Top Stories

Tocqueville on The Bull Market, Minsky Moment, And Black Swans

Sicart on the Bull Market: “What Feels Like Stability Often Is Only an Ephemeral Equilibrium” by Francois Sicart, Tocqueville

In his latest piece, Francois Sicart, Founder and Chairman of Tocqueville Asset Management, looks at the seemingly stable state of the current bull market and examines research on how and when such “stability” erodes. Hint: very quickly and without discernible warning.

He explores the “Black Swan” and “Fingers of Instability” research by Nassim Taleb and John Mauldin respectively, noting that: “…even experts who have analyzed how shocks to the system might strike have failed to offer precise warning systems.”

He concludes that currently: “…complacency generally reigns while the grains of sand (that will eventually cause an avalanche) are piling up politically, economically, and financially.

I think this is a good time to pause and wait, investing only in securities that might offer outsized potential gains over time if our analyses are vindicated, and keeping dry powder for future opportunities when valuations are more compelling.”

Bull Market: What Feels Like Stability Often Is Only an Ephemeral Equilibrium

The Merriam-Webster dictionary defines equilibrium as a state in which opposing forces or actions are balanced so that one is not stronger or greater than the other.  Such a state may well exist in nature, but in the affairs of men, even the definition implies that any equilibrium is inherently unstable and will eventually be broken.

It can, however, be maintained for longer than one might expect.  During the Cold War, for example, the military doctrine of mutually assured destruction (MAD) helped prolong a precariously peaceful nuclear balance between the USA and USSR until the fall of the Berlin Wall.

In the late 1970s and early 1980s, I developed a keen interest in the Great Depression.  I had several conversations with Charles P. Kindleberger, professor at M.I.T., former central banker, a leading architect of the Marshall Plan after World War II, and perhaps the greatest authority on the breakdown of world order before and during the 1930s.

He was famous, among other things, for his theory of hegemonic stability, which holds that the international system is more likely to remain stable when a single nation-state is the dominant world power, or hegemon.  The corollary, of course, is that when there is no hegemon, the stability of the international system is diminished.  In Kindleberger’s view, this is what had led to the Great Depression, as England no longer was able to exercise world leadership and the United States was not yet ready to assume it.

Today, a number of observers believe that the world leadership of the United States is waning, partly as a result of globalization and the growing independence and ambitions of emerging nations, and partly due to American politicians’ realization that America no longer has the resources to enforce its leadership in a more complex world.  To those observers, this raises the probability of major destabilizing events, both geopolitically and economically.

Adding to that school of thought, Henry Kissinger has just published a new book, World Order (The Penguin Press).  I haven’t read the book yet, but I cite from the review in the Financial Times (September 6):  “For the past 25 years, since the fall of the Berlin Wall and the collapse of the Soviet Union, the US has occupied the role of hegemon.  The unipolar moment is now coming to an inglorious end.”

However, before we yield to the temptation to speculate about economic depression and disaster, I should recall that, in the late 1970s, I had written a pamphlet ambitiously entitled, “Between Inflation and Deflation: The Dislocating World Economy.”  It spoke of the lingering deflationary effects of the first global recession since WWII (1974-75), aggravated by the tax-like effect on global demand of higher energy prices that followed the first oil shock (1973).  At the same time, it pointed to the novel problem posed by the difficulty for oil-producing nations to invest domestically the huge dollar surpluses suddenly accruing to them, and the challenge of recycling those surpluses elsewhere.

At the time, and still largely now, oil was purchased and sold in US dollars, and the conundrum of recycling OPEC’s surpluses had given birth to the Eurodollar market, where banks in Europe were trading dollars among themselves and extending dollar loans to borrowers without ever passing through America’s domestic banking system.  It was money-creation without any official supervision, without limits, and without regard to the monetary policies of the world’s central banks.  The ultimate inflationary risk could not be ignored.

The pamphlet was good enough to initiate a multi-year friendly relationship with the head of the Bank for International Settlements, who shared similar views.  But my point today is that, although inflation accelerated until 1981 and a severe, global recession ensued in 1982, the world as we knew it did not end:  Economies and financial markets muddled through!

One of the complications that has developed in recent years for business or investment planning is that the financial and economic worlds have become ever more tightly intertwined.  And, of course, in a financial world constantly bubbling with innovation, there are always some bankers ready to play havoc with the system – some out of malice, others out of naiveté.  That and the globalization of everything have transformed seemingly isolated incidents into possible triggers for chain reactions with potentially destructive global consequences.

Many of the destructive consequences of unruly business behavior, coupled with massive but qualitatively inadequate supervision, can be predicted in principle.  Unfortunately, other than to warn that “what cannot last forever, won’t,” and that the longer excesses are tolerated, the more likely they are to end up in disaster, those predictions are not very useful in investment practice.  The reason, as John Maynard Keynes famously wrote, is that “the market can stay irrational longer than you can stay solvent.”

I have been thinking about this because, since 2009, the world economies have been on the mend from the financially induced Great Recession, albeit too slowly and unevenly for many.  At the same time, thanks to aggressive central-bank policies, bull markets in stocks and bonds have been in force in most countries for more than five years.  Between resilient economic anxiety and spreading financial complacency, a stability of sorts seems to have set in.

Extrapolating as usual, many expect this stability to continue to prevail.  In terms of economies and markets, however, I don’t believe in such a thing as permanent stability.  So, we must ask ourselves:  How could the current state of equilibrium be broken?  There are no easy answers.

Besides sets of preconditions, such as those spelled out in Kindleberger’s theory of hegemonic stability (which gives no timing clues), I am aware of three theories of how disaster strikes economies and markets:

Bull Market: Nassim Taleb’s Black Swan Theory

This theory was introduced in Taleb’s book Fooled By Randomness (Texere, 2001), and has become a favorite reference for students of markets ever since.

As long as no one (or, at least, no European) had ever seen a black swan, all swans were presumed to be white.  The probability of a swan’s being white was thought to be 100 percent – certainty.  But once a single black swan was sighted (in Australia, in the late 18th century), that certainty suddenly disappeared.  At the same time, the probability of seeing a white or a black swan became unknown, for lack of data.

For Taleb, who taught statistics, most of our world is random, and almost all major (world-changing) events are “black swans” – unpredictable except in hindsight, because of the rarity of historical precedents.

Unfortunately, there are enough historical examples of black swans (from world wars to pandemics to such disruptive technologies as the Internet) to make a certain state of preparedness against the unpredictable part of any investment strategy.

We must prepare to be surprised, but without being able to predict when or by what.

Bull Market: John Mauldin and the Fingers of Instability

A paper by John Mauldin (April 7, 2006, before the start of the subprime crisis) describes the process through which stability transforms itself into instability, first stealthily and then suddenly.  He particularly cites and paraphrases from a book by physicist Mark Buchanan, Ubiquity: Why Catastrophes Happen (Three Rivers Press, 2000).  In the following section, I too will paraphrase liberally, from both Mauldin and Buchanan.

If you drop one grain of sand after another onto a table, a pile soon develops; eventually it takes only one grain to start an avalanche.  In 1987 three physicists from Brookhaven National Laboratory began to play the sand-pile game in their lab; but since actually piling up one grain of sand at a time is a slow process, they wrote a computer program to do it.
After a huge number of tests with millions of grains of sand, they found that there is no typical size for avalanches.

Some involved a single grain; others, ten, a hundred or a thousand.  Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down.  At any time, literally anything, it seemed, might be just about to occur.

Scientists refer to this as a critical state at which phase transitions occur – for example, when water turns to ice, or fissionable material reaches a critical mass that induces a nuclear chain reaction.  It is the point at which something triggers a change in the basic nature or character of an object or group.  Thus we refer to something being in a critical state or having reached critical mass (“tipping point” is the term currently in vogue) when there is the potential for dramatic change.

The Brookhaven physicists made another interesting observation.  After the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these “ready-to-go” grains somehow link up into a network of “fingers of instability.”

Unfortunately, while knowing about these fingers of instability helps us understand how stable states become unstable, it still does not tell us when avalanches might happen, or how catastrophic they might be.

While many [fingers of instability] are short, others slice through the pile from one end to the other.  So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate, or long finger of instability.

And Buchanan concludes:

Even the greatest of events have no special or exceptional causes.  After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point.  What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts.  Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

This experience in physics is strikingly relevant to what happens in financial markets.  Economist Hyman Minsky’s work bridges these two worlds with a theory of why long periods of economic and financial stability increase the danger of instability.

Bull Market: Hyman Minsky’s Financial Instability Hypothesis

The Levy Economics Institute of Bard College published Minsky’s paper in May 1992.  It later became a guidepost for interpreting the causes of the subprime crisis and Great Recession (2007- 2009), much as Robert Schiller’s Irrational Exuberance, written in 2000, had served to explain the dot-com bubble and its consequences in the early 2000s.
In a December 2007 letter, Mauldin gave a concise and articulate summary of Minsky’s thesis:

Dr. Hyman Minsky points out that stability leads to instability.  The more comfortable we get with a given condition or trend, the longer it will persist and then, when the trend fails, the more dramatic the correction.  The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements.  If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption.  Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.  [My italics]

Again, keen observers can warn that trouble is coming when excesses keep piling up, but the timing of the outcome remains elusive.

So, even experts who have analyzed how shocks to the system might strike have failed to offer precise warning systems.

It should be pointed out that even John Mauldin – whose latest book, with Jonathan Tepper, is entitled Endgame (John Wiley & Sons, 2011) – avoids typical “forecasting”; he mostly aims at explaining what is happening, where this might lead, and the risks that this entails.

I have often argued that precise forecasting is a futile exercise anyway:  Not only are the predictions overwhelmingly incorrect, but what really matters is how much you stand to gain if you are right and how much you stand to lose if you are wrong.  And that is mostly a matter of valuation.

Today, market valuations are not as overextended as they were at the peak of the dot-com bubble or before the subprime crisis, but neither are they at levels that, in the past, preceded periods of high returns in the stock markets.  Meanwhile, complacency generally reigns while the grains of sand are piling up politically, economically, and financially.

I think this is a good time to pause and wait, investing only in securities that might offer outsized potential gains over time if our analyses are vindicated, and keeping dry powder for future opportunities when valuations are more compelling.

François Sicart

Tocqueville on The Bull Market, Minsky Moment, And Black Swans

The full commentary is available from Tocqueville by clicking here.

More background on Tocqueville Asset Management by clicking here.