"The Truth About Last Friday’s Crash"

"The Truth About Last Friday’s Crash"

by Jim Rickards

"You’re probably familiar with the adage that stocks take the stairs up and the elevator down. Well, last Friday, the stock market took the elevator down. The Dow crashed 905 points or 2.53%. The S&P and Nasdaq indexes had similar falls, about 2.25% each. The reason for the decline was reported to be new fears of the COVID pandemic in the form of the Omicron variant.

Financial writers never have any difficulty coming up with an explanation for extreme market moves, even if the explanation is just an after-the-fact rationalization based on the headline du jour. No doubt the Omicron variant had something to do with the performance on Wall Street. Thin volume and low liquidity were also factors. Still, the bigger story (and the one not reported) is that the stock market was, and is, primed for a fall. And today’s popular investment model only makes the problem worse. Here’s what I mean...

Inflows of cash from passive investment managers have been allocated based on market cap. This means the seven biggest stocks (Apple, Amazon, Google [Alphabet], Facebook [Meta], Microsoft and Tesla) get the lion’s share of the allocation. This drives their prices higher, which attracts more inflows and buying and results in still higher prices.

Market bubbles and ridiculous valuations result when retail investors bid up stocks in the hope that a greater fool will pay them even more when they cash out. In these situations, the market capitalization becomes completely detached from fundamental value, projected earnings or any other tool used in securities analysis. It’s just a bubble with inevitable losses for the last buyers.

But feedback loops of this kind can work in reverse, except the crash happens much faster than the melt-up because of tight stops, redemptions, margin calls and a mad scramble for liquidity. And unfortunately, each crisis is bigger than the one before and requires more intervention by the central banks. The reason has to do with the system scale. 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.

Today, systemic risk is more dangerous than ever because the entire system is larger than before. 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. 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 ability of central banks to deal with a new crisis is highly constrained by low interest rates and bloated balance sheets, which have exploded even higher in response to the pandemic.

What I just described is an unsustainable feedback loop especially in view of a slowing economy due to supply chain disruption, the new virus variant and, yes, monetary tightening. The Federal Reserve is about to screw up. Again. The Fed announced their latest tapering program (reductions in asset purchases with printed money) a few weeks ago. The plan was to complete the taper by June 2022 and then begin a series of interest rate hikes in the second half of 2022 with a view to normalizing interest rates at around 2.25% by late 2023.

The Fed can’t make an accurate six-month forecast, so the idea that they can forecast the economy and set monetary policy two years in advance is absurd. The bigger point is that the Fed tried this before and failed. They tapered from 2013–2014 and then raised rates from 2015–2018 at which point the stock market crashed 20% in the three months from October–December 2018. After that, the Fed put rate hikes on hold and then eventually cut them to zero and added new asset purchase programs during the pandemic in 2020.

The latest from the Fed is that they may accelerate both the taper and the rate hikes in this new effort to escape the room. They will fail again. The economy is weakening due to supply chain disruption, new pandemic virus variants and low labor force participation among other factors. The Fed should be on hold until the situation clarifies. Instead, they are plunging ahead by tightening into economic weakness.

It’s just another in a long line of blunders for the Fed. Unfortunately, it will prove very costly to investors who mistake tightening for a strong economy. We don’t have a strong economy. We have a wrong-headed Fed. You still have time to lighten up your equity exposure and allocate more to cash and hard assets like real estate, gold and silver. It’s much better to be a little bit early than one day too late.

Below, I show you why the next market swoon could spiral rapidly out of control before anyone can stop it. Read on."

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"Robot Trading Will End in Disaster"

by Jim Rickards

"Today, stock markets and other markets such as bonds and currencies can best be described as “automated automation.” Here’s what I mean. There are two stages in stock investing. The first is coming up with a preferred allocation among stocks, cash, bonds, etc. This stage also includes deciding how much to put in index products or exchange-traded funds (ETFs, which are a kind of mini-index) and how much active management to use. The second stage involves the actual buy and sell decisions - when to get out, when to get in and when to go to the sidelines with safe-haven assets such as Treasury notes or gold.

What investors may not realize is the extent to which both of these decisions are now left entirely to computers. I’m not talking about automated trade matching where I’m a buyer and you’re a seller and a computer matches our orders and executes the trade. That kind of trading has been around since the 1990s. I’m talking about computers making the portfolio allocation and buy/sell decisions in the first place, based on algorithms, with no human involvement at all. This is now the norm.

Eighty percent of stock trading is now automated in the form of either index funds (60%) or quantitative models (20%). This means that “active investing,” where you pick the allocation and the timing, is down to 20% of the market.

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. But in all, the amount of human “market making” in the traditional sense is down to about 5% of total trading. This trend is the result of two intellectual fallacies.

The first is the idea that “You can’t beat the market.” This drives investors to index funds that match the market. 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 the late Jack Bogle of the Vanguard Group. Bogle insisted that passive investing is superior to active investing because of lower fees and because active managers can’t “beat the market.” Bogle urged 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.

Since 2009, over $2.5 trillion of equity investment has been added to passive-strategy funds, while over $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 overwhelming the elephant.

The second fallacy is that the future will resemble the past over a long horizon, so “traditional” allocations of, say, 60% stocks, 30% bonds and 10% cash (with fewer stocks as you get older) will serve you well. But Wall Street doesn’t tell you that a 50% or greater stock market crash - as happened in 1929, 2000 and 2008 - just before your retirement date will wipe you out. But this is an even greater threat that’s rarely considered…

In a bull market, this type of passive investing amplifies the upside as indexers pile into hot stocks like, for example, Google and Apple have been. 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.

Index funds would stampede out of stocks. Passive investors would look for active investors to “step up” and buy. The problem is there wouldn’t be any active investors left, or at least not enough to make a difference. There would be no active investors left to risk capital by trying to catch a falling knife. Stocks will go straight down with no bid. The market crash will be like a runaway train with no brakes.

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. 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.

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.

It comes back to complexity, and the market is an example of a complex system. 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.

Passive investors may be enjoying the free ride for now but they’re in for a shock the next time the market breaks. Welcome to the world of automated investing. It will end in disaster."

- dailyreckoning.com