in June of 1997, spread to Indonesia and Korea, and then finally Russia by August of ’98. It was exactly like dominoes falling.
LTCM wasn’t a country, although it was a hedge fund big as a country in terms of its financial footings. I was the general counsel of that firm. I negotiated that bailout. The importance of that role is that I had a front-row seat. I’m in the conference room, in the deal room, at a big New York law firm. There were hundreds of lawyers. There were 14 banks in the LTCM bailout fund. There were 19 other banks in a one billion dollar unsecured credit facility. Included were Treasury officials, Federal Reserve officials, other government officials, Long-Term Capital, our partners. It was a thundering herd of lawyers, but I was on point for one side of the deal and had to coordinate all that.
It was a 4 billion dollar all-cash deal, which we put together in 72 hours with no due diligence. Anyone who’s raised money for his or her company, or done deals, can think about that and imagine how difficult it would be to get a group of banks to write you a check for 4 billion dollars in 3 days. Systematic pressure on LTCM persisted until the fund was almost broke. As Wall Street attacked the fund, they missed the fact that they were the creditors of the fund. By breaking LTCM, they were breaking themselves. That’s when the Fed intervened and forced Wall Street to bail out the fund.
Those involved can say they bailed out Long-Term capital. But if Long-Term Capital had failed, and it was on the way to failure, 1.3 trillion dollars of derivatives would’ve been flipped back to Wall Street. In reality, Wall Street bailed out itself.
The panic of 2008 was an even more extreme version of 1998. We were days, if not hours, from the sequential collapse of every major bank in the world. Of course, the 2008 panic had its roots in subprime mortgages, but quickly spread to debt obligations of all kinds especially money market funds and European bank commercial paper. Think of the dominoes again. What had happened there? You had a banking crisis. Except in 2008, Wall Street did not bail out a hedge fund; instead the central banks bailed out Wall Street.
And as I mentioned earlier, today systemic risk is more dangerous than ever. Each crisis is bigger than the one before.Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system, and have much larger derivatives books. The bottom line is that capital market complexity is higher than ever and it signals that the next crisis will be worse than the last.
Also, new automated trading algorithms like high-frequency trading techniques used in stock markets could add to liquidity in normal times, but the liquidity could disappear instantly in times of market stress. And when the catalyst is triggered and panic commences, impersonal dynamics take on a life of their own. That type of automated trading algorithm was at least partly responsible for “Black Monday,” which took place 30 years ago today. The Dow plunged 22.6% that day.
Today’s markets are even more complex. And sudden, unexpected crashes that seem to emerge from nowhere are entirely consistent with the predictions of complexity theory. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses. This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008. The ability of central banks to deal with a new crisis is highly constrained by low interest rates and bloated balance sheets, which despite some movement in that direction, still have not been normalized since the last crisis.
For now, it’s not clear which way things will break next. Markets are still in a precarious position right now and volatility is creeping its way back. Regardless of which direction markets go from here, the threat of contagion is a scary reminder of the hidden linkages in modern capital markets. We’ve already had a correction this year. We‘ll see where the recent sell-off leads. But the next correction could turn into a 30% or 40% crash. The conditions are in place. But you can’t wait for the shock to occur because by then it will be too late. You won’t be able to get your money out of the market in time because it’ll be a mad rush to the exits.”
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Yes, Good Citizen, I hear you, “Oh, that could never happen… again!”
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* Freely download “Institutional Investors and Stock Market Volatility”,
by Xavier Gabaix, here:
by Xavier Gabaix, here:
Source: http://coyoteprime-runningcauseicantfly.blogspot.com/2018/10/the-odds-of-another-black-monday.html
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