As markets rise to fresh highs, the worries of the past months, much less previous years, seem to have happily dissipated. Gone are concerns about lost consumer income, falling productivity from reshoring production, or the growing horde of highly indebted companies sustaining themselves despite rising interest rates.
With the addition of augmented unemployment benefits and direct federal payments, worries about household debt have almost evaporated. Meanwhile, that indebtedness has grown throughout the crisis. Average wages have remained flat after a bump in April 2020 as legions of low-wage workers became unemployed. Household incomes, which include government transfer payments, remain high on the back of continuing federal support. In other words, the consumer is being propped up by Washington.
The news cycle offers a constant stream of programming designed to direct our attention to the moment rather than the sweep of the timeline. While the above realities remain, the stories vying for our attention currently are much rosier. Restaurants are reopening, schools are returning to the new version of normal, and a blizzard of fiscal injections is coming out of Washington. The newness blankets the old like a fresh layer of snow, smoothing and brightening the landscape. Unfortunately, this is precisely how avalanches are formed.
Anatomy of an Avalanche
As snow falls upon a mountain, some of the layer finds a firm foundation. Some does not. The density of the snow, the depth of the snowfall, drifting, and the substrate all affect the structure of the snow pack. If a 3-D map of the mountainside were made, we’d see patches of stability and patches of instability. As new layers are added, those areas can change, but they are certainly compounded. Over time, fragile portions become linked with finger-like fissures of instability that can transfer energy from one part of the landscape to another.
This is why the managers of ski slopes periodically stimulate avalanches. By causing small rearrangements of the snow formation, the number of fragile connections is disrupted, and instability is temporarily contained. Those who take to the slopes know that fresh snow only compounds what has come before. Aware that they cannot map the internal structure of how the snow has fallen, these preventive measures are the antidote to such blindness. Despite a placid exterior, the unknown below the surface is of utmost concern.
Fragile Financial Slopes
Avalanches have a season, typically December through February. Thus, caution routinely heightens during those months. Financial avalanches, when some catalyst triggers the interlinked fragility of multitudinous players to cause a precipitous fall across markets, are not seasonal. Economies can add excess and fragility for long periods without reversal. Economist Hyman Minsky’s theory of capitalism fragility, however, reminds us that moments of apparent calm are precisely the preconditions for fragility’s formation.
Worse, while a large avalanche may occur on a specific slope, the ability to create a systematic slide across an entire mountain range is absent. The ties within the financial system, however, create an interdependence that stretches round the globe. The vast complexity is ultimately unknowable. Further, the actors within that system are reactive. Snow harbors no innate intelligence. Bankers do. While regulation and stress tests attempt to ward off fragility before an avalanche hits, financial players create new means of circumventing such restraints. Given the complexity and unseen connections, regulators and central bankers run the risk of unintended consequences from any attempt at modulating the system. Paradoxically, the mechanisms to restrain fragility can ultimately be a further source of it.
Snow on Snow
Such skepticism may sound alarmist. There is always a bearish commentator warning of some corner in the market bristling with risk. And there is always some bull painting a rosy future and using the same argument of unknowability to advocate invested positioning well-diversified to mitigate whatever dangers lurk. The result is a general malaise of inaction that afflicts investors overwhelmed by opinions and data. Inundated with information, they become disaster-myopic.
That is why we herein present the avalanche, a cipher for the theory of fragile natural systems. Within its framework, the relevance of the news flow is more easily determined. Comparing media to a continuous flurry laying down new layers on the financial mountain, it’s essential to take a historical view when accessing fragility. While the headlines attend to the most recent layer of snow, it’s the depth that matters, not because deep snow causes avalanches, but because repeated layers cause the interlinking weaknesses.
If a public survey were to inquire about financial fragility today, responses might well include hedge-fund shorting (as in GameStop). It might show concern over Bitcoin’s 1000% price appreciation last year. Maybe it would warn of U.S. federal budget deficits or unpaid residential rents. Certainly, it should recall the explosion in SPACs (special purpose acquisition companies), those blind investment trusts floated by celebrities-turned-investment managers, who for 20% of the action, buy unnamed startup companies in hopes of emulating the fabled performance of this decade’s private-equity stars. That is the current “snow job,” but this layer does not obviate the unresolved issues that have come before.
A Brief History of Recent Snowfalls
We have routinely written on pockets of financial fragility only to have still more emerge before the weaknesses of their forebears have become manifest. In 2016 and 2018 we wrote in our annual letters about valuation risk. Forward returns from equities selling at high multiples to their earnings have always been poor or negative. In 2017 we warned of high household- and corporate-debt levels. Channeling Minsky, economic booms lead to overextended positions as greater debt loads become rationalized, given recent healthy cash flows. This dynamic, however, creates fragility as the composition of the balance sheet is a primary indicator of resiliency.
For investors, the risks are dramatic as covenant-lite loans strip them of traditional protections. Low yields have a similar effect. Losses to bonds from a reversion in interest rates are not linear. The lower the interest rate, the greater the market loss of a 100-basis point rise in yields. In the junk bond-space, spreads are the lowest since mid-2007, when the benchmark was considerably higher. Today the duration of that bond is considerably longer.
In 2019 we warned of low interest rates in general and the Pavlovian malinvestment that naturally results. Drawing attention to the inflation in junk-bond ratings, we saw parallels to the same dynamic that afflicted residential mortgages in 2007. Finally, we used the implosion of the WeWork IPO as a case study in fragile, unprofitable companies. The COVID-19 pandemic and its economic effects compounded all these dynamics in ways wholly unknowable. The central bank strong-armed debt markets to prevent junk bonds and ostensibly investment-grade bonds from collapsing in the March 2020 market crash. With continued artificially low interest rates, price discovery of these securities is precluded. What is unknown always contributes to fragile formations.
Since the Fed stepped in last year, its surge of liquidity has paved the way for IPOs of more unprofitable companies, their founders profiting stupendously in the process. Retail investors were shut-ins at home with direct federal payments to spend. They and investment managers alike readily bought the inflated shares. A more generous, and far more tragic, reading would be that many of the newly unemployed saw that the only way to more forward economically was through speculation. This has brought us to the unprecedented level of fragility in the market today.
Ski at Your Own Risk
In short, the complex system undergirding increasingly wanton speculation in the asset markets has become more and more unstable. Bubbles abound. Whether it’s the bubble in all manner of equity-type investments, low rates, belief in an omnipotent central bank, or relief and optimism about the recovery, these are simply new layers of snow as an avalanche threat grows daily by virtue of its increasing size, scope, and concomitant fragility. To focus on the catalyst, as pundits are wont to do, is to miss the point. Nearly 90% of avalanches are triggered unintentionally by skiers. The fault lies not with them but with the system too unstable to bear them.
The financial mountainside, with no one in high places willing to trigger small avalanches in order to avoid the big one, is in an unprecedentedly critical state. Even if you’re but one in 100, taking the lonely road less traveled may be the only way to be assured you’ll be around to play another day. There is, however, some consolation in knowing that the longer it has been since an untoward event has happened, the greater the probability it will.
 Friedrich A. Hayek makes plain the application of interconnected complex systems to finance in The Pretence of Knowledge (Nobel acceptance speech, December 11, 1974): “The social sciences, like much of biology …, have to deal with … [the] phenomena of organized complexity [which] … depends not only on the properties of the individual elements of which it is composed, but also the manner in which the individual elements are connected to each other.”