January 26, 2012
BY: Robert Hallberg, Topics: Black Swan Event
Black swan events were popularized by Nassim Nicholas as a metaphor describing an event that is both unexpected and has a major negative impact on the world. The financial crisis of 2008 was a prime example of a black swan event. It came as a surprise to most people and had far reaching implications to the financial system.
The term Black Swan is frequently used by the media and policy makers to describe catastrophic events that just happen, and everyone just seem to accept that they exist without ever asking why and whats behind them. But there is an explanation for black swan events. Jim Rickards, in his book Currency Wars link black swan events to complexity theory and explain why complex systems will ultimately lead to a black swan even.
According to Mr. Rickards, complex systems are spontaneous organizations, unpredictable, and need exponentially greater energy inputs to evolve. Complex systems start off with individual components called autonomous agents. They make the decisions and produce the results in the system. These agents can be small organisms in the oceanic food chain or individual investors in the currency market.
Secondly, a complex system require connectedness, which means that all these agents must be able to interact with each other through some kind of a channel or network, whether it consist of the electrical lines in the case of a power grid or Twitter feeds in the case of a social network.
Third, a complex system requires interdependence, which means that the agents are able to influence each other. For example, if someone is not sure how cold it is outside but see people wearing sweaters by looking out through the window, he or she might also chose to wear one. You also see this among momentum players in the stock market. It starts with a stock that is gaining some momentum. Then a few more traders notice the price action and jump in. The price continues to advance and attract more and more traders that bid up the price higher and higher. The system feeds on itself and many of the market participants would never have taken a position had it not been for the early traders bidding up the price.
Finally, complex systems require adaptation or more specifically, it requires that the agents are able to learn and adapt. Investors for example that have been practicing a buy and hold strategy on Wall Street might come to the conclusion that they may need to consider an alternative strategy. This adaptation can take place among each individual and on a case by case basis or it can be collective in the sense that the lessons and information spreads quickly among the agents.
The system becomes more and more complex and chaotic with the increasing amount of information traveling through its different channels. The agents receive too much information from too many sources and are stymied in their decision making by conflict and overwhelming signals.
The system becomes less and less stable as it grows in complexity with more and more information traveling through the different channels. This change from a stable state to an unstable state is called phase transition. When a volcano erupts it goes from a dormant state to an active state, or when the stock market drops 20% in one day, it state goes from being well behaved to disorderly. However, not every system is poised for a phase transition. The system must first be at a critical state which means that the system is assembled in a way that one action triggers another action until the whole system has radically changed.
But even a system in a critical state, that is inherently instable, can remain in that state for a long time, but once an action is triggered that push the system over the edge change happens very rapidly. A good example of a phase transition is an avalanche. The snowflakes will fall on a mountain top until one snow flake disturbs a few another ones. Those snowflakes will disturb more snowflakes until a small slide begins to take more snow with it, getting larger along the way until the entire mountainside comes loose.
One could blame the single snowflake for causing the avalanche but it is more correct to blame the unstable state of the mountain top. The snow covered mountain top was in a critical state and was likely going to collapse sooner or later, and if one snowflake did not start the avalanche, the next one would have.
The same process plays out in a stock market crash. Buy and sell orders hit the market all the time just like the snowflakes on the mountaintop. Sometimes the buyers and sellers are arranged in highly unstable ways so that one sell order triggers a few others, which are then reported by the exchange, triggering even more sell orders by nervous investors until the market take a big plunge. The process feeds on itself. Depending on the state of criticality in the system, sometimes the process dies out, but other times the process grows exponentially until something outside the system intervenes. Once the cascade stops, the complex system can return to a stable, noncritical state.
Just like the snow covered mountain top, our current financial system is inherently unstable and filled with imbalances. Many sophisticated analysts point out the imbalances, but the markets seems to operate normally for long periods of times without any disorderly disruptions, so most market participants discount the instability of the system. A stock market crash is an extreme event but it would perhaps be more accurate to call it extreme results from everyday events. Extreme results will happen with some frequency; it is the everyday events that trigger them because we dont see them coming precisely because they are so mundane.
The chart shows a time line of extreme events like market crashes. It take a long time, years or even decades, for a complex system to transition into a critical state, but once it got there and tipped over change in the form of a crash or collapse was almost instant.
It is difficult to predict the exact timing of black swan event, but we can study systems and watch weakness and imbalances build up. By understand the fundamental issue we can predict what is likely to happen but not exactly when it will happen. It will take a genius to estimate the number of snowflakes required to set off an avalanche, even with a system that is in a critical state.
Our Financial System
In late 2007 the financial market in America and around the world was in a critical state and it was starting to melt down. A financial avalanche was underway and it was threatening the entire system and not only the equity markets. The governments quickly came in and propped up the system. This did stabilize it but it did not make it more stable.
Ski patrols frequently throw dynamite on unstable slopes to reduce avalanche dangers and de-scale risk. In the financial system the opposite is happening. The financial ski patrol of central bankers is shoveling more snow on top of the mountain. The financial system is now larger and more concentrated than ever before and the risk of a system breakdown is much greater. During the last crisis the governments were able to step in to prop up the banks by taking on their debt, but the next collapse will not be stopped by government because it will be bigger than the governments.
The chart above shows the growth in global derivatives. Despite the crash in 2008 and collapse of Lehman Brother, which destroyed trillions of dollars in market value the total amount of derivatives are larger today than pre-2008.
To learn about trends and spot the next investment opportunity read the Casey Report from Casey Research. It's a monthly investment news letter that breakdown economic trends in a way that is easy to understand. They make recommendations based on economic reality and their track record is several times better than the market or any mutual fund for that matter.blog comments powered by Disqus