"Three Examples Of How Chaos Theory Affects Financial Markets"
"Bottom line: European banks are the Lake Victoria of the current rally
in global
financials and therefore also the source waters for the
ongoing lift in value stocks."
From ZeroHedge, November 6:
Submitted by Nick Colas of DataTrek Research Chaos Theory – the idea that a butterfly in Thailand could cause a
US hurricane – can actually create positive outcomes as well as mayhem.
Consider that European banks, German long-term bunds and the offshore
yuan are essentially the butterflies making for pleasant investment
conditions just now. All have turned sharply in the last 2 months after
previous discounting disaster. And all have more room to run.
Chaos Theory gets a bum wrap, and I think the reason is bad branding. The
most common explanation of the phenomenon is the classic “a butterfly
flapping its wings in Thailand can cause a hurricane in the Gulf of
Mexico”. Initial conditions, in other words, can have outsized effects
in complex systems like weather patterns. Fair enough, but one usually
associates Chaos Theory with bad outcomes like cyclones and stock market
crashes.
What about when initial conditions push their way through to create unexpectedly good outcomes? That’s
Chaos Theory as well, but no one talks about the mayhem created by a
lovely day… Bad branding, that, or at least misleading packaging…
Turning to the current sunny spell in global risk markets,
three examples of why Chaos Theory can work to investors’ benefit as
well as harm. Exhibit #1: European Bank Stocks:
In early August, the EURO STOXX Banks Index looked like it was
about to implode. At 77, it had not been lower since the 1990s. We wrote
about it, highlighting that several market bears thought the group was
destined to go into chaotic (there’s that word again) free-fall.
But then the group found its footing as Eurozone long-term interest rates bottomed (more on that in a minute).
From August 15th to now, the index is up 20%. Disaster averted, at least for now.
The group’s move has lit a fire under global bank stocks. US large
cap Financials are up 12% since mid August. Small caps are +8% and
Japanese banks are +14%.
Here is a 5-year chart of the index to give you some historical perspective:
Bottom line: European banks are the Lake Victoria of the
current rally in global financials and therefore also the source waters
for the ongoing lift in value stocks. Exhibit #2: German 30-year sovereign bonds:
Since the German government runs a balanced budget, long-term bunds are in perennial short supply relative to US Treasuries.
Along with that, the long duration of German 30-years makes this
asset singularly twitchy to market sentiment about Eurozone economic
growth.
At the end of August, when US-China trade talks were at their
nadir, the market for 30-year bunds was signaling the real risk of a
deep European recession. Yields got as low as -0.27%.
Now, the yield on 30-year bunds is positive again to the tune of
0.16%. Ok, not great but also not (quite) staring into the abyss.
Treasuries have followed along, assuaging concerns created by a
previously inverted yield curve.
Here is a 5-year yield chart for this paper:
Bottom line: the lift in long-term German yields since late
August was the spark that reignited the global market’s animal spirits
in September and October. Europe may be teetering on the edge
of recession, but lessening US-China trade tensions may save it from
falling into too deep a hole....
