Humans are wired to think in a linear fashion. Most things in life work that way, but we often fail to see the potential for non-linear outcomes.
Jamie Dimon touched on this topic in his recent annual letter …
“I am a little perplexed when people are surprised by large market moves. Oftentimes, it takes only an unexpected supply/demand imbalance of a few percent and changing sentiment to dramatically move markets. We have seen that condition occur recently in oil, but I have also seen it multiple times in my career in cotton, corn, aluminium, soybeans, chicken, beef, copper, iron – you get the point.
Each industry or commodity has continually changing supply and demand, different investment horizons to add or subtract supply, varying marginal and fixed costs, and different inventory and supply lines. In all cases, extreme volatility can be created by slightly changing factors.
It is fundamentally the same for stocks, bonds, and interest rates and currencies. Changing expectations, whether around inflation, growth or recession (yes, there will be another recession – we just don’t know when), supply and demand, sentiment and other factors, can cause drastic volatility.”
Over the years I’ve witnessed numerous events cause unexpected negative outcomes due to non-linearity. Here are a few ..
High Fixed Operating Cost Businesses – when businesses have high fixed operating costs and low profit margins, small changes in top line revenue can have a huge impact on a businesses profitability. When sales are booming this is a great benefit, but when things turn down, profit can disappear quickly.
Highly Leveraged Businesses – when businesses carrying a lot of debt turn down, profit can disappear quickly. While the value of the enterprise might decline by 50%, if the business is 50% geared it means the equity is wiped out. These can be very profitable short candidates..
“You have to remember that if you are shorting a leveraged company, with 90% of the capitalization in debt and 10% in equity, a 50% decline in the stock only wipes out 5% of the total capitalization. You have to look at the total capitalization.” Jim Chanos