Chaos Theory, and Other Comforting Topics.

April 4, 2011

Major market indices were higher last week. The DJIA gained 3.05%, the S&P 500 rose 2.70%, and the Nasdaq jumped 3.76%. Growth stocks outperformed value stocks. And the small cap index climbed 3.67%. The 10-Treasury yield closed 17 basis points higher at 3.44%.
The stock market is what physicists call an "unstable system." Like the physical world, the capital markets demonstrate "unstable aperiodic behavior in deterministic nonlinear dynamism."
In other words, you never know what will transpire next.
Consider The Butterfly Effect. Small changes in existing conditions result in dynamic and far flung outcomes within chaotic systems. A pipeline blows up in the Nigerian Delta. The price of oil rises. This negatively impacts U.S. consumer spending. Slows U.S. economic growth. Corporations lower expectations. And Uncle Harry gets laid off.
All of which is nearly impossible to forecast.
According to Chaos Theory, unstable systems never precisely repeat themselves. There may be discernible patterns, but there are so many variables left to chance that nearly anything can happen over time.
Bear markets lead to bull markets which eventually reverse themselves. Meanwhile, prognosticators of both the bullish and bearish persuasion speculate incessantly on what lay around the next curve in the road.
The media pundocracy opines on everything from radiation levels in Northern Japan to the impact of weather patterns on the Brazilian sugar cane harvest. Coincidentally, individual and institutional investors seek to determine what deserves a tactical response, and what should be filed away for later consideration.
All the while, markets move in directions that baffle the most seasoned global investors. Up, when it should head down. Down, when it should head up. Sideways, when the status quo is anything but the most logical direction.
Drastic, perpetual outperformance is the pipedream of amateur day traders who have just opened their first account and approach market timing like sports handicapping. Both of which tend to go poorly, over time.
To be a successful investor, you need not outperform every quarter. Perhaps you hope to outperform half the time, and then merely keep pace. In so doing, you manage to do that which so very few have been capable of: provide a consistent risk-calibrated return on investment over a market cycle.
But, Mr. Market will not cooperate.
Malignant weather patterns will destroy sugar cane crops in Brazil and India-just when you felt bullish. Earthquakes occur. Wars unfold. Energy costs fluctuate. Many of the variable upon which you counted will change. Often.
And so, you remain flexible. Open minded. Aware of the trends. Yet, cognizant of the possibility for interruption.
Many of the economists and strategists we respect feel that the global economy appears to be in a "pretty decent" position over the next six months. But "pretty decent" does not a good night's sleep make.
Accordingly, as employment strengthens and 4Q GDP is revised upward, Fed officials begin to question the need for a continuance of the highly accommodative credit programs as QE2 expires in June. While that underscores their confidence in the domestic economic situation, the end of easing would not be a net positive for the markets.
Last week saw the S&P 500 climb back above the crucial 1,300 level. For bulls to prevail, it will have to hold that for the next week, forcing the bears into a bout of short covering. So pushing the market higher still.
Yet, there remain many forces at play that could quickly drag markets lower.
Even as stocks sailed higher last week, the winds of war, political upheaval and economic uncertainty continued to break the surface. Much like the dorsal fins of dolphins, roiling the ocean's surface as they swim just out of sight. It is only a matter of time until they jump and break, spectacularly, upon the horizon, only to peak, fall and crash again into the sea.
So many variables and possible outcomes. But the current and long-term trends remain upward. Stay tuned...

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