This infographic shows how interconnected our financial markets are and how that could trigger the next crashGet the Full StoryScott Olson Getty ImagesComplex systems are all around us.
By one definition, a complex system is any system that features a large number of interacting components agents, processes, etc. whose aggregate activity is nonlinear not derivable from the summations of the activity of individual components and typically exhibits hierarchical self-organization under selective pressures.
In today’s infographic from Meraglim we use accumulating snow and an impending avalanche as an example of a complex system – but really, such systems can be found everywhere. Weather is another complex system, and ebb and flow of populations is another example.
Markets are complex systems
Just like in the avalanche example, where various factors at the top of a mountain accumulating volumes of snow, weather, temperature, geology, gravity, etc. make up a complex system that is difficult to predict, markets are similarly complex.
In fact, markets meet all the properties of complex systems, as outlined by scientists:
1. Diverse — System actors have different points of view. i.e. bullish, bearish, long, short, leveraged, non-leveraged, etc.
2. Connected — Capital markets are over-connected, and information spreads fast. i.e. chat rooms, phone calls, emails, Thomson Reuters, Dow Jones, Bloomberg, trading systems, order entry systems, etc.
3. Interaction — Trillions of dollars of securities are exchanged in transactions every day i.e. stocks, bonds, currencies, derivatives, etc.
4. Adaptive Behavior —
Actors change their behavior based on the signals they are getting i.e. making or losing money, etc.
And like the avalanche example, where a single snowflake can trigger a much bigger event, there are increasing signs that the complexity behind the stock market has also reached a critical state.
Markets in a critical state
Here are just some examples that show how the market has entered into an increasingly critical state:
Record-Low Volatility — The VIX, an index that aims to measure the volatility of the market, hit all-time lows this summer.
Bull Market Length — Meanwhile, the current bull market 2009-present is the second-longest bull market in modern history at 3,109 days. The only bull market that was longer went from the 1987 crash to the Dot-com bust.
Valuations at Highs — Stock valuations, based on Robert Schiller’s CAPE ratio which looks at cyclically-adjusted price-to-earnings , are approaching all-time highs as well. Right now, it sits 83.3 higher than the historical mean of 16.8. It was only higher in 1929 and 2000, right before big crashes occurred.
Market Goes Up — Investor overconfidence leads investors to believe the market only goes up, and never goes down. Indeed, in this bull market, markets have gone up 67 of the months an average gain of 3.3 , and have gone down only 34 months average drop of -2.6 .
Here are some additional signs of systemic risk that make complex markets less stable:
A densely connected network of bank obligations and liabilities
Over 70 trillion in debt added since Financial Crisis
Over 1 quadrillion in notional value of derivatives
Non-bank shadow finance through hedge funds and securitization make risk impossible to measure
Increased leverage of banks in some markets
Greater concentration of financial assets in fewer companies
In other words, there are legitimate reasons to be concerned about “snow” accumulation – and any such “snowflake” could trigger the avalanche.
In complex dynamic systems that reach the critical state, the most catastrophic event that can occur is an exponential function of scale. This means that if you double the system, you do not double the risk; you increase it by a factor of five or 10. – Jim Rickards, author of Road to Ruin
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