Thoughts from the Frontline: Black Swans and Endogenous Uncertainty

By John Mauldin


John is in Florida and feeling a bit under the weather, so this week we’re bringing back one of his most popular letters, from December 2007. In the letter he discusses the work of Professor Graciela Chichilnisky of Columbia University, one of whose key insights is that the greater the number of connections within an economic network, the more the system is at risk. Given the current macroeconomic environment, it is important to remind ourselves of how complacent we were back in 2007 and how it all fell apart so quickly, just as John outlined in this rather prescient piece.

This is a theme to which John has returned again and again, pointing out that reforms such as Dodd-Frank (the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010) fell well short of solving the problem of excessive interconnectedness among global financial players. It shored up the big “sandpile” rather than breaking it up into smaller, more manageable sandpiles. Now, if the Chinese, Japanese, and/or European sides of the sandpile should avalanche, the whole US side is likely to go, too.

John will be back next week with a report from Washington DC and the next installment of his series on income inequality.

How does the risk of default in California or Thailand get spread throughout the world, causing problem in money market funds in Europe and Florida? Yes, we can trace the linkages now, but was it possible to predict the crisis beforehand? And can we use what we learn to predict and hopefully hedge ourselves from the next crisis? Why do these things seem to be happening with more frequency? This week we are going to look at some economic theories that will give us some insight into the above questions. As it turns out, the more that individuals hedge their risk in economic markets – the larger and more interconnected the network – the more the entire system is put at risk. There is a lot of ground to cover, so we will jump right in.

Before we get to the economic theory, let’s review part of a letter I wrote in April of 2006 discussing chaos theory, as it will give us a useful mind picture to understand the latter part of the letter. This was part of a letter in which I laid out my thought that we would indeed experience a future crisis along the lines we are now seeing.

We are going to start our explorations with excerpts from a very important book by Mark Buchanan called Ubiquity, Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory, and critical states. It is written in a manner any layman can understand. There are no equations, just easy-to-grasp, well-written stories and analogies.

Ubiquity, Complexity Theory, and Sandpiles

We have all had the fun as kids of going to the beach and playing in the sand. Remember taking your plastic bucket and making sand piles? Slowly pouring the sand into ever bigger piles, until one side of the pile started an avalanche?

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’s 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 sounds, 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.”

The pile was indeed completely chaotic in its unpredictability. Now, let’s read this next paragraph slowly. It is important, as it creates a mental image that helps me understand the organization of the financial markets and the world economy. (emphasis mine)

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.

Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually, for all you physicists) we refer to something being in a critical state (or us the term critical mass) when there is the opportunity for significant change.

But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]…. In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains.

Thus, they asked themselves, could this phenomena show up elsewhere? In the earth’s crust, triggering earthquakes; in wholesale changes in an ecosystem; or in a stock market crash? “Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?” Buchanan asks. Could it help us understand not just earthquakes but why a cartoon in a third-rate paper in Denmark could cause worldwide riots?

Buchanan concludes in his opening chapter:

There are many subtleties and twists in the story … but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I’ve mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds – atoms, molecules, species, people, and even ideas – have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before.

Now, let’s think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the likelihood of an avalanche becomes 2.14 times as unlikely. We find something similar in earthquakes. In terms of energy, the data indicate that quakes become four times less likely each time you double the energy they release. Mathematicians refer to this as a “power law,” or a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

Fingers of Instability

So what happens in our game?

[A]fter 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.

Now we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind (again, emphasis mine):

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, economist Dr. 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. 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 in favor of 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 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.”

A second related concept is from game theory. The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

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Bank of Russia raises rates to calm financial markets

     Russia’s central bank raised all its interest rates, including the key rate, in what it described as a temporary move to “prevent the risk for inflation and financial stability arising from the recent increase in financial market volatility.”
    The Bank of Russia said the new rates would take effect from today, March 3, at 11 a.m. Moscow time.

OIL Elliott Wave Analysis: Corrective Rally

Crude Oil Four Hour

As expected, crude oil broke to a new high after recent slow and sideways price action above 101 which we think it was wave (iv) as already highlighted past week. As such, current move higher is most likely wave (v), final leg within wave A that may be looking for a top in this week around 105.00-105.50 area. With that said, traders should now be aware of approaching corrective reversal.

OIL 4hElliott Wave Analysis

Crude Oil One Hour

Crude Oil reached a new highs, so we have to be aware of a possible reversal in price as rally from 101 can be counted in five waves, so wave (v) can be near completion. Move beneath 103.68 will confirm a reversal.

OIL 1hElliott Wave Analysis

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Euro Trades Lower; Germany Final PMI Drops

By HY Markets Forex Blog

The 18-bloc euro remained lower against the US dollar on Monday. The currency bloc released a set of manufacturing data for February as the largest economy in region, Germany; released its final manufacturing data for February, showing that activity in the country contracted compared to the previous month.

Germany’s final manufacturing Purchasing Managers’ Index (PMI) dropped to 54.8 in February, compared to the previous reading of 56.5 seen in January and  slightly lower than analysts forecast of 54.7.

The euro traded 0.15% lower to $1.3778 against the greenback at the time of writing after rising to its highest level since Dec 27 in the previous session. The euro was dragged lower by the turmoil between Ukraine and Russia.

Market analysts are focusing on the upcoming European Central Bank meeting scheduled for Thursday, where policymakers of the central bank will assemble. The ongoing crises in Ukraine is expected to weigh on the market through the week.

Euro – Final PMIs

In France, the manufacturing activity came in slightly higher in February, climbing to 49.7 points, compared to the previous reading of 49.3 recorded in January.

While Spain’s manufacturing sector grew higher than expected in February, staying in the expansion territory for the third consecutive month. The PMI climbed to 52.5 points in February, slightly picking up from the previous reading of 52.2 seen in January and higher than analysts forecast of 52.0 points.

In Italy, the country’s manufacturing sector dropped beyond expectation in February, with the final PMI declining to 52.3 points, compared to the previous reading of 53.1 points recorded in January.

As for Germany, eurozone’s strongest economy; slowed down their activity in February, compared to the previous month but remained in expansion territory for the eighth month in a row. Germany’s final PMI came in at 54.8 points in February, compared to 56.5 recorded in the previous month.

The eurozone’s final manufacturing PMI declined beyond expectation, dropping to 53.2 points in February, down from 54.0 seen in January.


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Stocks In Europe Begins The Week Lower on Ukraine

By HY Markets Forex Blog

Stocks in Europe were trading lower on the first day of the trading week as the ongoing turmoil in Ukraine weighs on market sentiment. Meanwhile, market participants are focusing on the release of a string of Final Purchasing Managers’ Indices (PMI) for February from European countries, later in the day.

Futures for the European Euro Stoxx 50 dropped 0.99% lower at 3,100.50, while the German DAX futures declined 1.33% to 9,523.50. At the same time futures from France’s CAC 40 lost 1.03% to 4,344.30 and UK’s benchmark FTSE 100 fell 1.08% to 6,707.50.

The ongoing crises between Ukraine and Russia, stocks were seen dropping in Asia, with equities in Japan closing the session lower.

Stocks- Ukraine Turmoil

Ukraine is preparing for war after the Russian President Vladimir Putin sent more than 6,000 troops to the tense Crimean Peninsula over the weekend.

“This is not a threat: this is actually the declaration of war to my country,” said Ukrainian Prime Minister Arseny Yatseniuk. However, the Russian President Vladimir Putin said he had the right to raid his neighbor country, to protect Russian interests in Ukraine.

The US President Barack Obama threatened to cut off Russia economically, which may also include the removal from the G8. The next summit of industrialized nations, scheduled in the Russian city of Sochi in June has been cancelled by the G7.

An emergency meeting on Ukraine by the European Union foreign ministers will be held later in the day, while US Secretary of State John Kerry is expected to visit the country.

Stocks – Expected Final PMIs

Final PMI’s for February are expected to be released later in the day, analysts are forecasting to see little or no impact on the markets from the ongoing turmoil in Ukraine.


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Fibonacci Retracements Analysis 03.03.2014 (EUR/USD, USD/CHF)

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Analysis for March 3rd, 2014

EUR USD, “Euro vs US Dollar”

Last Friday, Eurodollar reached its first bullish target and Take Profits on my buy orders worked. During correction, I opened another buy order; next target is at level of 1.3875. I’ll move stops into the black as soon as price breaks maximum.

As we can see at H1 chart, pair reached its target at level of 1.38 right inside temporary fibo-zone. Right now, pair is being corrected and may test local level of 38.2% in the nearest future. It is rebounds from this level, price may start new ascending movement.

USD CHF, “US Dollar vs Swiss Franc”

Franc also reached its first target. However, in the future bears may continue pushing price downwards to reach their next target, which is near several fibo-levels at 0.8715. Possibly, after reaching it, price may start new and more serious correction.

At H1 chart we can see, that price reached channel’s lower border and started new correction, which is already 23.6%. Probably, pair may finally reach local level of 38.2%, rebound from it, and start new descending movement.

RoboForex Analytical Department

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Forecasts presented in this section only reflect the author’s private opinion and should not be considered as guidance for trading. RoboForex LP bears no responsibility for trading results based on trading recommendations described in these analytical reviews.





GBPUSD: Retains Broader Upside Bias Despite Hesitation.

GBPUSD: Though seen hesitating, we still look for the pair to resume its bullish strength triggered off the 1.6583 level. Note that the fact that it has reversed most of intra day losses suggests that its broader upside bias remains intact and trend resumption is imminent. Immediate resistance resides at the 1.6768 level, its Feb 28 2014 high where a break will turn focus to the 1.6822 level and then the 1.6850 level, its psycho level. Further out, resistance stands at the 1.6900 level. Its daily RSI is bullish and pointing higher suggesting further upside. Conversely, support lies at the 1.6675 level, its Feb 28 2014 low where a cut through here will pave the way for a run at the 1.6600 level. Further down, support comes in at 1.6550 level where a break will aim at the 1.6500 level. Further down, support lies at the 1.6450 level and possibly lower towards the 1.6400 level. On the whole, GBP continues to retain its medium term upside.

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Ichimoku Cloud Analysis 03.03.2014 (GBP/USD, GOLD)

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Analysis for March 3rd, 2014

GBP USD, “Great Britain Pound vs US Dollar”

GBP USD, Time Frame H4. Tenkan-Sen and Kijun-Sen are influenced by “Golden Cross” (1); Tenkan-Sen is directed upwards. Ichimoku Cloud is going up (2), and Chinkou Lagging Span is above the chart. Short‑term forecast: we can expect support from Kijun-Sen – D Tenkan-Sen, and growth of the price.

GBP USD, Time Frame H1. Tenkan-Sen and influenced by “Golden Cross” (1); the lines are very close to each other. Ichimoku Cloud is going up (2), and Chinkou Lagging Span is on the chart. Short‑term forecast: we can expect resistance from Tenkan-Sen – Kijun-Sen, and decline of the price.

XAU USD, “Gold vs US Dollar”

XAU USD, Time Frame H4. Tenkan-Sen and Kijun-Sen are close to each other above Kumo Cloud (1); all lines are directed upwards. Ichimoku Cloud is very narrow and going up (2), and Chinkou Lagging Span is above the chart. Short-term forecast: we can expect support from Tenkan-Sen – Kijun-Sen, and growth of the price.

XAU USD, Time Frame H1. Tenkan-Sen and Kijun-Sen intersected inside Kumo and formed “Golden Cross” (1); Tenkan-Sen and Senkou Span A are directed upwards. Ichimoku Cloud is going up (2), Chinkou Lagging Span is above the chart, and the price is on Tenkan-Sen. Short‑term forecast: we can expect decline of the price towards support from Kijun-Sen.

RoboForex Analytical Department

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Forecasts presented in this section only reflect the author’s private opinion and should not be considered as guidance for trading. RoboForex LP bears no responsibility for trading results based on trading recommendations described in these analytical reviews.





Powerful Insider Issues Warning to Growth Investors

By Powerful Insider Issues Warning to Growth Investors

“Go where there’s growth.”

It’s a mantra so simple that even novice investors immediately understand it.

Why? Because it makes perfect sense that companies operating in growing markets and increasing sales and profits can’t help but see their share prices rise.

I mean, why else does a company go into business? To grow, grow and grow some more!

So where’s the growth today? The answer might surprise you. But don’t let that keep you from scooping up the profits…

No One Will Believe It…

We’ve been told time and time again that emerging markets are home to the fastest growth rates in the world.

What people say doesn’t always jive with reality, however.

“Although it might be hard to believe, the U.S. and the developed markets are where the growth is,” according to Richard Bernstein of Richard Bernstein Advisors.

Sure enough, if we dig into the data, long-term earnings growth projections for Japanese stocks and U.S. small caps top the list.

Shocking, I know. But it’s nonetheless true.

Even if we evaluate growth prospects over the short run (i.e., the next 12 months), Japan and U.S. small caps still come in first and second place, respectively.

Now you understand why we’ve been banging the drum for so long on Japan and U.S. small caps.

Along the way, we’ve shared numerous specific investment opportunities.

In Japan, for instance, we offered up the WisdomTree Japan Hedged Equity Fund (DXJ). You’ll recall, it provides a hedge against currency valuations, while investing in some of the largest dividend-paying Japanese stocks. It’s up 20% over the last year and remains an attractive, low-cost and safe way to bet on a resurgent Japan.

My favorite play in Japan, however, remains the Japan Smaller Capitalization Fund (JOF). The closed-end fund invests in 146 small-cap Japanese companies. They represent the cheapest stocks in the country, as well as the ones with the most growth potential. Best of all, the fund currently trades at a 10% discount to NAV, which makes it an even more compelling bargain.

On the Domestic Front

When it comes to U.S. small-cap opportunities, a bevy of factors contribute to the rosy expectations. Like lower energy costs, increasing productivity, superior quality control and political stability, according to Bernstein.

He’s particularly fond of U.S. small-cap banks, thanks to much stronger balance sheets than their larger-cap brethren. While I don’t disagree with his assessment, I’m most optimistic about technology stocks. (For a quick refresher explaining why, go here.)

With that in mind, in November I brought 3-D scanning leader, FARO Technologies, Inc. (FARO), to your attention. And the company definitely fits the “growth” bill.

Sales and new order bookings increased 11% and 20%, respectively, in the most recent quarter. That figure is more than double the sector’s average growth rate of 4.9% – and it stands head and shoulders above the S&P 500 Index average sales growth of 0.8%.

Not long ago, I also shared a compelling small-cap, cyber-security play with you – The KEYW Holding Corporation (KEYW).

It’s up a solid 12% since then, on heavier than average volume, too.

Could a takeover be in the works, like I predicted? Time will tell. Regardless, the stock possesses significant growth opportunities – and, most importantly, it remains grossly undervalued.

Of course, our WSD Insider portfolios are chock-full of other, equally compelling, small-cap opportunities. I’m getting ready to add another fast grower to this exclusive list, which is levered to one of the hottest trends in the market right now.

And it’s completely off Wall Street’s radar, which sets the stage for dramatic gains. If you’re already a WSD Insider, stay tuned. The issue should hit your inbox early next week.

If you’re not a subscriber yet, what are you waiting for? You can sign up for a risk-free trial here, and you’ll be among the first to find out the company’s identity.

Ahead of the tape,

Louis Basenese

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