Just before Memorial Day weekend, a bridge on Interstate 5, north of Seattle suddenly collapsed sending cars and people into the freezing water 50 feet below. The collapse was captured on a surveillance camera from a nearby business. Looking at the video footage, it was clear that the collapse happened in a matter of seconds with no warning.
Prior to the collapse, cars and trucks passed over the bridge at an average rate of 71,000 per day with no reported problems other than a wide load on a truck that had struck a steel beam. The damage from the wide load was relatively small in reference to the superstructure of the bridge, so how could this happen? In a nation filled with engineers, on a federally regulated highway, on a bridge that has inspections every two years, how could it be that no one was made aware of any danger?
The bridge was built in 1955 and on its most recent inspection was rated a "5", on a scale of "0" (worst) to "9" (best). This bridge was constructed in a "fracture critical" design, meaning it could collapse if even one part of it failed.
I have driven myself and my family across this bridge many times in recent years. I never stopped the car prior to crossing to inspect the bridge myself, nor did I make any inquiries with the authorities as to the condition and safety of the bridge before taking a drive up I-5--even with a baby in the car. I simply trusted that the authorities keep everything up to snuff. The road was smooth and has repeatedly been resurfaced, which helps make the freeway drive comfortable--it didn't cross my mind to be concerned. My perception of the safety of the bridge did not match the reality of the danger that crossing it posed.
It is similar with the relationship between economic fundamentals and the current state of financial markets. The Federal Reserve has recently repaved the bridge (financial markets) by injecting trillions of dollars of liquidity into the financial system. This has caused the stock market to feel comparatively smooth to the average investor, even though it is at all-time highs. However, if you were to pull over and do a thorough inspection of the economy that underpins the market you would find that the steel beams have been severely weakened by age, vibration and rust.
It is my view that the oversize load, which proved to be the straw that broke the bridge's back, has already struck the economy in the form of the housing bubble of 2005-2009 and while the road (markets) seem as smooth as ever, all is not well in the economy below.
Structural weak spots make a collapse more likely in the event of even a relatively minor shock, as the weakened system is that much less able to absorb the shock without a collapse.
Structural Economic Weak Spots Since The Blow Of The Financial Crisis:
Higher debt to GDP. In an effort to alleviate the effects of the financial crisis on the citizenry, the government spent trillions of dollars on social programs. As can be seen in the chart below, the country has much less cushion to absorb a shock through government spending than it did before the 2008-2009 financial crisis.
Interest rates have been lowered to the zero bound, allowing no room to ease them further in the event of a shock. In 2007, interest rates were at 5%. This allowed for a significant amount of needed stimulus and shock absorption at the time of the financial crisis which not an option now.
Less people employed. The labor force participation rate has dropped to lows not seen since 1979. Less people pulling the cart and more riding also makes absorbing a shock more difficult.
Declining real wages and incomes weakens the ability of households and individuals to absorb financial shocks and downturns.
Dramatic rise in food stamp use. With nearly 50 million people now on food stamps, the social safety net is much less able to absorb shocks than it was in 2008.
Allowing the decay in fundamentals to continue unchecked even as the usage grows (all-time market highs), whether it is in bridge structure or economic structure, will surely lead to collapses. This will likely bring massive spikes of volatility and crashes in markets. Exactly the moment of collapse is hard to predict but past breaking points in markets can be used to get a rough idea.
One way to benefit from the initial shock is by having long dated, out of the money, put options. The mathematician Benoit Mandelbrot, in his book The (Mis)behavior of Markets, explains how options are priced in a way that does not adequately take into consideration the amount and frequency of extreme market movements. According to Mandelbrot, the options pricing model makes long dated, out of the money options a good deal during times of relative market calm. When the options price explodes higher from an unexpected market move, the options positions can be sold and could then be rolled into short stock index positions as the market further declines.
Disclaimer: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.
Disclosure: I am short SPY, IWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.