Is This Time Different?

An exploration of the current state of financial markets and the phenomenon that is crypto.

Photo credit: StockInvestor.com

When looking at history, it seems pretty obvious that we’re likely close to a downturn in the markets. Mostly this is due to the cyclical nature of the way markets work, not any one particular feature. Markets get overhyped, then there’s a reawakening and correction, which leads to a recession, which leads to people getting back into the market and then overhyping it, and on and on it goes.

However, a few things are odd this time around. Since the 2008/2009 recession, financial markets have been pretty steady in their growth. No huge years of growth and no huge downturns either. Instead, it’s looked like nice and steady growth with low volatility over almost a decade, which makes it one of the longest such runs in market history.

On top of this, interests rates have been at an all-time low and, while increasing slightly of late, have been low for a long time. Finally, there seems to be less risk taking in the markets because of new regulations that were put in place after the last recession. All of this leads one to believe that maybe this time is different? Maybe we’ve figured this whole public markets thing out.

Perhaps it is different. It could be the case where with loads of information, data, and sophisticated technology, markets are getting better at avoiding unnecessary risks and are making better decisions. Leading to a more stable market that avoids the pitfalls of overhype and over-depression.

Though you would be forgiven if you rolled your eyes at that last sentence. If people are still involved in markets, people will still be biased, emotional, and irrational. We are human after all.

But maybe things are different this time because people actually aren’t all that involved in the markets? Just examine the advances in financial technology. Robo-advisors that use smart algorithms to make better investment decisions on your behalf are on the rise. That should remove a lot of human bias and emotion from markets as well as increase the efficiencies.

Another example of humans being less involved in the markets is the massive growth of index funds. Billions and billions of dollars are being put into index funds every year. Index funds are essentially robo-advisors who do one specific thing. They are even less likely to suffer from any human biases because their algorithm isn’t really created by humans, it just matches exactly what the market says[1].

Finally, how about high frequency trading? As Michael Lewis points out in his book Flash Boys, these trading algorithms have completely changed the game in markets. Add index funds, robo-advisors, and high frequency trading together and it begins to look like humans really aren’t in the mix all that much.

The rise of machines in markets could mean one of two things, or perhaps a little bit of both. On the one hand, it could mean what I mentioned above, where the presence of sophisticated machines and algorithms are the overwhelming majority of investments being made in the markets and therefore have eliminated a lot of the market’s human flaws, even if active investment managers still get a lot of the press. Afterall, it is pretty boring to talk about algorithms on the news.

Yet on the other hand, it could also mean that we may be setting ourselves up for something even worse than human lead crashes. It’s possible that we don’t actually know how any of these machines or algorithms will react when something really bad does happen. They could just end up making everything even worse. Robo-advisors in particular are so new that they’ve only really been around after the last recession, so can we truly know how they will react when one does happen?

The same thing goes for index funds. Though they’ve been around a lot longer than robo-advisors have, there has never been this much money in them. They make up such a significant part of the market that even if only 25% of index fund investors decide to pull their money out at the same time, it could have a huge impact on the market.

Imagine if all the billions of dollars that are invested in markets via index funds or robo-advisors all of a sudden decide to sell? That could have a devastating impact on the markets, and I’m not sure we’ll know what to do about it.

And if you throw high frequency trading into the mix, you can see how things could spin out of control, really fast. High frequency trading algorithms have already been part of self-generated crashes, so it’s not crazy to think it might happen again.

We can hope that the humans who programmed all these trading algorithms took into account all the 2nd and 3rd order effects that could happen when they created them. But in reality we know that’s impossible.

Ok so we got the machines out of the way. But as long as humans still walk the earth, we are still going to get our hands into things. We crave action, we have a need to do something. We aren’t just going to sit around while the robots have all the fun, are we?

So where then is all the human energy being directed? I would argue that’s why we are seeing a rise in crypto, in both investor attention and money.

Crypto assets have the perfect storm going for them. On the one hand, there really is some fascinating technology. Whatever you think of the current valuations, it’d be inaccurate to call the actual underlying technology unimportant. Crypto assets offer a new way of building digital technology, with a built in payment system. It also has gotten the attention of everyone and their mother. And I mean that quite literally too.

But why, you might ask, is crypto attracting so many people to it? Maybe the technology is cool and maybe investors are over equity markets but that doesn’t explain everything about why people are in such a frenzy about it. In my opinion, people are in a frenzy about crypto because we have some deep desire for sky high returns and a fear of missing out (or FOMO for short).

Why do people play the lottery? For the promise of riches, no matter how small the odds are. People are good at dreaming. It’s arguably our greatest feature. Wouldn’t it be awesome to own $10 million? You can’t win what you don’t play, or so the saying goes.

Same thing for crypto. People see the money that some have made in crypto and think that could be them. Let me buy my lottery ticket and ride off into the sunset on my pile of millions that I’ll earn from buying the latest and greatest token.

So we have a financial market where people are overhyping it. Haven’t we heard this story before?

We’ve come full circle, though it’s really felt more like a zig-zag. The US public equities market is probably pretty safe and not that risky at the moment (or maybe not if you’ve been paying attention). And that’s not necessarily such a bad thing.

Yet it is leading many to make poorer decisions and go seek amazing returns elsewhere. So they’ve turned to the market where that seems to be happening to everyone today, crypto assets. That doesn’t make for a great recipe down the road. As they say, history may not repeat itself but it sure does rhyme. Is this time different?


Footnotes

[1] Yes, humans are involved in the companies that make up the lists for index funds but it’s unclear how much, if any, influence humans can actually have on the entire market as a whole.

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