from John Maudlin's weekly newsletter ...

(snip)"A second related concept is from game theory. The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

A Stable Disequilibrium

So we end up in a critical state of what Paul McCulley calls a "stable disequilibrium." We have "players" of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business and finance. Each player works hard to maximize his own personal outcome and to reduce his exposure to "fingers of instability."

But the longer we go, asserts Hyman Minsky, the more likely and violent the "avalanche" is. The more the fingers of instability can build. The more that state of stable disequilibrium can go critical on us.

Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. (Astounding. Was it less than ten years ago? Now Russian is awash in capital. Who could anticipate such a dramatic turn of events?) Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies. Something that had not been seen before happened. The historically sound and logical relationship between 29- and 30-year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified.

The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.

So, where are fingers of instability today? Where are the fault lines that could trigger another crisis? Are there any early warning signs? Matt Blackman of looks south at what he thinks might be the proverbial canary in the coal mine.

An Island of Deficits

Quick, which country runs the larger trade deficit, New Zealand or the United States? In percentage terms, the surprising answer is, New Zealand. The US had a record 7% (of GDP) trade deficit in the fourth quarter of 2005. But New Zealand saw its deficit hit 8.9% of GDP. Look at the chart below:





Writes Blackman: "But a quintessential star performer that has benefited from strong commodity prices in the last few years provided a warning that could be the beginning of a global market ripple effect. After 21 consecutive quarters of gains, New Zealand surprised economists both at home and abroad with the report that its economy had contracted 0.1% in Q4. The Reserve Bank of New Zealand had previously forecast a growth rate of 2.4% for the year and 0.4% for the quarter. There was little doubt that few, including the New Zealand Reserve Bank governor, expected such a rapid drop. And New Zealand was not the only trouble spot."

New Zealand has seen its currency drop more than 18% in the year ending March 2006. This should actually be expected, as large trade deficits have in the past eventually resulted in falling currency values. Everywhere, so far, except in the United States, where the dollar's reserve status and a powerhouse economy have kept the dollar higher than economic theory and history would have predicted.

There is another similarity between the US and New Zealand. "Housing prices jumped 75% between late 2001 and 2005. Even with 2-year fixed rates at 8.3% and floating rates of 9.6% as of January 2006, home prices were still appreciating at nearly 15% annually at the end of 2005."

And household debt? Household debt in NZ has risen from 100% of income in 1999 to 150% by the end of 2005, the majority of which is mortgage debt.

Rising debt. Soaring housing prices. Monster trade deficits. A rapidly falling currency. But investors are not worried. Note that the NZ stock market has risen nearly 10% in 2006.

It's a small island of 4,000,000 people (one of my favorite places in the world, by the way!). How does what happens in a country that small, with less than the population of a few counties in the Dallas/Fort Worth area, mean anything for the US?

The real and true answer is, we don't know. Maybe it means nothing. Just as we were told the problems with the Thai baht meant nothing. But it is the possible connections that we should be constantly thinking about.

What fingers of instability do I see turning red throughout the world economic sandpile? Everywhere I look, I find markets that are at very high valuations. Markets of all kinds tend to be mean reverting. Today, we diversify among nations and funds, between different types of debt and real estate. We have a diverse portfolio, we tell ourselves.

But everything is more connected than ever. If the Chinese and Japanese buy fewer dollars and US bonds, interest rates rise and the dollar falls which slows our economy and we can buy less of their stuff which slows them down and they buy less from Asia which slows their economies which affects the price of oil and commodities which (on and on). Everything is connected. It is a spider web of fingers of instability.

In a global world we have seen that things which did not correlate in the past can do so, and very quickly. The problem is that we cannot see the fingers of instability, the hidden connections, until the avalanche has started. So we have to pay attention. And we really need to hedge our portfolios. I am increasingly uncomfortable with long-only directional investments that seem to be at a trend high in terms of their valuations.

And so is good friend and market maven James Montier, global equity strategist as Dresdner, Kleinwort, Wasserstein in London. He sent this note to me a few days ago:

"Perhaps I am missing something but in my naive view of the world, peak earnings deserve discount multiples. Yet investors seem to be willing to pay pretty much top dollar for cyclically high earnings. This amounts to a display of faith in a new era. The one thing that history teaches us is that such faith has never been appropriate. Both the US and European markets are significantly overvalued.

"John Hussman has shown that US earnings have never grown by more than 6% peak to peak since 1950. Right now we are at the very top edge of this 6% limiting channel. That strongly suggests that US earnings are at a cyclical peak. The very best that we could hope for (without arguing for a new era) is that earnings crawl along the top edge of the band. Yet history suggests more often that earnings peak at the top edge of the band.

"Unsurprisingly, when earnings are close to the top edge of this 6% channel, equities tend to be priced at a discount to reflect the temporarily exalted nature of the earnings. If one excludes the bubble in the latter part of the 1990s, when US earnings are within 5% of the top edge of the band, then equities have on average traded on 9x (using a Hussman PE (price relative to peak cycle earnings) since 1950. Today with earnings at the very top edge of the band, the US market sits on a Hussman PE of 18x! Peak earnings on peak multiples.

"Nor is this situation unique to the US. A very similar picture holds for Europe. As with the US, European earnings have not managed to grow by more than 6% measured peak to peak since 1970. Current earnings are rapidly approaching the top edge of this earnings growth channel. Yet the European ex UK market is trading on a 17x peak cycle earnings. Normally (again excluding the bubble years) when earnings are within 5% of the top edge of the 6% channel, the European market would be trading on a Hussman PE of 11.5x.

"Both the US and Europe look expensive relative to peak earnings. They also look expensive on a broader range of valuation measures. For instance, across our nine measures of valuation (none of which include bonds) the US appears to be 54% overvalued. In the past when we have done a similar analysis on Europe, it has appeared to be 33% overvalued. However, this is flattered by a much shorter data set for Europe. If we take the average European valuation discount to the US since 1970, and apply it to the US long run averages we can proxy a 'long run' benchmark for Europe. When we conduct this exercise, we find that Europe is on average 63% overvalued!

"This suggests that those arguing that because Europe had a good year last year while the US went nowhere, Europe is now independent of the US, may well run into a valuation constraint far faster than they currently imagine. Neither the US nor Europe offer any value attraction. There is little to choose between them."

Today more than ever your portfolio should be targeting absolute return strategies. In a world with fingers of instability that may be connected in ways we have not seen in the past, caution is the order of the day. If we do see a slowing US economy later this year, the average complacent investor is not going to be happy as his diversified portfolio all seems to be going south at the same time."