Analyst warns about flash crashes ahead

If markets weren't already bouncing, they got another push this week. Photo / AP

If markets weren't bouncing because of presidential tweets, global debt, trade wars, coming elections and Senate hearing circuses, then they got another push this week from a top JPMorgan Chase & Co. analyst who says a stock crash spurred by electronic trading could unleash social upheaval not seen since 1968.

Marko Kolanovic, a senior analyst with JPMorgan, said in a report released Tuesday that an "autopilot" sell-off of passive mutual funds by super-fast computers could convulse markets, causing a precipitous decline similar to a flash crash with the potential to snowball.

"We will call this hypothetical crisis the 'Great Liquidity Crisis,' " he said in the report.

"This is a possible scenario," Kolanovic said in a follow-up email. "Definitely not a prediction. It is tied to the probability of a recession. We believe it will coincide with the next recession. We do think this is unlikely to happen this or next year."

Kolanovic says the rise of populism and trade tensions between the United States and the rest of the world could combine with rising interest rates to trigger a recession, setting the stage for a crash.

He said electronic trading could rapidly cause markets to fall dramatically. Without enough buyers to put a floor under stock prices, losses could cascade through pension funds, retirement savings and so on. Eventually the Federal Reserve could be compelled to step in and buy equities.

"For the Fed to come in and buy equities, you would have to a have a really long stock market fall," said Scott Wren, senior global equity strategist at Wells Fargo Investment Institute.

Kolanovic's less-than-three-page analysis is buried in a 168-page JPMorgan report on the financial crisis called, "10 Years After the Financial Crisis." The document includes analyses from dozens of the bank's researchers.

JPMorgan's official view is that there is no recession or crash imminent this year. The giant bank's prediction is for a substantially higher stock market.

In the past decades, Kolanovic said, investors have steadily invested in passively managed funds that track indexes, including exchange-traded funds. The investors have been attracted to such passive funds because of lower fees, their tax-friendly strategy of having less turnover and returns that frequently exceed actively managed funds.

"This shift from active to passive, and specifically the decline in active value investors, reduces the ability of the market to prevent and recover from large drawdowns," said Kolanovic, a theoretical physicist whose title is global head of quantitative and derivatives strategy.

Kolanovic said that since the financial crisis, US$2 trillion ($3t) has migrated out of actively managed funds where managers try to beat the market and into passive funds where they mimic the broad market. That rotation has made the market more vulnerable.

"The shift . . . reduces the ability of the market to prevent and recover from large drawdowns," Kolanovic said in his report.

Vanguard Group, with US$5.1t in its mutual funds, said index funds make up far less of the market than is widely believed. Index funds hold 15 per cent of the value of the total U.S. stock market and comprise 5 per cent of its trading volume, according to Vanguard.

"Whether you characterise the size of indexing by assets under management or the amount of trading volume, indexing is still a very small part of the market," said Jim Rowley, head of active-passive portfolio research with Vanguard.

US markets saw a "Flash Crash" on May 6, 2010, when the S&P 500, Dow Jones industrial average and Nasdaq dropped by a trillion dollars. The Dow dropped 998.5 points, or about 9 per cent, in minutes. The collapse lasted 36 minutes. The markets swiftly recovered most of their losses.

The US Department of Justice five years later charged a trader with using algorithms and other electronic bets to manipulate the market. Kolanovic, a frequest guest on CNBC and, dubbed "The Man Who Sees the Market Future," is sought after for his predictions on global markets. He recommended investors buy emerging market stocks during a CNBC appearance in June.

Citing the risks that Kolanovic enumerates, Wren said "you have a huge global debt building that at some point will come home to roost. Not in the next five or 10 years, but you are going to get a crisis at some point."

"He says it's not a prediction, but a risk scenario," Ed Yardeni, president of Yardeni Research, said of Kolanovic's comments. "Life is risky. If you sit down and try to figure out all the things that could go wrong, there's plenty."

"My problem is why this hasn't happened already," Yardeni said. "We have already had an ETF one-day crash back in 2010 and the market recovered right away. Why didn't we have a flash crash in ETFs in the beginning of this year when the market took a dive of over 10 per cent. Why didn't that lead to a liquidity crisis back then?"

Exchanges instituted safety measures to stem a future flash crash, including circuit breakers to halt trading in individual stocks to prevent sudden price swings. Regulators adopted market access rules that require brokers to monitor the flow of their customer traffic, and exchanges implemented a "kill switch" to alert brokers of unusual activity.

Kolanovic closed his analysis on a dire tone: "The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968."

"We've got a lot of upheaval right now," Yardeni said. "And by the way, if you bought stocks in the late '60s or the '70s, you'd be a multi-millionaire right now."