Frequency of Crises x Severity of Problems = A Constant......

Jeff Gundlach, Founder and Investment Manager at Double Line Funds, regularly hosts public webcasts, wherein state of markets and other important macro themes are discussed. In past, Gundlach has been pretty accurate in his calls on Apple, the Nikkei, the Yen, the Shanghai composite, pair trade on S&P-Spainish Index and natural gas. 
Recently hosted presentation titled "The Big Easy"  discussed long term implication of ultra easy monetary policy followed by global central banks. Presentation could be found on www.businessinsider.com and various other financial blogs. One of the key message from recent presentation was what Gundlach termed as  "Gunlach's Rule of Investment Risk". 

 Here's a rough transcription of the Gundlach's explanation from last night's call:

"This is what I call Gundlach's Rule of Investment Risk.  If you run things and you try to get them very smooth, without ever any downside, you're trying essentially to eliminate the frequency of problems.  I believe the frequency of problems times the severity of problems when they occur equals a constant.  Frequency times severity equals a constant.  That is Gundlach's Rule of Investment Risk.  When you try unnaturally to push into the future problems, and quantitative easing is designed to do that, you end up increasing the severity of the problem."

In summary:

(Frequency of Problems) x (Severity of Problems) = A Constant

(source: www.businessinsider.com)

Frequency of Problems/Crises x Severity of Problems = A Constant......

A very powerful equation to understand severity of crises....

I found above explanation and equation to be very profound and powerful.  2007-2008 crises have created huge fear psyche not only among investors and traders but public in general. Massive intervention by Central Banks and Government around the world reduced the impact and shortened the duration of the crises. End of the world crises was ended (or it seems so) in less than a year. Leverage which was the root cause of the crises has increased even more, thus ensuring that next crises will be far bigger than 2008 crises. Greater Leverage (debt) was applied as solution to the 2008 crises and various other crises that followed namely - Greece, Euro, US Fiscal, etc. 2008-2011 could be termed as period which had series of crises although intensity kept on going down. This fits very well with the above equation. 2008 crises was huge in its impact all global markets and asset classes were impacted. This was followed by Greek Crises which didn't impact all the markets equally and was mostly contained to Europe in terms of impact, though fear was global. Initially Greek aid by ECB was thought to be sufficient but with contagion spreading to Italy, Spain and France even larger dose of Financial medicine (in terms of OMT, Loosening of collateral rules,etc) was applied in 2011 and 2012 which effectively killed the crises impact. Subsequent crises had limited impact on asset markets but fear of 2008 crises resulted in even large dose of financial medicine being applied. Thus what we effectively had was higher frequency of crises namely 2008, 2010 (greece), 2011 (US Downgrade, EU Debt crises), etc but severity was gradually subsiding. 


Google Trends - Financial Crises (100 indicates peak search)

Note - Data Frequency is weekly


Historically crises were either isolated and or were part of regular business cycle. Also frequency was less in the sense that typical time between them was 4-5 years. Since currencies were floated in 1973 with end of Bretton Woods System, world has experienced major crises. We have had numerous crises in form of Oil Crises in 70's, Mexican Crises, Savings Loan Crises in US, Japanese Bubble, South American Countries Crises (Brazil, Mexico and Argentina) in early 90's, South East Asian Crises in 1997-98, Dot Com Bubble, etc. All these crises had lag in terms of years and were isolated to a country or region. However since 2008 we have had far larger number of crises with impact being much smaller of subsequent crises.

Conclusion
1) Since the frequency of crises increased with 2008 crises, we saw subsequent crises had smaller impact on various asset markets. By small i mean in terms of spread of the impact (source of epicentre might be impacted badly but spread was not as severe). Even larger dose of financial balm was applied with subsequent crises which resulted in lower impact of crises. 

2) Since underlying problem of leverage remains next crises will be far severe. However, in order for it be severe it has to be few years away. 

3) Fear Psyche has been so severe with higher frequency of crises that Dow/S&P at new highs are not be believed in, Improvement in economic data is considered one off, problems which have been historically present (like Debt Ceiling) are termed as crises, etc.