Stability Breeds Instability

Playing at the sand and water table

Two summers ago, Justin’s oldest daughter, three year-old Grayson, discovered the Fisher Price Sand and Water Table and life hasn’t looked the same since. This little 2′ x 4′ table, as the name implies, has sand on one side and water on the other (though usually not for very long) and has been the source of hours upon hours of delight. She pours, she digs, she builds, she tears down, she repeats. In this commentary, we explore how three physicists at a computerized version of a sand and water table have informed the way we think about complacency, market stability, and the road ahead.

In Ubiquity, Why Catastrophes Happen, Mark Buchanan wrote that in trying to discover the underlying cause of a vast range of tumultuous events, no better archetype of simplicity stands out than that of the sandpile game[1]. “Imagine dropping grains of sand one by one onto a table and watching the pile grow. A grain falls accidentally here or there, and then in time the pile grows over it, freezing it in place . . . And so it was in 1987 when physicists Per Bak, Chao Tang and Kurt Wiesenfeld began playing [a computerized version of] this sandpile game in an office at Brookhaven National Laboratory, in New York…The researchers ran a huge number of tests, counting the grains in millions of avalanches in thousands of sandpiles, looking for the typical number involved. There was no typical number. 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.”

Grayson unknowingly creating "Fingers of Instability."

So, the three physicists tweaked their computer program to show the sandpiles colored according to their steepness. Steeply piled “ready to topple over” sand grains were colored red, and stable, flat grains of sand were colored green. At the outset, of course, everything was green, but flip the switch and let the randomized sand sprinkling begin, and green sand piling up became red. They peered closer. One red pile threaded itself through sandy green plains to another red pile, and another, and another. These networks, later known as “Fingers of Instability”, seemed to map themselves effortlessly and complacently into place. If the next avalanche-inducing grain fell onto a red pile sparsely connected to other red piles, the damage was minimal and contained. However, if the next avalanche-inducing grain fell onto a red pile connected by dense networks to other red piles, it could set off a chain reaction, flattening the entire sand pile.

In other words . . . actually in the words of Economics Nobel Laureate Hyman Minsky, “stability breeds instability.” What we call complacency, Minsky called his Financial Instability Hypothesis, which goes something like this: when times are good, investors take on risk. The longer times stay good, the more risk they take on, until they’ve taken on too much and reach a point where the cash generated by their assets is insufficient to payoff the mountains of debt they took on to acquire them in the first place. Losses on such speculative assets prompt lenders to call in their loans. Cash strapped investors sell off even their less-speculative holdings to make good on their loans, leading to a wholesale collapse of asset values. And to think that Minsky (1919-1996) died 11 years before the real estate bubble.

Stability Breeds Instability

In real life, sand piles don’t change color to highlight areas of instability. No, from the outside, the pile of sand on my table probably looks the same as the pile on yours. It’s only in computerized models that the lights start flashing red and green. The following are some of the “red sands” (or the “stability that breeds instability”) that we see piling up. They might not seem to spell trouble; but that’s exactly Minsky’s point.

  • Investor Sentiment Positive and Increasing – The American Association of Individual Investors’ (AAII) bullish investor sentiment (a survey of the optimism of individual investors) has been this high only 17 weeks out of 1232 weeks (1.38% of the time). Also AAII’s bearish investor sentiment (a survey of the pessimism of individual investors) has been this low only 76 weeks out of 1232 weeks (6.17% of the time).
  • Market Pessimism and Volatility Low and Falling – Our own pessimism and volatility indexes have returned to the lows of 2004-mid 2007 and of April 2010, times that preceded market swoons.
  • Personal Hedging Activity Absent, Commercial Hedging Present – Patrick J. O’Hare, Briefing’s Chief Market Analyst, notes that the currently low CBOE Put/Call ratio is a sign of complacency (there’s little need to buy insurance). Conversely, he notes that the Commitment of Traders report shows commercial hedgers have a large net short position, which frequently precedes a dramatic shift in the current trend.
  • Riskier Assets Outperforming – Obviously stocks have outperformed bonds, and high yield bonds have outperformed high quality bonds, but more subtly, Morningstar’s “high uncertainty” risk universe has outperformed the “low uncertainty” risk universe since the July 2010 lows by a margin of 2.3.
  • “Smart Money/Dumb Money” Confidence Spread Falling – Sentiment Trader’s ratio of “smart money”indicators (indicators which typically “correctly” predict the market movements) to “dumb money” indicators (those that tend to get it wrong) is 0.458, markedly outside the normal range.
  • Mutual Fund Flows Shifting – Following 24 months of steady inflows to bond funds, retail investors have started pulling money out of bond funds and begun buying stock funds.
  • Drought of “Worst Days” Getting Longer – We keep a running list of the market’s 150 worst days since 1928. For some context, we had 13 in 2008 and 4 in 2009, but it’s been nearly two years since we’ve had a “worst” day. Unfortunately, we think investors have forgotten what those “worst days” really feel like.

Living in Red Sandville

Grayson "rebalancing" Her Cups

In spite of the above, we think fundamental reasons for owning high quality stocks in balanced portfolios remain: shares of low uncertainty risk, wide-moat, dividend paying companies are available at prices below fair value. Our emphasis on companies that pay rising and sustainable cash dividends makes accepting a world of uncertainties tolerable. However, a stock market up 16% since the end of August 2010, with red grains piling up on the sand and water table, raises the likelihood for an unexpected market setback of some degree and requires a plan.

Since each of our clients and their situations is unique, we think and behave in Red Sandville in different ways for each of them. For some, in addition to our shift to quality, we’re tackling it with minor rebalancing out of overrun assets into better valued assets. For others, we’re accumulating a much larger than normal cash position. This is where knowing the amount of risk that our clients’ stomachs and wallets can bear is so important. While our timing won’t be perfect and we might not experience a sand avalanche for some time, we are not going to forget the words of fellow advisor Charles Knott, “[Investment] opportunities come again and again, but our clients’ principal comes but once.”

Jonathan Smith
Managing Partner

BACK TO POST [1]We’d like to thank John Mauldin for helping us connect the dots between Minsky, Sand Piles, and Fingers of Instability in his weekly newsletter “Thoughts from the Frontline”, which can be found at www.johnmauldin.com.

Advertisements

About Jonathan Smith

likes: everything my wife cooks, refrigerator art, my wife, dogs, kids and friends, lighted christmas balls, vintage boats, children's lit, jesus dislikes: beets, short days, taking lighted christmas balls down
This entry was posted in Uncategorized and tagged , , , , , , , , , , , , , , . Bookmark the permalink.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s