Too Good For Too Long

by Adam Taggart, Peak Prosperity:

I'm writing this from my home in Sonoma County at the end of an intense week of witnessing firsthand the devastation caused by the many current fires burning in northern California. While it's hard to focus on anything other than the moment-to-moment developments of this still-unfolding disaster (which I've been chronicling here), it's already clear that the implications for my part of the state will last for many, many years to come.

It's amazing how instantly the status quo where I live has changed. The world my neighbors and I lived in when we all went to bed on Sunday night simply no longer existed by the time we woke up on Monday morning. Lives have been lost. Entire neighborhoods -- thousands of homes -- have burned to the ground. Businesses, hospitals and schools are now shuttered.

Having now experienced this personally -- on top of watching news reports over the previous weeks of similarly abrupt "before/after" transitions in Houston, Florida, Puerto Rico, Mexico City, Las Vegas and Catalonia -- I have a new-found appreciation for the maxim that when it arrives, change happens quickly -- usually much more quickly than folks ever imagined, catching the general public off-guard and unprepared.

We humans tend to think linearly and comparatively. In other words, we usually assume the near future will look a lot like the recent past. And it does much of the time.

But other times it doesn't. And that's where the danger lies.

The Cruel Math

In 1987 a Danish physicist named Per Bak released a landmark paper introducing the concept of self-organized criticality. Bak observed that complex systems draw stability through an ongoing cycle of corrective collapses that keep the overall system from becoming too over-extended.

His point is best understood by watching a sand pile being formed. The pile rises as more grains of sand are added to it, until it hits a critical mass. At that point, the addition of more sand grains is likely to cause a limited collapse of the pile. The more grains of sand added, the more frequent these localized collapses are:

The key takeaway is that the end result of these collapses is that the overall size and shape of the sand pile as a whole is maintained -- i.e. the smaller corrections are necessary for maintaining the ongoing stability of the larger system (in other words, the sand pile retains a constant shape over time)

Without them, the system would grow unchecked until toppled by other laws of physics, yet at this point the energy displacement of the collapse is so large that the system is destroyed or re-set (in other words, the sand pile would rise in height over time until it collapsed entirely)

In his later 1996 book, How Nature Works, Bak showed how the same rules apply to the complex systems around us -- earthquakes, traffic jams, biological evolution, forest fires, the distribution of galaxies in the universe — and financial markets, too.

His findings are universal to complex systems. Ongoing smaller corrections are necessary for long-term stability of the larger system. And while you can't predict exactly when the next correction will occur, the longer it takes to happen, the larger it will be (as it has more pent-up energy to displace). 

Another way to look at this is: If the smaller corrections don't happen, the system is being set up for a much bigger and more painful collapse in the future.

In many ways, we're seeing this manifest via the rash of recent disasters.

Let's look at hurricanes. 2010-2016 was one of the most mild periods on record when it comes to damaging storms making landfall in the US. For whatever reason, the usual seasonal "smaller corrections" just weren't happening as frequently in the Atlantic.

Bak's work would predict an increasing probability of an unusually busy season of destructive hurricanes to arrive. And, right on cue, 2017 has now been recognized as the 9th most-active Atlantic hurricane season in recorded history (and the season isn't over yet!). Underscoring the point, September 2017 proved to be the #1 single most active month for Atlantic tropical cyclones on record.

Similarly, the US West is coming off of a long stretch of regrettable forestry management practices -- logging large trees, fire suppression, and livestock grazing -- which reduced the natural occurrence and frequency of smaller-scale forest fires that prevented the build up of combustible flora. As a result, the system has become much more vulnerable to unchecked fires -- a situation made worse by the effects of the prolonged recent drought (just as the warmer temperature of the Gulf of Mexico is making hurricanes there more potent). Which is why the American West is experiencing its third most severe fire season in history this year.

Et Tu, S&P?

Don't forget that Bak's rules for complex systems also apply to financial markets.

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