Binary TwinsSubmitted by TR Financial Management Group, LLC on October 23rd, 2014
Our world is a complicated place. Pick almost any aspect of our lives and closer inspection will frequently reveal both complexity and complications. I use these two words intentionally to illustrate this quarter’s ideas. Borrowing from Nassim Taleb’s amazing book, Antifragile, complex refers to a mechanism or system that has many inter-related parts but fairly predictable behaviors and outcomes. A mechanical watch is a good example. Remove the back cover and one will find an assortment of gears, levers and springs all working in unison to move the hands of time. Yet, there is little concern that the mechanism will somehow run amok resulting in some catastrophic outcome. Complexity’s cousin is complicated. Like complexity, complicated mechanisms or systems have many inter-related components. However, the behaviors and results of complicated entities are not always predicable nor benign. One simple example is a large pile of snow sitting high on a mountainside. The pile is comprised of many inter-related components, in this case snowflakes. In most instances, these snowflakes will lay harmlessly until Spring. But on occasion, a tipping point is reached and an avalanche ensures. And, while one might be able to estimate the possibility of an avalanche, no one would claim the ability to predict one with any certainty. This unpredictable, catastrophic result is a discriminating feature of complicated entities.
Another aspect of complicated systems is they often involve a great deal of human participation. This alone brings unpredictability to the process. Politics is a branch of our world that can rightfully be described as complicated. Who among us would be willing to wager more than just a few dollars on the outcome of any impending political matter? And, how many times have we seen those outcomes somehow go askew? For today, however, we are most interested in the complicated nature of our financial markets.
We can safely state that our financial markets are comprised of countless participants, both human and computerized. There is also a high degree of inter-relationship amongst the four major markets (stocks, bonds, commodities and foreign currencies) as well as inter-relationships amongst the markets of different countries. All of these numerous participants and points of interaction usually keep the world’s markets both liquid (lots of trading) and in a constant state of price discovery (prices always moving about). To a large extent, these prices are moving up and down but in fairly predictable ranges and manners. This meandering movement of price can persist for long periods of time. Our own US stock market has been slowly climbing in relatively constrained fashion since early 2012 with few major upsets. On occasion, something will occur that rattles the market’s participants in such a manner as to start a mass exodus from a particular market. We have seen a number of these “financial avalanches” in the past 15 years: the collapse of the internet stock bubble, housing bubble burst, and the default of Greece, to name a few. In each of these, an attentive person could see that problems were developing. Like the snow on a mountainside, risk factors were piling up but still in check until the last straw. Yet no one would dare predict what would be that last straw and its subsequent outcomes.
Since the late 1990’s, there have been two colossal economic forces colliding in the global financial markets: inflation and deflation. Inflationary environments are more familiar because inflation has predominated the global economies since the 1940’s. Quite simply, prices for goods and services have continually increased due to ever-increasing consumer demand and monetary policies that favor ever-expanding credit creation. This inflationary force progressed in a largely unabated fashion until the major players of Asia began producing goods and providing high value-added services in a globally-competitive manner. For the first time in decades, there were forces in the global economy putting substantial downward pressure on prices. I certainly recall the continually falling prices for computers and electronics as the 90’s progressed. For a time, it was the roaring 90’s as good jobs were still plentiful and prices for the things we wanted were plummeting. Then, as the hangover from the big Y2K party began to set in, it was apparent that things were changing. Deflation was now a force to be reckoned with in the US.
This is not the first time that the world has experienced downdrafts. Deflation is in many ways part of a natural economic cycle whereby excess suppliers are forced out of the system. Essentially, deflation crimps cash flows, which slows demand in turn pushing the weakest (and usually most-indebted) suppliers out of business. It is economic Darwinism. Up until the 1930’s, governments were not large enough to combat such economic inevitabilities. Like the common cold, they just ran their course. And too, most currency systems were backed by physical gold so the financial engineering of today was simply not possible. Prior to the 1930’s these deflationary periods were often sharp and short recessions. Lasting perhaps 1-2 years. Since the dawning of governmental economic management, they tend to persist far longer as both the Great Depression of the 30’s and the Great Recession of the 00’s will bear out.
We have visited these binary twins of inflation and deflation in previous installments. Bringing them back to the forefront is the impending end of Quantitative Easing by the Federal Reserve. Scheduled to end this month, the Fed has been scaling back on its monthly bond purchases as it attempts to get the global economy off steroids. Many people have strong opinions on this matter, both for and against. I, myself, try to remain an impartial observer so as to not bias my own decision-making. Of late, I am seeing two clear signs of deflation’s awakening: falling commodity prices in conjunction with rising bond prices. The next sign of concern is rising stock market volatility. On this, we are experiencing some chatter but nothing alarming—yet anyway. As with any complicated system, no one knows with any certainty the system’s actual status. We can only remain attentive for conditions and events that might bring the next avalanche. It may be wide spread defaults in the auto loan market. Perhaps it could be an unexpected geopolitical conflict. Maybe the Argentinian economy and currency collapse again. That’s our challenge: No one can readily predict the next possibly calamitous sequence of events. We can, however, remain attentive and manage our exposures. This is after all, the only rational approach to managing life’s uncertainties. And, it is the approach I will continue to employ to the best of my abilities as we watch time and events unfold in our ever complex and complicated world.