Vulnerable Windows and Swinging Trap Doors

"The received wisdom is mistaken on how recessions are made. They are not simply caused by shocks. They are caused by a window of vulnerability in the economic cycle where the cyclical drivers of the economy have weakened to the point where it’s susceptible to a negative shock. Within that window of vulnerability, virtually any reasonable shock becomes a recessionary shock. That’s how you get a recession."

– Lakshman Achuthan, Economic Cycle Research Institute

Why do economies collapse into recession in ways that seem so difficult to predict? Why do financial markets collapse into free-fall with timing that’s so loosely related to market valuations? Much of the reason is that complex systems usually aren’t linear. In a linear system, a given change in some variable X always has the same expected effect on variable Y. In the economy, and in the financial markets, the same event can have zero effect in some conditions, and profound effect in another, often depending on much broader conditions that make the system vulnerable or resilient to shocks.

As a rule, long-term results in the economy tend to be predictably related to underlying long-term drivers. So for example, long-term economic growth is usually tightly related to the sum of labor force growth and trend productivity growth. Likewise, long-term stock market returns are usually tightly related to the initial level of market valuations and the long-term structural growth rate of the economy.

In contrast, shorter-term outcomes can be dominated by psychology and what Keynes described as “animal spirits.” Over shorter segments of the economic cycle, GDP growth may have a very weak relationship with structural factors like labor force growth and trend productivity, and economic fluctuations can instead be driven by cyclical fluctuations in the unemployment rate. Likewise, over shorter segments of the market cycle, market returns can have little or no relationship to valuations, and returns can instead be driven by the psychological inclination of investors toward speculation or risk-aversion.

If those episodes of “animal spirits” persist long enough to become over-extended, naïve observers may come to believe that “fundamentals don’t matter.” Instead, they extrapolate recent trends, blind to the fact that risk becomes most profound exactly when it has remained unexpressed the longest.

Even when surreal distortions in the economy and the financial markets make crisis and speculative collapse inevitable, it’s not enough to know that those outcomes are baked-in-the-cake. Imbalances aren’t resolved sooner just because the imbalances are larger. The fact that I fully expect the S&P 500 to lose 60-65% of its value over the completion of this cycle doesn’t mean that intervening periods of speculation and uniform market internals can’t periodically defer that outcome. Instead, crises emerge seemingly out of nowhere, when a vulnerable window or a trap door swings open. That makes it essential to monitor those hinges. Decades ago, the late MIT economist Rudiger Dornbusch put it this way: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”