A Butterfly's Wings in China: How Chaos Theory Affects the U.S. Market 13 comments
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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 (MSFT) or Pfizer (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.
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1
Looks like you are recommending to sell?
I've been having that internal debate. As much as your argument is true and wise, it could be equally true that given the current discount on stock prices, this level will be maintained and as we exit this recession missing the next bubble could be "costly".
We seem to have a history of creating bubbles to get ourselves out of trouble. Regardless of fundamentals, this behavior seems to be reliable since years now.
Isn't the next bubble already started with the printing of trillions of dollars? and would that not create a "run" on most asset classes?
The wealth destruction to date, just US alone, is around $15-20T. Many still hold the view there is nothing the gov't can do to counterbalance such loss, no matter how they try. Others disagree.
I'm in the former camp.
Analogy: What if you could concocted an ingenious plan, to become a "shadow" Fed, and printed perfect counterfeit trillions yourself ( literary license required here; the Fed doen't really "print" as in tangible dollar bills ). But you get cold feet, and instead bury the money, risk of getting caught is too high.
So, the money exists, but its buried. Is this inflationary? Does it affect at all velocity? Does it conribute to any new bubble creation?
It can be said, that unless the money created by the Fed goes from banks into the economy, the money is ( sort of ) buried. For that to happen, two crucial things must happen. The banks must be willing to loan, but more crucially there must be willing and ABLE borrowers. Businesses expanding, consumers buying, etc.
Yes, there is increased government spending, but it is slow, and really a drop in the bucket compared to the loss of consumer spending.
Until velocity increases, and I ageee with the author, only price and time is a true fix, we can only hope to muddle through. You may wish to bookmark this:
research.stlouisfed.or...
On May 26 05:11 AM christophe wrote:
> Thanks for the good advise.
>
> Looks like you are recommending to sell?
>
> I've been having that internal debate. As much as your argument is
> true and wise, it could be equally true that given the current discount
> on stock prices, this level will be maintained and as we exit this
> recession missing the next bubble could be "costly".
>
> We seem to have a history of creating bubbles to get ourselves out
> of trouble. Regardless of fundamentals, this behavior seems to be
> reliable since years now.
>
> Isn't the next bubble already started with the printing of trillions
> of dollars? and would that not create a "run" on most asset classes?
I like what you write but, what you recommend , what is the pattern that you discover that is not randomly driven?
Joseph , There is a global fracture between goverment and people
The ( global ) goverment have printing paranoia, information manipulation obsesion and the total untrustfulness from thier governmees.and because of that the only reference (historical and realistic) is gold.
you cannot print it, you have it or not.
You will see how the common people will ask and price in gold or a reference that is not manipulated by the goverments of the world.
no one likes unvalued money for his/ her services
Are you holding tjhe same dollars that the strip club guys are paying for dancing on the table?This dollars are as cheap as their ink and paper.
Driven by the desire for immediate gratification, our affection starved leaders wait anxiously for an acknowledgment of any kind - a wink, a smile, a personal phone number. Caught up in a fantasy of the moment.
Let's not forget, however, the rest of the analogy: The lonely walk home, the empty pockets, the sense of emptiness and self loathing... The realization that we have been played for a fool. Again, and again, and again.
Now we get to re-live this fiscal humiliation for a generation.
Does the author possess mystical power to PREDICT the cause-effect sequences of events based on the butterfly effect? I doubt it.
Are the flaps of butterfly wings the cause that results in weather pattern changes? Or perhaps it is just one possible cause out of millions of possible causes whose chaotic and unpredictable microeffects cumulatively over random periods products a random effect? Could butterfly wings in China or California be a stronger or lesser cause than butterfly wings out of Zimbabwe or Iceland? Who really know?
Double reverse ETFs track on a daily basis only and the path it takes determines the ultimate price.
Lets say a ETF and its reverse both start at $10. The underlying index may go up from 10 to 11 a +10% move, so reverse ETF goes down by 20% to 8. Now index goes down by 10% from 11 to 9.9, the reverse ETF is back only to 9.6 (20% gain on 8). You would expect it to have gained 2% as the underlying index went down from 10 to 9.9. Over longer durations the distortions can be enormous – several hundred %.
So using single reverse ETFs is a much better idea.
On May 26 08:53 AM Ludovici wrote:
> Thanks for the analysis. In other comment streams, I've heard it
> said that these reverse ETFs are unsuitable for holding more than
> a few days, because of the way they work. Do you agree? Could you
> explain why or why not?
Answwering your question as best I can, there is something to that argument – but not enough to keep me away from establishing a short position over a well-diversified index rather than selecting individual stocks.
The problem to which you refer is that inverse ETFs are constructed so as to return the inverse performance of the underlying index on a //daily// basis. On the surface of it, you may ask, why does that matter? The answer is: because large fluctuations in one direction or the other tend to skew the “daily” performance even if the long-term price action were to stay exactly the same. Of course, if there are numerous heart-stopping down days, instead of the up days we have seen the last two Mondays, you would actually do better in an inverse ETF than you would by shorting each of the stocks comprising that index.
That’s what I believe will happen next and I’m willing to put my money where my conclusions are…
Respectfully,
JS
On May 26 08:53 AM Ludovici wrote:
> Thanks for the analysis. In other comment streams, I've heard it
> said that these reverse ETFs are unsuitable for holding more than
> a few days, because of the way they work. Do you agree? Could you
> explain why or why not?
Thanks for your insights. Yes there is lot of chaos, Brownian motion - complete randomness. Markets were melting down a couple of months ago - now in complete euphoria. Which is right, both can't be. Bulls on Wall Street (almost everyone is – that is their business model and MO) - will tell you the latest is more right, till proven otherwise.
Today's confidence numbers - were they warranted? Lets see what is confidence - it is simply hope not reality. People are hoping to find a job, hoping then to spend money. Does this hope have a basis - job losses and home price falls are real and now. So why is hope disconnected with reality. Maybe it is the same hope - bubbles are made of - housing, dot com.
If 'green shoots' were true - why would Fed downgrade the economy last week. Why are S&P earnings forecasts coming down over last 3 months - from $49.09 on 3/22, to now $42.93 on 05/20. Why do we still have 500K+ job losses a month, why are home prices falling 2%+ per month. All this points to ongoing disaster not recovery.
Invested little in gold, rest cash. Much better opportunities will come by in the near future.
Like your namesake, Yoda, I nelieve you are wise to conserve your energy and choose reality over hope! One makes you feel good, the other keeps you from following the herd over the cliff...
Joe
On May 26 10:23 PM Fighting Yoda wrote:
> Joe:
> Thanks for your insights. Yes there is lot of chaos, Brownian motion
> - complete randomness. Markets were melting down a couple of months
> ago - now in complete euphoria. Which is right, both can't be. Bulls
> on Wall Street (almost everyone is – that is their business model
> and MO) - will tell you the latest is more right, till proven otherwise.
>
>
> Today's confidence numbers - were they warranted? Lets see what is
> confidence - it is simply hope not reality. People are hoping to
> find a job, hoping then to spend money. Does this hope have a basis
> - job losses and home price falls are real and now. So why is hope
> disconnected with reality. Maybe it is the same hope - bubbles are
> made of - housing, dot com.
>
> If 'green shoots' were true - why would Fed downgrade the economy
> last week. Why are S&P earnings forecasts coming down over last
> 3 months - from $49.09 on 3/22, to now $42.93 on 05/20. Why do we
> still have 500K+ job losses a month, why are home prices falling
> 2%+ per month. All this points to ongoing disaster not recovery.
>
>
> Invested little in gold, rest cash. Much better opportunities will
> come by in the near future.
Actually, you may be proven correct, but to this point, no, //we haven’t missed a thing.// You’ll note in my March 3 SA article, we went long all those lovely bank preferreds. We made 35-50% on all of them and were long “the market” until mid-April. Then in my 15 April article for SA I clearly stated that we were in the process of raising cash but had //not// yet begun to buy our inverse ETFs. All a matter of public record!
In my 19 April (Sunday) article we reported we had almost finished raising cash and were in the process of putting about 10% of the proceeds of sales into inverse ETFs. I actually Instablogged that article, you’ll notice, on Friday – it was published by SA on Sunday. That Friday, the DJI was at 8131. It closed at 8300 today. The difference, in 5 weeks, of just 169 points is “decimal dust” in the grand scheme of things. I took close to zero risk for our clients from 17 April until today, having no crystal ball as to the future direction then, any more than I do now. We “missed” 169 points – but were in cash sleeping quite soundly.
At this point, our golds are up, our income stocks are paying dividends, and our inverse ETFs are just about flat, with real estate profitable and financials and techs against us just a hair.
You have been a conscientious conscience but I just can’t consider 169 points incredible gains. As I stated in the last paragraph of this article, especially in this kind of market, "I would rather sell a month too early than a week too late."
If you think that is heretical, check out the article I just Instablogged this morning. No matter the manipulation of news and numbers that has everyone believing we are in an “incredible rally” when in fact it is virtually unchanged in 5 weeks, I believe a decline is imminent. I also state that periodic rebalancing – call it “market timing,” if you like, though that wouldn’t accurately describe the way we stair-step in and out -- is //essential// in bear markets. The article is aptly titled, “Buy and Hold is for Lemmings.” Saying that shakes a lot of people’s coconut trees but, for us, it’s worked for nearly 40 years. Why change now?
On May 27 01:05 PM Larylar1 wrote:
> This just goes to show that market timing does not work. Joseph,
> you've been in "boring stuff" for the past few weeks losing out on
> incredible gains, and the reverse ETF you have must have been getting
> killed. If the market does crash again, you're safe, but if it takes
> 2-3 months to do so, you've missed out on amazing gains