Sudden, severe stock sell-offs sparked by lightning-fast machines. Unprecedented actions by central banks to shore up asset prices. Social unrest not seen in the U.S. in half a century.
That’s how J.P. Morgan Chase’s head quant Marko Kolanovic envisions the next financial crisis. The forces that have transformed markets in the last decade, namely the rise of computerized trading and passive investing, are setting up conditions for potentially violent moves once the current bull market ends, according to a report from Kolanovic sent to the bank’s clients on Tuesday. His note is part of a 168-page mega-report, written for the tenth anniversary of the 2008 financial crisis, with perspectives from 48 of the bank’s analysts and economists.
Kolanovic, a 43-year old analyst with a PhD in theoretical physics, has risen in prominence for explaining, and occasionally predicting, how the new, algorithm-dominated stock market will behave. The current bull rally, the oldest in modern history by some measures, has been characterized by long periods of calm punctuated with spasms of selling known as flash crashes. Recent examples include a 1,600 point intraday drop in February and a 1,100 point decline in August 2015.
“They are very rapid, sharp declines in asset values with sharp increases in market volatility,” Kolanovic, the bank’s global head of macro quantitative and derivatives research, said in a recent interview. But those flash crashes occurred during a backdrop of a U.S. economic expansion; the new market hasn’t been tested in the throes of a recession, he said.
“If you have these liquidity-driven sharp selloffs that come at the end of the cycle, or maybe even causes the end of the cycle, then I think you can have a much more significant asset price correction and even more significant increase in market volatility,” Kolanovic said.
No one to step in and buy
In his report, Kolanovic explains how the major market trends that occurred after the 2008 crisis exacerbate selling during moments of panic. The massive shift from active to passive managed investments — he estimates that $2 trillion has moved that way in the past decade — has removed a pool of buyers who can swoop in if valuations tumble, he wrote.
The rise of automated trading strategies is also a factor because many quant hedge funds are programmed to automatically sell into weakness, he said. Together, index and quant funds now make up as much as two-thirds of assets under management globally, and 90 percent of daily trading comes from those or similar strategies, he wrote.