On eruptions, landslides, avalanches, etc.

A friend of mine called this morning and asked me what caused the US market to tumble overnight. As if. As if I had a clue. This is a guy who taught me heaps of technical aspects and has been in the financial and equity markets longer than I've ever owned a stock.

All I could do was stammer on and bumble something about ant hills and grains of sand and, in frustration, said it was the unexpectedly high CPI, although all the elements were already in place for the fall.

And when I finally got my mouth to mouth "CPI" he said, "thanks" and and hung up. He's a trader, not a philosopher, at least whilst the market is open. After the close he can philosophise with the best of 'em.

So, before I again stammer and bumble and get it all wrong, here it is from others who have a clue.

Why the CPI Did NOT Cause the Market to Go Down

Readers know that we have long considered asset markets - ANY negotiated market for that matter - to be complex adaptive systems. Like bee hives and ant colonies, complex adaptive systems are characterized by critical states - what we at Vicis call bifurcations. Critical states are nothing more that a state of underlying instability that exists but has not yet manifested.

When that unstable condition - that bifurcation - manifests itself in the system, the human brain automatically and reflexively searches for the proximate cause, even if the cause has nothing whatsoever to do with the emergence of the instability. We can't help that response - it's physiological even if entirely illogical.

The SPX reaction to the CPI statistic is a perfect example of the above process. Our models had the SPX in a very unstable condition - at a potential bifurcation at emini SPX 1300 - 1302 - yesterday. That instability revealed itself but its cause is manifestly NOT the CPI.

Understanding that complex adaptive systems - asset markets - very often do not have linear cause and effect relationships is an essential part of controlling risk.

The science behind this way of looking at things is well summarised by an article by John Mauldin a few weeks ago. He says there are islands of stability containing fingers of instability.

A model of and island of stability can be built by dropping singe grains of sand into a pile. As he describes it,

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 builds up 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 the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.

They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found out that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."

"To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, 'ready to go,' color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."

He then describes the fingers of instability within the islands of stability:

So what happens in our game? "... after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into 'fingers of instability' of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability."

"In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do 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 it always possible for the next grain to trigger an avalanche of any size."

Now, let's couple this idea with a few other concepts. First, Nobel laureate Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist; and then when the trend fails, the more dramatic the correction is. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings for current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.

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 a paradoxical rise to even more apparent stability. As the late Hunt Taylor wrote a few months ago:

"Let us start with what we know. First, these markets look nothing like anything I've ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters.

"Next, we know things have been getting less, not more, turbulent, and that the tendency towards market serenity (complacency?) has been increasing. This is counterintuitive. It's not as though the 21st century has been lacking in liquidity-shocking events. Since the bursting of the tech bubble, we've had a disputed Presidential election, 9/11, the collapse of Enron and Worldcom, the invasion of Afghanistan, the war in Iraq, US$70 oil, the largest debt downgrade in history and the failure of Refco, to name just a few. There seems to be an inverse correlation between market complexity and market stability, for now anyway....

"I've had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it. This is something old.

"But I have learned to trust my eyes and ears and overrule my heart, when I have to. Everywhere I look, technology is making things faster, more efficient, safer. I cannot find the law of physics or economics that says it cannot happen in financial markets as well. I think, because risk will be lower, return will be as well. And savvy investors may have to seek additional risk, and manage it well, in order to earn an excess return. This is something new.

"I think shocks will come, but they will be shallower, shorter. They will be harder to predict, because we are not really managing risk anymore. We are managing uncertainty - too many new variables, plus leverage on a scale we have never encountered (something borrowed). And, when the inevitable occurs, the buying opportunities that result will be won by the technologically enabled swift."

Some of the fingers of instability that Guambat has identified are inflation, the dot-commodity boom, and risque business.






And while Guambat has prematurely been expecting the direction the market took overnight, he had no idea when, nor in what shape nor how far the move may take. Like a air-guitar player with no hands, Guambat is playing this all by ear.