The Butterfly Effect

Investing is not just a job; to me, it's an all-consuming lifestyle! The job often feels like you need to be switched on all the time. I somehow feel the need to check the US close almost every evening and Asian markets as soon as I wake up, even though I'm supposed to focus on big picture, top-down issues for a living. The daily noise in the markets is not determining my views but the daily rhythm definitely helps me to build the bigger picture. It's that or I am just addicted to the buzz.

Luckily most of the markets are closed over the weekend, but by then there is so much reading to catch up on. There is the usual macro stuff to read, like economics and politics and then there is so much other news that is potentially relevant. As a self-declared 'information junky', I read all I can.

I think I have FOMO; the fear of missing out

The fear of missing that one special article or paper that provides a deep insight or a new trend. The fear of that odd idiosyncratic news item that would add conviction to an interesting trade idea. The fear of failure to recognise the ‘butterfly effect’: an idea from chaos theory that the flapping wings of a tiny butterfly can cause a tornado somewhere else on earth, weeks after.

This effect is present in markets as well. I guess many things in chaos theory are applicable to markets. For example on 9 August  2007, BNP Paribas froze trading on three of their funds which invested in assets known as collateralised debt obligations (CDOs). Equity markets dropped about 1% that day: nothing special and probably not even particularly related to these “flaps of the wings of the butterfly”. The S&P index made new highs a few months later and the fund closures were a distant memory for most market participants by then. One year later the global financial crisis (GFC) was upon us and Lehman Brothers filed for bankruptcy.  

The investment teams of LGIM did quite well through 2008. Tim and James, our resident economists at the time, were anticipating recession and the credit team worried about the build-up of excessive leverage.

What about today?

The build up of a bubble is not too difficult to spot; starkly rising asset prices are usually a good starting point in spotting a potential asset bubble, dramatically increasing debt ratios are a strong hint towards a credit bubble. The Bank for International Settlements has a great framework to spot credit bubbles. We use a similar framework. In this light, we believe China still poses substantial credit risks at the moment.

Many things in chaos theory are applicable to markets

The ‘Heiligenberg index’ is a range of indicators put in an equally weighted index. I keep track of this to help us predict both asset and credit bubbles. The index has signalled both the 2000 and 2008 bubbles quite well and the index is clearly elevated at the moment. 

Last August, when I last blogged about this index, I believed it was too soon to call the top. Markets are up more than 10% since then. So far so good.

Compared to last year the Heiligenberg Index has increased as market volatility is increasing and interest rates are drifting up. It is clearly getting more difficult to deny the markets are getting bubbly, but the index is at more or less the same level as in 2014. That proved to be a false signal. All in all, like last August, time I think it's too early to raise the alarm.

So it is not the formation of a bubble that is difficult to spot, it’s the timing of the popping of the bubble that is the problem. There is no standard playbook for it. There are no maximum levels of valuation or debt after which the bubble must burst. Actually, there is even no guarantee a bubble will burst at all. There is a great Financial Times article on this “The importance of bubbles that did not burst”.   

Yale’s Will Goetzmann complains that bubbles are booms that go bad — “but not all booms are bad”

The un-popped bubble in China, which pundits (and investors like us) have been warning about for years, is a case in point. We believe it is a credit bubble, waiting to burst. But it is difficult to determine when and there is a remote possibility it will deflate without bursting. Go defensive too early and you miss out on essential returns or pay out too much insurance premium.

The odds are stacked against investors timing a credit crisis. To increase those odds, we spend a lot of our research time analysing credit risk and our colleagues from the fixed income team are crucial in this discussion. This should help us better understand transition mechanisms that lead to a crisis (i.e. recognise the flapping of a butterfly before it turns into a proper tornado). However, we believe that credit problems are more likely to come to the surface when the economic cycle weakens, like in 2007, so our cyclical view remains crucial as well.

In that light, I reiterate what I said in early February. We believe global growth is doing well for now, inflationary pressures are building gradually but not alarmingly and we would expect our recession indicators to start flashing red around the end of this year.

Stay invested, stay diversified, but stay focused as well. No time to sleep.