At what cost?

Can the world thrive on 100% renewable energy?

A transition away from fossil fuels is necessary, but it will not be painless




A WIDELY read cover story on the impact of global warming in this week’s New York magazine starts ominously: “It is, I promise, worse than you think.” It goes on to predict temperatures in New York hotter than present-day Bahrain, unprecedented droughts wherever today’s food is produced, the release of diseases like bubonic plague hitherto trapped under Siberian ice, and permanent economic collapse. In the face of such apocalyptic predictions, can the world take solace from those who argue that it can move, relatively quickly and painlessly, to 100% renewable energy?

At first glance, the answer to that question looks depressingly obvious. Despite falling costs, wind and solar still produce only 5.5% of the world’s electricity. Hydropower is a much more significant source of renewable energy, but its costs are rising, and investment is falling. Looking more broadly at energy demand, including that for domestic heating, transport and industry, the share of wind and solar is a minuscule 1.6% (see chart). It seems impossible to eliminate fossil fuels from the energy mix in the foreseeable future.

But all energy transitions, such as that from coal to hydrocarbons in the 20th century, take many decades. It is the rate of change that guides where investments flow. That makes greens more optimistic. During the past decade, solar photovoltaics (PV) and wind energy have been on a roll as sources of electricity. Although investment dipped slightly last year, the International Energy Agency, a global forecaster, said on July 11th that for the first time the amount of renewable capacity commissioned in 2016 almost matched that for other sources of power generation, such as coal and natural gas. In some countries the two technologies—particularly solar PV in sunny places—are now cheaper than coal and gas. It is no longer uncommon for countries like Denmark and Scotland to have periods when the equivalent of all their power comes from wind.

Ambitions are rising. The Senate in California, a state that is close to hitting its goal of generating one-third of its power from renewables by 2020, has proposed raising the target to 60% by 2030; Germany’s goal is to become 80% renewable by 2050. But whether it is possible to produce all of a country’s electricity with just wind, water and hydro is a subject of bitter debate.

In 2015 Mark Jacobson of Stanford University and others argued that electricity, transport, heating/cooling, and industry in America could be fully powered in 2050-55 by wind, water and solar, without the variability of the weather affecting users. Forswearing the use of natural gas, biofuels, nuclear power and stationary batteries, they said weather modelling, hydrogen storage and flexible demand could ensure stable supply at relatively low cost.

But in June this year Christopher Clack, founder of Vibrant Clean Energy, a firm, issued a stinging critique with fellow researchers in the Proceedings of the National Academy of Sciences, the journal in which Mr Jacobson et al had published their findings. They argued that a narrow focus on wind, water and solar would make tackling climate change more difficult and expensive than it needed to be, not least because it ignored existing zero-carbon technologies such as nuclear power and bioenergy. They claimed the models wrongly assumed that hydroelectricity output could continue for hours on end at many times the capacity available today, and pointed to the implausibility of replacing the current aviation system with yet-to-be-developed hydrogen-powered planes. In their view, decarbonising 80% of the electricity grid is possible at reasonable cost, provided America improves its high-voltage transmission grid. Beyond that is anyone’s guess.

Others take a wider view. Amory Lovins of the Colorado-based Rocky Mountain Institute, a think-tank, shrugs off the 100% renewables dispute as a sideshow. He takes comfort from the fact that it is increasingly common for renewables sustainably to produce half a location’s electricity supply. He believes that the share can be scaled up with ease, possibly to 80%. But in order to cut emissions drastically, he puts most emphasis on a tripling of energy efficiency, by designing better buildings and factories and using lighter materials, as well as by keeping some natural gas in the mix. He also sees clean-energy batteries in electric vehicles displacing oil demand, as petroleum did whale oil in the 19th century.

Some sceptics raise concerns about the economic ramifications if renewables’ penetration rises substantially. In an article this month, Michael Kelly of Cambridge University focused on the energy return on investment (EROI) of solar PV and wind turbines, meaning the ratio between the amount of energy they produce to the amount of energy invested to make them. He claimed that their EROI was substantially lower than those of fossil fuels; using renewables to generate half of the world’s electricity would leave less energy free to power other types of economic activity.

Critics note that his analysis is based on studies of PV returns in Spain from more than half a decade ago. Since then solar and wind costs (a proxy for EROI) have plunged, raising their returns. What is more, other studies suggest returns from fossil-fuel-derived energy have fallen, and will decline further as they incur increased costs associated with pollution and climate change. A high share of renewables may be less efficient at powering economic growth than fossil fuels were in their 20th century heyday. But if the climate doomsayers are to be proved wrong, a clean-energy system must be part of the solution.


Trump Gives Beijing a Lesson in the Art of the Deal

The president’s moves are neither capricious nor naive, though they lack a certain diplomatic finesse.

By Michael Auslin

President Trump and Chinese President Xi Jinping at the G-20 summit in Hamburg, Germany, July 8. Photo: pool/Reuters


With only six months in office, President Trump has put his signature on America’s China policy. A strategy that may appear capricious to his critics in fact has a logic consistent with Mr. Trump’s guiding beliefs. He sought a deal with China, then concluded he would not get one, and so acted in what he believes is America’s best interest.

Mr. Trump’s approach is undoubtedly transactional, but it’s surprisingly realistic given China’s kid-glove treatment by most U.S. presidents. In potentially putting Beijing and Washington at loggerheads, it is also undeniably risky.

In June, the White House delivered three blows to China. First, it imposed sanctions on a Chinese bank and two individuals for abetting North Korea’s financial transactions. Second, it listed China in the category of worst offenders in human trafficking. Finally, it announced a $1.4 billion arms sale to Taiwan. The Trump administration also made several lesser-order jabs, among them calling for more freedom in Hong Kong and conducting another freedom-of-navigation operation near the contested Spratly Islands in the South China Sea. It did all this as Chinese President Xi Jinping tried to celebrate the 20th anniversary of the return of Hong Kong to China from Britain.

Any one of these actions would normally be enough to rock Sino-U.S. relations, at least for a while. Taken together, they constitute a significant break from the past two decades of diplomatic engagement between the two powers. Is this an enduring shift on the part of the Trump administration? Or simply shots across Beijing’s bow to get China to cooperate more with Washington and behave better abroad?

To Mr. Trump’s critics, the moves represent a recognition of his initial naiveté regarding China. When the president tweeted on June 20 that China’s efforts to help on North Korea had not worked out, he was derided for his apparent faith in Beijing’s promises and for flipping his opinion so quickly. The latest turnaround was seen as part of a pattern stretching back to the campaign and transition, when candidate and President-elect Trump warned that he would not shrink from putting economic and political pressure on China. Then, soon after taking office, the president radically shifted to a far more cooperative stance, going so far as to host Mr. Xi at Mar-a-Lago for a family-style summit.

But Mr. Trump’s moves are neither capricious nor naive, even if they do lack a certain diplomatic finesse. His interest has always been in the bottom line, and diplomatic niceties of the kind that have suffused Sino-U.S. relations since Richard Nixon’s epochal 1972 visit to Beijing are useful to him only if progress is being made.

Last month’s actions put Beijing on notice that Mr. Trump’s transactional approach is real, and so are the potential consequences for failing to make a deal. Moreover, each move serves some larger U.S. purpose, whether strategic (Taiwan) or tactical (North Korea). Chinese leaders have long been accustomed to strong words and no action from Washington; now they will have to consider how far the Trump administration may go.

By publicly calling out China, Mr. Trump risks chipping away at Beijing’s carefully polished image as a global leader and contributor to stability. Beijing, already upset by criticism leveled by Defense Secretary Jim Mattis about China’s militarization of the South China Sea islands, lashed back at the administration’s moves, especially the arms sale to Taiwan.

With a critical Communist Party Congress coming up in the fall, Mr. Xi will be loath to be seen as unable or unwilling to combat an activist U.S. policy in Asia. He may look for ways to check Mr. Trump’s recent moves, such as ratcheting up economic and diplomatic pressure on U.S. allies like South Korea, which is already in Beijing’s doghouse for accepting a new U.S. missile defense system. Mr. Xi may also try to regain some standing by challenging the U.S. Navy in the South China Sea.

Mr. Trump has made clear that he means what he says about deal-making. China said it would help and did not. That’s enough for Mr. Trump to put the world’s two most powerful countries on a potential collision course. He might be bluffing or he might be in earnest. Either way, the American president’s sharp dose of realism has the potential to reshape the world’s most important relationship.


Mr. Auslin is a fellow at the Hoover Institution, Stanford University.


China in Africa: A Different Kind of Military Theater

By Allison Fedirka


China has been trying to show the world just how militarily capable it is by expanding operations to other continents. This time, it’s focused on Africa. With much fanfare, Chinese military personnel set sail July 11 from the port at Zhanjiang for Djibouti, where they will help set up China’s first permanent overseas military base. China says the base will provide support for peacekeeping, anti-piracy and humanitarian operations. But media and military analysts have claimed that the Djibouti base is part of China’s so-called “string of pearls” strategy, which is meant to develop a network of military and commercial assets and relationships along the India Ocean to project power abroad. The base, however, is not an example of China’s military prowess but rather an attempt to boost China’s image at home and abroad.

China chose Djibouti as the location for its base because Beijing has an interest in ensuring the flow of trade from the Persian Gulf to China. Eighty percent of China’s seaborne oil imports pass through this route through the India Ocean, so it’s a vital part of keeping the country running.

And the need to ensure access to this route is the motivation behind the “string of pearls” strategy. China figures it can secure access to the Indian Ocean and through various chokepoints by building military and commercial facilities throughout the South China Sea, the Bay of Bengal and, to a lesser degree, the Arabian Sea. Facilities have already been developed in Bangladesh, Myanmar, Pakistan and Sri Lanka.

But these efforts are more a case of grandstanding than effective protection of Chinese interests. With a relatively weak navy, at least compared to the U.S. Navy, China lacks the ability to secure this route militarily. So instead, it is trying to portray an image of strength to distract from its actual weakness.


This photo taken on Dec. 23, 2016 shows Chinese J-15 fighter jets being launched from the deck of the Liaoning aircraft carrier during military drills in the Yellow Sea, off China’s east coast. STR/AFP/Getty Images

Few details about the facility have been made public, and what little is known suggests that the base has no military significance. Reports indicate that navy warships have been sent to the base, but there is no available information on the number of personnel to be stationed there, the length of their deployment or a timetable for operability. Some estimates suggest that 2,000 soldiers – likely marines and special operations forces – will eventually be stationed at the base.

By the end of the year, the facility will hold weapons and ammunition and will include wharves for stationing Chinese navy ships. It will cost the Chinese $20 million annually to rent the base, which covers 36 hectares near a commercial port owned by Chinese companies. There are plans to build an airfield, although they exist only on paper. There is one helicopter pad that should be completed by the end of the year. Notably, military expert Zhou Chenming told the South China Morning Post that the facility “is not a military base in the full sense” but that its capacity could be expanded later to repair ships and accommodate planes. From this, we suspect that the base has no aircraft and cannot service vessels. This doesn’t say much about the facility’s capabilities, and since so little is known about the nuts and bolts of the base, it would be difficult for anyone to reasonably conclude that it can help China project power abroad.

But more important is the fact that China’s navy lacks blue-water capabilities – the ability to operate in the deep waters of the world’s oceans. The navy has ambitious plans to develop these capabilities, but doing so takes a long time – at least one or two generations, assuming no major disruptions or pauses in the process. The navy does not currently have any operational aircraft carrier battle groups. Its sole operational aircraft carrier, the Liaoning, is a refurbished ship that initially launched in 1988. The Liaoning can carry about half the number of planes a U.S. aircraft carrier can. Its first live-fire exercises were held in December 2016, and its accompanying fighter pilots are only now graduating from initial training. The crew has little experience and requires years more training before the ship can be operationally effective. The Chinese navy, moreover, has yet to overcome basic logistical problems, including refueling. Most of the country’s naval vessels are not nuclear powered and must therefore stop at ports to refuel, limiting their capabilities and reach.

China can’t project power globally. It has to be selective in setting its priorities, and Africa isn’t at the top of this list. China’s real concerns are much closer to home. Any imports coming through the Indian Ocean destined for China must pass through the Strait of Malacca, a major chokepoint bordered by Malaysia, Indonesia and Thailand. Passage through the strait is secured by the U.S. Navy, but the Chinese don’t want to rely on the U.S. for access to such an important route. Chokepoints are also an issue in the South China Sea, where China and several other East Asian states are competing for territory. What capabilities and resources Beijing does have will be focused on this region rather than the Horn of Africa.


A New Course for Economic Liberalism

Sebastian Buckup
 France's new economic policy

 
GENEVA – Since the Agrarian Revolution, technological progress has always fueled opposing forces of diffusion and concentration. Diffusion occurs as old powers and privileges corrode; concentration occurs as the power and reach of those who control new capabilities expands. The so-called Fourth Industrial Revolution will be no exception in this regard.
 
Already, the tension between diffusion and concentration is intensifying at all levels of the economy. Throughout the 1990s and early 2000s, trade grew twice as fast as GDP, lifting hundreds of millions out of poverty. Thanks to the globalization of capital and knowledge, countries were able to shift resources to more productive and higher-paying sectors. All of this contributed to the diffusion of market power.
 
But this diffusion occurred in parallel with an equally stark concentration. At the sectoral level, a couple of key industries – most notably, finance and information technology – secured a growing share of profits. In the United States, for example, the financial sector generates just 4% of employment, but accounts for more than 25% of corporate profits. And half of US companies that generate profits of 25% or more are tech firms.
 
The same has occurred at the organizational level. The most profitable 10% of US businesses are eight times more profitable than the average firm. In the 1990s, the multiple was only three.
Such concentration effects go a long way toward explaining rising economic inequality.

Research by Cesar Hidalgo and his colleagues at MIT reveals that, in countries where sectoral concentration has declined in recent decades, such as South Korea, income inequality has fallen. In those where sectoral concentration has intensified, such as Norway, inequality has risen.
 
A similar trend can be seen at the organizational level. A recent study by Erling Bath, Alex Bryson, James Davis, and Richard Freeman showed that the diffusion of individual pay since the 1970s is associated with pay differences between, not within, companies. The Stanford economists Nicholas Bloom and David Price confirmed this finding, and argue that virtually the entire increase in income inequality in the US is rooted in the growing gap in average wages paid by firms.
 
Such outcomes are the result not just of inevitable structural shifts, but also of decisions about how to handle those shifts. In the late 1970s, as neoliberalism took hold, policymakers became less concerned about big firms converting profits into political influence, and instead worried that governments were protecting uncompetitive companies.
 
With this in mind, policymakers began to dismantle the economic rules and regulations that had been implemented after the Great Depression, and encouraged vertical and horizontal mergers. These decisions played a major role in enabling a new wave of globalization, which increasingly diffused growth and wealth across countries, but also laid the groundwork for the concentration of income and wealth within countries.
 
The growing “platform economy” is a case in point. In China, the e-commerce giant Alibaba is leading a massive effort to connect rural areas to national and global markets, including through its consumer-to-consumer platform Taobao. That effort entails substantial diffusion: in more than 1,000 rural Chinese communities – so-called “Taobao Villages” – over 10% of the population now makes a living by selling products on Taobao. But, as Alibaba helps to build an inclusive economy comprising millions of mini-multinationals, it is also expanding its own market power.
 
Policymakers now need a new approach that resists excessive concentration, which may create efficiency gains, but also allows firms to hoard profits and invest less. Of course, Joseph Schumpeter famously argued that one need not worry too much about monopoly rents, because competition would quickly erase the advantage. But corporate performance in recent decades paints a different picture: 80% of the firms that made a return of 25% or more in 2003 were still doing so ten years later. (In the 1990s, that share stood at about 50%.)
 
To counter such concentration, policymakers should, first, implement smarter competition laws that focus not only on market share or pricing power, but also on the many forms of rent extraction, from copyright and patent rules that allow incumbents to cash in on old discoveries to the misuse of network centrality. The question is not “how big is too big,” but how to differentiate between “good” and “bad” bigness. The answer hinges on the balance businesses strike between value capture and creation.
 
Moreover, policymakers need to make it easier for startups to scale up. A vibrant entrepreneurial ecosystem remains the most effective antidote to rent extraction. Digital ledger technologies, for instance, have the potential to curb the power of large oligopolies more effectively than heavy-handed policy interventions. Yet economies must not rely on markets alone to bring about the “churn” that capitalism so badly needs. Indeed, even as policymakers pay lip service to entrepreneurship, the number of startups has declined in many advanced economies.
 
Finally, policymakers must move beyond the neoliberal conceit that those who work hard and play by the rules are those who will rise. After all, the flipside of that perspective, which rests on a fundamental belief in the equalizing effect of the market, is what Michael Sandel calls our “meritocratic hubris”: the misguided idea that success (and failure) is up to us alone.
 
This implies that investments in education and skills training, while necessary, will not be sufficient to reduce inequality. Policies that tackle structural biases head-on – from minimum wages to, potentially, universal basic income schemes – are also needed.
 
Neoliberal economics has reached a breaking point, causing the traditional left-right political divide to be replaced by a different split: between those seeking forms of growth that are less inclined toward extreme concentration and those who want to end concentration by closing open markets and societies. Both sides challenge the old orthodoxies; but while one seeks to remove the “neo” from neoliberalism, the other seeks to dismantle liberalism altogether.
 
The neoliberal age had its day. It is time to define what comes next.
 
 


This Is How The U.S. Market Might Crash

by: Raphael Rottgen

- We could see a non-linear break in the market.

- This would be caused by a number of potential vicious circles of selling.

- Some of these potential vicious circles are the result of recent changes in market participant structure and activity.

 
 
 
I have developed the conviction that we will have a non-linear break in the market in the near future, say the next 3-12 months. "Non-linear" in the sense that it will not be along the lines of losing a few percent or so every week to enter a bear market over the period of a few months, but an exponentially accelerating sell-off, similar to 1987, for example, whereby we could lose 20%+ in one trading day. This is less based on arguments along the lines that certain valuation metrics for the (U.S.) market are high (an argument that could have been made years ago) and more on arguments that a number of mechanistic pieces are now in place that could cause this type of sell-off.
 
So, what would we need to see such a scenario?
 
1. We need a trigger
 
We need something that tips us into selling territory far enough. Far enough to overcome the vested interest of market participants to keep the party going (this, by the way, was one of the typical pre-crash characteristics that John Kenneth Galbraith identified in his book The Great Crash, 1929. Far enough to overcome the price thresholds above which armies of automated algorithms (and also human traders) simply buy on the dip. Like in a chemical reaction, there is an activation energy threshold to overcome to get it going, and, again like in a chemical reaction, you need a catalyst.
 
What could be that catalyst?
 
First, we could have a cataclysmic event. For sure, it would have to be something very traumatic - 9/11 was on obvious example (the Dow was down approx. 14% for the week after the market reopened). If it happens, it may well be something that we did not expect at all - if we had expected it, we would have been prepared for it psychologically, practically (hedging), etc. I recently got reminded of this when the Qatar crisis started to unfold, and I contemplated the remote possibility of a war involving Saudi Arabia (I am not saying this is likely).

Second, and I think more likely (we should of course hope this will be the trigger rather than the first option), we could see a stark sell-off in some remote-seeming corner of the world of financial assets. A remote corner, but one that is sufficiently connected to the overall network of financial assets that it has the potential to spread its "sell virus" via contagion. This, of course, was the example of the crisis of 2008, which started with seemingly localized blow-ups like that of two internal Bear Stearns MBS hedge funds in June 2007. As Galbraith put it, in an eerily prescient article in January 1987: "For the loss will come. The market at this stage is inherently unstable. At some point, something - no one can ever know when or quite what - will trigger a decision by some to get out."
 
Or, do we need such a hard, human-rationalize-able trigger after all? Remember the flash crash of May-10 (Dow down 9% at its worst)? Remember the weird price action in tech stocks that Friday a few weeks ago? I tend to think that kind of "catalyst" would not be enough, though, as it would not push us down far enough and/or fulfill the other two conditions for the crash to which we shall now turn our attention.
 
2. We need perpetuation of the selling
 
Ideally in a self-reinforcing "vicious circle" way, where selling triggers further selling. This, too, may happen in various ways.
 
First, with humans as investment decision-makers in the middle. As Edwin Levèfre already said in Reminiscences of a Stock Operator, "the greatest publicity agent in the wide world is the ticker tape" and "never argue with it [the tape]." People who see prices dropping like a stone may just sell themselves, too, and ask questions later - especially if they have reasonable justifications for doing so (see next point "We need absence of significant supportive buying" below). This is also true as selling right now can be easily rationalized: we are almost eight years into a bull market (one of the longest ever in the U.S.), market valuations are high (again, in the U.S.) on most traditional metrics, QE seems to be ending, growth in many sectors is unexciting, etc. Note that against many of these points, one could elaborate counterarguments - e.g., who cares how long the bull market has gone on for? Or, regarding market valuations: high multiples are justifiable, given the ultra-low interest rates.

I, for one, will place my bet that, once a sell-off starts, few investors will stop to argue that the equity risk premium is actually correct; more likely, the majority will simply remember that the CAPE of U.S. stocks is near 30 and that we might just go back to something in the teens (the long-run mean and median) and that this will not happen via earnings catching up with prices. Lastly, with human decision-makers in the middle, most of which also tend to be employed rather than self-employed, Keynes's famous quote applies: "it is better for reputation to fail conventionally than to succeed unconventionally." Selling will be the conventional thing to do (just like continuing to buy is the conventional thing to do for now).
 
Second, via good old-fashioned contagion and forced selling. Once the crash starts, even if it is in some remote corner of the asset network, it will often force investors who commingle some of the affected assets with "good" assets to sell the latter ones, too, and soon, the selling may reverberate through the entire financial asset network. The exact extent and speed of contagion will depend on where the contagion starts and on the network topography, which is virtually impossible to know, but I would bet that the markets are more interlinked now than they were during the last crisis.
 
The more leverage, obviously, the worse, as assets pledged as collateral (including and in particular margined stocks) lose value, which then generates margin calls and, if those calls are unmet, forced sales of the collateral, leading to another vicious circle.
 
Third, in some perverse hard-wired, machine-driven way - which is really the same forced selling as above, but on steroids, as there are no humans in the middle and things may unfold extremely quickly. Remember the role of portfolio insurance in the 1987 crash? (Now, I am dating myself). In brief, in case of price falls, portfolios were programmed to sell a portion of the portfolio value short, via futures. That sounded like a great idea at the time until it entered a vicious circle, whereby a fall in cash equities caused the future to fall (via the portfolio insurance programmed actions) which in turn caused cash equities to fall further which in turn caused the future to fall further, which - you get the point. Here, we note that a "financial innovation" was another typical pre-crash characteristic that John Kenneth Galbraith identified in this book. The 1929 and 2008 innovations were investment trusts and MBS/CDO/etc. What could be current financial innovation that may become a culprit?
 
How about a class of instrument that grew at 20%+ CAGR over the last 12 years (and keeps going) and of which there are now more types (almost 6,000) than U.S. stocks of at least some reasonable size (using the Wilshire 5000 as a proxy)? I am talking about ETFs, of course (and ETPs).

Unless I am missing something, I can see how ETFs and their underlying assets could develop the same unhealthy, vicious interplay (i.e., another vicious circle) as happened between futures and underlying shares in the 1987 crash. Selling pressure may start in either place, ETF or underlying assets, but then the other instrument(s) will get dragged down via hedging activity which in turn will drag down the initial instrument(s), and so on - yet another vicious circle. Arguably, this same effect may have just happened on the way up, albeit in a slower and more controlled way as is likely on the way down.
 
An ETF, of course, is also often an excellent way to promote contagion, as they nearly always rather indiscriminately mix "good" with "bad" assets, interlinking them in a rigid, mechanical way, allowing the good to be dragged down with the bad (or the bad to rise jointly with the good). Although I cannot prove it, I sensed this happening recently, when in May 2017 the Brazilian market was shocked by the release of wiretaps implicating the Brazilian president in potentially criminal activities. The prominent Brazil-tracking ETF EWZ was down more than 15%, and pretty much all of its component stocks were also down roughly this percentage, albeit they represent a wide variety of companies that even cursory fundamental analysis would show to be of rather diverse quality and valuation.
 
The growth of ETFs has been a major, major change in market structure and may well be the cause for many a hedge fund manager's frustrated proclamations about how the market is not rational anymore. Of course, it really probably just means the market is not rational anymore on the previous time frames, now that many ETFs reinforce the prevailing trend and hence extend the trend's lifetime. But, considering how many hedge fund investors have tended to become more short-term oriented, you can see how this dichotomy between increasing periods of market irrationality (read: drawdowns/losses) and decreasing investor patience can drive hedge fund managers into returning outside money.

Galbraith mentions the emergence of investment trusts as a sign of the pre-1929 froth. I read about the first ETF of ETFs earlier this year.
 
Another potential source of forced selling may come to us thanks to the same folks that have brought volatility to its knees over the last few years. While again I cannot prove it with hard data, I have by now heard ample anecdotes of large institutions reaching for yield (understandable in our ZIRP world) by shorting vol. This includes, for example, me having had to listen to a senior investment management professional of an insurance company gloating about how he makes lots of yield by basically coming to the office every day writing puts. Let's see - reaching for yield via massively shorting an asset class already trading at historical lows - might we have seen this before? AIG Financial Products Group London writing CDS pre-2008? I listened to that person and thought I was looking at the guy that Steve Eisman had dinner with in Las Vegas in the movie The Big Short.
 
In any event, that game works fine until the day it does not work anymore. If a market drop is big enough, those institutions that are short puts will want to, and need to, cover their positions - i.e., they will either buy back the puts, which will then cause the counterparty to hedge itself by selling the underlying in the market, or more likely (as in a severe fall there may not be any people around writing puts), the institutions will just sell the underlying assets themselves. In any event, this activity will depress prices and probably set off yet another vicious circle.
 
3. We need absence of significant supportive buying
 
If things go down rapidly, where could the bid come from?
 
Machines?
 
Some of them may reinforce the downward trend, by following simplistic trend-following rules. Eventually (but likely not quickly enough), many machines will probably be taken offline - which is arguably correct anyway, even, or, perhaps especially, if the machines are sophisticated machine learning-based ones - as these rely on patterns observed in past data and are plainly unreliable when faced with data points that have never been seen before or only seen very few times.

"Regular human" investors?
 
Given the speed with which things will unfold, they will probably fall back on time-proven heuristics rather than any sort of deep analysis. I would bet that "don't catch the falling knife" will be a widely remembered and applied heuristic. Note also that investors will be able to rationalize not buying in the same manner they rationalized selling, as elaborated above.
 
Risk-loving prop desks who can enter a trade early and ride out a draw-down?
 
Well, thanks to the Volcker rule (not debating its merit here), there are fewer of those around these days.
 
Central Banks?
 
Their balance sheets are already full of stocks - just look at the JCB's ownership of the Japanese equity market (it was a top 10 holder in 90% of Japanese shares already as of mid-2016; by the way, they also buy loads of ETFs) or even the staid, quaint Swiss National Bank, who held over $63bn of U.S. shares as of year-end 2016. However, now the trend seems to be to shrink balance sheets.
 
Private equity?
 
Yes, they are full of cash but cannot, and do not need to, act quickly enough - but they will come out having a heyday (payday?).
 
Failed attempt at an upbeat note
 
The only fact that in theory could counterbalance my pessimist view so far is that there is actually an increasing number of voices that warn about the potential of a sharp downturn in markets - e.g., Jim Rogers or Mark Yusko. If these are just the visible exponents of a much larger, silent group that shares this belief, then maybe in the end, the market is already reflecting actions reflecting that belief, and it is not vulnerable as it actually is not overbought and overvalued? Maybe without these cautious beliefs and the resulting positioning, the CAPE would be in the 30s?
 
I do not buy it. The difficulty is that for many investors, even if they do share the belief that the market will come down, it is in practice very difficult to act on that belief, especially if they are employed (same Keynes argument as above) and/or managing other people's money - other people who typically do not look kindly on relative underperformance (even in hedge funds!) or things like holding cash reserves (which they have to pay fees on). That is why "as long as the music is playing, you've got to get up and dance," as Citigroup's Chuck Prince famously said in 2007. And, then you are magically supposed to know exactly when to stop dancing and quit the party before drunk people trash the furniture and start a fight.

It is like a multi-player game of chicken, made worse by the high payoffs/incentives to stay in the game. As somebody more eloquent than myself, John Hussmann, has said: "The problem with bubbles is that they force one to decide whether to look like an idiot before the peak, or an idiot after the peak." Many a smart person has looked like an idiot before the peak, at least temporarily - e.g., Warren Buffett during the internet bubble and Crispin Odey more recently.
 
Most people do not have Warren's or Crispin's financial or psychological stamina, though.
 
I could go on, but I'll stop here. We have not even talked about the links to the real economy yet (the whole reflexivity thing), but that might have to be another article.
 
So, do you agree? If so, how are you preparing/positioning yourself?