August stock rout shows up fragility of consumer sentiment

The flash crash at the beginning of August saw the Hong Kong stock market fall by as much as 9 per cent in two weeks, bottoming out on August 5 after a sharp 3 per cent fall the night before in the US stock market. This caused a substantial fright among investors, occasioned by some difficult US employment numbers and talk of apparent weakness in the consumer sector. As we know, the markets quickly recovered, with investors using the biggest trawlers they could find to bottom-fish for investments. This has driven equity markets up – to close to their levels in July. On August 5, when market moods were darkest, David Roche and I talked about our views on RTHK’s 5pm business programme, The Close. Roche is a revered market strategist, and a role model of mine over 30 years ago. Nowadays, we’re happy to disagree with each other, as it makes for good radio. Yet we both had the independent conclusion that the market was not going to collapse much further. Since then, I have been trying to figure out why two widely experienced greybeards both came up with that conclusion within hours of the event. Some may say it was a guess; or maybe intuition borne from experience. But we both believed that the market was significantly overreacting to a limited piece of news. This instinct lies in the fact that market crashes require not just one bad narrative, but a combination of narratives coming together to cause a major disruption in the marketplace. This phenomenon is known as the multiple causation theory. Multiple causation can be observed in air crashes, where many factors line up to create a disaster. In 1989, for example, British Midland Airways Flight 92 crashed onto a motorway embankment when the pilots were attempting to make an emergency landing after the left engine failed. The experienced pilots of the almost-new Boeing 737-400 reduced thrust and subsequently shut down the right-side engine after smoke got into the air conditioning system. They had wrongly assumed that the right-side engine was at fault. On earlier models of the 737, the cabin ventilated from the right, but the 737-400 used a different system. Shutting down the right-side engine in this case did in fact reduce smoke and vibration coming from the left, and these symptoms reinforced the pilots’ belief that the right-side engine was at fault. This left the aircraft with little thrust. The proximal cause was pilot error in determining which engine had failed, which is normally an easy task. This only happened because of multiple issues: limited pilot training on a new aircraft layout; the absence of a 747-400 simulator that could be used for training; the failure by the manufacturer to properly test a new engine type; and pilot checks being interrupted by air traffic transmissions. Ironically, the passengers and cabin crew could see that the left engine was on fire, but it was assumed that the pilots knew this. Multiple causation can also be described as being like a block of Emmental cheese with holes in it. You may not be able to see through the whole block because the holes don’t line up but if you cut the cheese into slices and then move them around, you can align the holes to see right through the block. This analogy can also be observed in the stock market. Price movements, especially sharp ones, reflect how people behave. There are many parallels between market behaviour and behaviour in the natural and social sciences. What David and I were picking up was that the holes in the cheese were not aligned. The flash crash was a single narrative – albeit a powerful one. The key indicator that is likely to knock the market off its stride (and highlighted in this column) is indeed a rise in unemployment and a fall in consumer confidence. The market has not been knocked off its positive stride despite two major wars, sanctions, trade disputes and interest rates rising precipitously and staying high. The markets have been supported by consumption and employment remaining strong in Europe and the US. For the holes in the slices to become more aligned, sentiment must be more fragile and burdened by new and multiple “known known” and “unknown unknown” factors that are perceived to damage the global economy and consumer confidence. Perhaps the fourth quarter may see the slices move closer to alignment. The flip side is, of course, that the flash crash spotlights the Achilles’ heel of the current market like a laser. It may have been a flash in the pan but, in fact, it is foretelling the future and provides a lesson that we should be assiduous in learning. If consumers do lose confidence and slow their spending, as has happened in China, we could see a significant fall in global economic growth that could impair the value of leveraged investment assets. The flash has lit the path for the time when the holes in the block of Emmental come together.

August stock rout shows up fragility of consumer sentiment

.css-1c6uqr6{color:inherit;font-weight:inherit;font-size:inherit;font-family:inherit;line-height:inherit;overflow-wrap:break-word;}The meltdown proved temporary, but the causes for a more devastating outcome will line up if and when US employment and consumption begin to wobble

The meltdown proved temporary, but the causes for a more devastating outcome will line up if and when US employment and consumption begin to wobble