Stock Market Faces Flash Crashes, Liquidity Crisis: JPMorgan

An ominous anniversary in financial history is drawing near, as Sept. 15 will be 10 years since investment banking powerhouse Lehman Brothers collapsed, a pivotal event in the 2007-08 financial crisis that turned a year-old bear market into a full-fledged panic of selling. Marko Kolanovic, the global head of macro quantitative and derivatives research at the largest U.S.-based bank, JPMorgan Chase & Co., has marked the occasion by issuing a dire scenario of what the next financial crisis is likely to look like, CNBC reports.

Meanwhile, the current bull market will have lasted 9 1/2 years as of Sept. 9, delivering spectacular gains during its run so far. Investors with short memories will be unprepared for the next big shock to stock prices, increasing the odds that the next crisis will be particularly severe. Meanwhile, since earlier this year, a number of well-known market gurus have been issuing their own warnings that stocks are on the brink of plunging by up to 60%. (For more, see also: Why the S&P 500 May Fall More Than 60%: Hussman.)

What The Next Crisis Will Look Like

Sudden and severe stock selloffs
Liquidity crisis
Unprecedented Fed actions to bolster stocks
Worst U.S. social unrest in 50 years

Source: JPMorgan Chase, as reported by CNBC.

Computerized Crisis

A particular source of concern for Kolanovic is the growing importance of computerized trading and passive investing. As long as bullish sentiment held sway among investors, both these factors helped propel stock prices to new heights. However, once sentiment pivots toward the bearish, the lightning speed with which computerized trading algorithms operate can produce massive selling pressure that may overwhelm the markets in fractions of a second. Moreover, these programs tend to play follow-the-leader, with waves of selling inducing yet more waves of selling. (For more, see also: How Algo Trading Is Worsening Stock Market Routs.)

A Soaring Stock Market

Source: Yahoo Finance; gains computed from the last bear market low close on March 9, 2009 through the close on Sept. 5, 2018.

Ticking Time Bomb

According to Kolanovic, over the past decade about $2 trillion of investments have moved from actively-managed to passive funds, reducing the possibility that bargain-hunting managers will stem a wave of selling. Additionally, he estimates that up to 66% of all assets under management are now in index funds and quant funds, and that about 90% of daily trading volume is driven by these and similar strategies. 

Noted emerging markets fund manager Mark Mobius has voiced similar concerns about the explosive growth of passive ETFs and high-speed computerized trading. He sees a growing danger of a "snowball effect" in which a small wave of selling rapidly becomes an avalanche. (For more, see also: Contrarian Mark Mobius Sees a 30% Stock Plunge.)

The Great Liquidity Crisis

A plunge in stock prices is likely to cause what Kolanovic calls the Great Liquidity Crisis, with willing buyers for stocks becoming increasingly harder to find, sending prices down yet further. If the selloff reaches a 40% decline, he expects that the Federal Reserve will have to intervene, to prevent the economy from slipping into a severe recession, if not a depression. This is essentially what the Fed did in 2008-09, with its massive program of quantitative easing to combat that crisis.

Rising Social Unrest

With personal wealth cratering, and pension funds becoming severely underfunded, thus threatening deep cuts to benefits, Kolanovic raises the specter of the worst social unrest in the U.S. since 1968 as the result of a new financial crisis. That year was marked by rising discontent over the Vietnam War, as well as the assassinations of civil rights leader the Rev. Martin Luther King, Jr. and presidential candidate Senator Robert F. Kennedy.

Hedging His Bets

However, in an interview cited by CNBC, Kolanovic indicated that, should central banks such as the Fed intervene successfully to prop up asset prices, the status quo is likely to be maintained. Moreover, he sees low risk for a new financial crisis to develop until at least the second half of 2019.

Take the Next Step to Invest
The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.