"A similar effect is taking place in economic life. I spoke about globalization in Chapter 3; it is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are now interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks (often Gaussianized [bell curve] in their risk measurement)-when one falls, they all fall.

The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur...I shiver at the thought. I rephrase here: we will have fewer but more severe crises. The rarer the event, the less we know about its odds. It means that we know less and less about the possibility of a crisis." (Nicholas Nassim Taleb, The Black Swan, p. 225, probably and presciently written last year.)

How predictable was the current turmoil in the market one year ago? Six months ago? On one level, it was not all that hard to see that that there were going to be problems in the subprime mortgage market, especially in the BBB tranches (or portions) of Mortgage Backed Securities which were rolled up together into Collateralized Debt Obligations and given AAA ratings. Saying that there would be massive losses distributed throughout thousands of institutional portfolios was almost a given. I was not the only one writing about the problems that awaited us.

But it is one thing to predict a problem, and quite another thing to understand its full implications in the market. This week we talk about how these events in general come about and end up speculating how we get back to "normal" market conditions. Plus I look at the probability of the Fed cutting rates and speculate that they will eventually lower them much more than we now think.

The Black Swan

Last week, seemingly so long ago and so far away, I was wondering through St. James Park in London. It was a perfect afternoon in a perfect park, with willow trees reflecting on the pond and the Eye of London in the distant background. And then there it was. It swam into my vision. A black swan. A rather inelegant bird when compared to its august white brethren, but recognizable as a swan nonetheless. Seeing a black swan seemed to cap off the day, as I had just finished reading a book whose title was inspired by the dark fowl.

Just because all the data says that there are only white swans does not prove that black swans do not exist. All we can confidently assert is that no one has seen one - yet. To prove that a black swan does not exist would take an infinite number of observations, and yet only one observation is needed to prove they exist. And thus philosophers debated the black swan issue and showed that by induction you could reason they did not exist.

And that was the case until explorers did indeed find a black swan in Australia. The term "black swan" has come to mean an event or discovery whose existence was not predictable from the available data, and whose effect on society or the markets yields surprising and unexpected results. (And just to note at the beginning, not all black swans are bad. Sometimes they are very good, even if a surprise.)

I had been saving Nassim Taleb's latest book, "The Black Swan - The Impact of the Highly Improbable," to read on my summer vacation. Glancing through the book when I first got it assured me that I wanted to give the book more than a quick read. I was not disappointed. You can quibble over various points in the book (and I may at some point), or not like his confrontational style, but this is a book that demands to be consumed slowly and thoughtfully.

The Black Swan took me several times longer to read than normal. Not because it is not easy or fun to read (Taleb can be quite humorous), but because I had to regularly stop and think (and often to re-read several times) about what he was saying. I rarely read a book twice. So many books, so little time. Generally, I mark it up and return to important sections if I need to. This is one book that I will definitely read more than once. Let me strongly suggest you get the book and set aside some time to read it. You can get it at www.amazon.com.

Mediocristan Versus Extremistan

Taleb attacks (the correct word) the social sciences (in particular economics) which uses standard Gaussian bell curves to "prove" their points. Everything has to fit within the curve. There is little room in the neat world of the bell curve for events that are far from the center. He creates a world he calls Mediocristan which is the world of white swans, bell curves and predictability. He contrasts this with Extremistan which is the world of chaos, fractal geometry, power laws, black swans and where the unpredictable happens.

There are parts of our lives which inhabit Mediocristan and parts which dwell in Extremistan. Not knowing the difference can be problematic, if not fatal. And it is difficult to know where one country starts and the other ends. If you are in Mediocristan, then you can use your bell curve assumptions without fear. But if you wander into the murky border areas, you are no longer safe in your assumptions. And yet, the longer and deeper you go into Extremistan without a problem, thinking you are safe in Mediocristan, the larger the disruption is likely to be. Let look at a few quotes and some of his ideas here and there before we look the most recent eruption of a black swan:

"To summarize, in this (personal) essay, I stick my neck and make a claim, against many of our habits of thought, that our world is dominated by the extreme, the unknown, and the very improbable (improbable according our current knowledge) - and all the while we spend our time engaged in small talk, focusing on the known, and the repeated. This implies the need to use the extreme event as a starting point and not treat it as an exception to be pushed under the rug. I also make the bolder (and more annoying) claim that in spite of our progress and the growth, the future will be increasingly less predictable, while both human nature and social "science" seem to conspire to hide the idea from us. (Prologue xxvii)

"When I ask people to name three recently implemented technologies that most impact our world today, they usually propose the computer, the Internet, and the laser. All three were unplanned, unpredicted, and unappreciated upon their discovery, and remained unappreciated well after their initial use. They were consequential. They were Black Swans. Of course, we have this retrospective illusion of their partaking in some master plan. You can create your own lists with similar results, whether you use political events, wars, or intellectual epidemics.

"You would expect our record of prediction to be horrible: the world is far, far more complicated than we think, which is not a problem, except when most of us don't know it. We tend to "tunnel" while looking into the future, making it business as usual, Black Swan-free, when in fact there is nothing usual about the future. It is not a Platonic category!" (p. 135)

I think there is a physical reason that Taleb is right in that we will see more unpredictability I the future than we saw only a few hundred years ago, or even last century, as wild as that century was. I wrote a few years ago of Ray Kurzweil's book, The Singularity is Near. (Also very highly recommended - www.amazon.com). Ray wrote (in 2000) that the pace of change as encompassed by technology is accelerating.

"The first technological steps - sharp edges, fire, the wheel - took tens of thousands of years. For people living in this era, there was little noticeable technological change in even a thousand years. By 1000 A.D., progress was much faster and a paradigm shift required only a century or two. In the nineteenth century, we saw more technological change than in the nine centuries preceding it. Then in the first twenty years of the twentieth century, we saw more advancement than in all of the nineteenth century. Now, paradigm shifts occur in only a few years time. The World Wide Web did not exist in anything like its present form just a few years ago; it didn't exist at all a decade ago.

"The paradigm shift rate (i.e., the overall rate of technical progress) is currently doubling (approximately) every decade; that is, paradigm shift times are halving every decade (and the rate of acceleration is itself growing exponentially). So, the technological progress in the twenty-first century will be equivalent to what would require (in the linear view) on the order of 200 centuries. In contrast, the twentieth century saw only about 25 years of progress (again at today's rate of progress) since we have been speeding up to current rates. So the twenty-first century will see almost a thousand times greater technological change than its predecessor."

What Ray is saying is that most people project future growth in technology at today's rate of change. But the rate of change is accelerating, so that more and more change is packed into smaller and smaller amounts of time. While the vast majority of the thousand times greater technological change Ray is talking about happens in the last part of this century, some of it happens in the next twenty years. How much change are we talking about? Well, from when he first penned those words, the pace of change has picked up. At current levels, that means the 20th century was equivalent to about 20 years of progress at today's rate of change. That pace will continue to increase the amount of innovation we pack into just a few years. From his book Fantastic Voyage:

"...And we'll make another 20 years of progress at today's rate [of growth], equivalent to that of the entire 20th century, in the next fourteen years. And then we'll do it again in just seven years."

That means in the next 21 years we will see double the technological change that we saw in the entire 20th century. At that pace, we will see almost four times the rate of change within 25 years.

But that is just technology. There are also profound and rapid changes happening in the world of finance. Only a few decades ago, there was only a relatively small amount of derivatives in the world as compared to the totality of human commerce. Today we have a reported $450 trillion in derivatives. For us to think that such a thing can come about and not add to the unpredictable nature of the world is not realistic.

George Friedman of Stratfor points out (in a manuscript I just read for his new book, due out soon, we hope) that as humans we are dismal at projecting the future in a geo-political sense. Think about the beginning of every decade of the last century. Then move forward 20 years. Who got any prediction right? Did anyone see World War 1 in 1900 or even 1910? The rise of Germany and Hitler in 1920? The collapse of Russia in 1980? The rise of radical Islam in 1987? A war in Iraq in 2000?

And yet, we assume that the world of 2017 or 2027 will be not all that much different than today. But the only truly safe bet is that it will be radically different in ways that we cannot imagine.

As an illustration of the wildly unpredictable, I read this week (via Bill King) of a new discovery. "An Erie cancer researcher has found a way to burn salt water, a novel invention that is being touted by one chemist as the 'most remarkable' water science discovery in a century. John Kanzius happened upon the discovery accidentally when he tried to desalinate seawater with a radio-frequency generator he developed to treat cancer. He discovered that as long as the salt water was exposed to the radio frequencies, it would burn." http://www.breitbart.com/article.php?id=D8RIRI600&show_article=1

Dr. Roy Rostrum, a Penn State University chemist with a serious pedigree, reproduced the experiment. The process seems to release hydrogen. Apparently it takes more energy to do so than is released, so it is not perpetual motion. Will this lead to anything? Who knows? But there are scores of such random discoveries each year, all with wild unpredictability attached to theme. And as we increase the number of researchers and scientists and garage tinkers in the world, we should expect and will have even more unpredictability.

But this is all hard for us to get our head around. Living in such a rapidly changing world is psychologically difficult. So we resort to trying to simplify things. Returning to Taleb:

"We, members of the human variety of primates, have a hunger for rules because we need to reduce the dimension of matters so they can get into our heads. Or, rather, sadly, so we can squeeze them into our heads. The more random information is, the greater the dimensionality, and thus the more difficult to summarize. The more you summarize, the more order you put in, the less randomness. Hence the same condition that makes us simplify pushes us to think that the world is less random than it actually is." (p.69)

And that tendency lulls us into complacency. And that eventually results in a "Minsky Moment." Hyman Minsky famously stated that stability produces instability, and that the longer things are stable, the greater the instability that will result, precisely because we are unprepared for it.

When "Because" Isn't Enough

Having seven kids, I have answered more than a few hundred questions with the brilliant "because such and such." The younger kids will sometimes even accept such answers, when a true skepticism would be more in order.

I admit to sometimes giving in to such a rationale today. I, along with my fellow humans, like causality. B happens because of A. And it is tempting to ascribe a simple because to today's black swan in the credit markets. It is all the fault of the subprime mortgage lenders. If they had not made bad loans we would not have the problem.

I would suggest that the problem is more systemic than that. Assume that we had the rational laws in place five years ago that we will enact next year preventing bad mortgage underwriting. Then there would have been excess and a bubble in some other part of the markets at some other point in time. As humans, that is what we do. We push the limits of greed, especially when accompanied by the illusion of stability, until the bubble bursts.

Sometimes the "because" is a synergy of multiple events. The internet is not possible without multiple inventions. It was around for 20 years before it began its rather meteoric rise in the late 80s. There is no simple because, but the implications and the unpredictability of the results were not clear in 1987 to all but a few wild-eyed, and generally considered crazy, individuals.

"This in itself greatly weakens the notion of "because" that is often propounded by scientists, and almost always misused by historians. We have to accept the fuzziness of the familiar "because" no matter how queasy it makes us feel (and it does make us queasy to remove the analgesic illusion of causality). I repeat that we are explanation-seeking animals who tend to think that everything has an identifiable cause and grab the most apparent one as the explanation. Yet there may not be a visible because; to the contrary, frequently there is nothing, not even a spectrum of possible explanations. (p. 119)

Gliding Into Disorder

But all is not that bad. We tend to think of Black Swans as bad events. But as noted above, there are good black swans which positively impact human existence. And Taleb himself sees a glimmer of the positive:

"We are gliding into disorder, but not necessarily bad disorder. This implies that we will see more periods of calm and stability, with most problems concentrated into a small number of Black Swans." (p. 225)

It is easy to take the credit disruptions of today and straight line the present into the future. But it might be more useful to see how the previous black swans of financial disruptions were dealt with.

Let's look at 1987, 1998 and 2000. All three periods had rather solid US economies. All three had rather significant disruptions. And all three saw the Fed open the liquidity flood gates.

You can expect the same today. As I have often written, when the Fed embarks upon a new course, they will go further and the course will last longer than anyone thought at the beginning of the process. Who thought when the Fed began to loosen monetary policy in early 2001, when rates were 6.25%, that we would see 1% within a short period of time? And who thought it would stay that way for so long? And when they began tightening again? Who thought it would get to 5.25%? Back then, 4% seemed like a very high rate.

Right now, the market is pricing in rate cuts of 75 basis points by the end of the year and another 25 basis points within 12 months. I think that is low. If the Fed is cutting, it is because they see the economy weakening. And I think that means they will cut more than anyone expects. What is the end number? I don't know. But I bet it is a lot lower than 4.5%.

Why? Because the credit markets are going to take a lot longer to sort out the mortgage problems than we might think. And that means that a lot of homes are not going to move for some time, which is not good for consumer sentiment or spending. And there will be substantially less mortgage equity withdrawal. As home prices drop 10% and then 15% and then 20%, boomers are going to realize that a large part of what they thought they had for retirement in the equity of their homes is not there. That means they need to spend less and save more. While that is good as an individual policy, it is rough on the economy at large. I still think this process ends in a recession.

But John, (I hear you ask) if the Fed cuts rates, won't that make mortgages cheaper? The answer is that for conforming loans it will. But right now, if you want a home with a loan larger than $417,000, you are looking at interest rates as high as 9%, even with excellent credit. And if you have poor credit? There are no subprime loans for you, without substantial down payments.

The problem, as I repeat, is not the availability of liquidity. It is the lack of credibility. No one is buying paper they are not absolutely 100% sure about. And until a new mechanism is developed that will allow for transparency in the mortgage markets which will then allow for the securitization process to being again, it is going to be tough to get a mortgage for someone who does not fall with the confines of conforming loans (for foreign readers, those are agency loans made by quasi government agencies like Fannie Mae which have the implicit backing of the US government.)

It will take some time, but the current disorder will again become order and the process will begin again, with a bubble happening in some other market which will eventually come undone and create a new black swan event.

(And yes, the implications of lower rates means a lower dollar and thus higher gold.)

And let's end with a great quote from Taleb, which is not exactly on point, but is a great quote nonetheless.

"We humans are the victims of an asymmetry in the perception of random events. We attribute our success to our skills, and our failures to external events outside our control, namely to randomness. We feel responsible for the good stuff, but not for the bad. This causes us to think that we are better than others at whatever we do for a living. Ninety-four percent of Swedes believe that their driving skills put them in the top 50 percent of Swedish drivers; 84 percent of Frenchmen feel that their lovemaking abilities put them in the top half of French lovers." (p. 152)

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. Contact John at John@FrontlineThoughts.com.

Disclaimer
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.