The Hidden Time Bomb of Trumponomics

Way back in the 1960s, I owned a Volkswagen Beetle. Great little car. Had flowers on it. One night we were driving out to stay in an out-of-the-way hotel, when, around 11pm, the car suddenly died. There was no one else on the road and virtually no lights. It appeared as if we would be forced to sleep in the car, and its status as a makeshift bedroom was not one of the VW’s virtues.

I knew next to nothing about auto mechanics but, with little to lose, I thought to take a look. I opened it up and looked over the engine, which at least seemed straightforward. Soon afterward, a local police car happened by and the officer pulled up and asked if we needed help. I explained the situation and he said he didn’t know that much about car engines either but we should take a shot at it together. (Waking up the local mechanic did not seem an option.) We took turns poking around with no success until eventually I popped off the distributor cap with the officer’s screwdriver.

And there it was. A broken wire. He had some tape so we fixed the wire, started the car, and drove off to our romantic getaway.

Trying fixing a car yourself today. It is almost impossible to have even a vague idea of what is going on without both extreme sophistication and a computer

Why am I telling you this? Because stocks and other financial instruments have gone the way of cars.

Back in the old days, just about everyone traded the way Warren Buffett did—find a good company, preferably one whose future prospects were extremely bright, and then buy and hold. Risk takers were the ones who chose to buy and sell short term, sometimes even day trading. But in just about every case, the key was the underlying instrument, be it either a company or some other tradable asset.

Those days are no more. Now it is almost impossible to have even a vague idea of what is going on without both extreme sophistication and a computer. Simple trading has given way to what are called derivatives, which means their price, at least in theory, is derived from the current price or suspected future price of those underlying instruments, but now even that merely scratches the surface of how the overwhelming volume of the vast sums that trade every day in the hundreds, perhaps thousands, of financial markets changes hands.

Derivatives began simply with futures, which are the expectation of how an instrument will perform by a set date down the road; and options, for which someone buys, for a fee, the right to either buy or sell an instrument at a future price. In futures, if the price moves the other way, the buyer is on the hook for the difference, which can result in serious losses. In options, if the “strike price” is never reached, the option expires and the fee is pocketed by the seller with no further obligation, but the buyer’s risk is limited to the price paid for the option. (The seller’s risk, however, is unlimited.)

Options quickly became means to “hedge” trading positions, meaning that they would be bought to limit downside exposure if other trades, especially those with unlimited loss potential, moved the wrong way. (There’s a lot more to this, but with derivatives, the weeds get very thick very fast. So for the purposes of this exercise, let’s keep it simple.)

The price of an option varies on how much the stock is expected to move. If you wanted to buy a $200 option on a stock that has not traded that high in twenty years, it will be relatively cheap, but an option on a stock with wild prices swings or one that is closer to the current price is going to cost a lot more.

This is where things get interesting. How much a stock, or bond, or interest rate, or currency, or anything moves during a given period of time is measured by “volatility.” As derivatives got more and more complex, their volatility would be measured as well as that of the instruments they were derived from. These included the main culprits in the 2008 crash, mortgage-backed securities and credit default swaps, but as the number of artificial instruments grew, volatility itself began to be traded. Options also have volatility, so they can be traded, something of an option on an option.

And so, the index that measures volatility for the S&P 500, VIX, is traded through VIX futures and some exchange traded funds (ETFs) as instruments in their own right. But, again, one could also develop a trade on how much the VIX futures fluctuate, and then another on how much that fluctuates, and on and on to infinity…or absurdity. And these second and third and fourth and nth degree derivatives have proliferated, even more than in 2008, which accounts for the huge price swings that have become almost standard in modern finance, to say nothing of creating massive risk.

The point here is that like the over-engineered car, we now have over-engineered financial markets, both more and more removed from their original purpose, the car to get us from one place to another and financial instruments to allow ordinary people to invest in companies they believed in.

But every so often we are reminded, or should be, that the underlying instruments should not be ignored, as mortgages were in 2008. We are at a similar junction now.

Thanks to Donald Trump’s mercurial—and amateurish—economic policy, if it can be called that, with the game of tariffs-on-tariffs-off dominating the markets, volatility has become a tsunami rather than a ripple. And volatility is not just a Wall Street board game, but has real world impact.

Volatility is, at its core, a measure of uncertainty and uncertainty is poison to company planners. How much to spend, how many to hire, whether to build that new plant or sign that new import or export trade deal, or just about any important decision a major corporation, middle-sized business, or even a mom-and-pop enterprise has to make is based on their sense of what the future holds, how confidently they can predict how well that decision will hold up. Buyers feel the same way. When and what to buy, discretionary spending, especially for big ticket items or vacations, is based on how much consumers think they can afford, the confidence that some calamity won’t wipe out their savings. Without that confidence, the safest course for both is wait and see and not walk to the edge of the cliff.

Trump’s rationale for his lunacy is that he is a great dealmaker and this is all part of a brilliantly conceived plan to get the best deals for the United States. Although he was forced to sort of admit defeat on his current tariff boondoggle, there is no saying he won’t try it again. But even if he is right (unlikely though that may be) he will be so while keeping volatility high. And high volatility will eventually suppress business activity, and the base from which all of those derivatives are traded. With both companies and consumers leery to commit funds in an uncertain environment, a recession, even without tariffs, becomes far more likely.

Thus Trump, and the country, will almost certainly lose either way.