If you take an egg and drop it on the floor, it breaks. An egg is fragile. A golf ball, by comparison, is less fragile. It takes a lot more force to crack a golf ball.
What about stock prices? Housing prices? Bond prices? Are they eggs or golf balls? The answer is that it depends. They swing from being more like eggs to being more like golf balls… and back again.
What if we could build an index that captured fragility in some way? What would it tell us about asset prices now?
A brand-new research paper tried to answer these questions. One conclusion from the paper: The business sector is creeping up to levels of fragility not seen since 2007.
Below, we take a look at this new research.
To back up: Our publisher Addison Wiggin recently created Apogee Research Group. The idea is to commission studies to answer big questions about the financial system. Then we’d publish our findings, which we hope would lead to useful insights for investors.
I wanted to commission a study on fragility. I had been rereading the works of economist Hyman Minsky (1919-1996) over the past year. Minsky crafted the famous “financial instability hypothesis.” It is an elegant framework that explains economic instability by focusing on how economic units – firms, households and banks – finance themselves. (Instability here means the propensity to generate sharp falls in prices of assets. Essentially, fragility.)
Minsky created three types to describe the financing shapes these units could take: hedge, speculative and Ponzi. Let me use the example of a household to show you how this works.
A household using hedge financing would be one that could repay all of its debts – principal and interest – from existing cash flows. Speculative financing means it can pay interest with cash flows, but not principal. Think of a home equity loan in which the household must sell the house to pay off the balance. Ponzi finance means that the household can’t pay either principal or interest from existing cash flows. Such a household must sell other assets or borrow further to keep afloat.
