Now and then, financial market prices can fall much more than almost anyone expects. What’s different about those occasions, compared to more familiar, relatively moderate volatility? Maybe earthquakes and violent weather hold a hint.
Research into investor behavior has shown that people more readily take a chance when they see other people doing the same thing. This insight helps to explain the popularity of so-called “momentum” investing.
If people are influenced by what they see other people doing, even just a little, it produces what physical scientists call positive feedback effects. Events influence subsequent events. A system that operates with positive feedback is called a dynamic system. It will not necessarily run smoothly or average out over time. By nature, it can flip between calm and storm.
Dynamic systems can exhibit chaotic behavior quite abruptly after long periods of seeming calm. No one sees it coming. Yet, in hindsight, the event appears easily understandable as a buildup of stress in a system where one thing leads to another. Think of tornadoes, earthquakes. What about financial crises?
The chaos aspect of dynamic systems deserves a moment’s thought. Events can be very sensitive to small differences in initial conditions. One example is the so-called “butterfly effect.” It is said that the flap of a butterfly in Africa can launch a hurricane onto the U.S. coast. Yet, no one watching the butterfly would suspect it.
Benoit Mandelbrot’s wonderful book in 2004, “Misbehaving Markets”, establishes a mathematical basis for understanding financial markets as dynamic systems. The author’s work in this field goes back into the 1950s, and has been well accepted in the natural sciences, but went largely overlooked by economists until recently.
A recent book by a physicist takes a really hard look at financial markets and economics as dynamic systems. Forecast: What Physics, Meteorology, and the Natural Sciences Can Teach Us About Economics, by Mark Buchanan, relates the frequency and magnitude of sudden, large market movements to statistics for earthquakes. Both, he says, result from stresses that build slowly but release violently. Much of the book focuses on stresses that he sees shaping the financial crisis of 2008:
- leverage,
- complexity,
- crowding, and
- interconnectedness.
Market stress increases directly with financial leverage, that is, the use of borrowed money. At low levels, debt can enhance economic activity and investment returns. This happy result tempts investors to use even more debt. At some, high level, debt becomes destabilizing and destructive. No one ever knows where the boundary lies, but things can fall apart very quickly on the wrong side of it. For example, debt levels in the mortgage marketplace increased for years before reaching a level where the default rate spiked abruptly higher.
Complexity, such as the derivatives-on-derivatives phenomenon portrayed in Michael Lewis’s book, The Big Short, made it both easier for more financial institutions to get in on the action and more difficult for their managers to gauge the risks they were taking. One aspect of the complexity was that the new derivatives obliged financial institutions to make large payments to each other very quickly if too many mortgages defaulted.
Crowding came into play when financial institutions across the board basically demanded that other institutions make the large payments as promised. Immediately. Those who could not do so, such as Lehman Brothers, became insolvent literally over a weekend. This also highlights the fourth pathway.
Interconnectedness forces market participants to consider the actions of others when making uncertain, risky decisions. As recently as the 1980s, a defaulting mortgage was a problem only for the local financial institution that made the loan. By 2008, it became a problem for a global web of banks, insurance companies, pension plans, and investment funds.
In February of this year the U.S. stock market suddenly veered lower, plunging nearly 10% in a few days before recovering part of the decline. Analysis of this event points to margin calls, in which investors who borrow heavily to buy stocks are forced to sell stocks immediately after share prices fall. The selling can push stock prices down more, prompting further margin calls. The episode burned out in a few days but serves as a reminder that stresses grow with debt.
Trade policy is in the news again, as happens every few years. Tariffs come and go. The specifics can be a distraction. Rather, we’re watching developments with interconnectedness in mind. For decades now, businesses everywhere have increasingly sourced their inputs and sold their products globally. The world may be more dynamically interconnected by trade than ever before. The more dynamic, perhaps the more sensitive to small changes in trade policy.
Think of that butterfly. With increased interconnectedness, unintended consequences of a policy decision may unfold faster and more disruptively than might have been the case in the past.
BerganKDV Wealth Management recognizes that markets may have dynamic characteristics. It tells us that volatility can switch abruptly from “mild” to “wild”, as Dr. Mandelbrot put it. Financial plans can address this possibility with liquidity and asset allocation decisions designed to withstand infrequent episodes of severe market instability, and potentially even to avail opportunities that may appear at such times.
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