Scott Nation, chief investment officer of NationsShares and author of “The History of the United States in Five Crashes” discusses lessons from history. Nations says the all of the modern-day crashes have some sort of a financial contraption and an external catalyst that often has nothing to do with the markets. He discusses some of the financial contraptions today that could pose a risk in the future. Following is a transcript of the video.
Sara Silverstein: Our first guest today is Scott Nations, chief investment officer of NationsShare and the author of “A History of the United States in Five Crashes.” Very excited to be here with you. I am reading this book, reading it on Audible and the narration is pretty good, I’ll say.
Scott Nations: That’s good to hear.
Silverstein: I am most of the way through it right now. Can you tell me what the commonalities in studying the biggest five crashes in history, what you noticed or what you learned?
Nations: Well, the reason I really wrote the book. There are several. One is the drama in each one is really incredible. It’s a little bit like the Titanic. We all know how the story ends but we enjoy reading about the story, hearing about the story.
But the reason I wrote the book was because — the similarities between the five modern stock market crashes starting with a panic of 1907 and ending with a flash crash on May 6, 2010 — even though there’s more than 100 years separating them, the similarities are really striking and the goal of the book was to point out each of the similarities and show how they happen in each of the five modern stock market crashes, potentially helping people, identifying when they show up again. Now, this is not a the-sky-is-falling book. I think everyone who has even a passing familiarity with the stock market will enjoy it but the similarities really are striking.
We know that the stock market really gets ahead of itself before every crash. There’s an old Merle Haggard song, “I only fall when I’m on the mountain.” I mean, we know that the stock market kind of tough for the stock market to crash when it’s already in the trough. But there are several similarities. One is it there’s always some sort of financial contraption that gets out of control. We think it solves some sort of problem but there’s always a financial contraption.
And they’re also always some sort of external catalyst. They’re really touch off to crash. I like to say that there’s an external catalyst, often has nothing to do with finance, that pushes a market that’s on the ragged edge of equilibrium in the chaos.
Silverstein: And after studying all of this, is there anything that you’re seeing today that people should be concerned about that we’re not that we might be missing?
Nations: It’s easy to see what’s going on at anything and think, “Oh, maybe this lines up for a crash. Maybe this is the contraption, maybe that’s the catalyst.” But the I think the interesting thing is to look at the contraptions. And so for example, on May 6, 2010, the flash crash, the most recent modern stock market crash — the contraption if you will was algorithmic trading, which had absolutely no human interaction, no human filter, or no break that a human could apply. In 1987, it was an insurance program called the portfolio insurance which was supposed to solve a lot of problems. In 2008, it was the alphabet soup of mortgage-backed securities. And so I think one thing that people should look at now — and they should do this as long as their investors is — what contraptions are poorly understood not tested under stress and might unravel when the market does interrupt a period that is stressed? And you can look at that now and potentially see that. That doesn’t mean that just because there are new contraptions out there, new financial products out there, it doesn’t mean that the market’s going to crash. But that’s something that people can pay attention to.
Silverstein: And you are a financial engineering expert, you run a financial engineering firm and you talk a lot about the dangers of financial engineering — and as you mentioned just now. So looking at the products that we have right now, are there any that raise flags for you?
Nations: Well, I’m a giant fan of ETFs. But you can imagine a situation in which some of the really ill-liquid ETFs would have a tough time providing liquidity for people who want to get out, when the stock market was really under stress. And we know, we know that liquidity disappears when people desire it most. It’s just a function of the way the stock market works. It’s one of the reasons that stocks generate over time a better return than some other asset classes. It’s because you can’t just get out just because you want to.
I think there’s another potential contraption and that would be some of this risk parody investing. Parody meaning that there’s either some sort of leverage that’s used or people say, “You know I’m going to get out as the market starts to cascade lower.” Well, we know that that doesn’t work. We tried that in the past.
The risk parody investing, I think, really flies in the face of common sense when it — when we think that, “Well, I’ll just get out if things get bad,” because we know the market doesn’t let you out.
Silverstein: You said everything needs to have a catalyst and what kind of catalysts — what’s the commonality between the catalysts?
Nations: The catalysts are really interesting because again, they often have very little, if anything, to do with finance.
As an example, the catalyst for the Panic of 1907, which is the first of the modern stock market crashes, was the San Francisco earthquake of 1906. Which sucked up all of the liquidity, all of the free cash in Chicago, in New York and in London actually. And essentially all of the free money all the available money in those financial centres had to be shipped off to San Francisco to fuel the rebuilding. I mean, we have to remember that the financial center of the western half of the US had essentially been destroyed. And any money that was actually in vaults in San Francisco wasn’t available. Bankers were absolutely certain that the fires that followed the earthquake meant that if they open the vaults that all that money would burst into flame, so they weren’t even able to use the money that they had on hand. That liquidity crush is really what started the Panic of 1907 the next year.
In 1987, it’s interesting that we thought we were finally at war with Iran when we had the crash in October 19. We had gone to war, essentially war — our military had engaged the Iranian military the weekend before — and then we see that in 2010, rather with the flash crash, the catalyst was rioting, arson, and murder in Athens. We thought all of the Eurozone was going to come unwound.
The problem is the catalyst of the first crash was more than a year before the crash, the catalyst for the last crash was less than a day before the crash. And that time is collapsing, so investors have very little time now to see something, an event think, that might be the catalyst and the crash.