A Minsky moment resembles a snake attack: a sudden and violent destructive move, much like a stock market crash. It originates in a slow psychological process according to economist Hyman Minsky, namely a gradual weakening of the financial system through mounting debts in periods of irrational euphoria.

Can we verify this hypothesis? And is the Minsky moment actually unpredictable?

Like in Sergio Leone’s film, the story of the S&P 500 is played out with three characters:

In March 2021, we warned the Speculator of the likely end of the Price-Earnings ratio expansion cycle. In June, we warned the Moderate investor that the game was no longer worth the candle. Today, we address the Rentier: The S&P 500 earnings yield is now offset by inflation.

For 50 years, when the Rentier expressed dissatisfaction, it was a message for his two fellow investors to take shelter.

Ahhh, the simple scientific world of René Descartes! Single cause, single effect. In the economic world however, this unfortunately is not the case. One cause can even bring about two opposite effects.

A devaluation, for example, usually produces a deterioration in the external accounts first and then an improvement second. Economists call this phenomenon the “J-curve.”

However for more than 20 years, the financial policies of developed economies have turned the page upside down. The “J” has become an “η.” Immediate relief and pain for tomorrow.

The tapering in view of the US Federal Reserve now raises the question: Would “tomorrow” be the end of the summer?

Does China today play the role of the leaking seal at the origin of the 1986 Challenger Shuttle explosion? Chinese authorities are stiffening up against their own capitalism deemed too “Western,” be they in the tech, food-delivery, real-estate, or tutoring industries.

Here, we focus on the risk of propagation, from Chinese equity markets to world equity markets.

Managing portfolio risks has nothing to do with massaging the average volatility; it is all about not being caught in violent market bifurcations. There are ways not to time bifurcations, but time the risk of bifurcations. Why? Because like nature, financial markets exhibit measurable fractal forms for the better, and for the worse.

This letter introduces fractality for two reasons:

Two weeks ago, a friend of mine lost his tennis racket on the highway. The racket fell right out of his bag attached to the back of his motorcycle. He quickly took the first exit, returned to the spot, pulled his motorbike into the emergency lane, and spotted his racket lying there on the highway. Did he end up crossing the road to retrieve it?

Managing risk does not mean forecasting.

Will the financial market crash?

This is anyone’s guess; the future is unpredictable. But what about the risk?

Given the inflationary shock on oil developing month after month, the odds of a 50% drawdown on the S&P 500 have been multiplied by a factor of 100.

For seven months in a row, Gavekal-IS macro, monetary, and behavioral models remained very equity-friendly, serene as a Tibetan monk. In the meantime, Gavekal-IS publications displayed a series of macroeconomic warning signals building up for a potential climax around August or September. See for instance February’s “Inflation: The Equity Nightmare,” and “US PE Expansion: Game Over!” publications, and May’s “Economic Boom and Financial Bust.”

Today, Gavekal-IS models crossed the Rubicon: criticality is ahead, risk-off!

Behind the decomposition of assets’ returns in alphas and betas lies an equation of willingness, and a conceptual mistake. It hides the fact that economic growth per capita originates in innovation (Schumpeter) or optimization (Ricardo), with different outcomes. The mistake could misguide companies and economies to over-optimize their production systems, increase their fragility, and eventually, collapse.

Our previous publication, “The Four Monetary Quadrants,” revealed how the volume and price of money deeply influences asset allocation.  We now shift gears to the transition between one quadrant and another. Specifically, how to collapse model risk, select asset classes, and still sleep well at night.

Start by clearing out the dead wood!

Back in the late 70s, Charles Gave realized asset classes are very sensitive to two major macro variables: growth and inflation. Thus, he suggested a Four Quadrants’ framework for portfolio construction: inflationary boom, inflationary bust, disinflationary boom and disinflationary bust.

Here, we propose to mirror the concept, crossing volume and price, but from the monetary angle: the amount of liquidity vs. the remuneration of such liquidity.

A new “Quadrants’ representation” emerges to drive asset reallocations.

Information technology changed the world from knowledge transmission bottlenecks to instantaneous access and worldwide diffusion of non-events. Does this drastic change help investors decide between buying equities or bonds?

Well, look to our Youngsters!