a simple model for understanding freefall markets

I wanted to share with you a piece of wisdom from Edgar Peters who wrote a book about using Chaos Theory as applied to investing, called “Fractal Market Analysis.” The book is fairly long, but the one insight that I have continued to use for over ten years is about the underlying reasons for rapid market declines.

Peters says that there are two types of investors: those with a short-term perspective, and those with a long-term perspective. Investors of a short-term perspective are constantly trading because of their short embedded time horizon. So when they need to sell assets they have two constituencies that they can turn to: other short-term investors, or long-term investors. But what happens when there is a shock to the market? This shock could be September 11th; it could be the near bankruptcy of AIG, Fannie Mae, Freddie Mac; Gulf War II, etc. The overwhelming majority of short-term investors desperately want out of their investments. The problem is that liquidity is less in this situation because short-term investors can no longer rely upon each other to buy each other’s assets because they all want out…and now! So those short-term investors are very reliant on the longer time horizons of long-term investors. The long-term investor has built into her investment philosophy the belief in short-term shocks to the system that are good buying opportunities. So they provide liquidity to the desperate short-term investors and for a premium – meaning that they pick up assets on the cheap.

But what happens when long-term investors are scared enough to become short-term investors? Clearly what you have then is a disaster as liquidity is extremely difficult to find. The only thing that can happen in that situation is that prices must fall and rapidly. Clearly that is what we are experiencing right now, isn’t it? Long-term investors have become short-term investors.

But the reason this is an interesting model is not because of what is described above. No, the reason that this is an interesting model is because it causes you to think about the necessary causes that must occur for long-term investors to get so spooked. Having been a financial market professional for 15 years and a student of economic and financial market history I can say that these declines happen when long-term investors begin to doubt the soundness of the structure underlying the markets themselves.

So the prescription as a regulator is to do what it takes to ensure that faith in the soundness of the markets is always at the forefront of your mind. Not only that, but it means that if you have lost the faith of the long-term investors then you have to provide evidence that the structure is being rehabilitated. Sans that, then you have hemorrhaging, then coagulation. In short, there is no liquidity. The implication of this line of thinking is that it makes almost no sense to pump liquidity into a coagulated system, before you have addressed the causes of the problems. This is why it is very important for the regulatory agencies and politicians to get in front of the issue and talk more aggressively about steps they are taking to ensure the safety of the markets and simultaneously pump liquidity into the system. Does this make sense?

To summarize, long-term investors are the glue of financial markets, being the liquidity providers of last resort. However, they are only willing to do this as long as they have confidence in the financial markets themselves. Thus, regulators must always protect these foundations.

I hope that each of you is feeling marvelous! Yes, marvelous!

Jason