Daily Forex Commentary
By Jack Crooks

Key News
China's trade surplus surged 67% in July to the second-highest on record. (Bloomberg)

Key Reports Due (WSJ)
8:30am July Import Prices. Expected: +1.0%. Previous: +1.0%.
2pm Federal Budget Statement. Expected: -$34.5B. Previous: +$27.48B.

Quotable
"You've got to be very careful if you don't know where you're going, because you might not get there." - Yogi Berra

FX Trading - Crash dynamics
Last night I thought it might be appropriate to scan through a book I read (or tried to read) a few years ago. The title is Why Stock Markets Crash, and it was written by Didier Sornette. I'm not suggesting everyone, or anyone, rush out to find the book to learn the Holy Grail - there is none. And unless you are a math junkie, the book may be a bit disappointing. I'm not a math junkie (unfortunately) and most of it was well over my head - fluid dynamics, power laws, log periodicity and the like. Sornette is a professor of geophysics, not economics. But even so, I found it at times fascinating, as Sornette has a bunch of very different and original ideas on how all this stuff fits together.

Here is one idea I especially like. Read it slowly a couple of times and think about it before you dismiss it (I keep finding more when I reread and am on about a hundred times):

"As we already emphasized, the stock market is made of actors that differ in size by many orders of magnitude, ranging from individuals to gigantic professional investors such as pension funds. Structures at even higher levels, such as currency, influences spheres (US$, euro, yen etc), and with the current globalization and deregulation of the market one may argue that structures on the largest possible scale - that of the world economy - are beginning to form. This means that the structure of the financial markets has features that resemble that of hierarchical systems with 'agents' on all levels of the market.

"Of course, this does not imply that any strict hierarchical structure of the stock market exists. However, [there is a] critical phenomenon called 'log periodicity' in which, for instance, the probability or the hazard rate is not monotonously accelerating but is decorated by oscillations with frequencies accelerating as the critical time is approached."

Whew!

These structures, driven by the fact that we are organized into "social/professional networks" in our everyday lives, are more vast and interrelated than we realize. These structures "control the spread of information". (Think "six degrees of separation.")

Okay so far?

We tend to get market scaling (think fractal patterns) that links these structures into a hierarchical pattern.

Enough of that - here's a basic example: if we consider trend-following strategies, which seem to be common in all markets at all levels by many different actors, we know they provide a feedback loop. On the upside we call it a bull market. Everyone is happy. Analysts prove their worth, as they tout their winners and intellect. Banks keep multiplying loans and fees as their lending in effect bids up the underlying collateral they are lending against, in a reflexive fashion. Investors add more money to the trend because their rationales, or rationales of their gurus (substitute "charlatans" there if it fits), have been validated.

This process leads to "ever accelerating oscillations" because it creates a herding mentality. We can witness herding anecdotally. Just think of hedge funds. These guys are paid big bucks to come up with creative and independent ideas on how to invest money. Most of them are smart guys, or at the least well connected (ie, in a social/professional network). It turns out there is little independence and much dependence in this seemingly smart and creative group. They all do the same trades.

Now if you add tout TV (CNBC, Bloomberg, Nightly Business Report, etc) to the mix - creating even more herd-like behavior - the idea of the market consisting of hierarchical structures begins to make sense. I think.

There is much more, but we can sum it up like this: "Crashes occur as possible outcomes of long preparation, which we term 'herding', which pushes the market into increasingly unstable regimes. When in this state, there are many possible 'local' causes that may cause it to stumble ... From an efficient market viewpoint, the speculative attacks are nothing but the revelation of the instability and the means by which markets are forced back to a more stable dynamical state."

This is called a crash!

Black Swan offers a subscription-based currency advisory service for forex and futures traders.

Jack Crooks has actively traded in global equity, fixed income, commodity, and currency markets for more than 20 years. He is president of Black Swan Capital, a currency and commodities market advisory firm - BlackSwanTrading.com