Dangerous thoughts on the next crisis


There's an old trading aphorism that markets climb a wall of worry. Over the past 8 years, that wall has been even higher than usual. Every downward move triggered PTSD for investors who experienced the sickening plunge in 2008-09. And yet we find ourselves in 2017 with the Eurozone intact, the US humming along, and no sign of a collapse in China. Rising prices and valuations have brought relief, and perhaps even complacency to the average investor.

That complacency makes me nervous. It's not as catchy as being "fearful when others are greedy", but it seems prudent to "be cautious when others are complacent." Investors get paid for bearing risk (whether real or perceived), and when everyone is willing to bear risk, returns are compressed.

It's not all gloom and doom. I think there are a few good reasons why we're unlikely to see an economic collapse of the scale of 08/09 any time soon, since that period suffered from a horrendous combination of factors:

1) The proliferation and failure of complex financial instruments, many of which were considered "safe assets"

2) Concerns that the financial system was going to implode as systemically important banks collapsed

3) Excessively tentative monetary policy as a result of:

a) Misguided fears about oil prices and inflation expectations

b) Lack of belief in the power of unorthodox tools at the zero lower bound

c) Authorities who were distracted by the constant fire-fighting of the financial crisis

4) Investors and consumers who didn't believe that monetary policy could work, leading to an even greater demand for money and consequently lower spending and risky asset prices

None of these conditions are likely to exist in the next crisis. Monetary authorities have the tools to prevent a fall in nominal spending. Investors and consumers are much less likely to fear that the world is coming to an end. This is, frankly, great news for the stability of the global economy.

But there's a reason I've called this post "Dangerous thoughts on the next crisis":

i) Economic activity may not fall as much as it did in 08/09, but stock prices can. Falls in asset prices are about relative expectations, not absolute declines in economic activity. If investors believe in a rosy - or at the very least, less volatile - future, stock prices can fall dramatically when that future doesn't materialize (and let's be honest, volatility is part and parcel of markets).

ii) The next crisis will almost certainly not be centered on US real estate and the global banks. Investors and policy-makers who are looking at those sectors will miss warning signs.

None of this is to suggest that another crisis is around the corner. In David Tepper's immortal words, "I'm not saying go short, I'm saying don't be too frickin' long." The only problem is that Tepper made those comments THREE years ago. He's continued to be long stocks, and has undoubtedly done well for his investors over the last three years. But those lucky souls have David Tepper looking out for them. The average investor doesn't. The average investor has probably taken the rally in risky assets over the past 6 months as an "all clear" signal. But when you're climbing a wall of worry, that sort of complacency can see you losing your footing all too quickly.