STOCK MARKET CRASHES, HELICOPTERS, AND AIR PUMPS

The purpose of this article is to explain the importance of volatility and how it relates to stock market crashes. I use real world experiences to help people visualize the fundamentals~

A few years ago I was the pilot in command of an attack helicopter (an AH-64D Apache) and I had a brand-new lieutenant in the front seat as my co-pilot/gunner. He was a really smart guy and I was teaching him a neat concept about barometric pressures and weather patterns. Before conducting the flight, we had received a weather briefing that suggested poor weather was going to be coming through the area. In an effort to discuss some of the finer points of piloting, I asked the lieutenant a couple pop-quiz questions.

Before conducting any flight, it’s important to check the barometric pressure because the reading is supplied to the altimeter gauge. The altimeter is a very important gauge because it tells the pilot how high above sea level the helicopter is. In the event of bad weather, the pilot needs to know the altitude of the airfield and the altitude of the aircraft to ensure a safe landing. As we were discussing the implications of the barometric pressure, I asked my lieutenant if the pressure should be getting lower or higher throughout the day based on the anticipated weather. As expected, the lieutenant gave the correct response and said the pressure should be getting lower. When I asked him why the pressure should be lower, he didn’t provide many details to support his answer. That’s when I told him the story of the air pump.

If you’ve ever had the luxury of using an air pump at a gas station, you’ll notice the pressure gauge goes to zero when you press the button to fill your tire. The reason the pressure decreases in the gauge is because an increased velocity of air molecules coincidently reduces pressure. When air molecules are stagnant, or still, pressure will return to it’s normal reading. Next time you fill a tire with air, pay close attention to the gauge. When you’re adding air to the tire, the gauge will read zero. When you stop adding air, and everything become stagnant, the gauge will read the newly established pressure in the tire. This same fundamental works with an airplane wing. When an airplane wing has laminar airflow going over the bottom and top of the wing, a difference in pressure is created. The camber and angle of attack in the blade causes air molecules to travel faster over the top of the wing, compared to the bottom of the wing. This difference in air molecule speed, creates lower pressure on the top and higher pressure on the bottom – which results in lift.

This same situation can be applied to the barometric pressure in the air. When winds and turbulence occurs in the environment, the overall pressure decreases. Now, when you watch the weather channel, you’ll notice that they always talk about low pressure and high-pressure systems impacting your local weather. When you’ve got a high-pressure system in the area (air molecules are stagnant), you’ll have great weather. When you have a low-pressure system (air molecules moving rapidly), you’ll get horrible weather. In short, this is the easy way to remember it.

High pressure = calm or still molecules = great weather

Low pressure = turbulent molecules = bad weather

Now for the fun part – how does this relate to stock investing? One of the things I love about financial markets is how closely they resemble highly complex weather patterns that cover the earth. In the stock market, turbulence is often referred to as volatility. In fact some really smart PhD’s developed an index called the VIX, and its sole purpose is to track the volatility, or turbulence, in asset prices. If you want to read more about the VIX and how it works, here’s a great article.

Now, similarly to bad weather patterns, low-pressure systems don’t happen immediately. Instead, low-pressure systems start off gradually and rapidly gain strength as they get closer. If the VIX and weather patterns do hold similarities, let’s see if there are any historical references to demonstrate the comparison.

As you can see from the picture, when the VIX is high (similar to the molecules in the air racing around at rapid speeds), low pressure is created in markets. I’ve demonstrated these points in time with a red line that crosses through the high VIX numbers (top chart) and you can see the corresponding decrease in the Dow Jones Industrial Average (bottom chart). Similarly, when the VIX is low (similar to high pressure, or stagnant air molecules), there isn’t much price differentials and the market is closely related to it’s equilibrium or center point (green line). This obviously isn’t a perfect correlation, but it provides a glimpse into where we’ve been and where we might be going next. It’s kind of like this; If you’re having a bright and gorgeous day outside, it’s probably safe to say that the likelihood of having another nice day tomorrow is less probable.

Like all metrics, this is only one variable. When trying to fly a helicopter, you need to look at all the gauges to fully understand where you’re at in time and space. If I only looked at the altimeter and nothing else, I’d surely find myself in trouble – especially during turbulent times. That’s an important aspect that many investors forget. Instead, many latch on to one story or idea. During times like these, its important to really challenge your theories and ideas. My opinion is that the high VIX, or low pressure, we are seeing today is only going to get stronger from this point forward. I’m not the only one with this opinion. Famous Yale Professor, Robert Shiller feels the same way. By the way, Dr. Shiller predicted the housing bubble in 2007 and was awarded the Noble Prize.

I have numerous reasons for that forecast, some of which I’ve laid out in this article. To get a taste of one of my concerns, check out the chart below. This chart demonstrates the amount of margin (or debt) that’s being used on the New York Stock Exchange.

That chart is compliments of Doug Short. The main reason I’m such a bear is due to the unprecedented amount of credit expansion that has occurred since 2008/09. Here’s an article that talks about the 57 trillion dollars of debt that’s been added to the global economy since the last recession. Yes, trillion with a “T”. The thing people need to remember is this: Credit is a promise. Credit acts like real money, but it’s not – it’s a promise. When promises get broken, they often have a chain reaction. I believe this turning point of promise breaking started at the end of FEB 2015. I also believe the magnitude of the “low pressure” is a function of the promises, or credit, created between market cycles.

But even with my very bearish opinions, and articles of evidence, I think it’s very important for people to challenge my opinion. There are always fluke storms that surprise even the best meteorologists. One of my main objectives in writing these blog posts is to find a bull that can provide substantiating evidence for their position. As for my lieutenant and I, we avoided a wall of sand, by about 20 seconds on the way back from our mission. Remember; always keep the greasy side down, and in the financial world that means – Protect Your Principal!

~Preston

P.s. As usual, I want to hear why my analysis is wrong. If you’ve got some comments or questions about this post, be sure to leave it here on our forum.