..can be quite sobering to read Dan Ferris article below but in...

..can be quite sobering to read Dan Ferris article below but in the unprecedented world we live in today, anything is a possibility. One thing is clear to me and that is that the 'systems' are more vulnerable that we could possibly imagine. The risks are not fully known nor understood by us and just because they are not reported, it does not mean it is not manifesting somewhere.

..you may not know that some property funds are controlling redemptions due to liquidity, in other words it is not easy to get your money out. If things are difficult, it is not hard to imagine some fundies may restrict/limit redemptions or withdrawals in the midst of a market crash, because it would force them to force sell to get liquidity to pay out redemptions. Which means, your money could get stuck even when you want them, and you won't be able to get them out in time before the crash becomes something worse.

..As this thread has frequently said, If It Hasn't Happened, It Does Not Mean It Won't.

..while the market rally is being celebrated, it has also increased prevailing Risks; unfortunately I hate to say this but I hope that while the Yanks are celebrating their bull market rally, I hope that does not jeopardise the prosperity of the entire world when they implode and create a systemic event and cause collateral damage globally. We live in an interconnected world.  

..if many people park the money they cannot afford to lose and on which they live on in passive funds or specific stocks to speculate for high returns, it is all good while the going is good, but the moment when the market turns for the worse, we could get uncontrollable exits when all these people rush to get out because they know they can't lose that money, that is when we get an uncontrollable market event that spirals down out of control. While this is not the scene on our ASX, it is starting to become the scene in Wall St.


No one really understands catalysts... An uptick in financial emergencies... Small numbers get big fast... Mindless distressed sellers are incoming... Kindred bearish spirits... 'Normal accidents'... How markets really work... My 'Spidey senses' are in overdrive...
'Dan, if stocks are super expensive and long-term returns are likely poor... then what's the catalyst that'll make them fall?'

That's a typical question I get whenever I say that a particular asset or market is very expensive after rising a lot. I get the opposite question when an asset or market is very cheap after falling a lot.
Folks just can't embrace the idea that a market being way too cheap or too expensive is reason enough to buy, sell, or avoid it.

If stocks have risen a lot – like they have over the past year and a half – most people don't want to consider that they'll do anything but keep rising.

So when you show them why that's unlikely to happen for very long, the first thing they ask is "What will cause prices to turn around and head in the other direction?" In other words, what's the catalyst?

The real answer is that I have no idea. I don't often worry about catalysts because, like predicting the future, no one really knows how to figure them out. You see, even if you do find a catalyst, you have to find out why enough folks don't know enough about it to price it into the market.
So I admit that today's Digest is out of character...

But a compelling catalyst just dropped into my lap.

In a nutshell, the endless bull market that has taken stocks to new all-time highs and mega-bubble valuations could reverse if investors keep doing what a recent Wall Street Journal article says they've been doing more and more of over the past couple of years...
A record share of 401(k) account holders took early withdrawals from their accounts last year for financial emergencies, according to internal data from Vanguard Group. Overall, 3.6% of its plan participants did so last year, up from 2.8% in 2022 and a prepandemic average of about 2%.
Millions of investors regularly and passively purchase exchange-traded funds ("ETFs") that buy big stock market indexes like the S&P 500. So-called passive investing means that investors are buying stocks without any reference to the fundamentals of the underlying businesses. And these ETFs are overwhelmingly passively managed.

Over the past 10 years, investors have put about $4 trillion into U.S. ETFs, a 376% increase over that period. During the same period, assets in open-end mutual funds – most of which are actively managed – rose just 114%.

I've written about passive investing (which I call mindless investing) before, most notably in my September 1, 2023 Digest, where I pointed out that 45% of all U.S. investable assets are in mindlessly managed passive-investing vehicles.
But as long as folks keep buying, there's no problem, right?

Wrong... partly because they never keep buying forever. At some point, the selling begins. And seemingly small amounts of selling can be more than enough to set the market into reverse.

The Wall Street Journal article I cited above says that in 2022, 2.8% of 401(k) plan participants at Vanguard – one of the world's largest asset managers, with more than $7 trillion under management – took emergency withdrawals... which rose to 3.6% in 2023.

These seem like small numbers, but I suspect the tipping point that could switch the passive-investment flows from "buy" mode to "sell" mode is likely a lot lower than any of us might guess.
Remember what I pointed out back in September:
During the pandemic panic of March 2020 – one of the scariest market moments of anyone alive today – a Vanguard report found that only 1% of U.S. households abandoned equities completely...
It makes you wonder...
What would happen if 2% of households sold all their stocks? Or 5%? Or 10%?
I suspect Vanguard is a representative subset of all 401(k) participants in the U.S. And what will happen if 5% or 10% of all 401(k) participants take large emergency withdrawals?

Various types of retirement plans held a total of about $38.4 trillion at the end of 2023, according to a March 14 report by the Investment Company Institute. Imagine if 5% or 10% of those accounts started selling at roughly the same time.

That would be somewhere between $1.9 trillion and $3.8 trillion of equities hitting the market at once, looking for buyers. That's a pretty large chunk of the roughly $55 trillion total market cap of all U.S. stocks, most of which are small, illiquid names with low daily average trading volume.
Remember, these sellers would also be distressed because they're doing emergency withdrawals. So they'll just keep selling no matter how far the market falls. They must have that cash and will sell their investments until they get it.
So it probably won't take many investors hitting the 'sell' button to send the passive bull market juggernaut into bear market mode...

As I said in September, the mindless algorithm of a passive fund "receives $1 of cash and buys $1 of equity." If that reverses, it becomes "demand $1 of cash, sell $1 of equity."

Remember, in both cases, the transaction has nothing to do with the attractiveness of the stocks being traded based on any fundamental or technical considerations. The market is viewed simply as a bank account. You put money in when you can, and you withdraw it when you need it. And more Vanguard 401(k) participants than ever need money today.

The more stock prices fall, the more shares you have to sell to turn $1 of equity into $1 of cash. It could get scary since the sellers are distressed and as mindless in their selling as in their buying.
A steep market rout may or may not be imminent at this moment. But big declines followed by long periods of sideways action are a normal feature of markets... And the next one, whenever it occurs, is inevitable.

So right now, it's just a small percent of 401(k) participants making emergency withdrawals. But if the number keeps rising, it could one day reverse the trend of the past couple of decades.

A primary feature of that trend is that you could have bought any and every dip in the market, including the biggest ones, and you'd still be sitting on gains within a few years.

What if that's over for the next 10 or 20 years? And what if it's over because inflation and higher interest rates have sent more households into a state of financial emergency, so the only cash they have available is in their retirement accounts?

I've spoken about what could end the passive juggernaut with various investors before, and while no one knew what the catalyst would be... we all agreed it can't last forever.

But now, we have an idea of that catalyst...

Because if there's one inevitable fact of economic life over the centuries, it's that politicians will sacrifice the value of the currency for whatever purpose they want. And inflation means folks need more cash to buy the same amount of life's necessities. Higher interest rates that normally accompany inflation mean folks pay more, too.

I know this might sound like nonsense...
But I'm not alone...

I recently found kindred spirits at U.K.-based asset manager Ruffer. The company boasts a 29-year track record of delivering returns to investors of 8.1% annually, net of fees. The firm prioritizes capital preservation over capital appreciation, and it has about $28 billion under management. So it can't afford to say things that'll make its clients sell it all and head for the hills. Still, it's sounding alarms...

In its recently published 2024 review, Ruffer's co-Chief Investment Officer Henry Maxey wrote of the likelihood of a potentially large, sudden market drawdown today:
Our concern is that the reversal will have more in common with 1987 than any of the other crises in the last 30 years.
He's talking about the largest one-day drawdown in market history, when the Dow Jones Industrial Average fell nearly 22% on October 19, 1987, known to this day as Black Monday. Maxey cites concerns I've voiced before. For example, he details various aspects of the complexity of modern financial markets, then writes:
Fans of the HBO series Chernobyl will recognise what I am describing as a 'closely coupled system'. That is, one in which the components or elements are tightly linked together. In such systems, changes or disturbances in one part quickly and directly affect other parts. In our financial application, the system is complex, tightly integrated, interdependent and highly sensitive to liquidity conditions. Crucially, it predominantly sits outside the banking system, where much of the post 2008 crisis regulatory focus has been.

People often think financial catastrophes occur because herds of humans panic when the emotional pendulum swings from greed to fear. The next market sell-off will be much more mechanical, mathematical, precise and fast. Regulators and policymakers, meanwhile, are human – their reaction times are slower, with decisions made by committees.
It sounds like Maxey might have read Charles Perrow's 1984 book Normal Accidents: Living with High-Risk Technologies, which describes what engineers refer to as loosely and tightly coupled systems, and how the terms are generalized for organizations and complex technologies:
Loosely coupled systems, whether for good or ill, can incorporate shocks and failures and pressures for change without destabilization. Tightly coupled systems will respond more quickly to these perturbations, but the response may be disastrous.
Maxey is the only person besides myself who I've heard publicly worrying about the potential of a large, one-day drawdown in the stock market... and whether or not disalloweds' circuit breakers could do little more than buy investors some time to try to figure out what's wrong.

As I've written before, there are three circuit breakers on U.S. stock exchanges. These were adopted in the wake of the 1987 one-day crash. The first one kicks in when the S&P 500 falls 7% in a day. Trading is halted for 15 minutes if the drop occurs before 3:25 p.m. Eastern time. Trading is not halted if it happens after that. The second breaker triggers if the market falls 13% before 3:25 p.m. Eastern time. The third breaker triggers if the market falls 20%. In that case, the exchange is shut down, no matter what time of day it happens.

The circuit breakers halt all trading to help investors catch up to what's happening, keep a cool head, and not overreact in a blind panic. That's not unreasonable but, as Maxey points out, the circuit breakers can also exaggerate market moves:
When so much money is systematically managed – directly or indirectly – circuit breakers can buy a little time for policymakers to try to figure out what is going on. But they can also exacerbate moves. For example, I wonder how many traders of 0DTE [zero days to expiration] options know what price their option will be settled at if the market closes down 20% on a circuit breaker? Is it -20%? Or the price of the index at the open the following day – ie potentially a lot lower?
Spoiler: -20% is not the right answer.
In other words, just because you shut down the exchange on a Monday doesn't mean the market won't be down 20% again first thing Tuesday morning.

As I've noted before, I don't purport to know the complex inner workings of the software and computers that run the big stock exchanges. Nor do I know all the rules and regulations that apply to them.
My fear of a massive one-day decline is a philosophical position...

I simply don't believe that humans control markets... or even that humans created markets. Markets happen when the conditions are right, and humans don't control them. They merely participate in them.

You see, markets happen when humans reasonably agree on what's allowed in them and what's not allowed. For example, fraud and theft are not allowed. And you have to pay what you say you'll pay. I'm sure there are other important rules, but I'm just characterizing the basic conditions that make markets work.

Once those conditions are in place, well... anything goes. For example, the price of a garbage stock like GameStop (GME) or AMC Entertainment (AMC) can rise hundreds or thousands of percent in a few days. If you sold at the top, great... If not, you lose and you don't get the money back.

There are other examples. The price of oil futures went negative in April 2020. And on August 24, 2015, some stocks went to zero, before quickly bouncing back in a flash crash, making it impossible to calculate the value of many ETFs for several minutes.

There's no chance oil is worth less than zero... or that the companies that tanked and recovered in August 2015 were momentarily worth zero. It was just market behavior based on stuff humans do – which, again, is allowed as long as you don't commit fraud or theft and pay what you agree to pay.

All I'm saying is that if markets let this kind of stuff happen, is it so crazy to believe that they'd let the S&P 500 fall more than 20% in one day, circuit breakers or not? Or as Maxey implied, even if disallowed is successful in shutting down trading at a 20% decline... so what? That doesn't say anything about the prices investors are willing to transact at when the exchange reopens the next morning.

So maybe the time to start thinking more about this type of event is when more folks than ever are making emergency 401(k) withdrawals. My "Spidey sense" shifts into overdrive when no one is worried about a potential disaster at a time when a big decline becomes less unlikely... And I start thinking about how to prepare for it.