This is a strat.in ‘Runup to the Budget 2009’ series. Every day from now, till Monday, readers can find a finance related article uploaded at 5 pm IST . The articles will be unconventional, innovative and present a refreshing perspective. This is the first article in that series: With this article, we also welcome our new strater who wrote to us on the Write a post page, Amit Namjoshi, from Pune university. He is currently a Design Architect at Tech Mahindra.
‘An Economist’ according to a popular joke ‘is a trained professional paid to guess wrongly about the economy’. Of course this joke wouldn’t be funny hadn’t there been an element of truth in that statement! So should Mango Man (Aam Admi) rely on the predications by the Stock Pundits and Economist? In 1993 the OEDC or the Organisation for Economic development & co-operation analysed forecasts made between 1987 and 1992. Their conclusion- predictions were abysmally inaccurate so much so that they would have done a better job at prediction for inflation and gross domestic product had they simply guessed that the numbers in each year would be unchanged from last!
For Mango man (common man) yes that’s me; it is essential to understand the fundamentals of Economics before I go any further! A first step- begins with one of the core idea in economics known as the ‘Efficient Market Hypothesis’ (EMH). According to EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
In this conventional view economy is like a bath of water. At a microscopic level the individual atoms / molecules are constantly active a sight of chaotic movement. However at the surface for the commoner all of it seems to be calm where the water is still, in a state of equilibrium. Tilt the bath to the right and the water molecules will adjust their position to seek equilibrium. In terms of economy we relate that to, lowering of interest rates resulting in rise in borrowing and spending. This in turn stimulates the economy; which will quickly settle in at a new equilibrium. Therefore by this conventional view it should be impossible to outperform the overall market through expert stock selection. But there is a catch; no amount of equilibrium can explain the crash of the stock exchange of 1929 or the infamous black Monday of October 1987. Mathematical research in the past 2 decades proves this point. The 90’s saw researchers use computers to take an in depth look at these fluctuations. Gene Stanley from the Boston University investigated the fluctuations in the famous standard & poor’s 500 index (share prices of 500 large corporations of the NYSE). The study considered data from 1984 to 1996, Stanley and his team came to the conclusion that price change becomes about 16 times less likely each time you double the size.
So can we devise a pattern that can fit these fluctuations? Perhaps we can. The Power law pattern– in algebra it is any curve for which the height changes in proportion to the horizontal distance height = (distance)2. A few examples of power laws are the Gutenberg-Richter law for earthquake sizes (the Richter scale that logs the magnitude of an Earthquake), Pareto’s law of income distribution and scaling laws in biological systems (miniature models that are scaled down). To make it easy in the context of an example lets look at earthquakes. If there are two types of earthquakes type A and type B the law simply shows if type A earthquake releases twice the energy of type B, then Type A earthquake will happen 6 times less frequently. In the case of economic data studies by Stanly and team though the numbers don’t seem to add up the geometric pattern certainly does. The power law implies that there is no such thing as a typical fluctuation and therefore the large up and down swings are not at all unusual. What about volatility (calm and spike on a graph) in the market? Stanley and team found out that the market is far calmer at sometimes then others and if we look at fluctuations in volatility even that varies to a wide degree. To put in other words even volatility is volatile!
So when equilibrium seems to be the order of the world (remember the water bath) then the wild fluctuations fly in the face of efficient market hypothesis. Why is it that the orthodox economic theory falls flat when fluctuations should be more like the bell curve (as stated by Bachelier in 1900 a bell curve is a graph that looks like a bell)? But that is clearly not the case.
So what then are the causes of this mystery? For one market involves people; perhaps that has something to do with this phenomenon. Economist Thomas Lux in 1999 invented a game of stock exchange with only one kind of stock and three kind of brokers- pessimist( believing the market prices will fall), the optimist (believing the market prices will go up) and the fundamentalists (traders who stick to buying undervalued stock and sell over valued ones). However the game had one key aspect people; they can affect one another. Since humans can influence one another the division of traders was not fixed a pessimist could be influenced to be an optimist at times or the fundamentalist might just take pessimistic view of the stock on view of the strong trends as they are also highly influenced by meme (meme consists of any idea or behavior that can pass from one person to another by learning or imitation). The result – measuring the stats of the fluctuations Lux found them to match the ‘real thing’, a power law revealing a great susceptibility to fluctuations.
What does this mean for the average investor? Despite the confident predictions of the bulls and bears of the market, mathematical analysis and their indications, the existence so called ‘trends’ in the market in spite of all of this there is simply no way to predict any stock market. The power law for price fluctuations indicates that even the rough magnitude of fluctuations is unforeseeable. In a market organized to the Critical point (a critical point specifies the conditions at which a phase boundary ceases to exist. Water becomes vapor at 100 degrees Celsius is an example of its critical point) even the stock market crashes are ordinary though we should expect them infrequently. We have seen financial markets are wild at heart because opinions expectations, greed, pessimism, optimism of one investor can affect those of the other.
So what can we make of this, is there any way in which we can truly predict the market? And what if anything can the governments and governing agencies do get us as close to the world of accurate predictions? More importantly the world is now much more of a ‘global economy’. And therefore the current crisis brewing in one economic power house ‘United States’ entail a story of a global recession. Every day I wake up to the news of predictions from the who’s who of the stock market, the pundits of economics about the possible recovery however now I perceive them with a lot more skepticism and I realise I am passing a meme to you as well!
….. Mango Man (Aam Admi)