The Next Financial Crisis Will Look Like This

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Marko Kolanovic is J.P. Morgan's top quant. Here's how he envisions the next financial crisis

Фото: AP Photo/Richard Drew

The Next Financial Crisis

As Kolanovic explains as part of a 168 report issued earlier this month, a precipitous decline in stocks could cause the Great Liquidity Crisis.

Severe stock price declines. Lightening fast machine selling. Aggressive action by central banks.

The rise of passive investing and algorithmic trading could create the backdrop for a substantial stock market drop, according to Kolanovic.

While more recent flash crashes have occurred during periods of economic expansion, flash crashes during a recessionary period are less tested.

Kolanovic predicts those flash crashes could lead to declines in asset values and increased market volatility.

Passive Investing & Algorithmic Trading

Kolanovic identifies two investing trends that may increase stock market pain during large sell-offs:

  • passive investing
  • algorithmic trading

The approximately $2 trillion shift from active to passive investing has removed individual buyers who can buy the market after significant price declines.

According to Kolanovic, 90% of daily trading in the stock market is from index and quant funds. Quant funds, he writes, are programmed to sell market weakness - rather than analyze fundamental valuation, for example.

Similarly, electronic trading desks tend to sell when the market falls, which removes additional liquidity from the market.

When Will The Next Financial Crisis Happen?

In an interview with CNBC, Kolanovic said that while it's not possible to predict the timing of the next financial crisis, he doesn't see potential problems until the second half of 2019.

A trade war with China, the speed of interest rate hikes and the unwinding of bond purchases by the Federal Reserve are factors that could change that timeline.

Kolanovic notes that if markets fall by 40% or more, for example, the Federal Reserve may need to take drastic action to prevent a depression.

This would mean the Federal Reserve could purchase equities or attempt to stimulate the economy through additional tax cuts.

Consumer Debt

While the banking system and mortgage market are stronger today compared to the last financial crisis, consumers still hold substantial debt.

U.S. consumers collectively hold more than $1 trillion in each of mortgage debt, student loan debt and credit card debt.

According to the latest student loan debt statistics from Make Lemonade, there are over 44 million borrowers who collectively owe $1.5 trillion in student loan debt. This now makes student loan debt the second highest consumer debt category - second only to mortgages.

What You Can Do Next

So, what are your options if a stock market sell-off ensues and there is a "Great Liquidity Crisis"?

While there are multiple options that you could consider, here are three potential strategies:

1. Do Nothing

There is no way to predict if or when a stock market sell-off can occur.

Analysts and market observers have predicted a sell-off for years, and it still hasn't happened.

Therefore, you could do nothing and stay the course.

2. Sell

It's common sense: if you fear that the market will crash, you can take some chips off the table.

Whether you sell some or all - or sell over time - is your call, but taking money out of the market will protect you from a significant decline.

Of course, if the market continues to rise, you miss out on the upside.

3. Hedge

There are many ways to hedge your investments. One option is to buy S&P 500 put options to protect against a market decline.

When you buy covered put options, you make money if the market drops. If the market doesn't drop, you lose the premium you paid for the put option.

Zack Friedman, Forbes Senior Contributor

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