What stormy weather can teach us about stock markets

We regularly have stormy weather around the UK: Strong winds, flash floods, thunder, lightning and occasionally hailstorms strong enough to set off the alarms on cars.

Believe it or not, thunderstorms can teach us a lot about economies, stock-markets and house prices too!

Luckily, here in the UK, our thunderstorms don’t tend to produce hailstones big enough to cause this sort of damage.

Storm clouds that do this only tend to build up in warmer climates, although the process by which Thunderstorm Clouds develop is the same, the world over.

The one-story about hot air worth knowing 

You probably know that the air around the earth is in constant motion and that there are different types of ‘air mass’ at different places at various times, even around the British Isles.

Some air masses are warmer (and less dense) than their neighbours. So, for example, the air that comes down from the north pole is a lot colder than the air coming up from Africa.

While some air masses are wetter than others. For example, the air that arrives from Europe and Russia is generally dryer than our ‘prevailing’ Westerly winds which come from the Atlantic Ocean.

It’s these features of air masses (their relative temperature and moisture content) which make them either stable or unstable.

Thunderstorms develop in unstable air.

The interesting question, I think, is how unstable air behaves, and why economies (sometimes) behave in similar ways?

To explain this, and make the text easy to follow, I’ll use normal text to talk about the weather, and italics when talking about financial markets.

Comparing thunderstorms to asset markets

The air that arrives over the UK after a long journey over a (relatively) warm sea, carries a lot of moisture.

You can’t normally see the water in the air because it’s carried as invisible water vapour but we do know it’s there – and the ‘wetter’ the air, the bigger the potential storm.

Even if you’ve not studied meteorology (I had to for my pilot’s licence) this will probably make intuitive sense.

After all, you’re familiar with those ‘muggy’ (moist air) conditions that warn us of a big storm on its way, right?

Now just swap ‘moisture’ level for ‘credit availability’ from the banks.

Moisture content drives thunderstorms.

Credit availability drives economic booms and busts.

In both systems (weather and economic) once you have the right conditions for a storm, all you need is a trigger event.

The trigger event

Imagine we have the right conditions for a storm (a nice, moist, unstable air mass) then the trigger event is simply something that lifts the air up away from the ground, and this could happen in various ways:

• The sun can heat the ground which heats the air above it,
• Unstable air collides with another, denser air mass and is pushed up over it – this is called frontal lifting.
• The unstable air is pushed up over hills as it travels across the land – this is called ‘orographic’ lifting.

Our unstable asset markets work the same way.

All we need to start a storm – if we have the right (easy credit) conditions – is an initial lift in asset prices.

And we’ll certainly get that when hordes of people ‘grab at easy credit’ to buy more assets.

Getting back to our Thunder Clouds…

You may have noticed that, as the air gets lifted upwards and clouds start to form, they carry on rising at an increasing rate.

Watch closely, and you’ll see this happening on showery sunny days. Just look up to see those big fluffy storm clouds growing vigorously at their tops.

OK, but what’s so interesting about that?

Well, these thunder clouds can sometimes grow faster, (vertically) than many aeroplanes can climb!

What’s more, the vertical winds (up and down) inside these clouds (and the hailstones they carry) are so violent that they can destroy an aeroplane!

Yes, that’s perfectly true. As I said, I’ve been trained on this stuff as a pilot.

So, it should reassure you to know that pilots are very well trained in weather systems, and they avoid these storm clouds like the plague.

Airline pilots do not fly straight into storms.

They go around them.

And get you safely to your destination.

Nice job guys 🙂

Now let’s look at what goes on inside these clouds to make them so violent.

In simple terms, here’s how it works

1. The moist air is lifted – by any of the ways I listed above.
2. This air cools as it rises – because the air ‘aloft’ is generally cooler than at sea level.
3. Clouds start to form – as the moist air cools enough to condense into water droplets, just as when droplets form on the inside of a cold window.
4. And this condensation releases heat.
   • Yes, that does sound strange, but think of it like this. A puddle will disappear on a sunny day – because the water takes in heat to become invisible water vapour. And that process also works in reverse. Heat is given off when the invisible water vapour turns back into water droplets (cloud and rain) to make puddles.
5. This heat expands the air mass, making it float higher, like a hot air balloon that’s lighter than the air around it.
6. Return to step 1 and repeat.

So, in a nutshell:

A rising parcel of air cools but then generates heat as it condenses its water vapour into droplets, which causes the parcel of air to expand and to rise again.

So the parcel of unstable air just keeps going higher and higher, and that reminds me of this!

When do thunderstorms stop growing higher?

Well, that’s easy to answer:

Thunderstorms (asset prices) stop growing

when the (credit) moisture runs out.

In the tropics, where the air is very warm – and can carry lots of water vapour – these thunderclouds can keep on growing up to heights of 60,000 feet or more.

That’s about 4 times the height of Mont Blanc – Europe’s highest mountain, by the way. So, it’s ruddy high.

It’s also about twice the typical cruising altitude of an airliner.

That’s another reason why pilots go around them rather than trying to climb over them… they simply have no choice!

Of course, these thunder clouds collapse eventually – in an explosion of rain and/or hailstones.

The collapse comes when there’s not enough (credit) water vapour left to (lend) evaporate to create the heat and vertical winds to support all the assets water and ice inside them.

Now, we all know that after a storm has dumped all its rain and ice on the ground, the weather calms down, right?

We also know that we can’t prevent thunderstorms kicking off in the first place because we can’t control the amount of moisture in the air.

All we can do is to find somewhere safe – to sit back and marvel at these wet and icy and sometimes fiery monsters.

This is where economies are different.

Governments and central banks could, if they chose to, control the levels of credit pumped into our economic systems.

They just haven’t bothered to control it lately.

Indeed for nearly 40 years, they’ve persistently encouraged more credit to be extended – in an attempt to prevent an economic storm.

That credit has created a series of booms and busts in asset markets over that time.

First in Stock markets (between 1995 and 2000); then in property (up to 2008 – in the greatest housing bubble we’ve ever known) and more recently in bonds and Stock markets once more – although in these latter cases we’re yet to see a bust.

The authorities, it seems, will try anything to avoid the “end game” of the storms they start and do so by tempting investors into yet more borrowing at ultra-low rates.

Or, as with the UK housing market, with various house buying incentives.

The trouble is that total global debt has been rising since the crisis of 2008-09 and has grown faster than economic activity over that time. 

Take a look at these charts

Of private debt in the UK and USA – borrowed from- from Professor Steve Keen’s book, ‘Can we avoid another financial crisis?’

They show that the burden of debt is much higher now than it was 40 years ago and that we need a way to lower the moisture debt levels in our economic systems.

Unfortunately, there is currently no one (with political power – or any understanding of these issues) who can tell us whether that debt reduction can be achieved smoothly and quietly (perhaps with some modest inflation to erode the real value of debt over many years) or whether it’ll take another great storm.

If this interested you, listen to Lord Adair Turner, explain this debt problem in plain English.

(He used to be the head of the Financial Conduct Authority here in the UK – and was handed that job just as Lehman Brothers was collapsing in 2008. So, he knows a bit about crises!) 

Here at the London School of Economics, he outlines the really big debt issues facing the world and what we ‘might’ do about them.

You’ll see Robert Peston on hand here also – to challenge Turner’s radical ideas.

Turner’s book is ‘Between Debt and the devil’

Sorry if this all sounds scary

But these are the financial realities of the world at the moment.

We have way too much debt globally. 

It’s not going away and something will have to give.

What of stock markets and house prices?

Well, where they go from here, in the short term, no one knows. It all depends on the various factors that drive demand and supply – and we can debate all of those another time.

What we know, however, is that the prices of houses (and other assets) relative to people’s earnings (or the earnings of companies) have been lifted into the stratosphere by a lot of moisture credit availability… and by interest rates at 400-year lows. 

And big storms in market prices do NOT (as some advisers will tell you) only come along once in a generation.

They often cluster together – within a few years of each other.

Is this thunderstorm analogy perfect?

No analogy is perfect, but as an example of an unstable system – created by positive feedback loops – it’s a pretty good model.

The thunderstorm is certainly similar to a credit extended economic system with one difference.

In the economic world, we have ‘authorities’ who could interfere to prevent the build-up of too much moisture credit, but sadly they chose not to do that.

Instead, in recent decades, they’ve encouraged an ever-increasing amount of debt to build up, after the storm started building, and while we can’t be sure if their actions have helped matters or made them worse, most ‘informed’ opinion would say that we’re not in a good place, with debt levels, right now.

So, take care out there and check for storm warnings

No forecast is ever exactly right, but the CAPE might help you decide when to take your waterproof.

All the best for now,

Thanks for dropping in

Paul

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