Originally posted in TheStreet on May 3, 2016
Are investors more frightened of freak market crashes than the reality of such crises?
Sometimes fear of a freak, outlier event can be a lot worse than the event itself, at least when it comes to the markets.
Most of us are aware of the now famous credit crisis book by Nassim Nicholas Taleb, "The Black Swan: The Impact of the Highly Improbable." The central thesis of the book is of course that black swans, or freak market events, are more common than we expect in life, and in particular, in complex systems such as economics. The credit crisis was, therefore, no great surprise, and such crises can be expected to occur in one form or another on a fairly regular basis.
Well, that was Taleb's thesis. But it was also a thesis written at the height of negative market sentiment.
Subsequent serious academic work reported by Bloomberg by William Goetzmann, Dasol Kim and Robert Shiller looked at 26 years of survey data to test Taleb's thesis.
They found that people consistently expect things such as stock market crashes and earthquakes to happen more frequently than they really do. In other words, there may be black swans out there, but more important perhaps than their occurrence is our exaggerated fear of their occurrence.
There are indeed periods of irrational exuberance when we forget about the possibility of black swans.
But certainly since the credit crisis, it seems that there has indeed been an exaggerated angst that has gripped the global investing community. It is as if the crisis was sufficiently intense that it set off a type of Post-Traumatic Stress Disorder among investors, leading to everyone seeing specters around every corner.
This overarching sense of angst has had very significant effects since the credit crisis. Although there has been modest growth in gross domestic product in the United States ever since 2009, the recovery hasn't felt like a recovery.
We continue to suffer what economist Joseph Stiglitz calls the "great malaise," a lack of those animal commercial spirits.
Shiller himself sees this anxiety as driving this very low rate environment as most investors and banks keep the bulk of their assets in low-return fixed-income assets, which itself further lowers the yield on said assets.
This has also driven excess regulation.
No one can say that the credit crisis didn't merit a significant re-think of various parts of the U.S. financial regulatory architecture. But it is now becoming equally clear that the Dodd-Frank Act was a behemoth of a piece of legislation, 848 pages long, most of it with half-baked concepts that were left to be developed over time by sub-legislation.
Many now expect the very framework of large chunks of Dodd-Frank to require major re-engineering, given its excessively controlling and complex features.
The idea, for example, of bank living wills was probably a non-starter from day one. The concept was that banks must put in place plans for their orderly wind down in the event of financial failure, ones that didn't rely on government support.
But this was immediately a bizarre exercise for all financial institutions because it involved making up totally theoretical failure scenarios, some concatenation of events that is unlikely to have any bearing on the actual features of any next crisis. After all how on Earth could we predict what that crisis will really entail?
The Federal Deposit Insurance Corp. and the Federal Reserve made all the banks write their living wills twice, on the basis that they were too loosely drafted the first time, but more granularity here doesn't solve the conceptual problem. The situations conceived are so hypothetical that these living will models are often the case of garbage in garbage out.
In addition, for those institutions that matter - the systemically important financial institutions - living wills are a particularly absurd exercise because, by definition, these large financial institutions are simply not sustainable during periods of acute illiquidity without government support.
It seems, in other words, that Dodd-Frank itself was premised on their being black swans everywhere. And the capital requirements it imposes on banks, the compliance burden, the business line restrictions and high levels of liquidity buffers all mean that banks simply haven't been meeting much of even the legitimate credit demand in the United States.
The result, of course, has been huge growth since the crisis of the shadow lending market, which is legitimate lending done by non-depositary institutions. The shadow lending market has gone through a total re-birth since the crisis, as multiple research papers demonstrate.
There can be dangers of an excessively large non-bank lending sector, but again Dodd-Frank has embedded within it another mechanism for seeing black swans in this sector also. That is the Consumer Financial Protection Bureau.
The role of the CFPB in supposedly protecting borrowers from predatory lending is only just being defined now by the regulator. But there is already considerable confusion about the CFPB's ambit, and, indeed, even a recent court hearing indicated that the bureau may be acting outside the scope of the Constitution.
Meanwhile, the U.S. economy struggles to get above 2% GDP per annum, consumer inflation is negligible and growth is so anemic that the Fed's attempt to raise short rates and normalize monetary policy is materially struggling. So it is back to Shiller and Stiglitz, just too much fear in the system to allow growth really to ignite.
And so what does such economic neurosis really amount to? It isn't necessarily the product of there being too many black swans but the product of an irrational belief that there may be too many black swans.
And the big question then is when will it all end? When does the anxiety end, when is the neurosis cured and how?
Disclosure: Jeremy Josse is the author of Dinosaur Derivatives and Other Trades, an alternative take on financial philosophy and theory (published by Wiley & Co). He is also a managing director and head of the financial institutions group at Sterne Agee CRT in New York. Josse is a visiting researcher in finance at Sy Syms business school in New York.
The views and opinions expressed herein are those of the author and don't necessarily reflect the views of CRT Capital Group, its affiliates or its employees. Josse has no position in the stocks mentioned in this article.