This chart shows a daily plot of S&P500 Index prices. For each price, a letter marks the value for the date and you can see the page A1 main headline for that day from the Wall St. Journal in the legend. Since there are so may days shown not all the headlines are readable on this chart. But the most recent headlines, starting at bottom of legend, are visible.

Daily Wall St. Journal Headlines Tag S&P500

Now consider the same chart with the dates and headlines displayed only for the day on which the price changed from the previous day by a magnitude exceeding 3%. This graph  plots the changes. The headlines are labeled as before.

Wall St. Journal Headlines for +/- 3 % S&P 500 Daily price changes

The interesting result is that all the headlines are about government actions that could affect the markets, not economic/market action. It seems that judging politicians and central bankers is the primary investment skill needed now.

Video: Osama Bin Laden and The Banality of Evil

Economist Herb Stein famously said: “If something cannot continue forever, it will stop.” We now see many socio-economic systems in USA that cannot continue as they are forever, and which seem to be close to the point at which they could easily move into damaging and chaotic states. Let’s take a look at some of our favorites: But first, we need to roughly define a “Tipping Point”.

What’s a Tipping Point?

Every system has limits, including social systems. For every system there is some generalized boundary of system behavior and its use of resources that constrains system operation. When a system reaches its boundaries, some form of dramatic behavior can ensue. As systems approach these boundaries, they may cross their “tipping point.”

The “tipping point” is the state of the system at which catastrophic and usually unpredictable results emerge. For a simple, physical example, consider a sand pile. If you add sand by dripping handfuls on a flat plate, eventually you will have a cone and then it eventually takes only one more grain of sand to cause the whole pile to collapse. For socio-economic systems, people’s behaviors will change as the tipping point is neared. What will happen when these systems get close to their limits? We will make this general question more specific in several current socio-economic systems.

The Banking System Tipped

We have already seen a painful example of a system that tipped over its boundary: Banking. When people and corporations are unable to pay their debts (induced in large scale by government easy-borrowing policies), they default. Defaults vaporize money (the amount owed and not paid back), promoting deflation and breed wide distrust by lenders and leading to a freeze in economic transactions. Then government succumbs to the urge to stop the crisis by “bailing out” the biggest debtors. These government payments (effectively making money materialize) thus relieve the borrowers of the consequences of the risks they freely chose to take. Bailouts are examples of “moral hazard”, which is a condition in which risk-takers expect no unpleasant consequences since they expect to be indemnified by other People’s Money (OPM).

Systems Near Their Tipping Point

We have compiled a series of some of the more obvious social systems near their tipping points. We present them in tabular form, describing the system, a natural tipping point, and give some examples of what could happen once the tipping point is reached. This is the heart of the matter, and will affect almost everyone. We give a number for each system described, starting with Banking.

Financial

Demographic

Health Care System

State and Local Government

Foreign Affairs

The Biggest System: For How Long Can Government Itself Continue to Function so Incompetently?

People choose their governments for pretty basic reasons, such as maintenance of a legal system, operation of courts and enforcement of contracts, construction of shared infrastructures, protection from foreign invasions. Governments have naturally massively expanded beyond these basic roles, but one expects that whatever they do should at least be done reasonably well, even if not really in their charter. We are starting to see that governments have become so big they cannot successfully solve the problems they were elected to solve, let alone efficiently operate in their vast regulatory systems.

Government failures to competently manage recovery from natural disasters set off alarms, because one expects government to at least get that function right. Such management is one of the few things governments are actually required and expected to provide the tax payers.

Since the attacks of Sept. 11, 2001 (a failure of our expensive intelligence bureaucracy) the world has seen these catastrophic events and others:

• Tsunami in the Indian Ocean,
• Hurricane Katrina,
• Global flu pandemic,
• Global financial crisis
• Earthquake in Haiti,
• Oil spill in the Gulf of Mexico,
• Devastating floods in Australia and New Zealand.
• Earthquake in New Zealand
• Japanese earthquake, tsunami and nuclear crisis.

It seems that despite national governments having an uncontroversial mission to help its citizens recover from disasters, every government has been incompetent in trying to do so. This government incompetence seems evident even with the Japanese in their current crisis-the same Japanese who have the most disciplined society in the world, and who were famously meticulous in their preparations for earthquakes and tsunamis. Has government size reached a tipping point where it collapses under its own bureaucratic weight and becomes generally incompetent?

In many socio-economic systems in USA, this fear seems born out.

A recent article by Steve Greenhut in the Orange County Register elegantly describes the situation and the political framework. Quoting Greenhut (who refers to the Little Hoover Commission report):

This is a battle over the future of California, as communities spend more than a third of their budgets on pensions (plus even more for other retirement costs for public employees, such as health care), which means “an intensifying fight for diminishing resources from which government can pay for schools, police officers, libraries and health services.” And because public employees “appear to have little incentive to push for reforms,” they, too, will suffer, as they look at cutbacks in public services. Per the report, “A pension cannot grow without a job attached to it.” Maybe that reality eventually will get the unions’ attention.

Yet I’m convinced that the state’s public employee unions will take the state over the cliff rather than pare back their generous benefits. What happens when these pension costs push the state toward insolvency and the dominant political players refuse to give in? We might get to watch this unfold, and the result is unlikely to be pretty.

Little Hoover hit on the real problems: Governments are in the position of paying employees for more years in retirement than they worked thanks to the very low retirement ages creating, in essence, a shadow workforce that costs as much as the real workforce but doesn’t do any work! Police, fire and other public safety pensions must be addressed – California politicians cannot make a devil’s bargain and put the biggest part of the problem off the table, as did Wisconsin Gov. Scott Walker, who made a craven political calculation.

What will happen as the unions and the Democrat politicians (elected with massive help from union dues) defend their pension goodies? This is a system at it’s Boundary. Meaningful changes to make the system financially sustainable will hurt those who got the sweetheart deals, or the entire state can suffer by working to provide the pensioners with a risk-free future.

Consider yourself warned!

Cognitive decline and failure to take free money

http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf

An extremely clear and concise tutorial on the situation is available here:

Tutorial: Will Municipal Bonds be the Next Disaster?

As the author says in his conclusion:

Finally: In recent years, there has been a change in our national understanding of the sacred nature of contracts. We have seen untold numbers of homeowners default on mortgages with the justification that the bank should never have lent them the money. We have seen the banks improvidently speculate with other people’s money and then justify it by saying that they were only doing what the customer wanted. This same mentality is evident in municipal government. Harrisburg, Pennsylvania councilwoman Susan Brown Wilson exemplified the ominous trend when she said recently, “By no means should the citizens of Harrisburg (alone) be strapped with the debt created eight years ago by a prior administration.” Are we not responsible for what past administrations have done? Isn’t that principle what secures any bond issuance? If Ms. Wilson’s is becoming the prevailing attitude, muni bonds are nothing more than colorful paper.

The number of muni bonds on dealer desks wanting bids is as large as at any time in history. Maybe this is dumb money getting out, creating a golden opportunity. But it could also be smart money running from a market that has a lot of the characteristics of the pre-2008 mortgage markets: lack of transparency, legal obscurity, inflated values and deteriorating economics. That’s a risk investors can no longer afford to ignore.

You can see in this quote a slice of the attitudes now prevailing in the muni markets. But these attitudes of entitlement and avoidance of responsibility appear in the popular press, too, as exemplified by the endless blame game played by politicians and consumer groups.

States face dramatically growing pension obligations they created to buy votes, and their cities have broken finances. The states cannot print money. The new Republican congress almost surely will not add to state bailouts. So the pain will be transmitted to directly to states and some will suffer much more than others. Like California.

But the form that pain will take is unknown now, but it cannot be avoided.

• Extrmely low probability
• Extremely high impact
• Unimaginable a priori

Given this BSE, we have had a massive “pivot” from the health care fiasco in the making to focus on USA economy and jobs. The reason for this change is simply the one new Republican vote that can stop disastrous congressional economic policies.

OK, so how can this BSE save us? Bear with us for a bit.

We recently came upon this quote and find it quite descriptive:

“A democracy is always temporary in nature; it simply cannot exist as a permanent form of government. A democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. From that moment on, the majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to loose fiscal policy…”

by Alexander Fraser Tytler, Scottish lawyer and writer, 1770.

Now, consider this fact:

~50% of USA workers pay $0 taxes, while the rest of the workers (the “rich”) pay all the taxes.

We think it fair to conclude:

Half the population has incentive to free-ride on the others and will cheerfully vote for increasing burdens on those “rich”.

Our country is in peril from financial catastrophes and very poor political decisions. Most pertinently, the Scott Brown BSE may enable the inevitable lunge by Democrats for more taxation and thus massive class warfare to be avoided.

Almost every page of the health care bill HR3200 from the House of Representatives has at least one statement that can alter your life. When those 1017 pages interact, they will produce effects not imagined by the bureaucrats and politicians who wrote this thing. The odds those unpredictable Black Swans are good for you are nil. They will hurt you.

As an example, consider this from the New York Times of 1 OCT 09 in regard to the current Medicare:

Medicare is putting in place a new policy that may sharply curtail the use of the cancer drug Avastin as a treatment for eye diseases.

But the way the bureaucratic gears mesh in this case, the move could end up costing Medicare itself hundreds of millions of dollars a year, and individual patients thousands of dollars.

What happened is that Medicare added a new reimbursement category for doctors to use for very small doses of an existing expensive drug. As the Times writes:

But Medicare has now introduced a special reimbursement code just for the smaller doses of Avastin. And starting Thursday, the reimbursement of Avastin dropped to about $7.20 for the dose typically used in the eye.

That would mean eye doctors — who purchase Avastin and then are reimbursed when using it on patients — would lose money administering the drug.

The new policy would give eye doctors a financial incentive to switch to Lucentis, for which they would be fully reimbursed even though that drug is significantly more expensive.

If doctors do shift to Lucentis, “this will have a huge economic impact on Medicare, in the range of hundreds of millions of dollars,” said Dr. David W. Parke II, chief executive of the American Academy of Ophthalmology. “Members view this as a bureaucratic decision that is maybe necessary, based on statutes, but highly short-sighted.”

This illustrates the obscenity the Congress is creating by rushing to a new, vast bureaucratic system with enormous perverse incentives and deep complexities that can only make life worse for everyone.

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Scenario Planning is an important component of strategic planning for any corporate or government organization that intends to prosper and succeed over time. It applies to individuals, too. Of course, it applies to investing as well.

Wired magazine published a clear, concise description of how to do Scenario Planning for yourself. The author, Peter Schwartz, is one of the pioneers in the field. He uses an example of an aerospace engineer planning for his career in quite uncertain times.

Read the Wired Magazine Article