Last week’s commentary covered the potential arithmetic reality of future buy and hold investment returns for major US stock market indexes - they are likely to be quite poor over the next decade. With the ‘weighing machine’ suggesting such poor future returns, surely people are rational enough to allocate their precious resources efficiently?
This is just one of many examples of mania- despite future returns likely to be poor to a historic degree, people have been flooding into US stocks at a record pace.
Not only have flows into stocks been at record levels, but so has the use of leverage. But good old fashion margin-financed speculation is nothing compared to we modern degenerates!
That graph is from this WSJ article from September, showing how notional value of options exploded this year to surpass a cash market also going parabolic. Here is equity option contract volume from the same piece:
Notional gross value of global OTC derivatives as of June 30, 2021, was over $600 trillion according to the Bank of International Settlements (BIS). But legal fiduciaries who are advised by professional consultants surely would not get caught up in all this, right?
That chart shows asset allocation for the ‘P7’ pension systems for the US, UK, Japan, Australia, Netherlands, Canada, and Switzerland. While public equities are at a 20 year low, the ‘Other’ category includes alternatives like private equity, venture capital, hedge funds, CTA’s, etc., which tend to include significant embedded leverage. The combination of the two was at about 69% as of the end of 2020, or near a record high, despite funding levels being deficient in some countries, such as the US.
I could go on and on, but hopefully you get the point. Seemingly ‘everyone’ is caught up in the mania, and piling into risk assets, but also using record levels of leverage in order to do so. Common sense may suggest this will end badly….eventually. But what about timing?
I ventured into complex systems analysis starting in 2005. At best my knowledge is that of a ‘rocks for jocks’ academic standard, like the stereotypical big dumb jock who takes a watered down science class just to meet a requirement to graduate. But even a dumb jock can apply some of the simple concepts, such as self-organizing criticality, fractals, and power laws.
Despite this analytical framework maturing since the late 1980’s, it has been slow to be adopted in mainstream finance. This offers an information advantage to those at least aware and able to apply the basics.
Like the famed sand pile model central to the original science on self-organizing criticality, I think of leverage and flows as grains of sand - i.e. they contribute to building the financial sand pile. As the pile grows, it can appear stable to the eye, but all the while the system grows increasingly unstable as the level of criticality in the system increases.
Unfortunately, I am not aware of a way of predicting which grain of sand will ultimately catalyze the ‘avalanche', or the system’s release of energy via a phase transition as part of its move back towards a sort of equilibrium. For example, the common narrative on the 2007-2009 global financial crisis has been about subprime mortgages and Lehman Brothers being the ‘causes', but analyzing from a complex systems framework offers clarifying perspective.
The markets and global economy were inherently unstable, as the system had reached hypercritical conditions. Leverage and a prolonged global economic expansion had built the sand pile up to a very high level. This inherent condition was the ‘cause’, with accompanying deleveraging and risk assets declining symptoms of the pile collapsing in an avalanche.
So what does all this suggest for where we may be in the current market mania and mass delusion? The sand pile is likely the highest the world has ever seen, which suggests that underlying system conditions have never been more unstable. Given these initial conditions, and thinking of this through the lens of a ‘sand pile', my expectation is that a phase transition from the sand pile growing to an avalanche should be commensurate with the scale of hypercriticality and resulting high degree of pent up ‘energy.’
We’ve seen some signs of this impacting the most speculative areas of the US stock market. Here is a monthly log chart of the Ark ETF, which is analogous to the dot com and internet funds of the late 1990’s, IMO. Major holdings include huge mania stocks such as Tesla.
Thinking of this as a sand pile being built, we can then monitor for what may look like an ‘avalanche.’ Here is a daily chart over the last year:
Can see the initial drop off the peak on February 22, 2021, was severe, or my preferred term: impulsive. So initial conditions being hypercritical? Check. Signs of a significant ‘avalanche’ having occurred or at least started? Check. Are there any signs of other characteristics of complexity? Any fractals, power laws, or 1/f noise?
That is my rocks of jocks crude attempt at ‘fractal’ analysis. While this mega-momentum market segment has displayed these classic characteristics, the broader market indexes have not, as of yet. Here is the Nasdaq 100 (NDX) daily log chart:
Does not look very impulsive to me. But what complex system are we actually monitoring here? In my mind, financial markets are simply a manifestation of billions of flawed humans interacting, and a fractal of that larger system. My guess is that the recent avalanche in the most speculative market segments is indicative of that larger sand pile having already started, and that the broader US stock market will be a fractal down wind, as more and more markets get consumed by the invariant scaling. How about Germany? Here is the daily - looks pretty impulsive:
Here are the last 30 days via an hourly chart, where I’ve drawn in my crude fractal/power law tool:
Note the self-similar scaling in price behavior- now let’s look at the daily again for potential further scaling:
Appears pretty robust to me, but we haven’t seen similar yet in the broad US markets. When and will that occur? No idea, but remain on high alert looking for signs if/when it begins to transpire. Is it possible that the recent avalanche in things like ARKK, Chinese markets, etc., will re-establish a sort of temporary equilibrium from which the sand pile ascends to even higher new highs? I have learned the hard way not to underestimate the madness of crowds. Should have listened to Newton years ago:
“I can calculate the motion of heavenly bodies, but not the madness of people.”
- Isaac Newton after losing much of his fortune in the South Sea bubble