Weird begets weirdI said in an earlier piece on this topic:
I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.
So what’s weird now?
- Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
- Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
- Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
- Students and middle-to-lower classes borrowing too much (autos, credit cards)
- Interest rates and goods and services price inflation stay low in face of this.
- Low volatility (until now)
- Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks (smaller percentage on a big base)
- Low credit spreads
- Preservation of capital
- Dry powder
- Not finding opportunities
- Momentum gives way to negative arbitrages.
- Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”
Again, this is one where people are very used to selling every spike in volatility. It has been a winning strategy so far. Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored. Again, when the big volatility spike hits, remember, I warned you. Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer. Do you have enough wherewithal to survive a longer bull phase? To all, I wish you well in investing. Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail. And, all asset classes eventually go through failure.
So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap. Do you have the flexibility to buy in at better levels? Should you even touch it if it is like a knockout option? There are no free lunches. Get used to that idea. If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent. Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation. Where is debt building up? Are there unusual derivative positions building up? What sort of parties are chasing prices? Who is resisting the trend? And, when markets are falling hard, remember that they go down double-speed. If it’s a lot faster than that, the market is more likely to bounce. (That might be the case now.) Slower, and it might keep going. Fast moves tend to mean-revert, slow moves tend to persist. Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again. And once they have sold, the panic will end, and growth will begin again when everyone is scared. That’s the perversity of markets. They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad). Don’t let this situation be “too bad” for you. If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down. Preserving capital is not imprudent, even if the market bounces. In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions. Then when markets get weird, you can smile and bear it. The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”