Let me now bring these themes together. As any avalanche expert will confirm, it is almost impossible to predict whether the next precarious run in avalanche territory may result in a disastrous outcome. But what matters for risk is not the probability of the disastrous outcome, but the product of the probability, the consequence (together the “hazard”) times the exposure, times the vulnerability. Remove or drive any of these factors to zero, and the risk goes down to nothing. However, and this is important, the risk of an avalanche is not random. It depends much on certain factors (terrain, weather, and human factors), which might not be exactly predictable in isolation, but where we can make intelligent judgment calls to control our risks.
For instance, humans cause most of the deadly avalanches. In other words, just a small amount of additional weight at the wrong place can result in a slab of snow sliding over a weak layer and creating havoc. So what we do when faced with precarious terrain and other conditions does matter.
Humans also cause market melt-ups and melt-downs. Narrative Economics echoes this. The “economy”, whatever it means, does not by itself cause market bubbles and crashes. Human participants in the markets do by collectively spinning stories and acting upon them.
When investors realize the bull market of the last decade slipped past them, the fear of missing out on the next bull market will be like venturing out on a beautiful, sunny day after a massive snowfall – setting up perfect conditions for an avalanche in the markets. If 2010-2019 was the decade when investors hated the bull market in equities, 2020-2029 could very well be the decade where investors fall back in love with asset markets, and could be severely disappointed by the potentially precarious conditions lurking just beneath the surface that are a consequence of elevated prices and extreme faith in central banks.
To deal with such euphoria and panics psychologically is not easy. One only has to look at the asymmetry of the potential outcomes to see that venturing out on an off-piste steep slope after a massive snow dump is asking for trouble. Yes, you might (and probably will) survive, but paraphrasing Joel Greenblatt, it is like “running in a dynamite factory with a burning match – you might live, but you are still an idiot”. Buying negatively yielding bonds (I have a whole paper on this topic, and many posts in this forum), is not much different. Pity the investor who bought the German 30-year bond in August of 2019 at a negative yield of -0.12% and is now sitting on more than 15% of losses without ever earning a “coupon” (most likely this bond is in some bond-focused ETF, and the ultimate owner does not even know or care that he is spending part of his investment on a bond that will never pay him a coupon!).
Such unprecedented anomalies aside, the beginning of the new decade and the new year is full of sunshine and fresh “pow” on the slopes. Things are good, the economy is purring along, inflation is low, the Fed is supportive of asset prices, and there is plenty of money to go around. It is hard not to follow other brave investors into the wild world of speculation when the last decade has created unprecedented wealth for the brave (and patient). The markets have responded in kind with an almost vertical ascent. The forecast of the weather, at least as measured by economic policy uncertainty, continues to send warning signals, even though all looks sunny right now.
However, embedded in this pristine set of conditions are the elements that cause market avalanches. Any unexpected change in the “narrative” or the “story” can trigger a cascade without warning. Watch out for it as you go riding the slopes or markets this year. Once an avalanche is triggered, it is almost impossible to race away from it. To use a quote from Dornbusch “In economics (and markets, my addition), things take longer to happen than you think they will, and then they happen faster than you thought they could”.