Amid fragile markets, how to predict when the bubble will burst?

Economist Paul Samuelson famously quipped that stock markets accurately predicted nine of the last five recessions. The same could be said of financial economists. So-called leading indicators like market sentiment swing with the daily news. Optimism is the default option but bull markets die hard. Still, most seasoned financial economists now recognise that stock markets are becoming more fragile. And so does the crowd. The frequency of online searches for “stock market bubble” has surged since July. This quantification of the wisdom of the crowd is the essence of “narrative finance”: news stories and developing narratives move markets and these can be a plausible forecasting indicator of when markets become critical. The financial system absorbs shocks by adjusting prices using information from news signals passed through narratives. This price adjustment results in a new state of dynamic equilibrium between buyers and sellers – akin to the concept in cell microbiology. But as a market becomes fragile, the system becomes more sensitive to relatively small external shocks, which could trigger investor panic. If a shock is too severe, the stresses melt down the system. The late Benoit Mandelbrot, using fractal geometry, showed that extreme financial events repeat in similar patterns across timescales, like the natural phenomena of tides and landforms. For example, the youthful internet company AOL acquired the storied Time Warner during the dotcom crisis. Behold, one of the mega-deal headlines today is that the newly renamed Paramount Skydance (under youthful management) wants to take over Warner Bros Discovery. In the markets, even if history doesn’t exactly repeat itself, it rhymes. Market events generate financial volatility in clusters over all timescales and strike with consistent frequency, duration and ferocity. Mandelbrot showed that all bubbles end, the only question is when. The trigger for a crash may be an “unknown unknown” shock news event – such as a terrorist attack, pandemic or abrupt geopolitical or geoeconomic development. Alternatively, “known unknown” events, initiated by emerging news and narratives, develop like a train wreck in slow motion. They trigger a shock appreciation of legacy issues, like rising interest rates or appreciably slowing growth, reminiscent of an Ernest Hemingway character’s description of how he went bankrupt: “Gradually, and then suddenly.” The clues to a crash hide in plain sight – in hindsight, those triggers were obvious. All the great studies on crashes by Mandelbrot, John Kenneth Galbraith, Robert Shiller or Carmen Reinhart and Kenneth Rogoff follow the pattern given in Charles Kindleberger’s must-read: Manias, Panics, and Crashes: A History of Financial Crises. Manic markets result from easy money and an explosion of debt that encourages overconfidence, speculation and a contagious fear of missing out. Short memories make it easy to relax regulations and covenants. Inflated narratives about inventions and innovations expand the asset bubble to a critical level. We saw this with dotcoms in 2000, financial engineering in housing debt in 2008 and today in meme stocks, digital assets and the artificial intelligence bubble, which is raising unheard-of sums of cash. So when will the bubble burst? Jamie Dimon of JP Morgan Chase and Co and Ray Dalio of hedge fund Bridgewater Associates have a front-row seat to the financial system and have been speaking like Jeremiahs about the party ending. But no one can forecast the exact timing of a market reversal, so their views range from six months to as long as four years. They speak of their concerns for private credit, now the big banks have passed subprime lending onto non-banking financial lenders. Other narratives point to market fragility due to high public debt, fiscal deficits and stock valuations as well as the rapid run-up in prices, uncertain geopolitics and trade causing recession, and good bank earnings that mask endgame deals driven by cheap money. These are all narratives of a fin de siècle. In this uncertain world, Nassim Nicholas Taleb’s work suggests that investors face uncertainty, risk and volatility by improving the “anti-fragility” of their portfolios. The performance of an asset in a meltdown is often a good indicator of its future performance. Taleb’s “barbell strategy” builds redundancy by holding onto favoured risk assets like equities while balancing that risk with, say, high cash holdings. The record growth in money market funds is an indicator of wise investors raising cash. In a crash, stocks that did well in the final days fall hard but the quality ones recover first – although beware of buying back too soon. Zombie or low-profitability companies get crushed as they only survived because of low interest rates or optimistic narratives. Unfavoured stocks or markets, such as pharmaceuticals, are often comparatively robust. The US dollar is still likely to be a safe haven at the expense of fringe currencies. Gold is the asset of last resort and is rising like the leading indicator it was before the last global financial crisis. Kindleberger found that the system needs a powerful lender of last resort to stabilise a crash. In 2008, the talented Hank Paulson oversaw the US Treasury’s markets bailout. Questions remain as to whether the United States can still be the backstop, given its inflated balance sheets – and the quality of the available talent. Or could the next step be a Cyprus-style “bail-in”, where bank customers, not exhausted taxpayers, refinance the system with a confiscation of a slice of their cash accounts?

Amid fragile markets, how to predict when the bubble will burst?

.css-1c6uqr6{color:inherit;font-weight:inherit;font-size:inherit;font-family:inherit;line-height:inherit;overflow-wrap:break-word;}The news and stories that move markets could well be a leading indicator of when markets fail

The news and stories that move markets could well be a leading indicator of when markets fail