I analyze macroeconomic issues from a fundamental perspective, and I analyze market behavior from a technical perspective. Original macroeconomic analysis can be found here and both macro analysis and commentary can be found on my Caps blog. If you like or appreciate my analysis, please add yourself to my Following List

## Monday, November 23, 2009

### Recipe for Disaster

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 oragne trendlines)

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