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Wheels Started To Come Off

To us, the wheels started to come off in Q4 2018, with a fast melting S&P/Nasdaq, nosediving economic indicators and suddenly freezing credit markets. A bad month was all it took for Central Bankers to have second thoughts, for the supposedly-strong real economy to grind to a sudden stop, for markets to enter histerical convulsions.

 

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Confirmation Of Phase Transition Zone

A fragile financial system, that needs little much to kick off chaotic season, precipitously. The violent recovery experienced subsequently is also itself explained by the  descriptive metrics for complex systems in phase transition zone: it has the name of ‘bimodality / flickering’ (refer to slide 30 here). Strong but slower than in recent years, proving true another key characterisation of critical transition for a system, called ‘critical slowing down’. Slow but steady and progressive, in low volumes at first, indicating passive vehicles drove the market rebound all along. Back to value-insensitive auto-pilot. And back to the happy days of bad news / good news.

 

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A Single Bad Quarter Had Active Managers Burn Years Of Gains

The behaviour of many strategies over the last quarter of last year has information value. The magnitude of losses, together with the speed at which they accumulated, is indicative of the dramatic level of crowding, low diversity and widespread fragility the market has engulfed into. As of the third week of December, during market mayhem, how many managers had burned years of slowly accumulated gains in low volatility, and were plummeting at an alarming pace, in suddenly uncharacteristic volatility? Our thesis of low-diversity market structure met the first real empirical evidence.

The gap between active and passive narrowed more and more, low diversity disseminated, irrespective of the name tag for the strategy at hand. Forget passive vs active, risk premia vs risk parity, CTA vs quant, value investors vs momentum: if one was to do a factor investing analysis of the market as a one big whole, few factors only would explain it all: long Beta, Long Carry, Short Vol, Long Illiquidity. The single mantra of markets has become ‘be long, sell vol’: and you’ll do fine most of the time. And be wiped out in the other few. Remember the perils of crossing a 3 metres wide river, on average, with a 5 metres long bridge. Remember the best performer XIV ETP (up to the very day of r.i.p.). Remember Bertrand Russell’s cheerful chickens, always happy except one single day in their life.

 

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FED Panic Reaction Speaks A Thousand Words

Has the dramatic U-turn by the FED upon a single bad month of market performance been a tangible proof of how fragile the whole market construct has indeed become, or was it just folding to political pressures? How frail has investor and policymakers mentality become, how millennial-type has is morphed into, if a surgeon is used to treat a cold. Or, conversely, was it not just a cold but admission to a deeper malaise? Was a month of market woes enough to justify moving from Quantitative Tightening to Quantitative Easing? Because not hiking rates is not QE, but reinvesting maturing Treasuries is indeed QE. Not enough: active talks of MMT at the end of a 10-year bull run were then also deemed appropriate. Such an epic U-turn has the looks of a smoking gun. Excusatio non petita, accusatio manifesta.

 

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QE-7: Jumping The Shark

The latest attempt at spurring economic growth through yet another round of QE and talks of MMT have the FED enter ‘jumping the shark’ modality! The expression ‘jumping the shark’ is less known to Europeans than it is to Americans, familiar with the TV series Happy Days. It originates from the episode of Happy Days broadcast in Sept 1977 in which Fonzie, dressed in his trademark leather jacket, literally jumps over a shark on water skis (if you don’t believe it.. see it here). The episode, which came at a time when the long-running series was already considered past its best, was seen as the a virtual admission by the programme's makers that the series had run its course, and that they were deficient of ideas.

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Past its peak of marginal effectiveness, beginning a downhill slide to mediocrity or oblivion. The beginning of the end, for the tool.

 

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What Cost Is Too Great To Spur Economic Growth

Artificially boosting the economy and the financial markets with QE and tax cuts simultaneously, in the multi-trillions and for a prolonged period of time, swaps today’s semblance of stability and growth with tomorrow certainty of un-proportional risks to financial stability. Trading short-term solutions for long-term problems. When is it then that too much good money is thrown after bad, and accounts for therapeutic obstinacy? When is it that risks are too great to continue perpetuating the same policy over and over again, while even the slightest retrenchment shows the achievement for what it is: illusory, fragile, un-durable.

Meanwhile, financial systemic risk is only an afterthought.

 

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Asking The Right Questions

In the political arena, the biggest elephant in the room nowadays is unequivocally Income Inequality, progressively leading to political unrest, populism, identity politics and regime changes, in so many countries now around the globe, in a trend that seems well entrenched and set to power ahead.  Critically, Income Inequality is intertwined with QE and ZIRP, unmistakably. As we argued in a recent podcast with MarcoVoices (available here), it is then both surprising and unsettling to see that ‘policy makers never ask themselves, at this very stage, if a certain measure like QE4 or QE-forever out of the Federal Reserve, for example, would increase or decrease income inequality. And we think it’s about time that it does.’ Until it does, the risk of political discontinuity is high, and with it political retaliation against the haves vs the have-nots, against rich corporates vs households, against asset-owners vs asset-free, back feeding into price action at some point down the road.

 

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The Ideal Environment For Gap Risk And Chaotic Market Behaviour

Daily liquidity vehicles, be it ETFs or several other formats in major economies, have never been as large as they are today. Passive auto-pilot vehicles, either in the form of fully-quant funds, systematic, quantamental, CTA or supposedly-active-but-turned have never been as large a share of the total as they are today. Fickle retail investors never had as easy a direct access to markets as they have today through ETFs of the most disparate natures, often overselling liquidity (way above that of their underlyings) and diversification (often a fraction of what is portrayed).

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Unlocked hot money, retail driven, passively managed: the daily liquidity risk is highly underestimated today. With it, the so-called ‘gap risk’, especially overnight gap risk. Which bring us to the real danger in markets these days being the market itself.

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The risk of a $2trn daily margin call or redemption event in markets is not a theoretical exercise, it is indeed now a workable assumption. How would a market showcasing ‘phantom liquidity’ take it? What would trigger it? When the top three asset managers alone command a staggering $14trn of AuM, for the most part retail/daily/passive, the issue should be on every market regulator/participant table, and is not. Against that, there is no FED, ECB nor BoJ put together. A massive move overnight is then made entirely possible, by undiversified retail passive daily money.

 

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The Real Danger Is The Undiversified Passive Market Itself

With a market as full of potential energy and ready for transition as the one we live within, a catalyst is not needed. Or at least not a major catalyst. A small perturbation can be all it takes, at some unidentified point in proximity. The real danger is not trade wars, nor US recession, nor the FED, nor China, nor European Banks, but rather the structure itself of the market, which can implode under its own weight at a moment’s notice.

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Our blueprint for the next crisis is not 1987, 2000 nor 2008. But rather the ‘Quant Quake’ of August 2007. Also referred to as the ‘August factor’. At that time, renowned quant funds, including the famed Goldman Sachs QIS fund, lost 30% in short order: without any apparent reason - which itself tells a lot about market brittleness. Except this time around it may be 10-fold worse, insofar as it would not be isolated to quant funds but rather sprawling across fast through the undiversified passive expensive financial network. We discussed it recently in this outlook: A Glimse at 2019.

 

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Markets In Free Solo Climbing

In free solo climbing, that is rock climbing without a rope, the slightest mistake means certain death. Markets too are progressively pushing to the edge. The risk is that they will eventually find it.   

US Equities – the largest globally - climbed to peak valuations, in more and more passive and undiversified ways across its participants, growingly doing so in daily liquidity formats, higher leverage and weaker collateral than before (as tax cuts and fiscal injections make profits shine). European bonds themselves – the largest globally, in similar and simultaneous fashion, climbed to peak valuations, in defiance of inflation or any other usable metric. Loans in the US, and more surprisingly in Europe too, trade at historically low potential recovery rates, lite as ever covenants (if any), and minimal yields to (not) compensate for. No safety nets / buffers anywhere in sight, and it has been a while now. Clock is ticking.  

  

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Modelling Shock Waves Cascade Effects

In the quantitative analysis that follows, Fasanara Capital’s quants Alessandro and Yaniv created a network model simulation and presented a possible outcome of an idiosyncratic market correction, and subsequent fund redemptions in chain-effect. The results suggest that, in an healthy system, these kind of events should not trigger market-wide distress. However, the loss cascades observed in the market model suggest unhealthy conditions of market fragility. These loss cascades suggest that the structure of the market, as well as unsustainable behaviour by its biggest players, is jeopardising the stability and resilience of the system.

 

That is, the research suggests that there is a systemic fragility in the market, and this may put it at risk of collapse.

The note attached shows the impact on the NASDAQ of a cascade event triggered by an idiosyncratic shock to a single stock, under the current levels of fear and liquidity. It can be noticed that such an event could result in a market-wide drawdown of up to 60%, primarily caused by repeated withdrawal of capital. This is in response to bad performance that, in turn, forces an  asset  manager  to  liquidate  additional  assets  and  put  increasing  pressure  on  prices, eventually causing a market meltdown.