Wednesday, October 30, 2013

Instability Start on the Margins

What is the prudent response when hefty profits beg to be booked and assets purchased with leverage/debt start declining? Sell, sell, sell.

Many analysts have described the core-periphery dynamic: instability tends to manifest first in the periphery and then move inexorably to the core. Social and economic changes work in a similar fashion, originating on the margins of the economy/society and then gaining wider influence/acceptance once roughly 4% of the populace (a 64/4 Pareto Distribution) utilizes the innovation.

Everything from fashion fads to Internet usage follows this model of expansion from the margins to widespread acceptance.

Though we welcome this model of technology and fashion distribution, destabilizing financial crises tend to propagate in a similar way, from the margins/periphery to the core. For example, the "Asian contagion" crisis of 1997 began in Thailand, far from the core of the global economy. Once the crisis infected other Asian economies, it soon disrupted core economies.

In the same era, the losses experienced by one firm, Long-Term Capital Management (LCTM), ignited a financial firestorm that quickly spread to global capital markets.

How do we interpret India's brewing crises in currency devaluation (rupee) and inflation? The conventional view is that these are unique to India and therefore isolated. This was of course the conventional view of the Thai currency crisis of 1997--that it was unique to Thailand, and therefore of little concern to the rest of the global economy.

Financial crises spread not because conditions that triggered the crisis are universal, but because fear and loss of faith are universal emotions. What happens in financial crises is the initial disruption/instability causes participants to ask if risk is truly as low as advertised/assumed in the markets where they're exposed. Prudence demands lowering not just conventionally measured risk but potential risk and perceived risk, both of which may diverge radically from pre-crisis risk measured by various portfolio insurance methodologies.

In other words, potential and/or perceived risk triggers selling, which then raises the premiums on risk management. These indicators of risk then trigger a wider perception that risk is rising, which then unleashes more liquidation of assets. This prudent risk-management selling depresses prices, tripping margin calls, trading stops and thus more selling.

In a financial system that is heavily dependent on leverage, credit, phantom collateral and sky-high asset valuations, selling begets more selling, launching a self-reinforcing feedback dynamic in which selling leads to more selling that then triggers margin calls (i.e. selling assets that were purchased with borrowed money) and technical selling (i.e. selling when critical support levels are broken).

What is the prudent response when hefty profits beg to be booked and assets purchased with leverage/debt start declining? Sell, sell, sell, until the entire profit is booked and all at-risk debt is paid off. Anything less invites risk, loss and even insolvency if declines get away from those who purchased assets with leverage/debt.

Could India's currency/inflation crises spread to other nations? That is an open question, but what could easily spread is prudent doubts about the risks that are as yet unrecognized in other markets. If prudence demands selling first and asking questions later, risk is quickly repriced. That repricing itself triggers doubt, fear and a loss of faith in the supposedly permanent bull markets in bonds, real estate, stocks, 'roo bellies, quatloos, etc.

A financial sell-off doesn't even need a real crisis to spread like wildfire; it simply needs nosebleed asset valuations, excessive leverage/credit and risk priced at "the bull market is guaranteed to last essentially forever" levels. Prudence alone will ignite the conflagration.

Posts and email responses will be sporadic in October due to family commitments. Thank you for your understanding. 

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