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Chaos Theory proposes that any action anywhere in the world can influence phenomena elsewhere. The common example is that a butterfly that alters its usual pattern of pollen collection can create a different enough wind flow as to ultimately, along with his brethren and a thousand other seemingly disparate events and actions that cross numerous disciplines, will create, increase, or mitigate the effects of a tropical cyclone.

This, in turn, will affect the amount of precipitation coming from the Pacific which in turn affects farming in the San Joaquin Valley of California, the amount of snowpack at ski resorts like Squaw Valley and Diamond Peak in the Sierras, and whether the West’s fire season will be severe or benign. Chaos theory describes events that seem to be disorderly, but it’s all about finding the underlying order in apparently random data.

So it has been with the unfolding of the housing – subprime – credit – banker stupidity – brokerage gluttony – investor self-delusion – government panic – taxpayer fleecing crisis.

It was not that long ago, in May of 2008, when I began exchanging our client portfolios for cash, that a client asked me “Why are you selling these great stocks? How can someone else’s subprime loan affect my blue-chip stock portfolio?”

Put another way: Why should a butterfly in China, or some over-leveraged wannabe real estate mini-tycoon in California, affect the value of an investor’s corporate bonds or Microsoft (NASDAQ:MSFT) or Pfizer (NYSE:PFE) common stock?

Easy -- though the logic trail was for too long obscured by derivatives, swaps, reverse credit instruments, and the slicing and dicing of bad loans into mortgage-backed (or not backed) securities by your local “greed is good” brokerage firm. That butterfly’s flight ultimately brought the market down. As debt-rating agencies Moody’s and S&P (finally and belatedly) decided that subprime mortgages were (to use the technical financial term) “in the toilet,” they at last downgraded this debt.

S&P has now said it is changing the way it evaluates mortgage-backed securities, partly because of “unprecedented levels of misrepresentation and fraud.” Well, duuhh, tell borrowers they don’t need to show income or assets but only give a pinkie-swear that they’re good for the money and of course you’re going to see misrepresentation and fraud! Really, now, are you and I the only people with common sense left in the country? Do you hear those butterfly wings flapping away?

Since many hedge funds -- perhaps one of yours -- and many mutual funds – perhaps one of yours -- sought higher yields to goose returns, these toxic little dirt bombs are everywhere. Did someone actually believe that the government throwing money at bankers and brokers as if they were dollar bills at a strip club was going to change the actual dynamics of a bad market? Only two things change a bad market, and they exist in tandem: price and time. As prices of homes decline, more buyers step in. As people sense the times are tougher, they use their credit cards less. As fewer people shop, fewer malls get built. (There is regrettably no economic antidote for banker stupidity, brokerage gluttony, or government panic. Those are constants unaffected by principles of economic reality.)

The waterfall effect of a bad housing market is still with us. And credit card debt is horrendous. Bankers will obey the new credit card legislation but will simply charge fees that make up for the lost revenue in some other area. And let's not forget commercial real estate, a size-13 shoe ready to drop. We need more time and we need prices to correct further.

Right now, mutual funds, hedge funds, pension funds, et al, are holding their breath. Few are doing any new buying but none are selling, hoping this rally will continue. As Jesse Livermore said, “When I have to depend upon hope in a trade, I get out of it.”

I see forced selling from these institutions coming up on a number of fronts. For instance, if their prospectus or charter promises they’ll only invest in “investment-grade" debt, and half their portfolio has now been downgraded below that level, they must sell or be in violation of that prospectus. When taking these losses, they’ll also sell even their crème de la crème crown jewels from the rest of the portfolio so they don’t under-perform relative to their benchmarks. That’s how fund managers’ bonuses are pegged, after all. What’s the worst event an institutional portfolio manager can face? Losing his bonus. Oops! Sorry, I meant to say, of course, in the most sonorous tone, “Underperforming his benchmark.” Like there’s a difference!

Since we are talking, for illustration purposes only, about a butterfly’s wings “in China,” a word about emerging markets and China in particular. Given their poor record of corporate governance, transparency, and truth-telling in divulging growth numbers, I wouldn’t be a bit surprised to see Chinese exports and GDP actually be well below the published numbers – and unemployment well above.

Wow. It turns out that butterflies aren’t free, after all.

I would rather sell a month too early than a week too late. Trying to catch the top doesn’t work. The first day there’s a crack in the armor no one believes it. Then the next couple down days everyone expects at least a dead cat bounce, “then we’ll get out.” By the end of a week, you’re mentally exhausted and now you either decide to hold for the long term, kicking yourself for not selling earlier, or you panic out at prices no better -- or much worse -- than if you had taken your time to sell over a period of time as we have done. No muss, no fuss, no panic, no emotional mistakes...

DISCLOSURE: Mostly in boring, safe cash equivalents, with some income, a little gold, and inverse ETFs like EUM, SH, SEF, REW, and PSQ.

Source: A Butterfly's Wings in China: How Chaos Theory Affects the U.S. Market