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Recipe for Disaster

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November 23, 2009 – Comments (16)

I have worked a bit with Control Systems. I am by no means an expert. But the market right now looks to me exactly like an unstable control loop. For a little background on what I am describing, please read this post Why e is the coolest number and especially read the part at the end regarding LaPlace Transforms and integral convergence with respect to control systems.

But let me distill down a few concepts in controls. The first is a feedback loop. Whenever you have an input into the system (such as the the control stick to move the ailerons on your airplane), you want the actuator and the system to respond in a stable way. By this I mean when you move the stick to bank left or to pitch down, the actuators controlling the ailerons should move in a way that causes that movement and nothing else. They are two big exceptions that occur that cause big problems that aircraft designers need to avoid. The first is aileron reversal. This happens when the flutter speed is exceeded and the control surface (aileron) no longer can maintain aircraft orientation. Below the flutter speed the controls work normally, near the flutter speed the ailerons do not respond to inputs. Past the flutter speed the ailerons go into reversal, which means that a left bank on the control stick turns the airplane right. This is a catastrophic scenario to be avoided in the operating regime.

The next is oversteering. This is when your control surfaces give you too much movement and don't return to an equilibrium state on their own. If you pull up on the controls and the aircraft pitches up much more than you intend and you overcompensate by immediately pitching down, and again the controls are too strong and the aircraft pitches down too much. This is an example of runaway positive feedback. I saw one a video of a pilot landing an experimental aircraft that had exactly this problem. The ground effect as the aircraft was coming in for a landing was overwhelming the controls a producing a positive feedback. The aircraft oscillated wildly up and down just a few feet off the ground before crashing and skidding on the runway. Fortunately the pilot was safe.

The point is that control systems must be defined very carefully and that runaway positive feedback is detrimental to a control system.

And we are seeing perhaps some runaway feedback in the market right now. The bulls are getting uber-bullish and the bears are getting uber-bearish. On each large wave down bearish breadth is increasing, and on each bullish wave up bullish breadth is increasing. This has been happening over the past few months and prices are mostly sideways / slightly up. See the chart below. Look at the breadth right below the price (green and orange curves with the green and orange trendlines)

16 Comments – Post Your Own

#1) On November 23, 2009 at 11:42 AM, binve (< 20) wrote:

How does this resolve itself. One word .... badly.

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#2) On November 23, 2009 at 12:16 PM, Recover22kplan (45.84) wrote:

Thanks for all the work and posting of your charts - very kind of your to share

+ more than 1

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#3) On November 23, 2009 at 12:27 PM, dragonLZ (99.33) wrote:

binve, you have been predicting the crash since July (with your nice, colorful charts).

Has it happened yet?

It's been 4 months now, and the market just keeps going in the opposite direction of your predictions.

Your rating just shows how wrong you were so far (just as my rating shows I've been wrong too).

Sometimes, I think binve = Alstry + nice looking (but unfortunately, meaningless) charts...

p.s. Nothing personal, believe me... :)  Good Luck (unless you are shorting in RL stocks that I own in RL)!

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#4) On November 23, 2009 at 12:28 PM, Recover22kplan (45.84) wrote:

BTW - I think you might like the book  "The boy with square eyes" cute story I can imagine you stare at your screen in the work you do, it was a story I read many times to my son "the boy wonder". I would buy it for you if I knew how to send it to you in thanks - I know you  are a avid reader : )

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#5) On November 23, 2009 at 12:48 PM, Mark910 (< 20) wrote:

For an example of a runaway feedback loop look at last Fall....the market got to the point of 10% amplitude in a couple of days

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#6) On November 23, 2009 at 12:58 PM, columbia1 wrote:

I believe the aircraft you were referring to was one of the earlier versions of the F-22 or F-23, sporting front canards, a very violent reaction happened as each movement exceeded the last until all chaos broke loose!!

1+ Rec.

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#7) On November 23, 2009 at 1:10 PM, StopLaughing (< 20) wrote:

Your theory is interesting and may correlate with increased VIX numbers. However, based on this morning (very short run) what seems to be happening is a change (flattening) in the long run upward slope of the bull market. A Gann Fan effect where the market moves to a less steep upward angle.

Bears are still getting sucked in and squished. However, it takes a lot more to get the Bears in. The Bulls are wary but afraid to fight the trend. I think the trend will continue for a while. 

The $ will continue to sproradically weaken to or past the Bush lows. The Fed is not about to tighten in spite of any talk. The Bond Market will have to force the fed to tighten.

When we do top the drop could be very quick and steep. However, I do not know how deep. 

Inflation is understated but the economy still has pockets of deflationary pressure which may be bottoming. 

The Market is still controlled by the Fed. It will crash when the Fed becomes controlled by the Bond Market. 

 

 

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#8) On November 23, 2009 at 2:08 PM, binve (< 20) wrote:

Recover22kplan, Thanks, I appreciate that! I have not heard of that book, but I like the sound of it. We just had our first child (a daugther 2.5 months old) and that sound like a book I would like to read to her :) Thanks!

Mark910, Absolutely man. I take this idea to the next level in my next post, so stay tuned :) Also I read and recced your post this morning, couldn't agree more!

columbia1 , Hey man, you are absolutely right. I just didn't want to mention it by name :). Thanks bro!

StopLaughing, Those are very interesting observations, and I agree with you very much on part of the big picture. You might find this post of mine useful: My Positions and Projections..

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#9) On November 23, 2009 at 2:33 PM, FoolvsStreet (< 20) wrote:

Great post binve (1+Rec). And keep the good work. Don't get distracted by nonbelievers (the history shows that only few have the ability to do great things) 

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#10) On November 23, 2009 at 2:47 PM, binve (< 20) wrote:

FoolvsStreet , Thanks for the support! I appreciate that!..

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#11) On November 23, 2009 at 3:56 PM, binve (< 20) wrote:

Please read the next post for the conclusion to this post:

First and Second Derivatives of the SPX
http://caps.fool.com/Blogs/ViewPost.aspx?bpid=298547

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#12) On November 23, 2009 at 9:17 PM, rexlove (99.46) wrote:

I work in the controls industry and must say I had a hard time following your analogy. Gotta disagree with you here - the market does not look like an unstable control loop. If it were the swings would get bigger every day.

Binve - I think what we have here is (and I know this is hard to accept) ..... is a bull market. We're making higher highs and higher lows all the time.  

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#13) On November 23, 2009 at 10:09 PM, binve (< 20) wrote:

rexlove,

I work in the controls industry and must say I had a hard time following your analogy. Gotta disagree with you here - the market does not look like an unstable control loop. If it were the swings would get bigger every day.

Fair enough. But that wasn't quite the point of my analogy. So when I say I am not a contols engineer, I mean exactly that. It is not my profession / expertise. I have a lot of background in controls and I have worked with a lot of controls engineers. My area of expertise is performing thermal and structural analysis of aerospace vehicles and have been doing that well over a decade. And from a structural standpoint, control system inputs can sometimes be a very big input to my structural models. Hence I am very familar with the subject.

First you need to look at the link in comment #11. Both of these posts can be thought of as one, say a part 1 and a part 2.

Here is my analogy: Like I have said above, the price is narrowing and trending sideways / slightly up. So I agree with you on that part. But from a controls standpoint, if the price is narrowing like this than the physical analogy is a system that is perturbed and returning to an equilibrium state. This is the analogy. So to further the analogy, then the signals that accompany the control surface (to continue with the aileron analogy) the actuator pressure for a hydraulic servo should be dying down and the velocity will tend toward zero or some constant value.

And so for the the SPX price, the breadth (the hydraulic pressure in the analogy) and the velocity should be decreasing. And what I am saying is that even though the price is narrowing, the breadth is not decreasing. In fact it is getting larger in both directions as the price is narrowing. This is pointing to a future instability. That is where I was going. And with the link above, I am remarking that the velocity is not returning to an equilibirum position, and even though we are trending up, the oscillations are still staying high.

So I am not saying that this model necessarily predicts failure, nor am I saying it predicts a crash down. Like I say in the link above it could mean a "crash up". I am merely pointing out that there is a lot of volatility just beneath the surface of the price action (such as a feedback loop with postitive runanaway on the input signal, but the output (price) does not yet respond because there is a lag / inertia).

Maybe you think it is not the most appropriate analogy. I will concede that. But I don't think it is meritless.

Binve - I think what we have here is (and I know this is hard to accept) ..... is a bull market. We're making higher highs and higher lows all the time. 

Maybe. But as a point of clarification, we are making higher highs and lows on the SPX and Dow. There are many indices that have been making lower highs and lower lows since Sept/Oct. The Rusell 2000 being a very prominent one. Please see this post: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=297027..

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#14) On November 23, 2009 at 10:52 PM, topsecret09 (37.04) wrote:

#13) On November 23, 2009 at 10:09 PM, binve (24.73) wrote: There are many indices that have been making lower highs and lower lows since Sept/Oct. The Rusell 2000 being a very prominent one. Please see this post: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=297027    In my opinion,this Is the best point made here....   The OVERALL market, {mainly small, and a large portion of mid-caps are not participating In this move upwards. This Is by no means a BROAD BASED RALLY,and this has me concerned. Volume Is also unimpressive on moves to the upside. I do not buy It, period. Remember the man behind the curtain In the Wizard of Oz ? Not quite as Intimidating In person. Wecome to the Grand Illusion.......  TS

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#15) On November 23, 2009 at 11:00 PM, topsecret09 (37.04) wrote:

  And by the way,great charts....  I can appreciate your work as I too am a chartist first,ask questions later kind of Investor.  I do know that technical charting In this current market Is very strange. There are many Instances,at least for me where I find an awesome chart pattern/ trend that does the complete opposite of what I would expect,all things being equal....   Banks borrowing money for free,then pumping the markets with It Is one explanation to this Twlight Zone remake.....   TS

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#16) On November 24, 2009 at 8:10 AM, binve (< 20) wrote:

topsecret09, Thanks man! I totally agree, the risk spread between "risky" assets (small caps and financials) and "safe" assets (large caps) is widening. Very un-bullish if you ask me. And I agree, these are still dangerous waters no matter how you decide to navigate (TA or FA). Valuations at this point are almost meaningless, because of the liquidity pumping like you observe, but that also means stocks can stay overbought for a very long time. Interesting times, as the curse goes :) Thanks!..

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