I Took The Road More Travelled By... And It Was Swarming With Vicious High Frequency Traffic Jams

Courtesy of Tom Cochrane, we know that life is a highway. But did you know that so is the stock market? BNY's Nicholas Colas explains...

The Low Spark of High Heeled Boys

Summary: Sitting in traffic on busy summer weekends feels a lot like trading the capital markets at the moment. The HOV lane (bonds) seems to be moving, but there are quite a few folks in Ferraris and Bentleys (the smart money?) crawling along, not sure which lane to pick. There is a growing library of academic work on traffic jams and these studies seem oddly applicable to the life of an investor at the moment. As it turns out, traffic jams pop up for reasons other than crashes. Sometimes it is just one or two vehicles that stop short, setting off a cadence of slowdowns behind them. Other times it is a group of tailgating cars that can set off a serious slowdown by stopping short and setting off a chain reaction behind them. And even after a crash is cleared, traffic can stay snarled for a while, as drivers struggle with the stop-start aftermath of a temporary tie up. Any way you cut it, equity markets – and the domestic economy - feel a lot like a clogged freeway. Only time will get the traffic moving again.

If you need any more proof that capital markets are not efficient, visit NY State Route 27 in the Hamptons between now and Labor Day weekend. You will see a slow moving parade of the some of the finest cars in the world, crawling their way to restaurants and nightclubs. The occupants of these Ferraris, Porsches and Lamborghinis will wait for tables, service, food, and drinks before saddling up and slowly driving back to their rental houses along the same clogged one lane highway that connects all the towns of the East End from the Shinnecock Canal to Montauk.

The ironic thing about all this is that these “Masters of the Universe” (if that term still applies) don’t need to be stuck in traffic – there are free flowing back roads that cut through some of the most beautiful landscapes in the Hamptons. There are horse farms, apple and peach orchards, roadside stands with fresh-off-thestalk corn roasted over coals for sale, and the last wide open vistas the area has to offer. But no, Rte 27 is the most straightforward way, and the back roads need a bit of learning before you can avoid getting lost at night on their unlit blacktop. And since most folks just go out for 10- - 15 weeks during the summer they don’t bother to learn them. So they sit still in Watermill or Bridgehampton, letting the hours pass by, occasionally chirping the otherwise dull rumble of their Italian V-12 or turbocharged German flat-6.

Those are the folks you are competing with for incremental information – the people who don’t seem to want to go off the beaten track, even though the alternative path is faster and more pleasant. So despair not – there is still information advantage to be had over the V-12 set.

Learn the back roads.

That little rant aside, the topic of traffic generally and traffic jams specifically have been getting more attention in academic circles in recent years. That makes sense – road congestion got progressively worse in the last decade as commute times rose for workers who moved further and further away from their jobs because escalating property values pushed them away from population centers. And, as it turns out, the study of traffic has some striking similarities to how capital markets behave. Not such a stretch, when you think about it. Humans try to make time maximizing choices while driving – what lane to pick, how fast to drive, how close to get to the car in front, how many times to change lanes. Those choices can affect others driving alongside and either advance or retard the overall flow of traffic.

Of course, the precondition for a traffic tie-up is, well, lots of vehicles on the road, all wanting to go in the same direction. We have that in spades in the capital markets at the moment. Correlations are at record highs across industry sectors as well as asset classes. It is such an overarching problem that it does not have one fixed reason. Low interest rates and easy money are one – these push capital out on the risk spectrum in a very uniform manner, heightening the linkage between previously less correlated assets. Then of course there are macro concerns like taxation, government policy, and a still moribund economy that impact asset classes like bonds (for the good) and stocks (for the not-so-good). So the stage is set for traffic jams. We’ll use that as a euphemism for a market drop, not the stasis that accompanies an actual wall-to-wall collection of cars on the highway.

The catalyst for a traffic jam isn’t always a rubbernecking delay from an accident; it can, and often is, just a spot where everything inexplicably slows down.  There is even a name – a “jamiton” – for this kind of disruption. They are caused when one, or a handful, of drivers slows down unexpectedly. This forces everyone behind this cluster to slow down, and before you know it things are flat-out stopped. As it turns out the effect is similar to the shock waves of an explosive detonation. A more full description of the effect is included here, with some color from the MIT scientists that coined the term “jamiton”: http://www.sciencedaily.com/releases/2009/06/090608151550.htm.

Just like in the markets, amateurs have their points of view about what causes traffic jams/market declines. In this non-scientific description, a traffic science “layman” outlines how jams take time to resolve themselves even when the cause – an accident – has been cleared. It is a version of the same crowded lane/sudden slowdown effect outlined above: http://amasci.com/amateur/traffic/traffic1.html. The author calls the jam a “pressure wave,” created by the temporary slowdown of cars in front and the subsequent delay as the whole system just stops as a result.

So what do you do to help avoid jams? Keep your distance from the car or truck in front of you. That gives you time to slow down deliberately, rather than mashing the brakes and causing the cars behind you to stop short and create that “pressure wave/jamiton.” An impassioned appeal from another amateur follows: http://www.skaggmo.com/newsletter3a.htm.

We’ll finish off this note with a few observations about what this stocks-are-like-traffic-jams comparison means to investors and traders. The most important point is that jams – or market drops – seem to happen when everyone wants to go in the same direction (high correlations between asset classes). Jams occur once that stage is set because a relatively small number of participants do something unexpected. They can, in short, have a disproportionately large effect on the entire system. And – worse still - if a lot of people slow down at once, the system grinds to a halt. That feels a lot like what we have right now. Mutual fund outflows from domestic stock funds are effectively the retail investor putting their foot on the brakes – something they have been doing for 15 weeks straight. Combine that with plenty of distracting scenery in the form of lousy economic data and the jam gets worse.

One thing all traffic jam experts seem to agree on: when the chain reaction that starts a jam really kicks in, only time will unwind it. And that seems like the most accurate comparison point to stocks.