The Danger of a De-Risked Financial System

Bubble management is a delicate business, especially when you’re ham-fisted. This is surely the lesson of the week. American central bankers floated a trial balloon. It was a simple idea. Maybe they wouldn’t stay indefinitely committed to buying bonds and keeping interest rates low.

The market’s verdict on the idea was swift and furious. Aussie stocks fell 2.3%. Up until yesterday, the 5,000 level on the S&P/ASX 200 seemed within the grasp. After yesterday…it looks as elusive as ever.

But here’s the real question: should you take the Fed at its word? We know something important now, after the last 24 hours. Central banks can’t easily withdraw their monetary medicine without sending financial markets into an immediate delirium tremens. In order to save the patient, he must be permanently medicated. That’s what you call addiction.

Of course we could simply be over-reacting to the drama. There was a flurry of activity around our St Kilda offices yesterday. Alex Cowie was pounding the table to go long gold stocks. Murray Dawes fired out a sweeping short trade on the banks. And Kris Sayce floated serenely above the mayhem, looking for quality speculations in the small cap space.

Your editor sat and scratched his head. You can’t take these central bankers at their word. Stocks have gotten so far ahead of themselves (and earnings) that the authorities had to say something. They probably did not expect the notes from the January meeting of the Federal Open Market Committee to spark a global sell off. But they probably weren’t unhappy with it either.

In any event, here we are. Should you worry? Well, the time to worry is when you have time to worry. If you have time to worry, then it’s already too late to worry in any productive sense. Take a look at the chart below and you’ll see what we mean.


Source: StockCharts


The black line in the chart above is the Volatility Index (VIX). The VIX is often referred to as the ‘fear index’. The VIX measures implied volatility on S&P 500 index options. In simpler terms, when investors are using options to hedge the risk of a fall in stocks, the VIX picks up. When investors are comfortable with what they perceive as risk, the VIX goes to sleep.

For this reason, we would suggest renaming the VIX ‘the lazy index’, or ‘the ignorant index’, or perhaps ‘the wilfully stupid index’. A low reading on the VIX should be an alarm bell, not an all-clear sign. Any time investors are so content that they find it unnecessary to hedge their longs, they are in for a world of hurt.

You can see it on the chart. The VIX usually spikes after stocks have already begun to fall. This is like putting your seatbelt on after you’ve been in a car wreck. Insurance only works if you buy it beforehand. You hope you never need it. But if you buy it after an accident, not only is it a lot more expensive, but it won’t do you much good either.

But as we write, the market has picked itself up off the tarmac and is now motoring along nicely. The punters will soon forget about getting sideswiped by the Fed. The planned asset inflation can go on until the powers that be decide another wealth-transferring crash is in order. Carry on.

Meanwhile, these big one-day swings are a lot less stressful if you have a long-term plan that you’re sticking to. Our own plan is to buy more gold bullion when it goes down. The panic prices are a gift. It’s tough to recognise key buying opportunities, though. You have to be willing to go against your emotions. But when you encounter one of those ‘hold-your-nose-and-buy’ moments, you have to hold your nose and buy, or be content with being in cash forever.

For what it’s worth – and this is completely idle speculation – we reckon the dominant psychological trend in the market is the fear of missing out on bigger gains. High prices attract buyers. The momentum will build until the nervous punters sitting on cash get right back into the market. This will be the top.

But frankly, timing these moves is getting harder, and that’s assuming it’s even possible. It doesn’t help that you have a bunch of blabber-mouthed central bankers who are having second thoughts about their big monetary experiment. That brings us to a final point.

It’s not really our point. It’s a point made many times by many people, but worth repeating today. The more you try to de-risk a system, the more accident prone it becomes, and the more damaging the accidents are. The economist Hyman Minsky described this in the financial system by saying that stability breeds instability. Using the VIX as a measure of complacency verifies Minsky’s insight.

But it goes beyond the stock market. By using interest rates and monetary policy to try and prevent recessions, central bankers are making the world less safe and more likely to have a horrible accident. They are making the financial system more fragile, the point Nasim Taleb makes in his new book Antifragile: Things That Gain from Disorder.

You might not believe that the world becomes more dangerous precisely because you’re trying to make it safer. But studies show that after the introduction of seat belts, the number of car accidents went up. Why? Well, people must have felt that because the belts made them safer, and made accidents more survivable, it was okay to take more risks, drive faster, and otherwise abdicate responsibility for their own actions.

We’re not saying people get in the car and say, ‘Okay, today I’m going to drive like an idiot.’ Sometimes it looks that way, of course. But it’s a psychological phenomenon we’re talking about. If people are led to believe they are safer, they will quite naturally be less vigilant about risk.

The trouble is, a sense of risk is a highly useful advantage in evolutionary terms. Risk tells you when something big is at stake, and the quality of your actions and decisions matter. If you try to systematically eliminate risk from society – even if it’s out of good intentions – you aren’t helping people at all. You’re robbing them of a basic instinct which promotes their ability to look after themselves. You’re turning them into domesticated bipeds.

Besides, things like the circus would never exist if you completely de-risked society. Last night your editor took a cab down to Docklands with Money for Life Letter editor Nick Hubble. As you may know, Nick is a juggler. But at heart, we sense he’s also the sort of person who’d like to join the circus, but knows he’s not a big enough freak to qualify. Instead of joining, he watches with a kind of envious pleasure. Last night, we tagged along.

It was a Cirque du Soleil show about the love life of insects. Cirque du Soleil was hatched from the mind of a French Canadian. As such, it has that weird awkward charm of French-inspired popular entertainment. There are moments, with all the bright colours and dramatic lighting and live music, that you find yourself enchanted. You’re willing to suspend disbelief because you want to enter into a new, strange and vivid world.

There are other moments when you realise how absurd and comical the whole thing is. Any art that takes itself so seriously while being so self-conscious deserves to be ridiculed, or at least politely laughed at. Maybe this is the charm of the show, though. It’s always delicately poised between two possibilities: childlike wonder and buffoonery.

And to be fair, the circus is only playing at being art. It’s really more like stylised sport, or gymnastics with better costumes. And when it tries to be that, it exceeds all expectations!

There were grass-hopper like men bouncing 20 meters in the air and running up walls. There were tiny Chinese girls dressed as some kind of red ant, juggling things (including each other!) with their feet. There were contortionists, trapeze artists, artistic pole dancers, and an amazing young man who rode a unicycle on a slack line while pedalling with his hands.

You don’t learn how to ride a unicycle upside down on a slack line by avoiding risk in your life. You certainly don’t learn to juggle with your feet by avoiding risk. In fact, if you want to do anything, and if you want to live an extraordinary life (or at least attempt extraordinary things), you have to be willing to risk falling on your face. A few bruises and broken bones are valuable teaching experiences.

The trouble with today’s financial system is that the authorities are trying to de-risk it. By doing so, they’ve suckered everyone into behaving more recklessly. The system has become fragile, and investors are not planning for the long term. They’re engaging in high-risk, short-term behaviour in order to maximise their current position.

These are all symptoms of a culture infected with the inflation virus. As monetary values become less stable, risk-taking behaviour becomes more erratic, without people necessarily knowing (or caring) that their behaviour is high-risk. It’s a circus full of drunken clowns, perched on a high-wire, with no safety net below.

Our advice is to kick back, buy a bucket of popcorn, and enjoy the show. That’s exactly what we did last night. Of course you can only do that if you’re a spectator, which means having an investment strategy where you take a long-term view and do not have to worry about the day-to-day volatility of the market.

To close the week, then, is there salvation in eating popcorn while the world becomes a fabulous but fragile financial circus? Probably not. There are some things not even the free market can give you. Salvation is one of them. There is no options contract or pair trade that can deliver you personal happiness and spiritual calm. For that, you’ll have to look elsewhere. In the meantime, we’ll keep an eye on the circus for you and the reckoning will continue.

Dan Denning
for Markets and Money

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From the Archives…

As Gold Flows Eastward, It’s No Longer Money
15-02-13 – Greg Canavan

The Setting Sun – Japan’s Forgotten Debt Problems
14-02-13 – Satyajit Das

The Phony Boom in Stocks
13-02-13 – Bill Bonner

First Home Buyers Not Interested in the 30 Year Debt Trap
12-02-13 – Greg Canavan

Money, the Discredited Credit
11-02-13 – Greg Canavan

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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