Markets Hang “Between Order and Chaos”
Today we bear dramatic news:
Markets have entered a “phase transition zone”… the “magic space between order and chaos.”
This we have on the authority of the brains at Fasanara Capital.
But what will emerge on the other side — order or chaos?
Today our mood is heavy, our brow creased with thought… as we hunt the answer.
We begin with a hypothesis:
Since the financial crisis, central banks have acted as an overprotective parent… or an overzealous referee of a prize fight.
They have kept the bears separated from the bulls, chained in a neutral corner where they could do no harm.
That is, they have throttled off the violent combats, the savage brawls of the market.
“This stock is worth x,” shout the bulls in a normal market. “No — it is only worth y,” roar the protesting bears.
They are soon upon each other’s throats.
Into a cloud of dust they vanish, arms, legs, elbows, flying — and may the better man win.
Ultimately a winner emerges with the proper price.
The professional men call it price discovery.
Price discovery represents, to mix the figure a bit, the democracy of the marketplace.
Each investor has a vote. His vote may contrast bitterly with the other fellow’s.
But the better ideas will generally win the election… and the worse will lose.
The world is left with better mousetraps, superior companies, happier customers.
An Amazon cleans out a Sears. An Apple pummels a Compaq into nonexistence. A Google shows an AOL its dust.
And so on. And so on.
But after the financial crisis, the central banks rolled in with their tanks… and declared martial law.
The democracy of the marketplace went under the treads.
Is this company superior to that one? Does it deserve its stock price?
No one could say.
QE and zero interest rates put blindfolds over everyone’s eyes… and tape over their mouths.
“Passive” investing waged additional war on price discovery.
“Passively” managed funds make no effort to pinpoint winners. They track an overall index or asset category — not the individual components.
Passive investing has rendered actively picking stocks a fool’s errand.
Some 86% of all actively managed stock funds have underperformed their index during the last 10 years.
Explains Larry Swedroe, director of research at Buckingham Strategic Wealth:
“While it is possible to win that game, the odds of doing so are so poor that it’s simply not a prudent choice to play.”
Despite the gaudy averages, only a handful of stocks accounted for most of the market’s gains these past few years.
Through last August, for example, the FAANG stocks — Facebook, Amazon, Apple, Netflix, Alphabet (Google’s parent company) — accounted for half of the S&P’s gains.
But it was the false stability of Saddam Hussein’s Iraq. Hang the leader and the place goes to pieces.
In October the FAANGs began going to pieces. A period of vast instability resulted.
And the stock market came within an inch of a bear market by year’s end.
Since investors were all going blind, who could take up the load?
Markets began approaching Fasanara’s “phase transition zone.”
In a word… central banks have destroyed the market’s “resilience.”
The market has lost its key function of price discovery, its ability to learn and evolve and its inherent buffers and redundancy mechanisms. In a word, the market has lost its “resilience”…
Our inability as market participants to properly frame market fragility and the inherent vulnerability of the financial system makes a market crash more likely, as it helps systemic risk go unattended and build further up.
It is this systemic risk and loss of resilience that heightens the likelihood of a crash:
Conventional market and economic indicators (e.g., breaks of multiyear equity and home price trendlines, freezing credit markets, softening global [manufacturing]) have all but confirmed what nontraditional measures of system-level fragility signaled all along: that a market crash is incubating, and the cliff is near.
But how close is the cliff?
Complex systems like markets, argues Fasanara (and Jim Rickards), are especially vulnerable in this “phase transition zone.”
The butterfly flaps its wings in Brazil and normally that is that.
But in highly unstable conditions, the butterfly flaps its wings and whips up a hurricane off Florida.
Small inputs, that is, have outsized effects under instability… shifting “order” into “chaos.”
What are some of the flapping butterflies that could conjure the hurricane?
Among the eight Fasanara identifies:
Trade war. China. Oil. Trump and the Mueller investigation.
Any one of these — in theory — could tip markets over the chaotic border.
“Given our overall view for market system instability,” warns Fasanara, “it becomes crucial to monitor upcoming catalyst events, as any of them may be able to accelerate the large adjustment we anticipate.”
Meantime, we remain, suspended in the “magic space between order and chaos.”
Managing editor, The Daily Reckoning