Buckled Up For Structured Criticality

We’re baaaccck!.

We warned in our last post before leaving on holiday, “Look for some large sigma event, which is always the case when we are off the desk.”    How about a vol spike caused by worries over a nuclear exchange?   Nuclear war!

The potential implosion of a presidency?

We think yesterday’s presidential presser has a relatively high probability of being a (or the)  structured criticality event that we could look back to as the tipping point that leads to a very volatile autumn. 

Structured criticality is a property of complex systems in which small events may trigger larger events due to subtle interdependencies between elements. This often gives rise to a form of stratified chaos where the general behavior of the system can be modeled on one scale while smaller- and larger-scale behaviors remain unpredictable.

For example:

Consider a pile of sand. If you drop one grain of sand on top of this pile every second, the pile will continue to grow in the shape of a cone. The general shape, size, and growth of this cone is fairly easy to model as a function of the rate at which new sand grains are added, the size and shape of the grains, and the number of grains in the pile.

The pile retains its shape because occasionally a new grain of sand will trigger an avalanche which causes some number of grains to slide down the side of the cone into new positions.

These avalanches are chaotic. It is nearly impossible to predict if the next grain of sand will cause an avalanche, where that avalanche will occur on the pile, how many grains of sand will be involved in the event, and so on.  – Wikipedia

We love applying the conceptual framework of physics and dynamic systems models to economics and the markets, but think the obssession with the math has perverted the analysis and will someday lead to a doozy of a market meltdown when the algos collide and short circuit on a day to be named later.

In the hypothetical worlds of rational markets, where much of economic theory is set, perhaps. But real-world history tells a different story, of mathematical models masquerading as science and a public eager to buy them, mistaking elegant equations for empirical accuracy.

As an extreme example, take the extraordinary success of Evangeline Adams, a turn-of-the-20th-century astrologer whose clients included the president of Prudential Insurance, two presidents of the New York Stock Exchange, the steel magnate Charles M Schwab, and the banker J P Morgan. To understand why titans of finance would consult Adams about the market, it is essential to recall that astrology used to be a technical discipline, requiring reams of astronomical data and mastery of specialised mathematical formulas. ‘An astrologer’ is, in fact, the Oxford English Dictionary’s second definition of ‘mathematician’. For centuries, mapping stars was the job of mathematicians, a job motivated and funded by the widespread belief that star-maps were good guides to earthly affairs. The best astrology required the best astronomy, and the best astronomy was done by mathematicians – exactly the kind of person whose authority might appeal to bankers and financiers.  – Aeon

Hat Tip:  Jose Cerritelli

We have have repeatedly warned our readers of potential political instability and to watch “the American street.”  See here and here.

Our sense is we are headed for some heated political instability in the United States.

How will it affect the markets? 

Depends on trajectory of events,  but unless inflation or interest rates spike providing competition for risk assets,  don’t expect a bear market to start tomorrow.     We have always lived our financial career by Bagehot’s dictum:

“John Bull can stand many things, but he cannot stand  2.0 , [-1.5 or 1.25]  percent”  – Bagehot

We still maintain yield and return chasers will not retreat to their caves,  with,  the exception of short-term bouts, such as last week, unless policy rates  move up another 100-200 basis points and the monetary bases in the G3 shrink by double digit percentage points though quantitative tightening (QT).  That is how much liquidity (potential buying firepower) is still in the global system,  in our opinion, folks.

What we are looking for?

We still have high conviction the risk markets will experience a swift, short, and steep sell-off in October –  5 to 10 percent – based on:

1) seasonality; 2) the Fed balance sheet should, or could be shrinking ; 3) China’s Party Congress may have concluded, removing the country’s implicit policy put, and thus increasing the risk of a China policy or economic shock; 4) the new U.S. Federal government fiscal year begins October 1 and if the Trump administration has not passed any significant economic legislation, the markets may begin to throw in the towel; 5) there will be more clarity on ECB tapering; 6) even more elevated asset prices as the risk markets grind higher through the rest of summer as we suspect, setting up for a potential blow-off by the end of September; 7) nervousness over the debt ceiling; and, finally, 8) by then, the markets should be sufficiently overbought, overvalued and very vulnerable to event risk.  – GMM

Add to that possible key White House resignations.

What do you think the markets will do if Gary Cohn resigns?

That’s at least worth a 5 percent haircut off the S&P500, in our opinion,  and a spike to 20 in the VIX,  triggering another round of structured criticality.

The exodus of executives sparked talk that Gary Cohn, Trump’s top White House economic adviser and a key liaison to the U.S. business community, might resign in protest as well.

Cohn, who is Jewish, was upset by Trump’s remarks, though he is remaining with the administration for now, sources said.  – Reuters,  August 16, 2017

Cohn may also come to the conclusion that after the August Congressional recess he is wasting his time as he perceives that the Trump administration has lost all credibility on Capitol Hill and none of his policies has any chance of  being implemented.   If rumors begin to spread in mid-September,  markets will begin to wobble, bigly.

If Chief of Staff,  John Kelly,  goes?  Get shorty,  big time.

The 1987 Analog

Since we know crash talk is surely coming, we’ve put together a two-year trading analog of the S&P500 from end of December 1985/2015 to December 1987 and August 16, 2017.

Chart_S&P500 Analog

.

First,  over the 20-month trading period, the 1987 S&P500 outperformed the current 2017 S&P500 by over 31 percent as of today’s close.  Not much of an analog.

Second, the yield on the 2-year increased 287 bps (45 percent) from the beginning of 1987 to the eve of the crash with the 10-year up 252 (33 percent), peaking over 10 percent.   The 2-year is up only 13 bps (11 percent) this year with the 10-year down 22 bps (-9 percent).

Third,  the 1987 S&P500 peaked on August 25th and banged around until October 5th, where it was only down 2.6 percent from the peak.   It then fell 13.6 percent from October 5th to Friday,  October 16, the trading eve of the crash.  On Black Monday,  October 19, 1987,  the S&P500 closed down 20.47 percent, almost double the 1929 crash.

Similarly, the 1929 stock market peaked on September 3, 1929 and fell sharply to close down 32 percent on the eve of Black Tuesday,  October 29, 1929.  That crash sliced 11.7 percent off Dow Jones Industrial in one day.   In both cases, 1929 and 1987 the markets sent a loud signal and warning of an imminent crash as,  a matter of fact,  the markets were crashing before the big crash.

The major difference of the two markets is the Dow didn’t regain the September 3, 1929 peak until November 23, 1954, more than 25 years later.  The 1987 S&P500 reclaimed its August 25, 1987 high on July 26, 1989, less than two years.   Compliments of easy monetary policy and the circumvention of a great depression.

Upshot?

It’s probably time to buckle up.   We expect volatility to begin to pick up;  for the markets to start banging around until October;  then experience a Tower of Terror sell-off sometime in October.

Though the sell-off may be the day the algos go rogue, there is no doubt, the full firepower of the PPT and the Fed will be put to work.   Can they beat this new technology gone wild?

Gotta be quick on the draw as it could be over in the blink of an eye.

Could be wrong.   After all,  isn’t this astrology, folks?

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