Friday, January 31, 2014

Leverage and Instability

If you leave I won't cry
I won't waste one single day
But if you leave, don't look back
I'll be running the other way

It doesn't take much of a decline in domestic stock markets these days to grab people's attention and make them nervous. Of course, it has been a while since there has been a meaningful correction. Because the last couple of years have been largely a straight up move, price declines are more noticeable and newsworthy.

Small market declines also attract attention because systemic leverage is at all time highs. As leverage goes up, there is less general tolerance to downside price movement. Debt is high compared to equity. That equity can be wiped out with small declines in price.

As such, people are prone to react to small declines in price when they are levered. When prices go down, they must quickly unwind risky projects lest they will be rendered insolvent.

Policymakers have been expanding credit and borrowing more under the auspices of stabilizing financial systems. This is completely misguided.

Credit and debt de-stabilize. Small declines in price can send leveraged systems into chaos.

position in SPX

1 comment:

dgeorge12358 said...

Nonlinear systems are central to chaos theory and often exhibit fantastically complex and chaotic behavior.
~Chaos and Fractals, Larry Bradley