The Market's Unrelenting Cheer Makes Some Nervous

The Market's Unrelenting Cheer Makes Some Nervous
Periods of low volatility lead to greater risk-taking, which can lead to disaster. Would Hyman Minsky have said we're getting there? (Photograph by Scott Eells/Bloomberg)
Photograph by Scott Eells/Bloomberg

The late economist Hyman Minsky posited that a long stretch of calm on Wall Street and in the broader markets sows the seeds of its own demise. His 1960s-era “financial-instability hypothesis” didn’t get much love in the mostly deregulated half-century that followed—until so much financial laxity crashed and burned into 2008 and 2009. (Witness how blind the Federal Reserve was in the run-up to financial meltdown that would force it to take trillions of dollars worth of action.)

According to Minsky, investors take on more risk and debt in boom times, when complacency and easy money are the rage, until they hit a point when they realize they can’t service that debt. The ensuing rush to the exits is dominated by margin calls and forced selling; in an inflection known as a “Minsky moment,” markets fall, as does access to capital. The preliminaries to the ’08 financial crisis were marked by such instances, including subprime homeowner distress and the financial pyromania practiced by Bear Stearns, Lehman Brothers, and AIG.

In light of today’s calm and renewed risk-taking, could another Minsky moment be in the offing? Of late, that thought seems to be getting more mention on Wall Street.

“The ghost of Hyman Minsky hovers over Taleb’s work,” wrote Michael Lewitt, in the Jan. 1 Credit Strategist he edited. He was referring to Antifragile, the recently released bestseller by Black Swan and Fooled by Randomness author Nassim Nicholas Taleb. “The lesson for portfolio managers,” wrote Lewitt, “is we should stop worrying about things we can’t predict (such as the timing of the inevitable market dislocations to which current monetary and fiscal policy failures will lead) and instead focus on structuring our portfolios to be strong enough not only to withstand such events but even to profit from them.”

While Lewitt is arguing that you can’t necessarily time the elusive Minsky moments as much as brace yourself for them, there is fresh fodder for worry.

For one thing, volatility is at its lowest reading since June 2007, the month that a pair of Bear Stearns hedge funds blew up, sending shock waves across Wall Street. By at least one composite measure, aversion to risk is presently at a three-decade low. The U.S. markets have finally returned to pre-2008 levels, global debt issuance just staged a record year, and the individual investor is finally peeking his head back into the tent (a development that some on the Street swear is the best contrarian indicator of all). Bad credit? No credit? No problem.

All of this is being suborned by a super-accommodative Federal Reserve—far more generous than Alan Greenspan ever was during the early-to-mid 2000s swelling of the credit bubble.

Next, throw in the fact that leverage at hedge funds just hit the highest level to start any year since at least 2004, according to Morgan Stanley. At the New York Stock Exchange, margin debt among member firms rose in November to the highest level since February 2008—a month before Bear Stearns collapsed.

Robert J. Barbera, co-director of the Center for Financial Economics at Johns Hopkins University, is a Minsky expert. He explains that in the wake of a recession, safety is paramount until an economic recovery eclipses memories of the decline, and higher-risk/higher-return thinking takes hold. Then takes greater hold. And then. …

Barbera says that today’s recovery from a once-in-a-generation downturn is not as easily diagnosable. “A Minsky moment in the making?” he asks, via e-mail. “Not so fast! The deadly admixture that elicits Minsky like financial system crises is a combination of risky finance and CENTRAL BANK TIGHTENING OF MONEY AND CREDIT” (his caps).

It is true, Barbera says, that some financial measures are looking relatively risky. But the economic backdrop to date has not signaled that easy money the world over will soon be reined in. The paradox, he says, is that a rapid upturn in the economy would force investors to have to “radically recalculate” the Federal Reserve’s tightening schedule. The result is that the boom and the attendant prospects of tighter monetary policy—normalcy, if you will—could beget market distress.

“The delicious Minskyian irony?” he says. “Angst about a return to recession, which has persisted in this recovery for four years, keeps the Fed on hold and the asset market recovery on track. Unambiguous economic strength, and the recognition that Fed largesse is no longer needed on Main Street, is the more serious threat to asset market returns.”

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