Fragile Order Failing – Do You Hear Me Now, Butterfly?

Fragile Order Failing – Do You Hear Me Now, Butterfly?

Via The SwarmBlog.com,

“The woods are lovely, dark and deep, and I have promises to keep, and miles to go before I sleep. Do you hear me, Butterfly? Miles to go before you sleep.”

Down the Market Hole, Down in Mexico

Death Proof is an amazing movie. Even if the quality of the second half of film is a bit lower in my opinion, the first half is a masterpiece. Quentin Tarantino managed to a write a story that gradually and subtly become intriguing before destroying everything with one of the most brutal and violent car crashes ever filmed.

Somehow, one could regard that scenario and its epilogue as a metaphor for 2021 capital markets, as the mother of all crashes is likely to be the conclusion of one the largest speculative bubbles in all human history.

For months, people have argued that the best thing to do was “to ride the bubble,” as everyone knows that in some circumstances the trend can be “your friend.” This is what Benoit Mandelbrot called “Joseph effect,” meaning that movements over time tend to be part of larger trends and cycles more often than being random . And to be fair, most trend followers have done pretty well for years.

Many technical analysts keep claiming that they will be able to identify the top and to reverse their positions when we reach that moment. Besides, stop-loss orders are seen as a protection against any bad surprise such as a black swan event.

However, few of them take into account discontinuities of asset prices, also known as “Noah effect.”

Inspired by Mandelbrot’s works on fractal geometry, asset manager Edgard Peters put forward the “fractal markets hypothesis” at the beginning of the 1990s. According to him, the price of an asset can evolve by random walk, a persistent trend or mean reverts. When there is a persistent trend, the bull run is fueled by investors who have the longest time horizon. In other words, each sell-off will be bought, even if participants with a shorter time horizon might occasionally become net seller. In such a BTD environment, the trend is definitely “your friend.”

A brutal reversal may happen when investors with the longest time horizon finally decide to change their allocation. Given the convexity of the order book, the transition phase can be severe according to researchers Karp and van Vuuren: “If the trader’s horizon becomes dominant, and liquidity evaporates when sell orders far outweigh the number of buy orders, the fractal structure of the market collapses and violent price corrections become manifest.”

Sometimes, the avalanche is so massive that no one can see the crash coming, and stops are not always proven effective (e.g. October 1987).

Other times, some big players manage to quickly detect the beginning of a crisis, but do not count on them to help you get out this mess. Remember what Michael Lewis wrote in The Big Short: “In 2008, Goldman Sachs did not leave the house before it began to burn; it was merely the first to dash through the exit – and then it closed the door behind it.”

Therefore, the idea that there will always be someone to bid could lead to one of the worst crises ever as almost no one is prepared for that.

Stuntman Jay

But of course, there is the Fed.

However, Powell and his team have a problem. There is too much liquidity in the system, and they do not know how to deal with the monster they have unleashed in March 2020. What is more, money injections do not mean that order books will always be liquid from a market perspective.

FinTwit is very helpful to measure participants sentiment, and you may have noted that most people believe that a crash is not possible. That the bull market will continue until at least 2023. That authorities would never let stocks go down.

They may be right. But all of them are structurally short on volatility. In other words, if anything goes wrong, then the whole thing will blow up. And it will be too late to act (see Into the Swarm #2: The Greatest Trick Wall Street Ever Pulled).

What could go wrong? Well, a simple look at technicals shows us how weak this “invincible” market has gradually become: bearish divergences everywhere, bear flags, record leverage, extreme valuations, excessive concentration on a few assets, maximum exposure to US equities, and no more bearish positions.

Perhaps the most interesting signal comes from the VIX compression pattern, as regularly highlighted by Sven Henrich (Northmantrader.com).

The VIX is a fascinating indicator. Indeed, it is a proxy for stocks instantaneous volatility, and thus spikes are equivalent to earthquakes in geology (displaying the same type of power law distribution).

Such a compression pattern means that a narrative has become so dominant that most participants believe that there is no more uncertainty, leading to those intriguing fractal structures with decreasing spikes as long as everything seems under control. Somehow, they may be associated with wedges on stock indices.

But that fragile order will collapse as soon as something goes against the dominant narrative, creating a brutal form of dissipation of “energy” (i.e. a volatility spike), also known as “an avalanche.”

More interestingly, history shows us that such compression patterns always result in an upside breakout (at least since 1990). While further research based on chaos theory might help us to model those non-linear dynamics and perhaps to try to anticipate future spikes, it is already worth paying attention to Sven Henrich’s charts, especially as the level of complacency in the system has never been so extreme.

Whether people will like it or not (probably not), corrections are necessary phases as overwhelming narratives tend to create distortions in the economy and generate social issues that may translate into political crises afterwards.

If you regard the financial system as a car, then the questions is, where do you sit in the car? Stuntman Mike already warned you: “This car is 100% death proof. Only to get the benefit of it, you really need to be sitting in my seat.”

Tyler Durden
Fri, 06/18/2021 – 11:53

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