Finance

The “Flash-Crash On Steroids” Scenario

The “Flash-Crash On Steroids” Scenario

Authored by Bruce Wilds via Advancing Time blog,

An interesting way to exercise the brain is to imagine what some of us might consider the unimaginable. That is what I ask you to do now. Many investors continue to believe that even if the stock market drops they will be smart enough to get out after taking only a minor hit. Others simply think no way exists for these markets to fall sighting a lack of investment alternatives and what they see as the Fed put having their back.

After the financial crisis in 2008 when the market took nasty and violent swings many investors came away with the feeling they learned a few things that will enable them to leap to safety before it is too late. That brings us to today.

Almost everyone agrees that after years of moving ever upward this bull market is long in the tooth. Today with  the economy rapidly slowing and debt across the world having exploded it seems any opportunity to panic the bears should not go unexploited. It is against this backdrop that one allows optimist fellas to think, this time is different.

The thing many investors are not taking into consideration is that if the market falls like a flash crash on steroids they could be trapped. We have been assured that can’t happen because circuit breakers have been put in place to arrest panic-style moves, however, imagine a market that falls, trade is halted, and the market simply does not reopen for days or even weeks. As remote as this might seem remember Japan’s stock market has failed to reach the high it made decades ago. Today the Nikkei 225 trades around 25,750 even with the BoJ buying huge amounts of ETFs. See the 1980 to 2015 chart below.

Japan’s Nikkei 225 has yet to reach the high it made decades ago

Also, please take a moment to consider the possibility and the far-reaching ramifications of stocks falling from grace. Not only would active stock market investors get hammered but pensions, 401 plans, and a slew of other investment programs would be affected. While you are imagining this scenario realize that America’s stock market is the gold standard and consider how less stable global markets would react in countries like China and Brazil.

For a long time, I have been trying to develop a scenario for a market “super crash” and a reasonable map that would arrive at such a situation. To say I’m negative about this economy is a gross understatement. I saw the last housing bubble coming and predicted the crash. I continue to contend that we have never recovered from the Great Recession or corrected the many problems that haunt our financial systems such as derivatives and collateralized debt obligations. By printing money, imploding interest rates, and exploding the Federal Government’s deficit we have only delayed the “big one.”

These two quotes on macroeconomic stabilization and crisis speak volumes. First, from Macresilience;

“As Minsky has documented, the history of macroeconomic interventions post-WW2 has been the history of prevention of even the smallest snapbacks that are inherent to the process of creative destruction. The result is our current financial system which is as taut as it can be, in a state of fragility where any snap-back will be catastrophic.”

And next from Nassim Taleb (author of The Black Swan);

Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite.”

These quotes suggest an analogy with ideas about forest management when natural fires are suppressed. If random fires do not periodically clear away forest underbrush, we see a build-up of flammable material sufficient to power a massive conflagration. I certainly think an equivalent truth applies to financial markets. The longer it has been since a painful collapse, the greater the willingness to pile on leverage and complexity, such that the next crisis becomes unmanageable. The “Too Big To Fail” and other policies implemented since 2008 have distorted markets across the globe and laid the groundwork for “The Big One”, or what we will someday look back on as the mother of all sell-offs.

Over the years not only have we witnessed many cases of government overreach and many rule changes to protect the system at the expense of the people. What happened in Cyprus years ago should serve as a warning to anyone who thinks money in the bank is safe. A bad haircut, in this case, means you have been robbed. That may be the case if the government reaches in over a long weekend and steals money from your bank account. This is a horrible precedent to set, and the worst part may be how many people accept it saying it is OK as long as it is only on the larger accounts and only impacts the savings of someone else! It is very important to remember these low-interest rates come at a price, a dark side exists to current economic policy. In the long run, the benefits they bring may be outweighed by the distortions they cause.

By not taking steps to correct many of the ills lurking in our financial system we have made things worse. Absent are actual structural changes necessary for our economy to become sustainable. Instead, we have put band-aid upon band-aid, upon band-aid while what was necessary was the amputation of a diseased limb. After all the threats that this market has avoided, and sidestepped, some investors have come to think of it as invincible. This market has overcome a struggling euro, the financial cliff, the end of Greece as we knew it, a trade war, and a global pandemic.

Back in August of 2016, in a similar article, I warned about being complacent in dangerous times. My studies in “microeconomics,” and observations in the current real estate market, both as an owner and hands-on landlord allow me to predict, that we ain’t seen nothing yet! While Knowing such a flash crash is highly unlikely it is important we consider it could happen. Remember, none of the oil traders foresaw the oil contango  that occurred in 2020 and shook the oil industry to its core.

Tyler Durden
Fri, 05/20/2022 – 08:23

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