Written in Chiba, Greater Tokyo area, midst of earthquakes and nuclear radiation.
“Financial systems are more interconnected (i.e., globally) than ever. Changes that affect the whole world can and do happen in a matter of minutes and seconds.”
Megasignals – Glocalization and Openness in the Age of Turbulence, T. Arina, S. Inkinen, J. Parda, February 2011
The recent events in Japan, North African and Arabian countries highlight what we published timely just about a month ago.
In Japan, TOPIX dropped over 7% in the day of earthquake and then over 12% more on Monday 14th. The financial markets have become extremely volatile. Since the financial systems are so extremely interconnected, wipe out of wealth can happen literally in matter of minutes and seconds. Moreover, The whole financial system is extremely leveraged, which causes further amplification of excessive flash crashes and flash recoveries – TOPIX then rebounded on today Tuesday massive 6% almost just as easily as the sell-off occurred.
The key point to take away from this is markets are neither necessarily efficient nor distributed normally. That changes the whole outlook how one should view investing and trading of financial assets. Buy-and-hold strategies are not likely to work in times of extreme crisis, because diversification and long holding period strategies rely on theory of normal distribution and efficient markets. Years of market value accumulation in a common stock of a company and stock index can be wiped out in matter of seconds, changing ones retirement plans and dreams for good. Similarly it can change fortunes of a company for good.
Furthermore, Japan case highlights that markets are not necessarily efficient – sell-off spread first to all Asian markets and all financial assets everywhere, including the ones that have absolutely zero-exposure to Japan. This naturally creates possibilities for smart investors to buy stocks which intrinsic value is higher than price quoted in extreme shocks and offload them when flash recovery occurs. Stocks, commodities, currencies, and other financial assets that have almost no exposure to the event but move in tandem with rest of the market in global sell-off are likely to offer best returns.
One may be able to create more profits from investing in matter of days than from buy-and-hold strategies in matter of years – major stock indexes are pretty much where they were 10 years ago.
Pyramid economy?
“I believe that basically the system is broken and needs to be reconstituted. We cannot afford to have the kind of chronic and mounting imbalances in international finance.”
– Hungarian-American investor and visionary George Soros (October, 2009)
In current financial system, fiat monetary system, the amount of money can theoretically be increased to infinity. Incorrect monetary policies will lead to asset bubbles, overall debt in the system. Due to quantative easing by governments (printing money in common language), we have enormous leverage and liquidity in the financial systems.
Therefore, smaller events lead to massive crashes. The challenge for investors and traders is the kurtosis risk, that the flash recovery will not occur and the wealth is wiped out for a very long time, or for good, as happened in early 2000 tech sector crash (“.com crash”). Investors investing with well-diversified buy-and-hold strategy within the sector lost most of their money invested in the sector as most .com companies of that time never recovered, but went bankrupt.
Distinguished scholars, gurus and contrarians have commented that we live in a pyramid economy: The world’s financial system is likely to collapse (again) and the next shock will be worse than previous.
The next financial tsunami may be created by “9.0 on Richter scale” financial earthquake like the Japan tsunami. For example, default of a large country for example, that could trigger further defaults in the banking sector and possibly defaults of other countries would fit the bill.
Financial tsunami walls
As tsunami walls in coastal cities here in Japan were designed almost for anything, but not for extreme 9.0 earthquake and tsunami following it, financial models resting on normal distribution, are designed almost for anything, but not for the real world, which includes numerous extreme events. Unfortunately, very large part of the financial models in use today and investing & trading logic (or lack of it) derived from it rest on relatively efficient and normally distributed markets – i.e. not for real world.
The highly improbable events, aka “black swans,” have become highly probable with excessive leverage and liquidity and practically complete interconnectedness of financial systems.
One should build solid financial tsunami walls to prepare for the next larger financial tsunamis.
