Investors Would be Well Served to be Prepared for Non-Equilibrium Events.

It’s that time of year, when people, usually safely ensconced behind their devices, have to look up and face the crowds. Expect long lines on Election Day, long traffic jams during Thanksgiving, and (despite a huge shift to Internet shopping) long lines at the stores. Nowhere are people facing larger crowds than in politics and markets.

Data-oriented practitioners have officially reached celebrity/rock star status. It’s hard to argue with their success. Nate Silver built a business with 8.7 million unique monthly visitors based on his sober data analysis of the 2012 U.S. presidential election. Theo Epstein is two Cubs wins away from adding Chicago to the list of cities he will never have to pay for a meal in.

Relying on this success, many in our business, media, and political establishment have indiscriminately put their faith in the data. In particular, much of the political and media class has staked its reputation on the Equilibrium outcome, a Hillary Clinton win. There is no greater crowded trade in politics. No one has more to lose than this group were a Non-Equilibrium outcome to occur, that, of course, being a shock win by Donald Trump. Many media personalities, cable news talking heads, and politicians would lose credibility or even their jobs.

I have repeatedly written that in a Non-Equilibrium environment, you cannot rely blindly on data models and their predictions. In a given system, participants can sometimes, seemingly out of nowhere and often without central coordination, do the same thing. This is the core principle of self-organizing criticality. The event is then post-facto viewed as a shock, as something unexpected, as an extreme event. There often are no data models that can predict these events. The challenge for scientists is to identify when the conditions are ripe for such an event in systems such as earthquakes, politics, traffic patterns, and financial markets. It is by no means a perfect science.

Disciples of data would benefit from a study of complex systems. Every so often, data science fails. When it does, it fails spectacularly. That is how you explain President Reagan being behind 8 points in polls in late October 1980 and then winning 44 states. It’s how you explain President Obama emerging from obscurity to defeat Hillary Clinton in the 2008 Democratic primary. It explains how many forecasters including Nate Silver missed the rise of Trump. The ground shifted under everyone’s feet in 1980, 2008, and 2016. Very few saw it coming. It is in those moments that complexity science wins.

Financial markets, for much of the last 14 months, have been a state of Non-Equilibrium. Investors have weathered numerous shocks. I have discussed them here, here, and here.

Since ending August at 2170.96, the S&P 500 index fell 2.1% to end October at 2126.15. This, during a period of time when the Equilibrium candidate Hillary Clinton established a dominant lead in the polls. This price action goes against conventional wisdom that the market prefers the Equilibrium candidate. I respect the fact that market participants may simply be gun shy, fearing a Brexit replay. Recall that on June 23rd, risk assets traded up with abandon, even after the New York market close with S&P 500 and British Pound futures hitting swing highs in the overnight session, before collapsing.

Okay, so markets are neither at all-time highs nor seem gripped by euphoria. Can I conclude that investors are “better” prepared for a Non-Equilibrium event?

I remain concerned. Investors may be fighting yesterday’s war. Regardless of current price levels, the world’s largest asset markets seem to have become massively crowded trades.

  1. Investors have chased riskier assets, seeking return in a zero/negative interest rate world. For example: Investors have bid up high-yield bonds significantly this year. The IShares High Yield Corporate Bond ETF is up 5.75% as of today. Also, investors have piled into longer-dated bonds chasing yield, resulting in a noticeable rise in duration. The average duration of Barclays U.S. Aggregate Bond Index was 5.46 today, well above its 10-year average of 4.9.
  2. Passive investing continues to grow, driven by hard-to-beat numbers from an eight-year bull market in stocks. Passive investing has concentrated investors into the same names. According to the Wall Street Journal, Vanguard’s US based passive funds owned 5% or more of just 3 S&P 500 companies in 2005. Today, that number is 468. Respected market analyst Nikolaos Panagirtzoglou, Managing Director of Global Market Strategy at JPMorgan recently stated: “The shift towards passive funds has the potential to concentrate investments to a few large products. This concentration potentially increases systemic risk making markets more susceptible to the flows of a few large passive products.”
  3. Markets are as interconnected as they have ever been. This is not news, but what is worth repeating is that this interconnectedness is heightened by a low rate environment, as valuations in asset classes such as stocks are boosted by low rates. Ray Dalio, founder of Bridgewater Associates, the world’s largest hedge fund, recently said during a speech delivered at the Federal Reserve Bank of New York’s 40th Annual Central Banking Seminar on Wednesday, October 5, 2016: “For example, it would only take a 100 basis point rise in Treasury bond yields to trigger the worst price decline in bonds since the 1981 bond market crash. And since those interest rates are embedded in the pricing of all investment assets that would send them all much lower.” Respected market analyst Mario Kolanovic of JPMorgan has repeatedly said that pervasive quant strategies in use by large funds, namely option hedges, volatility targeting, managed futures CTA, and risk parity, exacerbated selling during the last few market shocks and will do so again.

Let us follow a possible sequence of events:

  1. A Non-Equilibrium event unleashes shockwaves on global markets.
  2. Positioning in the bond market causes significant losses
  3. Selling spills over into correlated and underpinned markets such as equities
  4. Concentrated passive investments absorb significant losses. Active investors rush to the door.
  5. Selling is exacerbated as risk parity, volatility, and managed futures CTAs all sell in response to model signals.
  6. The rush to exit large crowded trades through a small door strains market stability, liquidity, and counterparty robustness.

A taste of this happened last August-September and can happen again.

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Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the author only. There can be no assurance that developments will transpire as forecasted and actual results will be different. Accuracy of data is not guaranteed but represents the author’s best judgment and can be derived from a variety of sources. The information is subject to change at any time without notice.