The Flash Recession

By November 29, 2017Blog

The Flash, a comic book superhero possessing super speed and extreme reflexes that appear to violate the laws of physics. The Flash Crash, not a superhero moment, a rapid, deep, and nose bleeding fall in the price of quoted securities caused by high frequency trades operated by computers whose interconnectedness magnifies losses. The Flash Recession, an event that has not yet happened.

Talk to stock market historians and they’ll assign bear markets into three main groups, Cyclical that blow the froth off prices, Eventdriven caused by shocks and Structural, nasty problems in the engine room, the last being the Dot.com burst the response to which morphed into the housing debt burst that caused the GFC. In The Pivot I contend that the structural problem of excessive debt hasn’t been addressed, that the next bubble could be an almost everything type and that we are in an interregnum between events. It is why I’ve been covering Australian housing as a potential weak spot in what may be global events yet to come.

The chart from Goldman Sachs puts into juxtaposition the huge run up in asset prices on the left compared to the much more tepid pace of economic growth since 2009 on the right. One or the other looks like it is going to adjust. The bulls are betting that the game isn’t over just yet and either way they’ll spot it and get you out. They didn’t last time, relying on Economists and Analysts to detect early warnings.

As I explore in The Pivot, conventional models including those relied upon by Central Banks use mathematical models that assumes the world to be one that produces a bell curve of possibilities. These rank extreme events, so called tail risks, as so remote as not to be deserving of attention.

That’s what the Long Term Capital Management fund thought too, before it went wallop in 1998.  That the two leading economists, Myron Scholes and Robert Merton who designed the model had just received the Nobel Prize for economic science, didn’t stop the real world from paying a visit and bringing with it the first near miss to the global financial system.

Goldman Sachs computerized trading repeated the trick in 2007 and required it to lead a bail out of its Global Equity Opportunities fund with billions of dollars in emergency capital because an extreme event occurred. Goldman’s Chief Financial Officer David Viniar explained to the Financial Times “We are seeing things that were 25-standard deviation moves, several days in a row” That’s an outcome 25 periods removed from the central line that splits the bell in half, placing a sigma 25 so far out the tail that it ought not to have happened since the Big Bang.

The models are of course wrong, that’s the problem. Nature keeps producing extreme outcomes more frequently than we are prepared to accept in conventional models. Global economics is transmitted through a financial system that is shaping and reshaping on interconnected feedback loops in a constant dynamic state of change. It is a complex system and it’s not very stable under an excessive debt load.

The Flash Crash

What troubles risk experts is the scope for a new type of recession, one that appears out of the blue in a rapid series of adjustments driven by unexpected interconnections in automated trading and algorithms which have exploded on to the scene since first announcing their potential in so-called flash crashes, sudden bizarre falls in market prices.

These are the unknowns, just what is the capacity for chaos caused by computerized trading acting in concert across unfathomable feedback loops? No one can tell and the understanding may only be reached when inexhaustible AI meets game theory.

You can file away Regulators spotting any impending bother under fiction, financial rules are always built to handle the last crash, after it has happened. Even when there’s lots of evidence of so-called systemic risk, there’s a natural tendency to put the telescope to the blind eye if it means upsetting the establishment. It would be a brave Australian Central Banker who today would go public with a warning that its economy is close to snapping under an excessive housing bubble.

Collectively Central Banks have injected $19 trillion into the prone body of the global financial system after the GFC heart attack. Suffering from negative interest rates large surges from cash deposits into risk assets has put a big focus on cost reductions, inspiring huge growth in passive Exchange Traded Funds that use a variety of computer-based trading to chase up the asset bubble global QE has created. It is a self-fulfilling process, the wall of money pushes up prices to ever higher levels.

Fintech is arriving and with it predictions of AI reducing risk as machines learn the game but these technologies, because they rely on mining data over the past number of years pose obvious risks to users and there is zero data on the effect of a concert of AI acting unison in blinding speed in a unison of feedback loops. So what is least understood is the potential for a small downturn at a time of prolonged calm to spark feedback loops as computers rapidly move to close out positions. But what is the potential for impact on society if we are not out of the woods, merely moved to a darker spot?

Extreme monetary policies haven’t just acted as a transmission vehicle to the balance sheets of the Plutonomy, which I argue in The Pivot, but has bred a disconnection between fundamental value and the prices of many assets as waves of capital chase dwindling yields. Add in feedback loops and, despite the apparent calm with volatility at all-time lows, what we may have is a tectonic zone where one small event could trigger a large one.

As ever, the owners of capital most especially the top 1% who will own AI just as they own any new lever, will see in these events greater opportunities to grow their fast expanding wealth but despite so-called full employment, workers, especially in the US, remain indebted, stressed and cheesed off with median incomes unchanged for twenty years.

So it is not just markets that are a pressure cooker, society has little capacity to rinse and repeat austerity if a fresh crises erupts. The wealthy this time will have cause to worry, so too established political parties that have pandered towards them with trickledown economics. One senses a world poised for change.

So how close are we to fresh pivotal events? No one knows that’s the truth but prolonged calm, such as we’ve seen in markets this year, it has been observed is often the precursor to snap backs because it causes a rush of exponential inflows of fresh money, convinced that the only way is up.

Long periods of stability begets instability, a meteorologist taking a view across LCTM 1998, Dot.com 2001 and GFC 2008 might have another name for the phenomenon; The Eye.

Why this is so and how you can prepare Plan B is outlined in The Pivot now available from Jack & Jill www.jackandjill.ie for €20 all of which goes to finance paediatric nursing hours.

If you’d like to discuss any aspects of the above please do give us a ring on 045 409364 or email eddie@eddiehobbs.com.

Eddie Hobbs, Nov, 2017

Unit W9A1, Ladytown Business Park,

Newhall, Naas, Co. Kildare, W91 T211.

Tel: +353 45 409364

Fax: +353 45 409196

Email: eddie@eddiehobbs.com