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Chaos Theory


escalation of risk arrived at a crticial point...

escalation of risk arrived at a crticial point...

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  • 1. Shamik Bhose ; Chaos Theory- Jump Point & the Perception of RiskThough I believe that significant downside awaits the markets here in India but I have a strong view thatmarkets have already entered an extended period of choppy trading days . There are number of reasonswhy I consider that to be a probable scenario: --Markets adhere to the law of averages over time and itstrue everywhere …. decade of extraordinary returns are averaged out by a half a decade of underperformance or a decade of choppy market.In the US, 1920s roaring bull market returns got average out in 30sand 40s ...1950s bull market wasaveraged out by the 1965-1975 period... 1980-2000 bull market was averaged out by 2001-2010market.... ..At an index level India clocked a return of 45% CAGR over last 6 years (2002-2008)... I believewe could be a in for half a decade of choppy markets. At an index level, one years gain will be wiped outby another years decline and largely it is going to be a slow grinding market. Intermittent sharp declineswill occur but will get evened out by months of choppy sessions...If you watch closely, the sentiment indicators are swinging from extreme fear to complacency and backto fear at a very quick interval. So after a decline of 10-12%, sentiment is becoming so bearish that themarket is quickly finding a floor.... Same thing is happening on the way up, after a rise of 10% or so,markets are going sideways for weeks... Such a quick shift in sentiment is bound to occur afterthe heightened trending period of 2002-2008... A quick drop, and participants fear of 2008 is back and arise and their is reluctance to buy at higher levels... This type of undercurrent should keep the marketbracketed...Economic scenario is mixed bag at best. it seems, somehow the global economy is managing to grindalong... Again a good excuse for bull and bears to fight it out for a long time.....This is a market whereonly people with lizard like characteristics will win, wait-wait-wait, and when an opportunity presentsitself, grab it... and again sleep...So many prop shops with traders humming the trading terminals and looking for a multibaggers everyday will face the brunt.... This is a time where stock picking will give u the juice... A time tobuild your capital in other asset classes or business areas and keep it intact.. so that in the next bullmarket there is enough to ride it.... Bull markets offer effortless ride, the less u do, the more money umake, u just need to be there with your capital... Its this period where the temptation is strong to squeezeout performances of the last decade but its advisable not to fall in that trap.... Asset class rise in like waves tandem and crisis 2 is starting via inter connectivity……… Risk is a four letter word !!! Ever since the collapse of Lehman Brothers in 2008 an insidious force has taken over the behaviour of global financial asset prices. Almost no asset class or region has escaped, yet it is a phenomenon little discussed beyond risk management departments and trading floors. This phenomenon is known as “Risk On – Risk Off” and is currently dominating the way markets ;
  • 2. Either the market believes future prospects are good and risk is on; or the market believes future prospects are bad and risk is off. There is no middle ground. When risk is on, assets such as equities and commodities rise whereas credit spreads narrow and the Japanese yen falls. When risk is off, these instruments switch into reverse. Correlations between assets that historically hardly moved together are now highly polarised, being strongly positive or strongly negative. Perhaps an extreme point of view but worth reading as some of the premises are coming true and some are in progress……………..As for China and stimulus led growth and slowing down …….. I think the slowing is already underway and real estate is a horrible mess with no buyers and empty houses but prices going up.This is a major problem brewing and like Japan in 1990 where a golf club was more costly than an entire district in California. China will have a decade long implosion in prices when this comes to its end. But I am not anti bull just watching bearish news gather steam. Neither buyer nor seller be as Shakespeare once said…………. My own thesis is that economies and markets for various goods and services have normally bounded rates of growth or decline due to competitive and feedback dynamics. Extreme variance from the normal rate of change may sometimes be indicative of a future reversion to the mean…The extreme growth of banking as a function of GDP in the US is one example. The extreme variance of median income versus median home value in the US is another example. Technology, finance and unshakable faith in the future all coalesce into magnificent projects and works which transcend commercial sensibility; they are collective dreams writ in stone, steel and glass. ..I have no real idea of US equities but broadly feel that they will be chicken market now, neither bull nor bear but ranged to trending weak over the next few years……….sort of a slow death deflation like Japan… My guess is that the Great Pyramid in Egypt , the Mayan pyramids and other peaks, monuments and temples or civic structures in civilizations probably coincided with bubbles as well. The next big towers going up are in China in 2012 and Korea in 2014. Get ready to set your economic stimulators to full stun.Full disclosure: I am an architecture, astrology and history fan so probably lack full economic objectivityin this area ………………..Shamik blogs and comments via facebook and linkedin : : Uploaded To- after Adam Smiths groundbreaking publication of The Wealth of Nations in 1776, the samemath was applied to economics. The maths of that period was grounded in two fundamental concepts:The mathematics used to analyse and understand financial markets comes from the physical sciences. The mathsdeveloped in the 1600s and 1700s helped describe and eventually understand physical ;
  • 3. Mechanical determinism - the notion that if you knew the starting co-ordinates and speed of every objectin the present using the clockwork precision of the equations, it was possible to predict accurately theirfuture locations at any point in time; andStable equilibrium - everything in nature finds the proper balance between the many forces that tug at it. For example, a ball rolls until it comes to rest at the bottom of the bowl, and if nudged one way oranother, it comes back to the same equilibrium spot.Similarly prices, like the ball in a bowl, move around until they find their proper equilibrium point thatsuccessfully balances the forces of supply and demand. If supply or demand undergoes a change, theprice of a good would move again until finding its new equilibrium price. Volatility was due to nothingmore than the markets searching for that equilibrium price. According to this idea, the faster and moreefficiently information flowed in the market, the lower volatilities should be (directly the opposite of howmarkets have been seen to behave).Another concept inherited from the physical sciences was the notion that if economists could figure outthe right equations, then it would be possible to have the same clockwork precision for market dynamicswith future price movements as predictable as a planets orbit. It did not take long for the physicalsciences to realise that the ideas of equilibrium and determinism are idealisations with limited practicalutility. By the early 1900s they had developed new statistical tools that described reality much better butonly because of a critical assumption that all objects are totally independent of one another.Economics followed suit The Efficient Markets Hypothesis (EMH) was created to capture theassumptions required to make the math work: every price is independent of every other price;information flows instantaneously and without distortion to every market participant; and all marketparticipants are rational investors. While assumptions like these may work for physical objects, they arenot credible when describing human market participants. Although the assumptions may bequestionable, the model itself produces results that work well some of the time. It works well enoughthat there are plenty of example of success to stave off the critics.However, it also fails often enough to question its validity.Today most models of market dynamics, including those used in risk management, continue to bebased on the EMH. They rely on the fundamental assumptions of equilibrium and they thereforemiss the mark whenever ‘normal market conditions are not being ;
  • 4. This has been the state of affairs for over 200 years. Progress is being made. We are getting better atunderstanding the causal aspects of market behaviour. However, this is not through evolutionarychanges to the models but rather through completely new approaches. About 20 years ago an entirelynew field of science began to take form in studying complex adaptive systems that describes thedynamics of large groups of participants that interact with each other in various degrees. Informationtravels between and among these participants at different speeds (not instantaneously like assumed inthe EMH). So some participants have faster access to information than others. The quality of theinformation can also change as it passes from participant to participant.Markets and whole economies behave in large part like one of these complex adaptive systems. So dobiological systems. For example, the collective behaviour of cells in an organ, the collective behaviour oforgans in an animal and the collective behaviour of animals in groups such as bees in a swarm andpeople in a city exhibit many similar behavioural aspects that fall under the field now known as‘complexity science. One of the hallmarks of complex systems is the absence of equilibrium and theubiquitous presence of volatility. Unlike the EMH that predicts volatility should diminish as informationflows more efficiently, many complex systems predict periodic increases in volatility and also show thatvolatility is actually a necessary component for the system.Unlike the classical methods of economics and most of the methods in the physical sciences, complexadaptive systems cannot be modelled bottom up. Rather than breaking the system down into itssmallest parts and trying to rebuild the total, complex systems are modelled at intermediate levels andat the total level.Many of the most important features of complex adaptive systems are not the result of interactions betweenindividual participants but waves of interactions stretching across many participants at once. Despite the factthat markets have been shown to behave as complex adaptive systems, this approach is so differentfrom what established economists are accustomed to that it has not yet been widely accepted.To make matters more difficult for the complexity advocates, it is not grounded in the same math that economistsuse. It is not even the math that physicists and chemists use most of the time. Unlike the math of moderneconomic theory, this math cannot be written down in equation form on a single sheet of paper.Rather, it uses massive computer clusters running advanced simulations.The current financial crisis facing markets and economics is reminiscent of the crisis that physicists faced in theearly 1900s after the discoveries of the electron and atomic nucleus that did not behave as any of their modelspredicted. An entirely new form of maths was needed: quantum mechanics. After the financial crisis of 2008 and2009, there is no longer any doubt that economics and market analysis could benefit from a similar overhaul. A newform of maths to understand economics and markets is complexity ;
  • 5. .Research develops provocative insights on the financial markets and on the hedge fund industry. Theprimary focus of the research has concentrated on the drivers and characteristics of secular stock marketcycles, the impact of inflation and interest rates on the stock and bond markets, and various aspects ofhedge funds and the hedge fund industry. The intention of the research and its publication on this site isto present rational perspectives based upon a diligent analysis of historical data. Through organizing thedata logically, information is created. Through understanding and developing perspectives on theinformation, knowledge is generated. With knowledge, one can then start to make informed decisions.This research is intended to be observation-based rather than prediction-oriented. It intends to provideinformation and perspectives to assist in rational decisions. The research does not provide predictions orrecommendations on investment alternatives, although you may find the implications quite compelling.Harry Markowitz, Nobel Prize co-recipient for Modern Portfolio Theory and the Capital Asset PricingModel, published “Portfolio Selection” in The Journal of Finance during 1952. He led with: “The process ofselecting a portfolio may be divided into two stages. The first stage starts with observation and experience and endswith beliefs about the future performances of available securities. The second stage starts with the relevant beliefsabout future performances and ends with the choice of the portfolio. This paper is concerned with the second stage.”As Markowitz emphasizes, it is the investors responsibility to use “observation and experience” todevelop “beliefs about the future performances.This research is developed to provide practical insights for investors that dont have 75 to 100 years towait for historical average returns. Highlights from each section include:Stock MarketThe overall market is highly volatile and affected by generally long secular cycles. You may wonder "Is itworth the risk?". As well, returns in the stock market depend upon the level of and trend for inflation.Youll gain insights toward the obvious question "What can we expect from here?".Twenty years is not enough to ensure positive returns in the stock market; from current and recent levelsin the P/E ratio, expected returns appear disappointing. Pundits are professing: "Returns will improvewhen the economy begins to recover!". Hope is not a strategy. Though traditional wisdom relates P/Eratios to interest rates, that relationship only works in periods of positive inflation. With the risk ofinflation or deflation on the horizon, the analysis titled "P/E Ratios & Inflation" will clarify that P/Es aredriven by inflation. As well, see "Stock Market Returns & Volatility" for a surprisingly strongrelationship between the level of volatility in the stock market and its direction.Interest RatesShort-term interest rates (one year or less) are generally determined by the Federal Reserve; long-terminterest rate yields are driven by inflation or inflation expectations in the economy. The relationshipbetween interest rates and inflation was not evident before the 1960s. The research and dynamic modelbegin to develop perspectives toward "What are the implications into the future?" ;
  • 6. Our prediction (notwithstanding that we have just entered another period that breaks The 6/50 Rule):"Interest rates will change by at least 50 basis points (0.5%) within the next 6 months!" Theres over 40 years ofhistory—virtually without exception—in our favor. Chances are that it will be a good bit more than that,too. See the details and charts titled "The 6/50 Rule."Hedge FundsWhereas stocks and bonds depend upon trends in their markets to provide returns, hedge funds seek togenerate profits from inefficiencies in the markets or from enhanced risk management. Youll receiveinsights relating to "Will investments that seek consistently positive returns from skill-based strategies, ratherthan passive participation in the markets, become an increasingly popular choice by investors?".Pictures tell the story that statistics understate. We present a series of graphs reflecting the return patternof various types of investment funds. The contrast demonstrates some of the differences between mutualfunds and hedge funds. In addition, youll see an assessment of hedge fund performance in relation tothe stock market in a colorful, statistics-packed chart titled "Stock Market Return Environment."Financial PhysicsFinancial Physics represents the interconnected relationships among several key elements in theeconomy and the financial markets that determine the stock market’s overall direction. This section andits presentations will provide a highly provocative and insightful perspective on the relationship of theeconomy (the source of wealth) and the equity markets (the measure of equity wealth). Whereas othersections present analyses of historical data to provide perspectives, this section is dedicated to exploringthe fundamental factors and economic relationships that drive trends and valuations in the financialmarkets.Valid Research primarily develops and publishes research in the form of charts and graphs to provideinvestors and market spectators with poignant perspectives on the financial markets. The objective is toimpart insights about the reality of the markets. Occasionally, articles are written when graphics wouldnot be appropriate or when requested by specific publications or clients…..Shamiks Articles : : < Uploaded To->The Efficient Markets Hypothesis (EMH) was created to capture the assumptions required to make themath work: every price is independent of every other price; information flows instantaneously andwithout distortion to every market participant; and all market participants are rational investors. Theseassumptions ignore asymmetry of information between one group of investors to another. Whileassumptions like these may work for physical objects, they are not credible when describing humanmarket participants.Although the assumptions may be questionable, the model itself produces results that work well some ofthe time. It works well enough that there are plenty of example of success to stave off the critics. However,it also fails often enough to question its validity. Today most models of market dynamics, including thoseused in risk management, continue to be based on the EMH. They rely on the fundamental assumptionsof equilibrium and they therefore miss the mark whenever ‘normal market conditions are not being ;
  • 7. Nowhere does it say that investors should strive to make every last dollar of potential profit;consideration of risk must never take a backseat to return. Conservative positioning entering a crisis iscrucial: it enables one to maintain long-term oriented, clear thinking, and to focus on newopportunities while others are distracted or even forced to sell. When excesses such as lax lendingstandards become widespread and persist for some time, people are lulled into a false sense of security,creating an even more dangerous situation. Correlations between asset classes may be surprisinglyhigh when leverage rapidly unwinds.Correlations have continued to increase despite falls in individual asset volatility.The consequences are profound and if it is not your foremost concern as an investor then it probably should be.The most obvious manifestation is the lack of diversification which is now available to you.Equities, interest rates, energy, commodities and currencies now move in tandem.The benefits of diversification are thus destroyed and the volatility of once low-risk portfolios greatly increases.Even looking further a field to emerging markets does not helpRisk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not thesame as risk. Do not trust financial market risk models. Reality is always too complex to be accuratelymodeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing andreassessing the risk environment in real time.Looking at China & EU : The Lessons Of History Economist Philip Cogen defines hyperinflation as anon-annualized inflation rate of 50% or more in a single month. As a consequence of this flight ofconfidence, such a government is forced to print money to meet its obligations. This further underminesthe value of its currency, often culminating in a frenzied collapse. That is hyperinflation, and onlygovernments and central banks cause itThis leads to the question, being asked from Beijing to Brussels: Does the risk match the reward? Anegative response to that question could lead to hyperinflation.Do not accept principal risk while investing short-term cash: the greedy effort inevitably leads to theincurrence of greater risk. A broad and flexible investment approach is essential during a crisis. Youmust buy on the way down. It is almost always better to be too early than too late, but you must beprepared for price markdowns on what you buy.Look at the federal budget for fiscal 2009. That year, the budget deficit was $1.55 trillion, with totalexpenditures of $3.52 trillion. If the government borrows the entire amount of the deficit, it would have aborrowing rate of 44% of total expenditures. In 2010, the figure also has exceeded 40%. Can thisimbalance continue without triggering a hyperinflationary spiral? At this point the government debtbuyer asks the questions posed earlier: Can a nation financing 50% of its budget expenditures in ;
  • 8. debt market growitself out of a collapse? Is the reward likely to match the risk of owning governmentdebt?Without the support of foreign buyers, government spending will have to be paid with newlyprinted money, and the inflation consequences will be dire. Historically, nations default when the bulk ofthe debt is owed to other nations, but the U.S. still owes most of its debt to its own citizens.Ratings agencies are highly conflicted, unimaginative dupes. Investors should never trust them. Besure that you are well compensated for illiquidity – especially illiquidity without control – because it cancreate particularly high opportunity costs. At equal returns, public investments are generally superiorto private investments as they are more liquid and amidst distress more likely to offer attractiveopportunities to average down.Having clients & or brokers, intermediaries with a long-term orientation is crucial. Nothing else is asimportant to the success of an investment or a financial firm. The government – the ultimate short-term-oriented player – cannot withstand much pain in the economy or the financial markets. Bailoutsand rescues are likely to occur, though not with sufficient predictability for investors to comfortablytake advantage.Gold trading at more than $1,350 an ounce, despite no appreciable increase in the consumer priceindex, is much more understandable when you realize that in periods of hyperinflation, gold tends toappreciate by 2,000% to 50,000% against a hyperinflated currency.Do the gold bugs know somethingwe dont? In time, the markets will surely say whether this is so. But unless drastic measures are taken tochange the trend of deficits, or unless purchasers of U.S. government debt ignore all rational measures ofrisk, a psychological breaking point is approaching. When this happens, history tells us thathyperinflation is not far ;
  • 9. Another Finger of Instability Ubiquity, Complexity Theory, and sand-piles; Stability Leads to Instability: A Stable Disequilibrium Chaos Theory - 3 Billion and Counting = Jump Point = Abrupt Delta = Critical Mass = Jump Discontinuity = Step Phase Change"To trace something unknown back to something known is alleviating, soothing, gratifying andgives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown - the firstinstinct is to eliminate these distressing states.First principle: any explanation is better than none... The cause-creating drive is thusconditioned and excited by the feeling of fear ..."Friedrich NietzscheI am often told that the letter I wrote well over three years ago on ubiquity and complexitytheory and the future of the economy was the best letter I have ever done. I went back to read it,and it has aged well. I basically outlined how a financial crisis would unfold, and now it has.On reflection, I think that there are perhaps other, even larger, events in our future than therecent credit crisis and recession; yet, just as in 2006, there is a great deal of complacency. But aswe will see, there are fingers of instability building up that have the potential to create largedisruptions, both positive and negative, in our future. And for the political junkies in the room,I offer a brief insight into what may be one of the more intriguing behind-the-scenesdevelopments in recent years."Any explanation is better than none." - NietzscheAnd the simpler the explanation, it seems in the investment game, the better. "The markets went upbecause oil went down," we are told (except that when oil went up, then there was another reason forthe movement of the markets). But we all intuitively know that things are far more complicated thanthat. However, as Nietzsche noted, dealing with the unknown can be disturbing, so we look for thesimple explanation."Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feelwe know something. And the behavioral psychologists note that this state actually releases chemicalsin our brain that make us feel good. We become literally addicted to the simple explanation. The factthat what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not importantin achieving the chemical release. And thus we look for reasons.The credit crisis happened because of Greenspans monetary policy. Or maybe it was a collectivemania. Or any number of things. Just as the proverbial butterfly flapping its wings in the Amazontriggers a storm in Europe, maybe an investor in St. Louis triggered the credit crisis. Crazy? Maybe not.Today we will look at what complexity theory tells us about the reasons for earthquakes, tornados, ;
  • 10. the movement of markets. Then we look at how the world and that investor in St. Louis are all tiedtogether in a critical state. Of course, what state and how critical are the issues.Ubiquity, Complexity Theory, and Sand-pilesWe are going to start our explorations with excerpts from a very important book by Mark Buchanan,called Ubiquity: Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, aretrying to understand the complexity of the markets. Not directly about investing, although he toucheson it, it is about chaos theory, complexity theory, and critical states. It is written in a manner anylayman can understand. There are no equations, just easy-to-grasp, well-written stories and analogies.As kids, we all had the fun of going to the beach and playing in the sand. Remember taking yourplastic buckets and making sandpiles? Slowly pouring the sand into an ever bigger pile, until one sideof the pile started an avalanche?Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops.Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it buildson itself and it seems like one whole side of the pile slides down to the bottom.Well, in 1987 three physicists, named Per Bak, Chao Tang, and Kurt Weisenfeld, began to play thesandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling upone grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as muchfun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested inwhat are called nonequilibrium systems.They learned some interesting things. What is the typical size of an avalanche? After a huge number oftests with millions of grains of sand, they found that there is no typical number. "Some involved asingle grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involvingmillions that brought nearly the whole mountain down. At any time, literally anything, it seemed,might be just about to occur."The piles were indeed completely chaotic in their unpredictability. Now, lets read this next paragraphfrom Buchanan slowly. It is important, as it creates a mental image that helps me understand theorganization of the financial markets and the world economy. (emphasis mine)"To find out why [such unpredictability] should show up in their sandpile game, Bak and colleaguesnext played a trick with their computer. Imagine peering down on the pile from above, and coloring itin according to its steepness. Where it is relatively flat and stable, color it green; where steep and, inavalanche terms, ready to go, color it red. What do you see? They found that at the outset the pilelooked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. Withmore grains, the scattering of red danger spots grew until a dense skeleton of instability ran throughthe pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-likeaction, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots werewell isolated one from the other, then a single grain could have only limited repercussions. But whenthe red spots come to riddle the pile, the consequences of the next grain become fiendishlyunpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chainreaction involving millions. The sandpile seemed to have configured itself into a hypersensitive andpeculiarly unstable condition in which the next falling grain could trigger a response of any sizewhatsoever."Something only a math nerd could love? Scientists refer to this as a critical state. The term critical statecan mean the point at which water would go to ice or steam, or the moment that critical mass induces ;
  • 11. nuclear reaction, etc. It is the point at which something triggers a change in the basic nature orcharacter of the object or group. Thus, (and very casually for all you physicists) we refer to somethingbeing in a critical state (or use the term critical mass) when there is the opportunity for significantchange."But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, adevilishly unstable and unusual condition that arises only under the most exceptional circumstances[in highly controlled experiments]... In the sandpile game, however, a critical state seemed to arisenaturally through the mindless sprinkling of grains."Thus, they asked themselves, could this phenomenon show up elsewhere? In the earths crust,triggering earthquakes, or as wholesale changes in an ecosystem - or as a stock market crash? "Couldthe special organization of the critical state explain why the world at large seems so susceptible tounpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in athird-rate paper in Denmark could cause worldwide riots?Buchanan concludes in his opening chapter, "There are many subtleties and twists in the story ... butthe basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization ofthe critical state does indeed seem to be ubiquitous in our world. Researchers in the past few yearshave found its mathematical fingerprints in the workings of all the upheavals Ive mentioned so far[earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring oftraffic jams, the patterns by which instructions trickle down from managers to workers in the office,and in many other things. At the heart of our story, then, lies the discovery that networks of things ofall kinds - atoms, molecules, species, people, and even ideas - have a marked tendency to organizethemselves along similar lines. On the basis of this insight, scientists are finally beginning to fathomwhat lies behind tumultuous events of all sorts, and to see patterns at work where they have never seenthem before."Now, lets think about this for a moment. Going back to the sandpile game, you find that as you doublethe number of grains of sand involved in an avalanche, the likelihood of an avalanche becomes 2.14times more likely. We find something similar with earthquakes. In terms of energy, the data indicatethat earthquakes become four times less likely each time you double the energy they release.Mathematicians refer to this as a "power law," a special mathematical pattern that stands out in contrastto the overall complexity of the earthquake process.Fingers of InstabilitySo what happens in our game? "... after the pile evolves into a critical state, many grains rest just on theverge of tumbling, and these grains link up into fingers of instability of all possible lengths. Whilemany are short, others slice through the pile from one end to the other. So the chain reaction triggeredby a single grain might lead to an avalanche of any size whatsoever, depending on whether that grainfell on a short, intermediate or long finger of instability."Now, we come to a critical point in our discussion of the critical state. Again, read this with the marketsin mind (again, emphasis mine):"In this simplified setting of the sandpile, the power law also points to something else: the surprisingconclusion that even the greatest of events have no special or exceptional causes. After all, everyavalanche large or small starts out the same way, when a single grain falls and makes the pile justslightly too steep at one point. What makes one avalanche much larger than another has nothing to ;
  • 12. with its original cause, and nothing to do with some special situation in the pile just before it starts.Rather, it has to do with the perpetually unstable organization of the critical state, which makes italways possible for the next grain to trigger an avalanche of any size."Now, lets couple this idea with a few other concepts.First, Nobel laureate Hyman Minsky points out that stability leads to instability. The more comfortablewe get with a given condition or trend, the longer it will persist and then, when the trend fails, themore dramatic the correction. The problem with long-term macroeconomic stability is that it tends toproduce unstable financial arrangements.If we believe that tomorrow and next year will be the same as last week and last year, we are morewilling to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longerthe period of stability, the higher the potential risk for even greater instability when marketparticipants must change their behavior. (And, three years later, we can now all see that truth. But itwas not as obvious to a lot of people in 2006.)Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words,the more "fingers of instability" that are allowed to develop a connection to other fingers of instability,the greater the potential for a serious "avalanche."Or, maybe a series of smaller shocks lessens the long reach of the fingers of instability, giving aparadoxical rise to even more apparent stability. As the late Hunt Taylor wrote, in 2006:"Let us start with what we know. First, these markets look nothing like anything Ive ever encounteredbefore. Their stunning complexity, the staggering number of tradable instruments and theirinterconnectedness, the light-speed at which information moves, the degree to which the movement ofone instrument triggers nonlinear reactions along chains of related derivatives, and the requisite levelof mathematics necessary to price them speak to the reality that we are now sailing in unchartedwaters."... Ive had 30-plus years of learning experiences in markets, all of which tell me that technology andtelecommunications will not do away with human greed and ignorance. I think we will drive the carfaster and faster until something bad happens. And I think it will come, like a comet, from that part ofthe night sky where we least expect it."A second related concept is from game theory. The Nash equilibrium (named after John Nash) is a kindof optimal strategy for games involving two or more players, whereby the players reach an outcome tomutual advantage. If there is a set of strategies for a game with the property that no player can benefitby changing his strategy while (if) the other players keep their strategies unchanged, then that set ofstrategies and the corresponding payoffs constitute a Nash equilibrium.A Stable DisequilibriumSo we ended up in a critical state of what Paul McCulley called a "stable disequilibrium." We haveplayers of this game from all over the world tied inextricably together in a vast dance ;
  • 13. investment, debt, derivatives, trade, globalization, international business, and finance. Each playerworks hard to maximize their own personal outcome and to reduce their exposure to "fingers ofinstability."But the longer we go on, asserts Minsky, the more likely and violent an "avalanche" is. The more thefingers of instability can build. The more that state of stable disequilibrium can go critical on us.Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel.Russia was defaulting on its bonds. Things on the periphery, small fingers of instability, began toimpinge on fault lines in the major world economies. Something that had not been seen beforehappened: the historically sound and logical relationship between 29- and 30-year bonds broke down.Then country after country suddenly and inexplicably saw that relationship in their bonds begin tocorrelate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified.The fingers of instability reached into Long Term Capital Management and nearly brought the financialworld to its knees.So, where are the fingers of instability today? Where are the fault lines that could trigger another crisis?Are there any early warning signs? I see two possibilities, one positive and one negative.Chad Starliper sent me the following graph. It shows the debt-to-GDP ratio for the US, adding invarious levels of debt. For instance, the ratio of debt to GDP for all levels of government debt is 87%.But if you add household and business debt along with the GSE (government-sponsored enterprises)like Fannie and Freddie, the ratio rises to 331%. If you add in future benefits of Social Security andMedicare, the number becomes more like 1, ;
  • 14. The Obama administration tells us that the government deficit is going to be well over $1 trillion a yearfor at least ten years. And that does not take into account the outlier years in the 2020s when the reallyheavy lifting of Social Security and Medicare kicks in.There is a truism that goes a little like, "If something cant happen, then it wont." Let me make aprediction. We wont have a trillion-dollar deficit in ten years. Why? Because it cant happen. Themarket will simply not allow it.As I have written, we can run large deficits almost forever, as long as the deficits are less than nominalGDP. While it may not be the wise thing to do, it does not bring down the system.But when you start adding to the deficit in amounts significantly larger than nominal GDP, there is alimit. Each dollar, like the grains of sand, adds to the potential instability of the system. Is it $2 trillionmore? $3 trillion? No one can know, but the longer it goes, the worse the ensuing financial earthquakewill be.The current political class and their intentions are dangerously close to killing the golden goose. It isone thing to steal the eggs; it is an altogether different thing to kill the goose through ignorance of theconsequences. And the size of the deficit, for as long as they plan to have it, will most assuredly kill thegoose. Just as I was writing in 2006 about the potential for a crisis, and yet the party went on for quitesome time, I think the party can limp along now. But there will come a point when the party is over.Interest rates on the long end will rise precipitously, forcing mortgages up and making the deficit evenworse. It will be an even worse crisis than the one we have just gone through. And there will be feweroptions for policy makers, and none of them will be good or pleasant. And it will take most peopleunawares. They will see the current trend and project it into the future. And they will be hit hard.Can we avoid this calamity? Yes, we can wrestle the US budget deficit back under some kind of control,close to nominal GDP or on a clear trajectory to get there within a reasonable time (say, a few years). Asnoted above, we can run deficits close to nominal GDP almost forever. But there is no politicalwillpower to do that now. And so, the market will at some point force the hand of the political class.That investor in St. Louis, or China or (????) will decide not to buy government debt at such low rates.The avalanche will start. And everyone will be surprised at the ferocity of the crisis. Except you, gentlereader. You have been warned.Let me re-emphasize that point. If we do not get our act together, theresults could be truly serious. And it is not just the US. Japan, as I have written, unless it changes, willhit the wall in the next few years.There are some really sick actors in Europe. You are going to have to be far more nimble and preparedfor this next crisis, should it arise, than you were for the last ;
  • 15. 3 Billion and CountingAnd now for something a little more positive. From the beginning of the wireless revolution and thedevelopment of the internet, it was not until 2001 that we finally had one billion people connected. Itonly took another six years to add another billion. And sometime in 2011, somewhere in the world, wewill add yet another billion. We are adding some 70,000 people a day, with smarter and cheapercomputers, phones, and netbooks. By some estimates, there will be five billion connected to thenetwork by 2015.A study done in 2005 of 21 developing countries by Leonard Waverman of the London Business School"... showed that an extra 10 mobile phones per 100 people in a typical developing country leads to anadditional 0.59% of growth in GDP per person." (Jump Point) Think of each one of those additional connected people as a grain of sand. We have already seen alarge surge in productivity from the internet and mobile phones. Farmers in India now know what theprices are for their products and dont have to take lowball offers from middlemen. Fishermen inIndonesia can call around and find where they can get the best price for their days catch.Tom Hayes argues in his book Jump Point that, because of the growing connectivity, rather largechanges are coming to the way we organize our lives. It is a very interesting book and one that I willreview in depth at some point. But what Hayes calls the Jump Point is what I referred to as critical mass. "Inmathematics it is called a jump discontinuity. In engineering, this is known as a step phase change. Inclimatology, it is called an abrupt delta. I call it a Jump Point - a change in the environment, in this casethe business environment, so startling that we have no choice but to regroup and rethink the future."(from the introduction)Not all of the changes are benign. The potential for business and marketing models to be turned ontheir head is rather striking. I recommend the book to those who are thinking about the future. It iseasy to read, provocative, and well written. You can get it at I wrote this three years ago:"Today more than ever your portfolio should be targeting absolute return strategies. In a world withfingers of instability that may be connected in ways we have not seen in the past, caution is the order ofthe day. If we do see a slowing US economy later this year, the average complacent investor is notgoing to be happy as his diversified portfolio all seems to be going south at the same time."That is still true today.See my comments in or via profile / home of Shamik Bhosego too Shamik Bhose articles & or Shamik Bhose articles or/ ;