Last week’s letter reviewed and affirmed that the ‘Lacy Hunt Macro’ analytical framework remained worthy of retention within the Circle of Trust. As laid out in the first post of The Worked Shoot, that framework is one of the four analytical pillars which undergird the broader process deployed for this Substack. The last of the four reviewed in that initial letter was ‘Complex Systems,’ with a review of where we stand on that front the topic of this week’s letter.
First a bit of origin story- this topic is one I stumbled across in 2005 while exploring analytical tools to try and navigate what I had concluded in 2001 was likely to be a prolonged period of a secular bear market in US equity markets. From 2001 to 2005, I explored all sorts of frameworks and tools, from Ned Davis’ macro models, to Lowry’s supply and demand-focused technical indicators, etc. I cannot remember who, but I read someone mention complexity and reference Mark Buchanan’s book, Ubiquity: Why Catastrophes Happen, which is a sort of complex systems ‘book for dummies’ like me.
Having never taken a course in physics, the book changed how I interfaced with reality, but also completely altered the way I viewed economics and financial markets. It created a more robust framework with which to analyze cycles and help pull the other pillars together - it became the ‘glue’ so to speak.
The last time this topic was delved into in any depth was in the Where are We in the Process letter from December 29th, 2021. Obviously, a lot has transpired subsequent to that date, but through the lens of complexity, most of it makes sense, in my opinion. If you have not already, I encourage going back and reading that post.
The sandpile model is a relatively simple example to help introduce the basic concepts, and one Buchanan used in his book. Conceptually, I think of the various forms of economic and financial leverage as the ‘grains of sand’ in this domain. It is important to distinguish between economic and financial leverage, in my opinion, with the last two major bear markets offering a contrast.
The 2000-2003 bear market was one of economic leverage. The tech and telecom boom of the 1990’s resulted in massive over-investment and interdependency of those industries. The mania fueled IPO’s which fueled growth, which fueled demand for routers and bandwidth, etc - a feedback loop of exponential growth which created hypercritical and unstable system conditions. That was a sort of economic leverage, as a lot of the economic activity was ‘artificial’ in a sense.
That concept of interdependence is an important one, as complex systems often have hidden interdependencies, or ‘hidden’ in a similar sense to the discussions of Einstein and Schrodinger about a cat.
The 2003-2007 period was one of many financial grains of sand being piled up, with artificially low interest rates serving to feed the leverage beast. What was thought to be ‘contained’ was actually just a symptom of an unstable system and the top of the sandpile beginning to avalanche. There were many hidden interdependencies, both financial and economic, and a rather large avalanche of sand occurred.
What makes the current cycle so alarming to me is the confluence of both financial and economic leverage globally, along with the impact of the pandemic on the sandpile. Each economic block and/or country typically has its own sandpile, or ‘fractals’ within the bigger sandpile.
It is not common for a bunch of these component sandpiles to all reach critical or hypercritical conditions around the same time. The broader system tends to be more robust, as one country reaches a re-normalization when another is in the midst of its own ‘avalanche.’ For example, in 2008 China and India both grew at high single digit rates. In fact, a good chunk of the world economy, or component sandpiles, did not avalanche like the US and much of the west.
The pandemic and related policies served as a sort of sandpile reboot function, as a vast amount of the component sandpiles all synchronized in ‘avalanching’ and then began to pile on new grains of sand at unprecedented rates. Huge government stimulus pulled forward economic activity while financing it via debt. Yes, some sandpiles are more critical than others, but the obvious and hidden interdependencies provide important context to the obvious avalanches unfolding in Europe, China, Sri Lanka, Ecuador, etc.
This synchronization and confluence of both economic and financial leverage suggested to me that the world was entering 2022 in perhaps the most economically and financially unstable condition in modern times. Through the lens of complexity, analogies to 2018 make very little sense. There was no mass synchronization of the component sandpiles, collapsing of global supply chains (another component/fractal complex system), etc., so the Fed ‘pivot’ came amidst completely different conditions and renormalization took place.
Now we have government policymakers and central bankers seemingly ignorant of the importance of viewing the world through the lens of complexity. People running historical backtests to find analogs are seemingly ignorant of the importance of complexity.
The global sandpile reached record heights in 2021 with the component sandpiles synchronized by the pandemic. The subsequent cascading has been occurring for months, yet most remain unaware. With central banks tightening aggressively, what was already likely to be very challenging conditions for renormalization are being made even worse.
Is the cat alive or dead, or both? How about your portfolio and financial security?
Jim Rickards is a big advocate of complexity theory. Read several of his books and watched a good number of interviews. Very entertaining but old school inactionable.