The Acquittal Of Fear: How The Financial Crisis Changed Our Perception Of Reality

Late last year, when markets were in the throes of a quasi-meltdown characterized by a near-collapse in stocks, sharply wider credit spreads, grievous outflows from leveraged loans and sharply higher equity volatility, I lamented the investing public’s perverse fascination with calamity.

In the course of doing so, I cited a number of disconcerting developments, including an apparent inability on the part of market participants to discern their own role in various outcomes, a blind spot which I argued was in part responsible for the self-feeding “doom loop” that took hold in December.

Below is an excerpt from “Fear And The Market’s Perverse Fascination With Calamity” (which I’ll venture to say is the only market-related post in history to use a scene from Jacob’s Ladder as a banner image):

It’s no longer clear to me whether market participants are pricing in [legitimate] concerns or pricing in an increasingly dire narrative and then using the resultant selloff to justify that same narrative in a self-feeding insanity loop.

It’s interesting how insanity becomes contagious. The underlying force that binds everything together – this process – is that fear has become the new cognitive principle.

And fear is self-reinforcing. If you spread fear, it looks like you have a deep knowledge of things. If you are calm, it is like being ignorant.

In the same post, I also suggested the financial media and “FinTwit” (silly shorthand for the small community of Twitterati who focus on markets) were exacerbating the situation. To wit:

The cacophony emanating from the Twitter peanut gallery and the financial media is deafening and, actually, the tone of some reader comments and e-mails betrays a kind of perverse fascination with the prospect of an economic downturn and concurrent market meltdown – you masochists, you.

Some parts of my assessment were consistent with commentary emanating from the street. For instance, JPMorgan’s Marko Kolanovic suggested in December that the pernicious liquidity-volatility-flows feedback loop was potentially being exacerbated by the interplay between algos and a “vicious” media (and social media) cycle.

In a December 7 piece, Kolanovic acknowledged that it’s natural for volatility to rise and for credit spreads to widen as monetary policy tightens and central bank accommodation is gradually rolled back. With that out of the way, he famously offered a pointed critique of how misinformation is disseminated to market participants. “For instance, there are specialized websites that mass produce a mix of real and fake news, often… present[ing] somewhat credible but distorted coverage of sell-side financial research, mixed with geopolitics”, he wrote, before warning that “if we add to this an increased number of algorithms that trade based on posts and headlines, the impact on price action and investor psychology can be significant.”

A month later, in a post-mortem of the December chaos, Kolanovic wrote that “already fragile sentiment was undermined by political uncertainty from the US administration, the December FOMC meeting, a slowdown in economic data, and a viciously negative news and social media cycle, [which together] brought a large amount of selling from mutual fund investors in an environment of poor liquidity.”

The only thing missing from Kolanovic’s assessment was an allusion to the idea that fear has become somewhat synonymous with “knowing things”, which means those who spread fear are seen as not only legitimate, but in fact better informed than those who are rational.

In the post-crisis environment, fringe portals and a handful of familiar talking heads have created a cottage industry for what amounts to market agitprop centered around (often conspiratorial) dour narratives. These broader narratives are built on perhaps a half-dozen general themes. Those themes serve as templates, which are used to mass-produce repetitive content on a daily basis. The content itself (i.e., any one individual article or post) is, in most cases, poorly written and immediately relegated to everyone’s circular file, but, crucially, the underlying narratives contain kernels of truth. Those kernels are extracted and extrapolated upon by market participants and the media.

In his latest note, Deutsche Bank’s Aleksandar Kocic addresses the “low-volatility puzzle”, noting that “instead of being reassuring, these conditions have become a source of confusion and unease.”

The note is characteristically brilliant (in fact, this one has a claim on being one of Kocic’s best pieces, which is saying something considering that everything he writes is profound), and we’ll highlight different sections of it in separate posts.

For our purposes here, consider that Kocic frames the underlying confusion (the low-volatility “puzzle”) in terms of the “evental” nature of the financial crisis. “Generally, events separate time to before and after“, he writes. “They have the ability to change reality itself and/or the way we perceive reality.” For Kocic, the crisis achieved those effects.

We’ll get to the discussion of how the crisis changed reality itself later. What we want to point out here (i.e., in the context of everything said above about “fear”), is Kocic’s take on how the crisis changed our perception of reality.

“Perhaps the biggest disconnect between the pre- and post-2008 world is encapsulated in the change of the attitude towards tail risk as a barometer of fear”, he says, noting that “in the past, fear has had bad reputation”. It was a sign of “incompleteness”, Kocic says, and was thus “something one needs to outgrow.”

But that’s changed in the post-crisis world. As alluded to above, fear has not only been acquitted, it is ascendant, supplanting other modes as the primary rational frame of reference.

“Post-2008 period can be seen effectively as an exoneration of fear”, Kocic remarks, adding that “fear has become a sign of wisdom, elevated to a new heuristic as well as a course of considerable profit”.

How does that affect markets? Well, it manifests itself in spurious conclusions, flawed analysis, confused perspectives, revisionist histories and, ultimately, a gradual distinguishing of volatility over time, interrupted by episodic turmoil.

Here is Kocic’s take on the dynamics I delved into late last year – as you’ll see, his exposition is infinitely more eloquent than my own…

On the back of this shift in attitude, the resulting excessive caution by both investors and policy makers led to generally lower risk tolerance and has been the leading cause of gradual collapse of market volatility.

Extinction of volatility diminishes the depth of field which affects the relationship between markets and economy. This creates the lost-dimension effect. What we observed is being replaced by its two-dimensional projections onto screen or paper in terms of graphs depicting spurious relations. History becomes replaced by physical duration and empirical analysis by the art of (incorrectly) forecasting the past, which is further reinforced through different channels of media misinformation.

This repetitive falsity gives rise to the transparent horizon – a high entropy/low volatility environment as a product of technological extension of the markets’ natural domain.