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GENIUS
WILL FAIL AGAIN "Stability
is destabilizing" One of the nice things about being a Canadian online trader is that occasionally US and London markets are closed whilst ours are open. Like today. Dull is hardly the way to describe the market action on those days, but it does give us time to sit back and try to look at the bigger picture. I'm going to give a brief outline of some things which are going through my mind, including two possible scenarios going forward. First, a little background on me. I used to do numerical modelling of oceanographic and atmospheric processes. Big models on big computers running hydrodynamic equations trying to replicate and predict real world turbulent regimes. Fun stuff. Anyway, there was a general rule that the bigger and more complicated the model (i.e. closer to reality), the greater the likelihood it would (to borrow the great SCTV phrase) "Blow up real good!", in other words go numerically unstable. When they did that, I would look over the critical parameters and then try to fix, damp, smooth, whatever, to try and get the models to work. It wasn't easy, and certain aspects of modelling are considered intractably insolvable problems. You just have to try and minimize the damage. There are two reasons I bring this up. First, just before the models would go unstable, they would usually start exhibiting unreal behaviour. Typically, this meant they would start to develop large swings in value, both in time and in "neighbouring" grid points. The swings would amplify and then something else would go unstable. I would look at a "timeseries" of say temperature at a point, and you could see the instabilities getting bigger. When I left the science world to trade stocks for a living, I thought I had seen the last of these kinds of figures. Unfortunately, this was not the case. Timeseries of financial instruments are starting to look a lot like a model about to go unstable. Bonds drop a point in one day, recover the next, silver drops 30 cents as hedge funds exit en masse, the dollar rallies a full point, and so on. The model analogy is not so far fetched. There are hundreds, if not thousands, of computers doing dynamic risk hedging every day of the week, all interacting and buying and selling protection of one sort or another. There are hedge funds trading hundreds of billions of dollars in a heartbeat waiting to jump on the next trend. It's a potent combination, and getting bigger every day. One of the advances made in fluid numerical modelling was stability analysis. You'd look at the equations and the way they were implemented and look for unstable "modes". Unfortunately, this was usually done after the mode had made its presence known in a more painful way. And when the models got more complex, so did the stability analysis to the point where it really wasn't of much help. I bet the Fed and the big derivative players have all kinds of risk scenario models running, and I also bet they're behind the curve in where these markets are really at. My models would therefore go unstable purely by their own internal structure. No exogenous shock was needed to get the ball rolling. I know Jim Puplava and others have written about the 10 sigma shock which will create financial havoc, but it may not be necessary. The rogue wave within. It's a real possibility. Ok, let's look at another aspect of modelling. It was possible to smooth out bottom topography, limit changes in model variables to small increments, force conditions back to reality and so on, but the price paid was that the model bore little resemblance to reality. Stock markets, unfortunately, also look a lot like these kinds of models at times. The heavy hand of stability is all too evident, and asset classes are valued on the most unreal bases. In my kind of modelling, it was easier to achieve that kind of stability in a global model. Not having to correctly match boundary conditions (at a model's edge) was a big help in keeping the model stable. The financial analogy is all too clear. The credit bubble is global, and no country is still on the gold standard, which means the whole system is never marked to market. There is no market in the traditional sense anymore. Gold used to represent the ultimate boundary condition for an economy. Print too much money or live beyond your means, and foreigners would demand specie as your devalued currency returned home. Again, others have written at length about the true state of today's world economy and where inflation is showing up since the US is not forced to either pay for its consumption or its profligacy. Yet. Recent M3 money growth statistics are indicating some of that money is starting to come home. So, I think the inflation versus deflation argument is kind of irrelevant. Sensible analysts like those on FSO have very clearly indicated what kind of inflation and deflation we will get. We will get both in different things, which often happened as my models went unstable. Quite unexpected and bizarre behaviour would happen. It was all unreal, and a feature of whatever model I was running at the time. What really matters is under what kind of an environment it will play out. More stability, but less reality, or a breakdown of some kind. Which is more likely? The Feds have clearly indicated what they will do. Print money, monetize debt if they have to (and it is starting to look that way), stabilize the stock markets, suppress gold. How long can they keep their stable global model together? What will the bond markets and "hot money" do? If they're smart, they'll follow Warren Buffet on the next wagon train out of the country. But of course, hedge fund money is dumb money these days. They'll follow the crowd. If not for the bullion banks' suppression, gold would seem primed for a major up tick. The commercials have reduced their net short positions, the hedge funds have sold 85% of their holdings on the recent swoon (I told you they were dumb), and more South African mines are closing. In addition, the mood is quite negative. So, here's my prediction. I just love that quote from Minsky at the top of this article, and use it as my starting point for a lot of useful things. The point is that the cost of the powers over-stabilizing "un-real things", is that "real shortages" are looming. Looks like it might be tin, or maybe copper, to be the first to run out, but once one goes, all of the industrial commodities will come under intense buying pressure again. Inflationary expectations will be more than a sound bite. We may not be able to get copper. Period. Then we find out how the risk models fare when there's real risk. Stay loose, keep some cash and a core holding of good commodity stocks, have a plan and, Good Luck. We'll all need it.
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