The fundamentals of market crises: Avoiding a financial black hole

Discussions with clients

clock • 4 min read

Advisers should be forming judgements about the likelihood of developing market crises and discussing them with clients, writes Dr Quintin Rayer, head of research at P1 Investment Management.

Although markets regularly have periods of falling prices, it seems easy to focus on the upside, directing relatively little effort towards spotting the next crisis.

Press coverage seems short-term, with negative events rapidly forgotten. While discussions with managers tend to concentrate on the positives and the potential for downward market moves can seem neglected. 

Recent events show that political events often impact markets (for example Brexit and the US Presidential Election), with outcomes differing from mainstream opinion.

In this context, it seems strange that financial advisers do not spend more time discussing the potential for future financial crises. One might expect these discussions to extend both among themselves and also to client conversations. 

This article explores some fundamental causes of financial crises, and sketches a possible approach for better managing investments in the face of this uncertainty. 

Financial crises

Advisers know that stockmarkets are prone to bear markets.  For investors, these are a source of great concern since stockmarket crashes can result in declines of 25% or more. 

Markets often appear driven as much by sentiment as by economic reality and, as suggested by former Federal Reserve chairman Alan Greenspan, can suffer from "irrational exuberance". 

Jim Rogers predicts worst crash of our lifetime

Market values are perceived to be linked to economic cycles - but, since participants seek to anticipate investment opportunities ahead of competitors, are forward looking. 

Investors must forecast economic and investment outcomes with incomplete information. This can result in decisions coloured by human behavioural biases. With many market participants, many views are generated -not all of these can be correct.

Even if 'normal' economic cycles could be predicted from interest rates, unemployment and other data, national economies are subject to influences from foreign countries via trade, government decisions and wider geopolitical events. 

Countries may be 'serial defaulters' on their debts; tending to over-borrow during good times leaving them vulnerable during downturns.  

Governments can treat favourable shocks as permanent developments, fuelling a spending and borrowing spree that eventually ends badly. 

Financial innovations can permit illiquid assets to command higher values than previously, such as during the US subprime mortgage crisis of 2007.

The complexities of financial markets may make them prone to instabilities, making them capable of amplifying small events with potentially catastrophic consequences. 

Long periods of stability can lead to debt accumulation until dangerous levels of leverage are reached.

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