Self Organized Criticality And How It Applies To Markets

In their recent episode of the VALUE: After Hours Podcast, Taylor, Brewster, and Carlisle discussed Self Organized Criticality And How It Applies To Markets. Here’s an excerpt from the episode:

Jake Taylor:
Yeah, sure. So there’s this Danish theoretical physicist whose name is Per Bak, shortest name on record I think. It’s only six letters total, but that’s great. So he has this this famous thought experiment where you imagine this hand of God that is full of sand and it’s dropping down a one little grain at a time into a pile, and it forms this one pile.

Jake Taylor:
And each sand particle will then trigger some level of an avalanche. Typically it’s a small, almost unnoticeable little bit of slide, but every once in a while there’ll be a really big slide and we never know what the grain of sand is it’s going to be. And what this was trying to explain was a couple things.

Jake Taylor:
One, is what they called self-organized criticality. So this thing has its own, separate from the grain of sand, it has its own characteristics that play out. The grain of sand is the cause, but the interaction between the sand is what actually is the emergent phenomena that we’re looking at there.

Jake Taylor:
So what’s interesting about this is that if you plot out the avalanches, it follows that familiar power-law curve where you have a lot of small outcomes and then the occasional very large outcome. And what the difference between a Gaussian distribution, a normal distribution, and a power-law distribution is, take something like height which is a normal distribution.

Jake Taylor:
The more data that you gather on it, the more the estimate gets accurate. But in a power-law like these avalanches, the more that you add, the more estimates that you add, actually the bigger the things that you can measure become. Like you start catching these very, very rare events that happen.

Jake Taylor:
So everyone’s pretty familiar with this idea already. Here’s what’s interesting that I found when I went back and read the original stuff on this. In that analogy all along there was a table that the grains of sand were falling onto, and in my mind I never thought about this before, I never put a table underneath the pile of sand, but in his original construction that’s what it was.

Jake Taylor:
So the size of the avalanches are completely dictated by the size of the table, so the bigger you make the table, the less large avalanches that you’ll have. But then when you do have the big avalanche it will be even bigger than anytime with a smaller table. Does that make sense?

Tobias Carlisle:
You might have to run that by me one more time.

Jake Taylor:
Okay. Imagine a very small table you’re pouring sand onto. When it eventually falls onto the floor it’s going to be a smaller amount of sand.

Tobias Carlisle:
Okay.

Jake Taylor:
Imagine a very large table you can really pile that table up-

Tobias Carlisle:
Okay, I got it.

Jake Taylor:
… and eventually it crashes. Well, my insight was that what if really the Fed is really just a table and it’s trying to make itself bigger and bigger, but really all it’s doing is making the eventual sand pile avalanche that happens be a bigger disaster to deal with.

Tobias Carlisle:
I like that analogy. Bob Seawright wrote an article that came out a few years ago that I grabbed some of for a Forbes article called What To Do When The Market Punches You In The Mouth? Regrettable title, because I’ve discovered since that that gets used all the time. It’s based on that Mike Tyson quote, “Everybody got a plan until they get punched in the mouth.”

Jake Taylor:
Spot on impersonation.

Tobias Carlisle:
Yeah, thank you. He makes the great point that the ’87 crash, everybody thinks of that as program trading, there was a whole lot of futures used to hedge the market and then when the market went down hedging in the futures created this cascade of selling. They interviewed Michael J. Fallon, who was the president of the NYC, and he gave a list of five things.

Tobias Carlisle:
And fifth on his list was futures trading, he didn’t think it was particularly significant. The only point is that it’s just one of those phenomena that you can’t predict, but after it happens we want to stick a reason to why it happens. I kind of think this time around it’s just one of those… we hadn’t had a crash for a long time.

Tobias Carlisle:
I don’t know what the root cause of that was. Possibly that’s Fed pinning the rates so low for so long, having QE going on and on, values just getting dislocated from underlying, or price is getting dislocated from the underlying values. Chris Cole uses the analogy of the redwoods. You have to burn back the tender of the redwoods otherwise if you don’t do that and you just let the tender grow, you get these explosive wildfires that come through every five or 10 years.

Tobias Carlisle:
And so if you don’t have little crashes, you get much bigger crashes. So I think that that makes sense that if you eliminate that possibility for a little crash, which gives everybody… If you think that the market could crash, you probably carry a little bit more cash rather than running levered, what do you call that? Acquisition, the N+1 strategy all the time. I think it’s an interesting theory.

Jake Taylor:
Bill?

Bill Brewster:
I don’t know. I don’t know what I have to add to this. I mean the Fed would not be doing what they’re doing if it didn’t have any impact, right? But I’m not well-versed enough to know how the balance sheet expanded and contracted relative to the overall size of the market over the last 10 years.

Bill Brewster:
I know they’ve been active way way longer than I thought they would be and I don’t suspect that they’re just going to exit the market once, I don’t know, say in June or July. That said, I do understand from a policy standpoint coming in to stabilize the market here, and I mean I think we got enough shit to worry about.

Bill Brewster:
I’m not sure that right now is the time to go full hands-off and just let the market… I mean you’ve got a natural demand shock, you’ve got oil supply shocks, if we don’t try to at least stabilize the market, I mean you’ve got the real potential for real true systemic risk, and I think that they’re trying to prevent that right now.

Bill Brewster:
Now whether or not they can, I don’t think that we’re going to get to the end of this, and these bailouts or whatever just means that equity is going to be fine. I mean companies are going to be screwed and if over the next 12 months we try to stave off bankruptcy just by continually bailing people out, then from a policy perspective I’d be much more worried.

Bill Brewster:
This to me seems like, or a lot of what I see going on, and I don’t know all of it, but seems to be solving for a liquidity problem, which is short term.

Jake Taylor:
I don’t think that my argument would be that the last month’s worth of activity was necessarily the problem. It was the 10 years before that, that made a pretty big ass sand pile, and the table did not shrink at all in that time period enough to make the smaller shocks… I mean you could just look at the VIX as a sort of a proxy for how much disturbance have we had over the last 10 years, and it was nothing. It’s been historically incredibly low.

Tobias Carlisle:
Why not take that opportunity to raise rates and switch off the QE or all of that stuff?

Jake Taylor:
Shrink the table a little bit.

Tobias Carlisle:
Yeah. I mean what is the function of the Fed if it’s not supposed to be acting as that counterweight to all of that?

Jake Taylor:
The adult in the room.

Tobias Carlisle:
Yeah, I mean there’s a lot of fiscal priming going on. That would have been a good opportunity, you would think, to kind of pull back a little bit on the monetary, see how high you can get those rates.

Bill Brewster:
The thing that is tough for me to reconcile mentally right now, is they started to do that, and on December 21st, 2018, the SMP was at $240 per share.

Tobias Carlisle:
This is SPY.

Bill Brewster:
Yeah. And now we’re looking at just a massive, massive economic problem, and we’re at 283 a share, and the reason is policy response, but you’re really just… I mean let’s say the Fed can do everything that they want, they’re not getting the spreads back to where they were in December, right? Like spreads have blown out a little bit, and the the fiscal stimulus-

Tobias Carlisle:
High yield spreads, is what you’re talking about there?

Bill Brewster:
I think generally even [crosstalk 00:12:00]-

Tobias Carlisle:
Every spread.

Bill Brewster:
… I think are a little bit wider. And then like even the fiscal stimulus, you’re just catching up. I mean you’re replacing stuff. It’s not stimulus, it’s just plugging a freaking hole. So I don’t understand, the bullishness right now is a bit confounding to me on a market level, like market wide basis.

Tobias Carlisle:
Do you see anybody out there who is like, “This totally makes sense to me? I fully expected a bottom on March 23, and then just rocket to the new all-time highs.” Do you talk to anybody who who’s like, “This is what I thought was going to happen?”

Bill Brewster:
Only people that are full of shit.

Tobias Carlisle:
Yeah, if people who are telling you that’s what they did on March 23.

Bill Brewster:
I think it’s funny. Real quick, I think something that’s funny is you’re starting to see hedge fund letters that used to tout performance that are now talking macro and it’s like, “Oh, interesting how you’re hiding.”

Tobias Carlisle:
There’s a good question up on the screen. You guys can’t see it.

Jake Taylor:
50 Pages epidemiology instead of the returns.

Tobias Carlisle:
There’s a good question up on the screen-

Bill Brewster:
That would be one that I was thinking of.

Tobias Carlisle:
… “Do you guys think the Fed even matters if you’re a micro economic business oriented investor? Isn’t the important thing just competitive advance and execution?” That’s kind of the point that you’re making a little bit, isn’t it Bill? You’re just like, “Just ignore it. It’s out of your control, just keep on functioning.”

Bill Brewster:
Yeah, I mean it 100% matters. I mean if you have debt markets that completely lock up, then all of your fundamental analysis changes. But, yes, I do think that focusing on what the business is more likely to look at is where I spend more of my time.

Tobias Carlisle:
I mean some of the Fed actions are just the Feds going to do what the Feds going to do. I personally disagree with them, but who cares? I have to go in there and do what I always do. Actually it doesn’t really change anything that I do. All I do is I come on podcast and kind of whinge about it.

Jake Taylor:
Bitch about it, yeah.

Bill Brewster:
I mean, look, if they’re compressing yields and you’re buying assets, I think you have to at least think a little bit about whether or not you’re paying what would be a fair price or whether or not it’s manipulated. But we live in the world we live in, I don’t see them going away any time, so what’s manipulated vs. theoretically right, I don’t know. That gets into stuff that’s just too hard for me.

Jake Taylor:
Yeah, it does matter though, right? I mean it hugely impacts most of the valuations you’re looking at. Pricing I mean, not valuations. But valuations as well.

Tobias Carlisle:
Well, it affects valuations.

Bill Brewster:
Yes, valuation.

Tobias Carlisle:
I can get a fixed valuation.

Bill Brewster:
100% it does.

Tobias Carlisle:
This stuff is all just too hard for me, it just breaks my brain when I think about it. But the level of government debt, that was once the concerning metric. That was something that people used to talk about a bit, and Ken Rogoff did that study where he said there’s a tipping point where you get too much debt, your currency and your government collapses, or your currency at least collapses.

Tobias Carlisle:
You can’t raise money through debt anymore for an extended period of time, but then somebody found that he’d hard coded one of the cells in his spreadsheet, and Krugman came out and dunked on him pretty hard, and that argument kind of just went away. But I just can’t see how it doesn’t matter.

Tobias Carlisle:
We’ve seen credit crisis in our lifetimes, like in other countries. Clearly it happens all the time.

Bill Brewster:
Yeah, well, I mean the whole process has made me super grateful in a lot of ways. I think you look at the death numbers and it’s a testament to what the United States can accomplish when we work together, and that’s pretty freaking awesome considering that it was sort of more of a decentralized plan than I thought that it would be. But man, the ability to have your own reserve currency right now, I mean you got to protect that.

Jake Taylor:
Are you talking about Bitcoin?

Bill Brewster:
Yeah, that too.

Jake Taylor:
Okay, sorry.

Bill Brewster:
But it gives a lot of options that emerging markets just aren’t going to have. I mean imagine being in Argentina right now with what they had going on going into this shit, and then they’re going to have to stop their economy for a little while. I mean, man…

Jake Taylor:
And pay back dollars.

Bill Brewster:
Yeah, dude, that is going to be brutal. So I don’t know.

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