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Fingers of Instability - Vintage Value InvestingThe markets are complex systems; they can turn on a dime. While things might be travelling along nicely, it doesn’t take much for sentiment to take an aggressive turn, the market to become pre-occupied with the negatives and all of a sudden the market is a lot lower. While the market’s participants will look back and point to ‘this reason’ or ‘that reason’ as the event blamed for the sell-off,  in reality the situation is no more alarming than the negative news snippets that the market would ordinarily take in its stride.

I find a useful mental model for explaining this phenomenon in the markets is the sandpile analogy; where a pile of sand develops from dropping individual grains from above. The sandpile continues to grow until a critical state is reached from which a single grain, no bigger than any of the previous grains, can bring about a collapse in the structure. As I’ve said before, it only takes one stone to start an avalanche. The real difficulty in this of course is that no one can predict which grain will be the one that triggers that avalanche.

One of the best books I’ve read on the concept of critical states is Ubiquity – Why Catastrophes Happen by Mark Buchanan. I picked this book up from Bruce Berkowitz’s recommended reading list. Mr. Buchanan delves into the unpredictability of complex natural and human cataclysms created by dynamic critical states.  His theory on the ‘fingers of instability’ that run through sandpiles is a useful construct to work with when thinking about financial markets.


“After the sandpile evolves to its critical state, many grains rest just on the verge of tumbling, and these grains link up into “fingers of instability” of all possible lengths.  While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability. The power law simply reflects this situation, and points to the riddling instability that underlies the sandpile’s workings. In this simplified setting of the sandpile, the power law also points to something else; the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche, large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organisation of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size” Mark Buchanan

Like sandpiles, as financial asset prices rise, markets have a tendency to reach a critical state, balanced uneasily from whence anything can happen. An indistinct piece of information or an individual market order can create an unexpected abnormal and exceptional, non-linear reaction.

“As George Soros has pointed out, the proximate cause of a panic is never the real cause any more than the last straw actually breaks the camel’s back” Andy Redleaf

“It’s always hard to know when you are in a bubble, and if you are in a bubble, when it is going to pop. It’s a lot like the chaos theory image of dripping sand onto a little pile that’s shaped like a cone on the beach. The pile gets higher and higher and finally suddenly there will be a little avalanche.” Ed Thorp

“When catastrophes occur, we naturally seek to identify the principal cause so we can avoid another disaster or at least derive some comfort from knowing what happened. We like it best when we can point to one specific, easily identifiable cause, but that is not always possible. Many scientists believe that large scale events in biology, geology, and economics are not necessarily the result of a single large event but rather of the unfolding of many smaller events that create an avalanche—like-effect. Per Bak, a Danish theoretical physicist developed a holistic theory of how systems behave called ‘self-organised criticality’. To illustrate the concept of self-criticality, Bak often used the metaphor of a sandpile” Robert Hagstrom

Throughout history, each subsequent stock market correction has been characterised by an innovation which has been unique to that period; either it was new, or its adoption was at a level of unprecedented proportion. In the crash of 1929 the blame for the collapse was laid at the foot of ‘margin debt’. In the 1987 stock market crash it was ‘portfolio risk management tools’. The tech crash was characterised by ‘new era valuation methodologies’, while the Global Financial Crisis saw exponential growth in ‘dis-intermediated opaque structured products’.

Unfortunately, on Wall Street, innovations typically come with unintended consequences.

“When Wall Street gets innovative, watch out!” Warren Buffett

“In reflecting on the societal impact of various areas of innovation, complexity and connectivity, it is easy to recount examples with mostly positive or mixed consequences. But in the realm of finance, as much as we traders appreciate the opportunity to unpack and trade complexity in securities, structures and markets, we wonder if the overall impact of financial innovation, including derivatives, structured products, high-frequency trading and communication advances, is a net negative, albeit with a possibly long delay before the drawbacks become visible” Paul Singer

Turning to the sandpile as the metaphor for markets, these innovations represent the long fingers of instability’Crazy valuations, cheer-leading brokers, unethical salespeople, conflicted ratings agencies, illiquidity, and opaqueness are a few of what I consider the ‘shorter‘ or ‘intermediate fingers of instability‘. Combined, they resulted in a brittle foundation for asset prices, vulnerable to the next piece of negative news or price action.

So what are the ‘fingers of instability‘ that run through today’s markets?

The biggest risk to market structure today is the increasing dominance of ‘Passive Investing’ [ETF’s & Index Funds], High Frequency Trading and Volatility targeting. These strategies are price indiscriminate [ie they have no regard to the underlying fundamental values of the companies] and when combined with increasing Connectivity and Illiquidity pose material risks to markets. I’ll cover off on each of these..

High-Frequency Trading [HFT] and Market Illiquidity

HFT has been sold to the regulators and the masses as ‘market-makers’ or liquidity providers. HFT certainly adds to the volume traded, but volume is not liquidity. Most HFT firms end the day with no net position – whatever they’ve sold, they’ve bought, and vice versa. An easy way to understand the difference between liquidity and volume is to imagine the market had only two participants, both HFT firms. Each firm traded 1,000 shares back and forth between themselves 100 times a day. To an outsider, the volume would appear as 100,000 shares of daily volume. Imagine now, a third entrant, a genuine buyer, enters the market to buy 10,000 shares. After they’ve bought their first 1,000 shares there is no liquidity.

Furthermore, HFT firms access trading flow data with lower latency, meaning they get trading information quicker than other participants. A genuine buyer sends an order into multiple exchanges [as markets are now far more fragmented], and the HFT firm co-locates their own servers within each exchange to interpret and react to that flow data before its onward journey to the next exchange. The original purpose of the exchange, to match genuine buyers and sellers of stocks and promote price discovery for the efficient allocation of capital, no longer holds true.

HFT is essentially removing liquidity from the market because it knows what you are doing and can do it before you.”  John Burbank

“Seeing someone’s order to sell, the High Frequency Trader sells first, causing the stock to fall, and then buys it back at the lower price. How is this different from the crime of front-running?” Ed Thorp

“.. the systemic risk in these High-Frequency Trading systems. We saw this in the flash crash of 2010. The market just fell apart because some computers couldn’t handle the volatility. Technological risk is high, and that’s a problem, a real problem. The cancellation of orders is a real problem. The lack of public information and the lack of transparency are big problems.”  John Bogle

“[HFT is] not a liquidity provider. It may create more volume but that’s not the same as being a liquidity provider. To the extent that it is front running, I think society has generally been against front running for good reasons… Here they’ve gained an advantage by figuring out how the system worked and getting there first and that adds nothing” to economic activity.” Warren Buffett

When volatility increases, HFT has a tendency to widen spreads or become inactive. The traditional market-makers, the specialists on the NYSE, and proprietary trading desks, have all but vanished. Following the Global Financial Crisis, regulators banned proprietary trading by Investment Banks in an attempt to prevent large losses and mitigate government bailouts. The unintended consequence of that action is less liquidity provision.

“[HFT] Trading creates the appearance of liquidity and depth, but this can and does, vanish with no notice in a millionth of a second. Traditional structures have disappeared, including: specialists who actually made orderly markets, standing ready to buy and sell to keep markets flowing; the big financial firms as partnerships, where executives’ net worth was tied to the stability as well as profitability of the firm.” Paul Singer

Passive Investing [ETF’s and Index Funds]

An increasing number of investors have moved to ‘passive’ products [albeit the term is a misnomer – investing in an index is an active decision, and which index anyway??] for their ease of access and low cost. The majority of these investors rely on just ‘price’ as their investment signpost. As passive investing takes a larger share of the investing universe, new money flows to the biggest index components regardless of price.

“Owners of Index Products have no real interest in the business performance of the underlying portfolio companies, and little or no knowledge or appreciation for what those companies actually do for a living, or how well they do or could do it.

Nobody knows what this pattern means, and nobody has seen anything like it. It is not capitalism. It is not communism. It does not resemble anything that people have contemplated when thinking about markets, the virtues of private ownership of the means of production, and the prospects of growth and prosperity for masses of citizens.

Moreover, nobody knows how the passive style of investing will play out and evolve. There is a real likelihood that it, and its apparent stability, is unsustainable and brittle. But markets can be “wrong” for a very long time before they decide to change direction.”Paul Singer

It is when market participants have no knowledge of the underlying companies they own that risk rises. There is no price point they can tether to in deciding whether to buy, hold or sell. No price is too high for an index fund to buy and no price is too low to sell.

“It is not liquidity or perfect price discovery that ensures good pricing but it is knowledge of value. It is when we lack this knowledge that we demand liquidity and price discovery as poor substitutes.”  Andy Redleaf

Likewise, investors in ETF’s more often than not have no idea what their ETF’s own and thus are worth. ETF’s are typically constructed to be ‘marketed and sold’ without regard to their investment merit.

“The inclusion criteria [for index related products] are certainly not what in the past was quaintly referred to as “investment criteria.” Paul Singer

ETF’s are very efficient, very easy and very simple. There is no question about that. Therein lies part of the problem. It makes it easy for someone to say I want to buy Germany but doesn’t even look to see what’s in the German ETF or if it’s a good ETF to own.  It could be a terrible ETF but nobody looks anymore.  There are excesses developing in the ETF business. When we have the next bear market a lot of people are going to find out they collapsed and went down more than everything else because that’s what everybody owns.” Jim Rogers

If and when prices decline, it is the price action that becomes the news. Selling begets more selling as no-one knows the right price. It becomes a circular reference; people ask, “why do I own this biotech ETF? I’ve got no idea what it owns or what it’s worth .. get me out!”

“People who buy for non-value reasons are likely to sell for non-value reasons.  Their presence in the picture will accentuate erratic price swings unrelated to underlying business developments.”  Warren Buffett

“Investors with no knowledge of (or concern for profits, dividends, valuation or the conduct of business simply cannot possess the resolve needed to do the right thing at the right time. With everyone around them buying and making money, they can’t know when a stock is too high and therefore resist joining in. And with a market in free fall, they can’t possibly have the confidence needed to hold or buy at severely reduced prices.”  Howard Marks

“The more investors invest by asset class rather than by picking individual companies, the more the market will tend to move as one, intensifying herd behaviour and the likelihood of panics, making hundred year floods even more likely.” Andy Redleaf

“I also think share prices are increasingly distorted by the collective buying and selling of ETFs. As more and more trading happens without any thought about valuation, price discovery has to be  somewhat less efficient… I have no idea when, but a reckoning will come and people will run away in blind panic.” Peter Keefe

But getting out isn’t always that easy. Often the constituent components are far less liquid than the actual ETF. While things go smoothly no-one cares. Like a movie theatre, the exits work fine until someone screams ‘fire’.

“With all technology, and all these ETF’s and quantitative systems introduced I do have concern technology has outpaced markets ability to handle it.. and when get into next bear market could be a messy affair. Unravelling of structured issues. Quant trading are momentum based not value based. “A body of motion tends to stay in motion”.Quantitative trading worries me. There is risk of some outsized outcome.” Leon Cooperman

Quant Trading

As active managers have struggled to keep up with the market indices, more and more investors have moved to index products and quant-based strategies. More money is now being managed by computer systems, many of which base their investing decisions on momentum or trend-following systems. This strategy focuses on buying stocks which have outperformed, again with no regard for underlying values. The strategy works until it doesn’t. The buying on the way up is incremental. When the market turns down however, the volume of selling increases significantly, as not only the current flow needs to be sold, but all the accumulated stock on the way up as well.

Quants and their computer models primarily extrapolate the patterns that have held true in past markets. They can’t predict changes in those patterns; they can’t anticipate aberrant periods; and thus they generally overestimate the reliability of past norms. They know all about how things will work if times are normal, but their analysis is of no help when events occur that reside in the far-off, improbable tails of the probability distribution” Howard Marks

Volatility Targeting

Volatility targeting is a strategy that rebalances between risky assets and cash in order to target a constant level of risk [or volatility] over time. Many institutional investors and hedge and mutual funds managers have embraced the strategy in an attempt to improve portfolio returns.

These strategies have introduced unknown risks and may lead to breakdowns where volatility rises, causing such managers to sell shares, which further drives up volatility, requiring the manager to sell even more shares – a circular reference.

The October 2017 stability report from the IMF note “during volatility spikes, these [volatility targeting] strategies can lead to significant asset sales to pare back leverage. Such an episode took place in August 2015, when a representative volatility-targeting investment strategy cut its global equity exposure drastically. The size of US equity holdings held by volatility-targeting investment strategies may be larger than $0.5 trillion today. Although this is less than 2.5 percent of the market capitalization of all US publicly traded equities, the trading volume related to deleveraging from these trading strategies could be much larger, particularly at times of equity market stress.”

Richard Bookstaber recently touched on risks of volatility targeting strategies on Wealthtrack:

“A lot of asset managers do what’s called volatility targeting, they tell their investors they will manage investments so they have on average a volatility of say 12%. Which means in a typical year, you may see your investments go up or down 5% or 10% or maybe 12%, but you are not going to see 20% moves unless something strange happens.  If volatility now for equities is 12% and you have a billion dollar portfolio you can hold 100% equities. Let’s say volatility shoots up to 24%, if you are targeting 12% volatility, now you have to sell half your assets. Suddenly half a billion dollars of equities is going into the market and you’re not the only one doing it. There are a lot of strategies like this where as volatility goes up people have to de-risk and reduce exposure. So rising volatility leads to a drop in the market, which add further to volatility and a further drop in the market. You get this cycle between rising volatility and a reduction in prices and returns. The big concern are these strategies that are rule based and have positive feedback, they accentuate moves.” Richard Bookstaber


The increasing inter-connectivity of the markets and the speed at which algorithms interpret trade data and execute orders means the safeguard of human common sense is rendered obsolete. Risk management models that draw on historical data can’t intuitively make sense of a crisis situation. This can lead to ‘flash crashes’, where stock prices collapse in a matter of seconds.

“The stock exchanges have converted from “open outcry” where wild traders face each other, yelling and screaming as in a souk, then go drink together. Traders were replaced by computers, for very small visible benefits and massively large risks. While errors made by small traders are confined and distributed, those made by computerized systems go wild – in August 2010, a computer error made the entire market crash the “flash crash“; in August 2012..  the Knight Capital Group had its computer system go wild and cause $10 million dollars of losses a minute, losing $480 million.” Nicholas Nassim Taleb


Today’s markets have become increasingly dominated by passive investing, quant trading and volatility targeting strategies, where orders are executed without regard to price. Liquidity is being compromised by disappearing and front-running HFT and the absense of specialists and proprietary traders. This new market structure features trading speeds beyond human comprehension which together with fewer and fewer fundamental active managers [they’ve lost the money to index funds!] increases the potential for disorder.

If you understand the value of the businesses you own and like you can take advantage of the sell-offs triggered by the ‘fingers of instability‘. Ultimately, the more participants there are who invest without regard to underlying values the better for long term investors – prices and values do ultimately converge! Recognising the causes of technical corrections helps keep emotions intact while others are panicked and, or paralyzed.

Paul Singer’s profound understanding of markets and risk has allowed Elliot Associates to compound capital successfully over 40 years with only two small down years.  He opines that when you witness episodes such as the ‘flash crashes‘ of recent years, it is highly probable you are observing the future. He understands the risks in modern innovations and how they combine to make markets prone to disorder.

“All the innovations and complexity in the modern world of finance combine in different ingredients at different times with different catalysts and triggers, to create fragility, not stability.”

Clearly the way the market operates has changed over time, as has the very market itself. Human intervention has been minimalized to make way for so-called technological advancements. Computers now run the show, yet they lack the capability to recognise underlying value. And while continued change in this regard is inevitable, new innovations can have far reaching negative impacts on the market, leading to further avalanches, collapses or crashes. So knowing what your investment portfolio contains and its worth is fundamental to success, as is a working knowledge of the ‘fingers’ that can destabilise entire markets. Because who knows? Your next trade could be that single grain of sand…