Bubble Management

Why you cannot regulate away risk...

BUBBLE management is a delicate business, especially when you're ham-fisted, writes Daily Reckoning Australia editor Dan Denning.

This is surely the lesson of the week. American central bankers floated a trial balloon. It was a simple idea. Maybe they wouldn't stay indefinitely committed to buying bonds and keeping interest rates low.

The market's verdict on the idea was swift and furious, and stocks fell sharply.

But here's the real question: should you take the Fed at its word? We know something important now, after the last 24 hours. Central banks can't easily withdraw their monetary medicine without sending financial markets into an immediate delirium tremens. In order to save the patient, he must be permanently medicated. That's what you call addiction.

You can't take these central bankers at their word. Stocks have gotten so far ahead of themselves (and earnings) that the authorities had to say something. They probably did not expect the notes from the January meeting of the Federal Open Market Committee to spark a global sell off. But they probably weren't unhappy with it either.

In any event, here we are. Should you worry? Well, the time to worry is when you have time to worry. If you have time to worry, then it's already too late to worry in any productive sense. Take a look at the chart below and you'll see what we mean.

Source: StockCharts

The black line in the chart above is the Volatility Index (VIX). The VIX is often referred to as the 'fear index'. The VIX measures implied volatility on S&P 500 index options. In simpler terms, when investors are using options to hedge the risk of a fall in stocks, the VIX picks up. When investors are comfortable with what they perceive as risk, the VIX goes to sleep.

For this reason, we would suggest renaming the VIX 'the lazy index', or 'the ignorant index', or perhaps 'the wilfully stupid index'. A low reading on the VIX should be an alarm bell, not an all-clear sign. Any time investors are so content that they find it unnecessary to hedge their longs, they are in for a world of hurt.

You can see it on the chart. The VIX usually spikes after stocks have already begun to fall. This is like putting your seatbelt on after you've been in a car wreck. Insurance only works if you buy it beforehand. You hope you never need it. But if you buy it after an accident, not only is it a lot more expensive, but it won't do you much good either.

But as we write, the market has picked itself up off the tarmac and is now motoring along nicely. The punters will soon forget about getting sideswiped by the Fed. The planned asset inflation can go on until the powers that be decide another wealth-transferring crash is in order. Carry on.

Meanwhile, these big one-day swings are a lot less stressful if you have a long-term plan that you're sticking to. Our own plan is to buy more gold bullion when it goes down. The panic prices are a gift. It's tough to recognize key buying opportunities, though. You have to be willing to go against your emotions. But when you encounter one of those 'hold-your-nose-and-buy' moments, you have to hold your nose and buy, or be content with being in cash forever.

For what it's worth – and this is completely idle speculation – we reckon the dominant psychological trend in the market is the fear of missing out on bigger gains. High prices attract buyers. The momentum will build until the nervous punters sitting on cash get right back into the market. This will be the top.

But frankly, timing these moves is getting harder, and that's assuming it's even possible. It doesn't help that you have a bunch of blabber-mouthed central bankers who are having second thoughts about their big monetary experiment. That brings us to a final point.

It's not really our point. It's a point made many times by many people, but worth repeating today. The more you try to de-risk a system, the more accident prone it becomes, and the more damaging the accidents are. The economist Hyman Minsky described this in the financial system by saying that stability breeds instability. Using the VIX as a measure of complacency supports Minsky's insight.

But it goes beyond the stock market. By using interest rates and monetary policy to try and prevent recessions, central bankers are making the world less safe and more likely to have a horrible accident. They are making the financial system more fragile, the point Nasim Taleb makes in his new book Antifragile: Things That Gain from Disorder.

You might not believe that the world becomes more dangerous precisely because you're trying to make it safer. But studies show that after the introduction of seat belts, the number of car accidents went up. Why? Well, people must have felt that because the belts made them safer, and made accidents more survivable, it was okay to take more risks, drive faster, and otherwise abdicate responsibility for their own actions.

We're not saying people get in the car and say, 'Okay, today I'm going to drive like an idiot.' Sometimes it looks that way, of course. But it's a psychological phenomenon we're talking about. If people are led to believe they are safer, they will quite naturally be less vigilant about risk.

The trouble is, a sense of risk is a highly useful advantage in evolutionary terms. Risk tells you when something big is at stake, and the quality of your actions and decisions matter. If you try to systematically eliminate risk from society – even if it's out of good intentions – you aren't helping people at all. You're robbing them of a basic instinct which promotes their ability to look after themselves. You're turning them into domesticated bipeds.

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