Which Financial Black Swans Are Scariest?

Source: SeattleBubble

Source: SeattleBubble

Remember when the markets took a dive of 5% last week and everybody said it was a "correction"? 5% is not a correction, it's a haircut. We reproduce below a few examples of market crashes to give context for what's in store at the end of a poorly managed bullish market cycle sporting several asset bubbles -- let's call it 20 to 40%.

But for the few wizards out there, it's hard to know where the fire starts. So we instead want to point you to three places where there's kindling and smoke. First, the volatility trade. Read this spectacular piece on why the world is far more exposed to being short volatility that may seem. It argues that in addition to the explicit $60 billion shorting volatility instruments like VIX, there is $1.5 trillion in implicit volatility shorts through strategies like risk parity (i.e., assuming we can trust historic correlations and standard deviations), and another $3.8 trillion in share buy-backs that create the illusion of growth and stability. As we saw last week, volatility may not be correctly priced, after 9 years of rising equity markets and low interest rates. During crises, correlations across asset classes go to 1, because end of the day we are just humans trading perceived value.

Second, and this could be a long shot, inflation and unemployment could be much higher than measured according to ShadowStats. This is purportedly due to changes in the approach to measuring CPI in the 1980s and 1990s, which had the net result of keeping entitlements payments in the US lower. Most economists disagree with ShadowStats, and modern efforts like the MIT Billion Prices projects finds that data from large online retailers tracks CPI fairly closely. But there is a non-zero probability that politics has impacted macro economic data. This type of argument supports the gold-bugs and the Bitcoin maximalists. But guess what, Bitcoin's 50% value drop was pretty correlated with the overall market, so it does not appear to be a great hedge in the short run. Because the short run is an ocean of inexperienced sentiment.

And last, younger generations are more heavily indebted than prior ones, especially with persistent student debt. Carrying around this burden implies an additional tax on Millennials which they pay to the government before buying a house or spending on consumption. The cost of this debt is 600 bps higher than the price banks get at the discount window. No wonder Millennials are printing their own money in the form of crypto currency, hoping to inflate away the debt through lottery. What other options are there?

Enjoy the tinfoil hat!