The Truth About “Black Swans”

Why the Impossible Keeps Happening Were you forwarded this email? [Sign-up to The Daily Reckoning here.]( [Unsubscribe]( [Daily Reckoning] The Truth About “Black Swans” - The computers are in charge of your money… - Who’s going to catch a falling knife?… - Then Jim Rickards shows you why “black swan” events are much more common than experts think… Recommended Link [How war impacts the stock market]( Russia's invasion of Ukraine has already sent the stock market down 10%. But that's just the opening act for the new Russia-China Alliance. There's a [major event]( involving China that's heating up... and it could boil over as soon as Augu s t 21st, 2022. [Click Here To Learn How To Protect Your Retirement]( Portsmouth, New Hampshire July 20, 2022 [Jim Rickards]Dear Reader, What investors may not realize is the extent to which investment decisions are now left entirely to computers. I’m not talking about automated trade matching where I’m a buyer and you’re a seller and a computer matches our orders and executes the trade. That kind of trading has been around since the 1990s. I’m talking about computers making the portfolio allocation and buy/sell decisions in the first place, based on algorithms, with no human involvement at all. This is now the norm. Eighty percent of stock trading is now automated in the form of either index funds (60%) or quantitative models (20%). This means that “active investing,” where you pick the allocation and the timing, is down to 20% of the market. Although even active investors receive automated execution. In all, the amount of human “market making” in the traditional sense is down to about 5% of total trading. This trend is the result of two intellectual fallacies. The first is the idea that “you can’t beat the market.” This drives investors to index funds that match the market. The truth is you can beat the market with good models, but it’s not easy. The second fallacy is that the future will resemble the past over a long horizon, so “traditional” allocations of, say, 60% stocks, 30% bonds and 10% cash (with fewer stocks as you get older) will serve you well. But Wall Street doesn’t tell you that a 50% or greater stock market crash — as happened in 1929, 2000 and 2008 — just before your retirement date will wipe you out. But this is an even greater threat that’s rarely considered… In a bull market, this type of passive investing amplifies the upside as indexers pile into hot stocks like, for example, Google and Apple have been. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock. Index funds would stampede out of stocks. Passive investors would look for active investors to “step up” and buy. The problem is there wouldn’t be any active investors left, or at least not enough to make a difference. There would be no active investors left to risk capital by trying to catch a falling knife. Stocks will go straight down with no bid. The market crash will be like a runaway train with no brakes. It comes back to complexity, and the market is an example of a complex system. One formal property of complex systems is that the size of the worst event that can happen is an exponential function of the system scale. This means that when a complex system’s scale is doubled, the systemic risk does not double; it may increase by a factor of 10 or more. This kind of sudden, unexpected crash that seems to emerge from nowhere is entirely consistent with the predictions of complexity theory. Increasing market scale correlates with exponentially larger market collapses. This is the world of automated investing. It will end in disaster. Below, I show you why “black swan” market crashes happen much more often than you might imagine, and why they’re more predictable than you imagine. Read on. Regards, Jim Rickards for The Daily Reckoning P.S. I fear that a [“Financial Fourth Horseman”]( is set to show up in the markets with near mathematical certainty on Ju ly 27 at exactly 2 p .m. Much like the four horsemen in the Book of Revelation, I believe four events are destined to devastate the markets. [And the fourth will take place any day now.]( And once it does, it could mark the beginning of the most significant financial events in our lifetimes. Tragically, it could lead to economic chaos not seen in this country since 1929. To help you prepare, I’m hosting an exclusive online briefing this coming Su nday, Ju ly 24, at 7 :00 p .m. EDT. Registration is simple — click [this link]( and you’re in automatically. My team will send you reminders as we get closer to the date. This is obviously an urgent situation. [Go here now to register.]( Recommended Link [Stunning New Prediction for 2022]( You’re going to want to see this — America’s #1 futurist just came out with a stunning new prediction for what could happen in 2022. And surprise, it’s got nothing to do with Trump. Or trade wars. Or the ongoing gyrations on Wall Street. In fact, this could be your one chance to ignore all that upsetting “fake news”… and get back to the business of getting exceedingly rich instead. [Click Here Now]( The Daily Reckoning Presents: Why the impossible is more common than you think… ****************************** Markets and Black Swans By Jim Rickards [Jim Rickards]I began studying complexity theory as a consequence of my involvement with Long Term Capital Management, LTCM, the hedge fund that collapsed in 1998 after derivatives trading strategies went catastrophically wrong. After the collapse and subsequent rescue, I chatted with one of the LTCM partners who ran the firm about what went wrong. I was familiar with markets and trading strategies, but I was not expert in the highly technical applied mathematics that the management committee used to devise its strategies. The partner I was chatting with was a true quant with advanced degrees in mathematics. I asked him how all of our trading strategies could have lost money at the same time, despite the fact that they had been uncorrelated in the past. He shook his head and said, “What happened was just incredible. It was a seven-standard deviation event.” In statistics, a standard deviation is symbolized by the Greek letter sigma. Even non-statisticians would understand that a seven-sigma event sounds rare. But I wanted to know how rare. I consulted some technical sources and discovered that for a daily occurrence, a seven-sigma event would happen less than once every billion years, or less than five times in the history of the planet Earth! I knew that my quant partner had the math right. But it was obvious to me his model must be wrong. Extreme events had occurred in markets in 1987, 1994 and then 1998. They happened every four years or so. Any model that tried to explain an event as something that happened every billion years could not possibly be the right model for understanding the dynamics of something that occurred every four years. From this encounter, I set out on a 10-year odyssey to discover the proper analytic method for understanding risk in capital markets. I studied physics, network theory, graph theory, complexity theory, applied mathematics and many other fields that connected in various ways to the actual workings of capital markets. In time, I saw that capital markets were complex systems and that complexity theory, a branch of physics, was the best way to understand and manage risk and to foresee market collapses. I began to lecture and write on the topic including several papers that were published in technical journals. I built systems with partners that used complexity theory and related disciplines to identify geopolitical events in capital markets before those events were known to the public. Finally I received invitations to teach and consult at some of the leading universities and laboratories involved in complexity theory including Johns Hopkins University, Northwestern University, The Los Alamos National Laboratory and the Applied Physics Laboratory. In these venues, I continually promoted the idea of interdisciplinary efforts to solve the deepest mysteries of capital markets. I knew that no one field had all the answers, but a combination of expertise from various fields might produce insights and methods that could advance the art of financial risk management. I proposed that a team consisting of physicists, computer modelers, applied mathematicians, lawyers, economists, sociologists and others could refine the theoretical models that I and others had developed and could suggest a program of empirical research and experimentation to validate the theory. These proposals were greeted warmly by the scientists with whom I worked, but were rejected and ignored by the economists. Invariably top economists took the view that they had nothing to learn from physics and that the standard economic and finance models were a good explanation of securities prices and capital markets dynamics. Whenever prominent economists were confronted with a “seven-sigma” market event they dismissed it as an “outlier” and tweaked their models slightly without ever recognizing the fact that their models didn’t work at all. Recommended Link [Biden Just Signed Death Warrant On Your Freedom]( [Read more here...]( If Biden’s Executive Order 14067 comes to pass, a former advisor to the CIA and Pentagon is predicting legal government surveillance of all US citizens; total control over your bank accounts and purchases; and indefinite Democrat control past 2024. He says Covid was a trial run for how to control a population. Dems will use their “pandemic playbook” to silence any dissent. See exactly what to do before it happens. [Click Here ASAP]( Physicists had a different problem. They wanted to collaborate on economic problems, but were not financial markets experts themselves. They had spent their careers learning theoretical physics and did not necessarily know more about capital markets than the everyday investor worried about her 401(k) plan. I was an unusual participant in the field. Most of my collaborators were physicists trying to learn capital markets. I was a capital markets expert who had taken the time to learn physics. One of the team leaders at Los Alamos, an MIT-educated computer science engineer named David Izraelevitz, told me in 2009 that I was the only person he knew of with a deep working knowledge of finance and physics combined in a way that might unlock the mysteries of what caused financial markets to collapse. I took this as a great compliment. I knew that a fully developed and tested theory of financial complexity would take decades to create with contributions from many researchers, but I was gratified to know that I was making a contribution to the field with one foot in the physics lab and one foot planted firmly on Wall Street. My work on this project, and that of others, continues to this day. This approach stands in stark contrast to the standard equilibrium models the Fed and other mainstream analysts use. An equilibrium model like the Fed uses in its economic forecasting basically says that the world runs like a clock. Every now and then, according to the model, there’s some perturbation, and the system gets knocked out of equilibrium. Then all you do is you apply policy and push it back into equilibrium. It’s like winding up the clock again. That’s a shorthand way of describing what an equilibrium model is. Unfortunately, that is not the way the world works. Complexity theory and complex dynamics explain it much better. Distress in one area of financial markets spread to other seemingly unrelated areas of financial markets. In fact, the mathematics of financial contagion are exactly like the mathematics of disease or virus contagion. That’s why they call it contagion. One resembles the other in terms of how it’s spread. What are examples of the complexity? One of my favorites is what I call the avalanche and the snowflake. It’s a metaphor for the way the science actually works but I should be clear, they’re not just metaphors. The science, the mathematics and the dynamics are actually the same as those that exist in financial markets. Imagine you’re on a mountainside. You can see a snowpack building up on the ridgeline while it continues snowing. You can tell just by looking at the scene that there’s danger of an avalanche. You see a snowflake fall from the sky onto the snowpack. It disturbs a few other snowflakes that lay there. Then the snow starts to spread… then it starts to slide… then it gains momentum until, finally, it comes loose and the whole mountain comes down and buries the village. Some people refer to these snowflakes as “black swans,” because they are unexpected and come by surprise. But they’re actually not a surprise if you understand the system’s dynamics and can estimate the system scale. Question: Whom do you blame? Do you blame the snowflake, or do you blame the unstable pack of snow? I say the snowflake’s irrelevant. If it wasn’t one snowflake that caused the avalanche, it could have been the one before or the one after or the one tomorrow. The instability of the system as a whole was a problem. So when I think about the risks in the financial system, I don’t focus on the “snowflake” that will cause problems. The trigger doesn’t matter. In the end, it’s not about the snowflakes; it’s about the initial critical-state conditions that allow the possibility of a chain reaction or avalanche. Are you prepared for the next avalanche? Regards, Jim Rickards for The Daily Reckoning P.S. I fear that a [“Financial Fourth Horseman”]( is set to show up in the markets with near mathematical certainty on Ju ly 27 at exactly 2 p .m. Much like the four horsemen in the Book of Revelation, I believe four events are destined to devastate the markets. [And the fourth will take place any day now.]( And once it does, it could mark the beginning of the most significant financial events in our lifetimes. Tragically, it could lead to economic chaos not seen in this country since 1929. To help you prepare, I’m hosting an exclusive online briefing this coming Su nday, Ju ly 24, at 7 :00 p .m. EDT. Registration is simple — click [this link]( and you’re in automatically. My team will send you reminders as we get closer to the date. This is obviously an urgent situation. [Go here now to register.]( --------------------------------------------------------------- Thank you for reading The Daily Reckoning! We greatly value your questions and comments. Please send all feedback to [feedback@dailyreckoning.com.](mailto:dr@dailyreckoning.com) [James Rickards][James G. Rickards]( is the editor of Strategic Intelligence. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. 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