What Could Go Wrong? Politics, Crises, and Machine Trading

By Christopher R. English, President of Lumen Capital Management, LLC

This is the final article in a series that covers the bearish argument for stocks. While there are plenty of factors that could cause the markets to become more chaotic, I've tried to feature the most prevalent events that could lead to something more than a simple correction for stocks. I've been discussing these in what I believe is the most highly probable to least likely to occur. In our last letter we talked about two things that could result in a bear market: valuation declines and an economic slowdown. Today, we’re going to turn our attention to three more factors that could lead to a long-term secular bear market. 

Decline Due To Political Chaos

Politics can greatly affect the markets. There is a bearish argument that President Trump is such a divisive and polarizing figure that his administration will ultimately wreak havoc on the economy and the markets. Those touting this argument believe stocks have rallied since the election because investors have been energized by the pro-business policies of the Trump Administration. However, the counterpoint to this is that the ongoing political gridlock in Washington and any potential political crisis from the ongoing investigation into Russian manipulation of our elections means that these pro-business policies are in danger. Not to mention the polarizing nature of the President himself. The belief is that stocks could fall precipitously if any of these worries become reality. Many worry that Trump’s scandals will rival Watergate and the economic fallout if this occurs could be just as negative.

Before I continue though I want you to know that I do not write about politics and I always attempt to divorce politics from my understanding of the economy. As such, I strive to only write about how I believe the political process and system will affect my client's investments. In this regard, it is irrelevant to me who is President or who controls the Congress. You have to play with the hand you're dealt when investing money, regardless of whomever you might prefer to see as President or whatever are your political beliefs. 

Therefore, and solely in context with what I said in the preceding paragraph, let's discuss the role the media is so far playing in their confrontations with the President. In our current political climate, the media is playing a significant role in our reactions to the President. The press hates Mr. Trump, particularly the coastal-based media outlets. The only president the so-called “4th Estate” has perhaps loathed more is Richard Nixon. The President seems to return the favor with the exception of those outlets that are biased towards him. Mr. Trump made the media look bad during his campaign by exposing their biases along with WikiLeaks and in an era where there are more news outlets than ever, more traditional news organizations risk being made to look irrelevant by newer means of communication. As a result, traditional media outlets are trying to do everything they can to destroy the President. Some of this is obviously personal but the real reason is that the President and his allies are perceived as mortal threats to traditional media's existence. 

I caution you on this not because I want to influence your views or because I am trying to make a political statement, but because the press will distort almost every aspect of whatever economic plan this administration puts forward. Instead of letting sensationalized headlines rile you up, pay attention to how the market reacts, not on any given day, but over a series of weeks. If the plan is economically promising, stocks should react positively. 

For example, any overhaul of the tax code is going to have winners and losers. Who do you think will complain the loudest? The cries of anguish from the losers will be presented in a manner that appeals to the base instincts of their audience. They won't tell us anything about the long-term potential positives that might result from the changes but will focus only on what they don’t like. Those changes, and how they will impact the economy, must be our litmus test in regards to the markets. Regardless of whether the changes are good or bad, they are what will drive market returns in the years to come. 

Watergate Part Two?

The Trump/Watergate analogy has been thrown around all too often lately. While it’s too soon to know how things will play out with the President’s issues, I will caution you against relying too heavily on the Watergate similarities. Watergate occurred against a backdrop of runaway inflation, largely stemming from the Arab oil embargo after the 1973 Arab-Israeli war and a slumping economy. Whatever the ultimate resolution to the President’s problems is, the economic situation does not resemble that period of our history in the least.

The Unexpected

Let’s be real, things happen outside of our control on a regular basis. When a crisis occurs, there is a domino effect, impacting various aspects of our lives. This can be true even for events seemingly far away. Take for example the 2011 Fukushima nuclear disaster that resulted from an earthquake and tsunami. That event initially seemed confined to Japan but it took on international significance as the reactors in the plant melted down. Energy companies in any manner connected to nuclear power suffered as a result and markets remained stagnant for months as the world saw lower economic growth out of Japan, it is a given that things like international crises, wars, and natural disasters will happen in the future. The unknown is always the timing. Something could happen tomorrow, not until next year, or never. 

A geopolitical event or an unexpected shock, such as a destabilizing natural disaster, would likely lead to a market decline, but there’s not much we can do about it. We monitor these occurrences to the extent we can and take into account the most likely events that could happen. But one cannot invest assets worrying about when the sky will fall. That is as true when stocks are expensive as when they are cheap.

Economic Scandals and Asset Bubbles

Very few people will ever forget the bank scandals that occurred in 2007 and 2008. The excess and abuse of authority from these institutions rocked our economy and led to the largest economic contraction since the Great Depression. The financial services industry is much more heavily regulated today than it was a decade ago. It is impossible to assert that there will never be another scandal or financial collapse but the probability of that occurring right now is much less than it was back then. Banks are required to carry higher reserves today and face scrutiny in a more comprehensive manner. Their improved capital structures resulted in every bank passing the most recent Federal Reserve stress test. That is the first time this has ever happened since the tests began. If there is an issue with banks it will likely be in some overseas market. US financial institutions should be in a much better position to weather a problem today than even a few years ago. 

Technology companies have been some of the best-performing assets since 2009. Unlike the early 2000s, their rally is hardly about speculation in tiny stocks nobody has ever heard about with no earnings or growth prospects. There is also no similar widespread national speculation in assets like housing, which kicked off the last recession. Credit standards have been too tight to have a replay of our previous crisis. The only place this has been evident in the high-end housing market with the influx of foreign money such as in Manhattan or Miami Beach and that seems to be correcting on its own with no seeming national impact. Just because things are different now doesn’t mean we couldn’t see a financial issue of some sort, but at this point, it’s not the obvious trigger. 

Machine-Trading 

Finally, let’s discuss the possibility of issues with algometric or computer trading leading to a sudden and violent decline in stocks. We can’t discount the idea that an algorithmic-induced trading panic could occur. We have seen short-lived flash crashes resulting from issues related to machine-based trading that ran amok. The first of these occurred on Monday, October 19, 1987. That event has been largely attributed to computer programs related to so-called “portfolio insurance” relentlessly selling down the market for over a 20% one-day loss. The most recent of these was May 6th, 2010, when stocks lost around 10% in a very short period of time. I would say there is a certain probability that we could experience another of these at some point. While regulations have been put in place to try and stem this sort of panic selling, the only way one will ever know their effectiveness is to see what happens when they are tested. It is possible that some of the machine dominated trading could find a way to trade around these regulations. 

If and when something like this occurs, it will be important to understand the events surrounding the situation. When an event happens out of the blue with no other economic or breaking political news, it will likely be short-lived, with the natural arbitrage of the markets stepping in as buyers likely swoop in to pick up perceived bargains. No matter how frightening it may seem to investors, make sure to keep a calm head. If there is no fundamental upset to the economy in these situations, it is best to stick to your investment plan. The fact that machine-trading crashes are so few and far between likely means that while the occurrence is a real possibility, it is also rare. Additionally, markets recover from these things relatively quickly when there is no change to the overall investment or economic climate. 

As much as we’d like to, we can’t prepare for every possible economic situation. What we can do is create a portfolio that fits your unique risk/reward parameters that should over time help you cope with the inevitable ups and downs of the market. Are you worried about where you stand and think your portfolio needs another look? Call my office at 708.488.0115 or email us at lumencapital@hotmail.com.

The next article in this series will come later this summer and is going to be about what I believe is the greatest long term potential I see in regards to both stocks and the world economy for the next decade. Stay tuned!

Back Friday.

About Chris

Christopher R. English is the President and founder of Lumen Capital Management, LLC-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors, developing customized portfolios 

that reflect a client’s unique risk/reward parameters. We also manage a private partnership currently closed to outside investors. Mr. English has over three decades of experience working with individuals, families, businesses, and foundations. Based in the greater Chicago area, he serves clients throughout Illinois, as well as Florida, Massachusetts, California, Indiana, and other states. To schedule a complimentary portfolio review, contact Chris today by calling 708.488.0115 or emailing him at lumencapital@hotmail.com

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