(This is Part 6 of a series. Go back to Part 5.)
In general, we humans—perhaps all sentient beings in the universe—seem to take the view that if something hasn't happened yet, it won't. The danger signs are everywhere, from more violent hurricanes to the unfathomable global debt structure to the skyrocketing price of fossil fuels to the melting of the polar icecaps.
In the face of these oncoming hurricanes, complacency seems to reign. And not just complacency, but extreme complacency. We step outdoors, it's a nice sunny day, everything seems to be normal—what's the problem? No need to listen to Cassandras and worryworts.
A few engineers and officials tried to warm that the levees in New Orleans weren't prepared for a Category 4 storm, but these warnings went unheeded. Life went on. A major hurricane had never struck New Orleans before—why should one do so this season? Besides, if one does strike we'll muddle through it somehow.
There are a number of dedicated people trying to warn about ecological catastrophe now, but the vast majority of us are still ignoring it. We read isolated stories—"Wild tigers will be extinct in 20 years" or "The Amazon is receding" or "Underground aquifers are being depleted" and so on, but it's not yet obvious to connect the dots and realize that nothing less than the viability of life on earth is at stake—and with it the fate of the human race.
This complacency is most easily measured in the financial arena, where statistics are a way of life. For instance, let me tell you about the stock market:
Even though the S&P 500 (the standard measure of the U.S. stock market) has only recovered 62% of its all-time high in 2000, bullish sentiment now is higher than it was then. Everybody has learned by now to buy on the dips. And everybody knows that "over the long haul the stock market gains 9% a year."
In fact, there's an indicator called the VIX which actually measures complacency in the stock market. The lower this index is, the more complacency there is about the market. The lower it is, the less investors are concerned about a stock market decline.
And where is the VIX now? Well, it's close to the lowest levels ever recorded. Hmm, that's interesting.
Then we might look at mutual fund cash levels: The more bullish mutual funds are, the more fully invested they are and thus the lower their cash levels are. It is a contrary indicator: Low cash levels are historically found at major market tops and high levels at major market bottoms.
The mutual fund cash level is kind of a complacency measure itself, since low levels of cash mean less and less money is being held in reserve for a financial panic or a major bear market. And where is the mutual fund cash level now? Well, let's see, at 3.9% it just happens to be the lowest in history.
Complacency reigns. Housing prices rose 13% nationally last year (far above the growth in incomes), and surveys have shown that the public expects real estate to rise a wholly unrealistic 15-20% annually. It's striking that such expectations mirror the expectations that existed about tech stocks just before the Nasdaq began a crash in 2000 that took it down some 76% so far.
Complacency also reigns among bond investors. The spread between the interest rate on U.S. Treasury Bonds —still considered the safest in the world—and the interest rate on the bonds of an emerging market is called the
country spread. In essence, it measures how much risk investors think is present in the bonds of that country.
Recently the country spread for various emerging market countries reached the lowest levels ever, indicating an extraordinary amount of complacency among investors.
Though the bonds of emerging market countries have traditionally been thought quite risky—as demonstrated
in recent defaults by Argentina, Russia, Turkey, etc.—investors now seem to believe that the risk in such bonds has become extremely slight. This is so even though debt levels have reached biblical proportions around the globe.
Among mathematicians, sigma is a term used to describe how unlikely an event is, whether it's an earthquake or a hurricane or a stock market crash. A 2-sigma event, for instance, is two standard deviations away from the norm. 96% of all events fall within the 2-sigma boundaries. A 3-sigma event is even more unlikely: 99% of all events in a given area are less than 3-sigma.
So to imagine a 5-sigma or 10-sigma event is difficult to even conceive. Yet history shows that such events happen a lot more often than the normal bell curve would dictate. This is called the fat tails phenomenon.
Even though high-sigma events are not expected, they do happen. The stock market crash of 1987 was a 22-sigma event. The assassination of the Archduke Ferdinand that started World War I was at least a 10- or 20-sigma event, yet it happened. Many other examples could be given.
In my opinion, the U.S. and the world is on the precipice of a series of high-sigma events in the financial, energy, ecological and infrastructure spheres in the coming years. This prediction can be made because the systems in these areas and others have become so overstretched—and thus extremely fragile.
Because nature presents periodic stressors to all systems, a system that becomes increasingly fragile will sooner or later collapse, as we see in everything from the break in the New Orleans levees to the fall of the Roman Empire.
Once a system has become fragile, its collapse can be brought about by even a seemingly minor event. And because everything has become so interconnected these days, a trigger in one area could fairly quickly trigger high-sigma events in other fragile areas. A real energy crisis would soon become an economic crisis. And an economic crisis would soon impact the ecological and infrastructure dimensions.
It's all interconnected: A crash in the dollar—quite likely at some point given our vast current account deficits—would probably trigger a collapse in the bond market. A collapse in the bond market, in turn, would surely trigger a collapse in the stock and real estate markets, and so on. And because the U.S. economy is so gigantic, a financial implosion in the U.S. would affect the entire world.
All of this must surely sound very depressing. Yet my effort here is not to depress, but simply to present things as they might actually be rather than how we might wish them to be. If this picture is true, perhaps we can bring some clear-sightedness to our situation and our efforts.
And believe it or not, there is a tremendous silver lining in the midst of all this, which we'll look at next...
(This is the end of Part 6. Go to Part 7.)
—jim sloman, 9.12.05
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