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Anticipating the Next Minsky Moment

Kevin T. Cooper, CFA®

Vice President | Head of Investment Research


If you’re unfamiliar with it, a “Minsky moment” represents the tipping point that precedes a full-on market collapse. The term refers to the work of Hyman Minsky, an American economist who labored in relative obscurity in the latter half of the last century before he died in 1996. Minsky’s work didn’t gain recognition until the 2008 financial crisis. In hindsight, his theories provided a seemingly prescient description for how the subprime mortgage fiasco built up and then subsequently imploded.

What Made Minsky’s Views So Controversial?

Minsky’s work was encapsulated in his financial instability hypothesis (FIH), which called into question the ability of the free market to bring lasting prosperity. The FIH was both innovative and contentious in its time because it viewed the cause of market crashes as coming from within the economic system itself rather than from external shocks. The seeds of the next market crisis are therefore sown in times of growth and stability—times that look exactly like those that governments strive to achieve. In a nutshell, Minsky’s FIH posed that: 

Minsky’s research showed the economy morphing through three stages of credit lending, each involving increasing levels of risk leading up to a crash:

  1. The Hedge Phase – The most stable stage in which borrowers’ cash flows cover interest and principal payments. Lending standards remain high.
  2. Speculative Borrowing – Increasing risk in which borrowers’ cash flows cover only their interest payments, but not principal. Borrowers are betting that interest rates will not increase, and that the value of their assets will continue to grow.
  3. The Ponzi Phase – In a booming economy, lending standards become less conservative. Borrowers don’t expect their cash flows to cover principal or interest; rather, they bet that rising prices will enable them to sell the underlying asset at a higher price, enabling them to repay their debt and make a profit. This is the riskiest phase in the cycle.

Minsky Cycle

Source: MSIM Global Multi-Asset Team analysis.

Based on his views of the systemic weakness of free markets and in contrast to the laissez-faire economists of his day, Minsky called for greater government regulation of securities markets.1 Minsky is credited with pointing to bankers, traders and financiers as sometimes “playing the role of arsonists, setting the economy ablaze.”2 It’s easy to see why his pessimistic ideas weren’t warmly embraced during his lifetime.

Where We Are Today

As we continue forward in the longest running bull market in history, Minsky’s theories remind us that good times don’t last forever. In terms of the credit cycle, in the U.S. today, nonfinancial corporate debt is greater as a percentage of GDP than before the last financial crisis. High asset valuations are a symptom of Minsky’s Ponzi Phase. Apart from the 2001 dot-com bubble (in which companies without earnings skewed the overall market’s P/E reading), today’s stock market valuations have grown to levels not seen since the 1970s. These are just two metrics within a sea of data pointing to the possibility of a maturing economic cycle.

The Advisor’s Takeaway

We are now ten years into the current cycle. Given this backdrop, now is an excellent time to prepare for a downturn without trying to time it. As we’ve said in past blogs, economic cycles are inevitable, but trying to get in and out at the right time is a losing game. With this in mind, you may want to consider:

  1. Talking to clients about risk and economic cycles. Make sure they know that bull markets don’t last forever. For ideas on how to do this, read our blog on coaching clients through volatility
  2. Reassessing their risk tolerance, testing for scenarios that include market downturns.
  3. Selling richly valued investments, which will take a disproportionate hit in a downturn versus more conservatively valued securities. 
  4. Rebalancing portfolios at least yearly to lock in a “buy low, sell high” framework. Without rebalancing, your clients are holding on to overvalued securities that will likely suffer more in a crash. For more information on rebalancing, click here.
  5. Managing sequence-of-returns risk for clients nearing retirement by moving them into strategies with a proven track record of risk management in times of market volatility.  

Conclusion

We tend to extrapolate the current stability we see into the distant future. We fall into a lull of believing that this time is different, imagining a “new normal” in which valuations don’t matter and markets will continue to rise. According to Minsky, however, the longer the party lasts, the greater the downfall will be and the less likely we’ll see it coming. The next Minsky Moment may be next year or just around the corner. Are your clients ready for it?

 

Tan, Thomas. “Introducing the Minsky Theory – Stability is Destabilizing.” Seeking Alpha. May 8, 2008.
2 Cassidy, John. “The Minsky Moment.” The New Yorker. January 27, 2008.

WRITTEN BY

Kevin T. Cooper, CFA®

Vice President | Head of Investment Research

PUBLISHED: October 16, 2019

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