Death By Quant

In 1998, LTCM almost blew up Wall Street because bond spreads broke from history. They were trading with a model that had unbounded potential, but considered it bounded because history lacked an extreme move. A turkey problem: turkeys think the farmer loves them until the day before Thanksgiving.

In 2008, Wall Street almost blew up the world because home prices broke from history. Home prices never went down nationally. The quants created the correlation with their financial models though, they made it possible and it happened.

Today, I see similar setups throughout the market. Consider this discussion of yen weakness being a threat.

WSJ: Japanese Yen’s Drop Raises Potential for Broader Market Trouble

But the yen’s rout might cut into Japanese demand for Treasurys. That is because as the yen weakens, Japanese investors with dollar-denominated assets will have to pay more to hedge against the risk of currency fluctuations cutting into their returns.

This is the exact opposite of reality, but there are models that assume this is how the market works because it has worked in the past. The model is not prepared for Turkey Day. At higher-order stages of collapse, money flows to higher-order monies, which in this case includes U.S. treasuries and U.S. dollars.

I like to say, somewhat teasingly as I am a fan of Austrian economics, that Austrian economics only works about once a decade. I'm referring here to forecasting for investment purposes, not for guiding a government or society over the long-term. During the boom periods, many economic models work because the system isn't stressed. The same way the CCP or any other central planner can appear genius during a boom. It is only when the system breaks that the model fails. Between the busts, the tail can wag the dog. The tail can wag the dog for so long than "everyone" thinks the tail is the dog, and the dog the tail. Or maybe the dog doesn't exist anymore.

The endgame is when the Japanese investor incinerates the yen by dumping U.S. treasuries, triggering a rise in yields than feeds back into a weaker yen. In the endgame scenario where European, Chinese and American investors join in, global rates rise to the point where the yen has to be defended by rate hikes...that trigger currency collapse. Japan's total debt to GDP exceeds 1000 percent. There's no need to be precise because we're playing global thermonuclear war. What is the increase in nominal GDP if the average yield on Japanese debt is 3 percent? At 1000 percent debt-to-GDP, it's 30 percent. Catastrophic deflation or inflation are the options when a system this stretched reaches the crisis point. The euro and yuan are toast in that scenario too. Then the dollar as the last domino when the system reflates.

I have been ever so slowly increasing the amount of time I spend researching Japanese stocks. Still very little time spent on it, but up from zero in recent years. At some point the Japanese market could warrant substantial attention, and better to pay that attention before everyone else figures it out.