Why stock-market crashes happen

Published: Oct 7, 2014 2:46 p.m. ET

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"I think the greatest illusion we have is that denial protects us. It's actually the biggest distortion and lie. In fact, staying asleep is what's killing us." - Eve Ensler

October tends to be one of those months when crash headlines hit, largely because of the October 1987 crash which took markets back in time by about nine months. I personally never define a crash by percentage decline, but rather by how much the clock gets reset by the move. The Summer Crash of 2011 put stocks back in time by about eight months much in the same way the 1987 crash did, but with a comparatively smaller percentage loss.

What is the ultimate source of a crash? I believe it largely has to do with prolonged disconnects. Much of the reasoning behind my "call" in 2011 for a Summer Crash was related to glaring strength in health care, utilities, consumer staples and Treasurys into the end of Quantitative Easing 2, as inflation expectations dropped and equities pushed higher. The length of time those defensive areas led was so long that in some ways it had to mean a crash was to come as absolute price resynced to relative movement.

The thing is these disconnects can clearly last for a long time, and make any kind of strategy based on historical triggers — which tend to do well in large samples — appear broken. As the co-portfolio manager of the alternative absolute return ATAC Inflation Rotation Fund ATACX, +0.23%, I know this first hand. We built our name in 2011 and 2012 around the inflation-rotation strategy philosophy.

Since the taper tantrum began in May 2013, many of these risk triggers, with hindsight, simply did not work. Of course, the reality of buy low, sell high is that no one ever does it when things are desynced, even though that may be precisely the time to bet on normalization in a strategy that bases history for its rotations using award-winning research.

And yet, every strategy based on historical cause and effect has periods where it is out of step in the small sample of time, as opposed to the large sample of history. In this small sample of time where the deflation-pulse thesis of mine has held true, it is easy to think that the current environment is the way markets will be in the future. That could not be further from the truth when a significant distortion is underway which can be the set up for a crash. It is this distortion which Quantitative Easing 3 created, and which could converge upon its end.

Put simply, stocks are not supposed to be a deflation or disinflation hedge. Yet, we believe the severe disconnect between stocks and inflation expectations shows something is ridiculously wrong.

Can this gap persist? Maybe, but I doubt it given that QE3 is ending, and very clear changes to market behavior recently. This gets resolved in one of two ways — either a significant crash-like move in equities, whereby Treasurys severely outperform, or sudden fear of inflation which breaks bonds.

With complacency as high as it is and growth expectations continuously lowered, it seems more likely than not that the distortion above gets resolved with equities on the downside. That alone means risk triggers would not only have a chance to severely outperform, but also brings back much needed volatility for strategies that rely on tactical asset allocation and historical cause and effect.

Narrative always follows price. The narrative has been that the economy is fine and that the Fed won. What will the narrative be if the above distortion gets resolved in the blink of an eye?




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