Welcome to Finance and Fury, 

For the past few Monday episodes been talking about complexity theory and markets – check out

  1. Last two eps – went through phase transition, feedback loops and how markets become fragile and some signs this is happening
    1. Most recent episode: https://financeandfury.com.au/how-do-you-know-that-the-share-markets-are-likely-to-be-in-for-a-collapse/
    2. Previous episode: https://financeandfury.com.au/how-to-analyse-share-markets-by-treating-them-as-a-complex-system/
  2. When applying complexity theory to current state of financial markets – exhibit characteristic of the point of criticality
    1. Lack of resilience (fragility – glass v plastic vase), flipping feedback loops = critical tipping points where markets are unstable
    2. In any system – the interaction between chaos and order builds resilience – The criticality of the balance between order and deterministic chaos is an optimal evolutionary solution for systems – too many feedback loops create a loss of resilience
      1. Making it dangerous – likely to enter chaos and then an alternative stable state – think of the gym – overtraining
      2. Know first hand – used to do 10-12 hard workouts a week – after almost 2 years body would shut down
    3. Today’s ep – looking at the things that have created a lack of resilience and what might shatter the vase
  3. Transitions are not inheritably negative – some may trend to order, not disorder
    1. Important point it the identification and the awareness of criticality – and the direction of the transition
    2. And the sensitivity of a complex system to parameters – i.e. ‘deterministic chaotic behaviour’ – ‘chaos is when the present determines the future, but the approximate present does not approximately determine the future’
      1. Butterfly effect – a small change in one state of a deterministic nonlinear system can result in large differences in a later state
  4. First – visualisation or measurement tool – basin of attraction – what is the pull to an unstable state –
    1. Imagine a normal distribution – dome shape – bottom – 0 – 100 – goes up – peak at 50 – basin of attraction is spread out equally over the whole 0-100 –
    2. Now say some point of attraction occurs – the basin of attraction narrows something pulls of the peak down the peak
  5. An attractor’s basin of attraction is the region of the phase space, over which iterations are defined, such that any point (any initial condition) in that region will eventually be iterated into the attractor.
  6. Characteristics and current states of the market – what feedbacks reduced resilience
    1. Extreme indebtedness – i.e. debt saturation – think of the economy like a cloth – it has a limit on absorption – ShamWow can absorb a lot – but a small pond or swimming pool? Think of money as the water and the economy as the cloth – has debt tolerance limits
      1. Despite the record-low interest rates available to service such debt – The falling productivity of new credit lending is visibly at play. (decreasing marginal effectiveness of lending) –
        1. Bank policies are for low-risk high collateral lending – where does it go? Housing
        2. Over last half-decade or so – flipped 20/80 to 80/20 residential to business lending
      2. Rephrased in the context of complexity theory, the basin of attraction is not as steep as before.
    2. Extreme leverage to buy financial assets – NYSE leverage is at all-time highs. A long trip up the basin of attraction.
      1. Extreme monetary policymaking brought the cost of capital close to zero, depriving the system from resilience through preservation of so-called ‘zombie companies’ and other mis-allocation of resources – misallocation of resources
      2. The market is no longer a marketplace where buyers and sellers meet for exchanges – rather a buyers frenzy
      3. Negative feedback loops flipped into positive feedback loops – creating a singularity between public and private flows in hovering up assets price-insensitively – one-sided regular flows
  1. Extreme valuations – markets have reached bubble valuations – disconnected to fundamentals
    1. Using most valuation metrics – the corporate debt to GDP, the price to book, enterprise value on sales and EBITDA
    2. US equity valuations at all-time highs when compared to trend growth – Extreme valuations for bonds and equities simultaneously, now unable to hedge one another.
    3. Patterns of correlation between major asset classes. Bonds and equities have been negatively correlated in last few decades – recently have been positively correlated – worth watching – bonds might not be the hedge
    4. Inability for valuations on Bonds to progress from here – mathematically – due to zero-bound on interest rates and pricing mechanics on bonds – prices are capped out
    5. Other anomalies like European bonds trading at negative yields
  1. Changing the structure of markets – the rise of passive strategies / ETFs – creates price-insensitivity of share markets
  2. Current investments – one-sided risk of the investor community, long-only, fully invested, short volatility
    1. The shift from active managers to passive managed ETFs in past years (for almost $3trn) is only the tip of the iceberg, and encapsulates the difference between risk-conscious and risk-insensitive investing, resulting in the clash between under-weighted longs (active managers) and over-performing longs (passive vehicles). Beyond ETFs, other quasi-passive players prosper as they mechanically go long with leverage, follow the trend or sell vol: the end result is that today it’s all one single giant position, and market risk became a systemic risk.
    2. The structure of markets resembles that of a pressure cooker, owing to the synchronicity of three elements:massive concentration of passive or quasi-passive players (90% of US daily equity flows), massive concentration in few fund players (top 4 Asset Management shops account for almost $15trn in AUM), massive concentration/correlation of investment strategies (90% are either volatility-linked or trend-linked).

 

The Question then becomes one of identification of such critical tipping points

  1. What is the level beyond which a small change can provoke a large swing, a big transformation? What is the last snowflake on the snowpack that the system can take in before transformation?
  2. May be several critical switching points, not just one, on one key variable. The resilience of the system may degrade to some tipping point where a small perturbation can push it into another state. The loss of resilience makes it flip, eventually, at a point.
  3. Like all systems – you have within and from outside – the system and the environment

 

Tipping points within financial markets – where can we go from here?

  1. Valuations may go higher – occurrence of a ‘melt-up’ – US started more QE, same with other central bankers – a possible scenario for markets to continue through their threshold – more fuel in the tanks based around leverage
    1. Cash balances are thin, while leverage is already high – Most investors classed are now close to full investment, between 90% and 100% of disposable assets: private clients, pension funds, insurance companies, sovereign wealth funds, mutual funds, hedge funds – little cash left to put into markets though – so all new funds
  2. But Debt metrics are beyond classic measures of tolerance in several countries – USA, Japan, now in China and Turkey,
    1. Marginal effectiveness of new lending is on the decline – when measured using the credit-to-GDP gap’ of the BIS – shows that the new money being printed and put into the markets isn’t effective in stimulating any growth
  3. When will Quantitative Easing reach its peak – seemed to be running out in mid-2017
    1. Still an active tool in the hands of Central Banks, although capacity constraints are known – but is now expected to continue for a little while before it goes into reverse – which would trigger a big collapse of markets
    2. But the tipping point may be already in – 2017 marked the peak in Quantitative Easing at $3.7trn of asset purchases $300bn p.m.
      1. As this liquidity tide goes off – markets will start to face their first real crash test in 10 years
      2. Only after the QE is ceased will we know what is real and what is not in today’s markets
    3. We will be living through the unintended consequences for many years – zombie companies let to live and saturate the system blocking the rise of newcomers – political instability and populism (critical income inequality).

 

Endogenous Tipping Point: The Market Itself – Every element of today’s markets has a potential tipping point

  1. Now that Central Banks controlling markets – them stepping away from QE, the ‘momentum and volatility factors’ entering turbulent waters are the first suspects – as passive and quasi-passive investors battle one another in a race to the bottom. A sudden rupture can be endogenous, and come from within
    1. Financial booms can’t go on indefinitely, they can fall under their own weight
  2. Obviously, as always, there can be exogenous triggers too, tipping the balance and leading to a rapidly changing state.
  3. Exogenous Triggers – It is because we are the edge of chaos and feedback loops are broken, system is degrading and at risk of deep transformations that triggers matter. In normal circumstances they would matter less and you may expect policymakers to have more of a control upon intervention.
    1. May the trigger be Cryptocurrencies? Left unchecked by regulators, they have grown to a level where they must matter for global systemic risks, at 750 billion dollars, with emphasis on its volatility – come back to this in another ep
    2. May the trigger be China? The extreme credit expansion of recent years seems a textbook case study to prove wrong the theories of a Minsky Moment. A total on- and off-balance sheet bank credit of 40trn, at almost 4 times GDP, a credit expansion well above trend (in danger zone according to BIS credit-to-GDP ratio gap measures), Corporate China at above 250% debt on GDP in only few years, a budget deficit at 13% of GDP (including local authorities) are classic recipes for overdue system failure.
    3. May the trigger be inflation? Presumed by most to be dead, it is showing signs of resurrection, all the while as wages started to react to a tight job market in the US. US rates are stationing right at multi-decades downward trend-lines, the break of which would wreak havoc.
    4. May the trigger be a ‘USD shortage’ or de-dollarization? The drop in the USD creates a drop in what most assets are priced in
    5. May the trigger be political risk – political framework itself may be on the verge of a regime shift under the weight of ever-rising ‘wealth effect’ of QE
    6. The populism in political circles that was visible in 2016 (Trump, Brexit, Italian Referendum) and 2017 (Germany, Catalonia, Eastern Europe) is therefore expected to play an even bigger role in 2020.
    7. There will be an inevitable critical transformation in politics sooner or later due to economics – created by politicians and banking groups – In the words of Will Durrant: “in progressive societies the concentration [of wealth] may reach a point where the strength of number in the many poor rivals the strength of ability in the few rich; then the unstable equilibrium generates a critical situation, which history has diversely met by legislation redistributing wealth or by revolution distributing poverty.” Rephrased by Justice Louis Brandeis, ‘’we can have vast wealth in the hands of a few or we can have democracy. But we cannot have both.’’

 

In Summary

– All the signs are there but what the trigger is – who knows – next week we will look at the chances of Australian market going up from here

– RBA increased M1 massively in the past few months – sign of the first QE moves which would push market prices up

 

Thanks for listening, if you would like to get in contact you can do so here: http://financeandfury.com.au/contact

 

 

 

Are we in a property bubble and if so, why?

Welcome to Finance and Fury,  Are we in a property bubble? There is no question that the Australian property market has become significantly overpriced – but is it a bubble and due for a significant downturn? – For this – only talking about capital cities – most of...

Say What Wednesday: Is this the solution for pollution?

Welcome to Finance & Fury, the ‘Say What Wednesday’ edition. I recently received a great email from Nick, on a fantastic topic. So, I’ll read most of the email as background to today’s discussion;  “Hey Louis, I’ve recently be thinking about an issue that I think...

Can identifying as another gender save you money on your insurance premiums?

Welcome to Finance and Fury, The Say What Wednesday Edition This week question comes from Matt - Not so sure if this is your area of expertise or have come across this at all, although I have a question regarding insurance and identification of gender. People know...

Is Disability Insurance redundant now with the introduction of the NDIS?

Welcome to Finance and Fury, the Say What Wednesday Edition This week’s question comes from John. Hey Louis, Really enjoying your latest episodes, thanks again for the great content. I saw recently there was a question raised around superannuation reform that TPD...

The Foundation Building Blocks of your Financial Future: Budget, Debt Management, and your Balance Sheet

Episode 32 The Foundation Building Blocks of your Financial Future: Budget, Debt Management, and your Balance Sheet Welcome to Finance & Fury! Today’s we’ll be looking at how to start, once you’ve set your financial goals. This is the starting point for anyone...

What is momentum investing and can this be the best investment strategy in a world where fundamentals mean little?

Welcome to Finance and Fury. This episode is about what is momentum investing and can this be the best investment strategy in a world where fundamentals mean nothing?   Over the past few years – value managers – or those that try to estimate the fair value of a...

New Miniseries overview

Hi everyone, and welcome to Finance and Fury. Today won’t be a full episode, unfortunately, I am a little unwell. I am providing a bit of an overview of what the next few episodes will be about. When making investments, it’s all about considering what will be the best...

What are some different forms of currency and which ones are in our best interest?

Welcome to Finance and Fury. Today’s episode – look at the potential kinds of money what are the best kinds of money are the best for the population In the modern economy - The unprecedented expansion of money supply – created some economic and political consequences...

The Cash Bill – stabilising the financial system for negative interest rates, Bail Ins and more, all at your expense

Welcome to Finance and Fury Last Monday's ep – Cash Restrictions Bill – Went through black economy and outline of regulations Today – Go further into implications of this – along with other considerations such as bail-ins and negative rates why bill needed – not for...

Cannibalism, Nazism and property rights

Furious Friday - Part 2 Cannibalism, Nazism and property rights Welcome to Part Two! If you haven't already...listen to Part 1 before jumping into this episode Let’s look at these claims: Means of production owned by the public or state This removed property rights –...

Pin It on Pinterest

Share This