Bear Territory

After every football victory, the California Golden Bears declare that the ground on which they stand is Bear Territory. “You know it! What? You tell the story! What? You tell the whole damn world this is Bear Territory!” Watch this particularly lively rendition after a win in The Big Game over Stanford (starting about 1:20 in; my youngest is at the top of the screen and was number 46 for Cal).

Lots of experts and alleged experts in recent days have been declaring that we’re in a different sort of “bear territory” as the market has gotten off to perhaps its worst start to a year ever. Much of the follow-up discussion has focused upon the likely catalyst(s) for a big and continued market move down. Trouble in China is most often mentioned, closely followed by terrorism and oil, but others can be and are offered. And, indeed, sometimes a least a few people can see a crisis coming, even if it can take a maddeningly long time to pay off for those who read the tea leaves correctly (such as the few who were truly prescient in the run-up to the 2008-09 financial crisis or the 2001 tech bubble). Remember the truism: the market can remain irrational longer than you remain solvent.

To make matters worse, getting it right one of those times doesn’t make someone any more likely to keep being right (see Paulson, John and Josh Brown’s excellent analysis here). Because of our general loss aversion, we are remarkably vulnerable to strong claims of impending doom. Peter Schiff is still saying, as he has for years now, that we’re going to Hell in a hand-basket and that gold (which closed 2015 at $1,062.80) is going to $5,000 per ounce. And as he does pretty much every year, Marc Faber is again calling for a market crash in 2016. Some year one of them might eventually (if only coincidentally) be right but, even as and while we’re waiting, they both get regular hits on “business” television and the press. We are no better in the aggregate (and are probably substantially worse) at predicting market crashes than we are at predicting the markets in general — which is to say, we are truly dreadful at it.

Part of the reason for our difficulties (in addition to the brute fact that there are too many variables involved to predict what’s going to happen next) is that markets don’t need any clear and obvious catalyst in order to cascade downward. Think back to Black Monday, October 19, 1987, for a terrifying example. Coverage by The Wall Street Journal of that day began simply and powerfully. “The stock market crashed yesterday.”

On that fateful day, after five days of intensifying stock market declines, the Dow Jones Industrial Average lost an astonishing 22.6 percent of its value (for its part, the S&P 500 dropped 20.4 percent), plummeting 508.32 points after a 5-year run from 776 in August of 1982 to a high of 2,722.42 in August, 1987. Black Monday’s losses far exceeded the 12.8 percent decline of October 28, 1929, the start of the Great Depression. It was “the worst market I’ve ever seen,” said John J. Phelan, Chairman of the New York Stock Exchange, and “as close to financial meltdown as I’d ever want to see.”

But a closer look at the coverage and its aftermath is revealing, especially for what is missing. There is no “smoking gun.” According to the Big Board’s Chairman, at least five factors contributed to the record decline: the market’s having gone five years without a major correction; general inflation fears; rising interest rates; conflict with Iran; and the volatility caused by “derivative instruments” such as stock-index options and futures. Although it became a major part of the later narrative, Phelan specifically declined to blame the crash on program trading alone.

In other words, the market collapse had no definitive (or even clear) trigger. The market dropped by almost a quarter for no obvious reason. And while it’s counterintuitive, that observation is wholly consistent with catastrophes of various sorts in the natural world and in society. Wildfires, fragile power grids, mismanaged telecommunication systems, global terrorist movements, migrating viruses, volatile markets and the weather are all self-organizing, complex systems that evolve to states of criticality. Upon reaching a critical state, these systems then become subject to cascades, rapid down-turns in complexity from which they may recover but which will be experienced again repeatedly.

This phenomenon was discovered largely on account of the analysis of sandpiles. Scientists began examining sandpiles and discovered that each tiny grain of sand added to the pile increased the overall risk of avalanche, but which grain of sand would make the difference and when the big avalanches would occur remained unknown and unknowable. This finding is consistent with the “butterfly effect” in chaos theory, which refers to the idea that a small change at one place can result in large differences in a later state somewhere else. Thus a hurricane’s formation might be contingent upon whether or not a distant butterfly had flapped its wings several weeks earlier. It’s eerie — really bizarre even — but nonetheless true. If you doubt the science, take a look at one simple example, using magnets (or, in more scientific jargon, a small perturbation, in this case a magnetic field disruption, causes a chain reaction).

For markets, that means that we should not expect ever to be able to identify the trigger of any correction or crash in advance or to be able to predict such an event with any degree of specificity. This understanding emphasizes the need to manage one’s risks carefully and aggressively. But it also means that if one’s investment time horizon is a long-term one, s/he should probably tune out the noise about “bear territory” and worry about something else. Even though it probably won’t be — markets generally go up, for very good fundamental reasons — tomorrow could be the day that the market tanks…but you shouldn’t expect to see it coming.

7 thoughts on “Bear Territory

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