The Great Debt Crisis of 2008-10 was the result of inordinate leverage created by arcane derivative instruments like debt tranches, Collateralized Mortgage Obligations (CMO), Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS). Some of them were even further leveraged, eg CDO squared and cubed. The degree of interconnection was extraordinary and once one or two dominoes fell, the result was a disaster.
Fast forward to today. Are there similar leverage and risk transmission mechanisms in place? Yes, there are.
1. Exchange Traded Funds (ETFs): once a tiny portion of markets, they are now very popular with retail investors and speculators alike. The biggest ETFs are index trackers, and they MUST buy or sell to follow the underlying index. There are literally thousands of them, with assets estimated at $11 trillion for the US market alone - that’s a massive 20% of total market cap. To make it worse, a mere 10 companies account for 40% of the entire S&P 500 index, which itself is capitalization weighted. Therefore, a very large percentage of stock owners who MUST follow the index are currently sitting atop an extremely narrow market. The operational market leverage risk is unprecedented. By the way, many of the ETFs are 2x and 3x trackers, using futures and options, so there is even more leverage involved.
2. Algorithmic trading. By definition, algorithmic trading is mechanistic. Create a “formula” and follow it, again and again. A massive 70-80% of all daily trading volume in US equities is now algo based and, more worrisome, some 40-45% of this is retail. Algo is, therefore, another layer of “hands-off, brains out” market participation. Like all algorithmic models, algo trading is optimized to perform well under current conditions and is based on current assumptions. This is strongly reminiscent of the debt “tranching” model which was based on flawed assumptions and precipitated the Great Debt Crisis.
Put everything together: ETFs, algo and an extremely narrow market. The leverage risk transmission mechanism is, in my opinion, very dangerous and prone to a China Syndrome incident. Can anyone throw a switch to prevent it? Can it be done fast enough to stop a meltdown?
Final word: a market exhibiting the above characteristics can be very easily manipulated.
Ah.... Was waiting for you. =)
ReplyDeleteSighz.... unfortunately, you question is easy to answer.
Can anyone throw a switch to prevent it? Sure the fed.
Can they do it fast enough? Sure, they can start printing before a crisis even starts.
=)
Hello there KOC!
DeleteYes, the Fed.. sure, they can backstop margin calls as lenders of last resort. But, today’s risk problems lie mostly in the cash market, I think. The Fed can do nothing if an ETF investor wants to sell or if the algo robot keeps pushing the “sell” button.
Unless, of course, the Fed starts buying stocks directly.
you mean like the Japan govt bought Japan etfs? =)
DeleteThat said, I think the thesis that there is a crisis coming is wrong. We are already in the crisis, and right in the middle of a 1929 selloff. Just plot the S&P in terms of gold, it has gone down by half, and looks like it is getting ready to go down by another half.
btw, I was half right eh?... you can't rise interest rates without getting the second coming of trump.... wrong about the fact that they would not dare raise interest rates. =)
ReplyDelete