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Todd Moses
Sep 1, 2021 · 11 min read · Member-only · 10 53 Todd Moses
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The Architecture of Markets: Fear, Greed, and The Uncertainty Architect

Seasons Following

The wind and waves of a storm are closely related to the turbulence of
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Meteorologist Edward Lorenz, the father of Chaos Theory, discovered

weather is not so straightforward. Paul Halpern, the author of “The
Quantum Labyrinth,” writes, “weather is determined by a set of measurable
factors, such as temperature, pressure, and wind velocity.” However, Halpern
reveals, “a minute change in initial conditions yielded radically different
behavior.”

Financial markets behave similarly. Mandelbrot describes, “To all the

complexity of the physical world of weather, crops, ores, and factories, you
add the psychological complexity of men acting on their fleeting
expectations of what may or may not happen-sheer phantasms.” His work
proves that prices have memory and market behavior has seasons. A theme
Solomon declares years earlier in Ecclesiastes 3:1, “To every thing there is a
season, and a time to every purpose under the heaven.”

Microstructure Analysis
In the “Handbook of the Economics of Finance,” Hans R. Stoll declares, “The
field of market microstructure studies the cost of trading securities and the
impact of trading costs on the short-run behavior of securities prices.” It is
the study of how prices change with new information. Author of “The
Science of Algorithmic Trading and Portfolio Management,” Robert Kissell
explains, “Market microstructure continues to be one of the fastest growing
fields of financial research.”

Georgetown law professor Chris Brummer describes, “Exchanges are

meeting places — physical, electronic, or both — where traders can come
together to orchestrate the purchase and sale of financial instruments.” A
financial time series includes a collective memory of the past with the
current sentiment about the future. Thus the study of markets is the
examination of human interaction. Their behavior in regards to the rules
provided dictates the market properties.

The Polar Vortex

Mandelbrot writes, “one cannot help but marvel that the movement of
security prices, the motion of molecules, and the diffusion of heat could all
be of the same mathematical species.” Perhaps the most surprising is the
fact that both weather and markets have seasons controlling them.

The National Science Foundation (NSF) details, “Large-scale weather

patterns…from the El Niño-Southern Oscillation (ENSO) in the tropics to the
high latitude Arctic Oscillation (AO) play a significant part in controlling the
weather on a seasonal time scale.” As a result, meteorologists now measure
the current season to predict the next.

A similar occurrence in financial markets, Mandelbrot explains, is that

“Today does, in fact, influence tomorrow.” He reveals, “If prices take a big
leap up or down now, there is a measurably greater likelihood that they will
move just as violently the next day.”

A mild forecast preceded the winter of 2002–2003. NSF reports, “Instead the
biting cold of January propelled natural gas prices to an all-time high, and
heavy snows paralyzed the transportation infrastructure in all the major
eastern cities during February 2003.” The reason for this was a
misunderstanding of the effect of the polar vortex. NSF reports, “When the
polar vortex warms, the jet stream is pushed south leading to colder winters
across the eastern United States and Europe.”

Financial markets have their polar vortex. Not the “band of strong westerly
winds that forms in the stratosphere” described by the National Oceanic and
Atmospheric Administration (NOAA). This financial polar vortex is the
collective memory of past events. Mandelbrot explains, “it is common sense
that events in the distant past continue to echo in the present.”

People, Fear, and Greed

Author of “Trades, Quotes and Prices: Financial Markets Under the
Microscope,” Jean-Philippe Bouchaud writes, “At the heart of all financial
markets lies a common ingredient: people.” These people act according to
their understanding of the information and rules presented. It is not the
input into one system but multiple inputs into multiple complex machines
that make up market behavior. Therefore, determining what happens next
should be nearly impossible.

Each market participant has their motivation and interpretation of the

information provided. All are pulling and pushing to generate the tension of
buyers trying to buy low and sellers hoping to sell high. Add to this the
aspects of fear and greed and rational decision making is seriously
threatened. Traders regularly buy high and sell low while simultaneously
adding leverage to their accounts.

Bouchaud, a physicist turned fund manager, declares, “Although the actions

of a single person may be difficult to predict, the beauty of statistics is that
large-scale systems populated by many different people often exhibit robust
regularities that transcend individual behaviors.” A fact Topological Data
Analysis proves. In 2021, Post Doc Guillaume Tauzin and fellow researchers
successfully predicted market crashes from anomalous data.

Markets Effect Markets

“The 29.2 percent collapse of October 19, 1987, arrived without warning or
convincing reason; and at the time, it seemed like the end of the financial
world,” explains Mandelbrot. The crash was not isolated to a single market
but affected exchanges worldwide.

Named Black Monday, this stock market crash unexpectedly hit eight
countries like a financial tornado. What began in Hong Kong triggered
crashes in the New York Stock Exchange (NYSE), Malaysia, Mexico, New
Zealand, Hong Kong, Australia, and Singapore. Monetary policy was the
catalyst with automated trading causing mass destruction.

Wealth Management, Troy Segal, explains, “computer programs

automatically began to liquidate stocks as certain loss targets were hit,
pushing prices lower.” She continues, “To the dismay of the exchanges,
program trading led to a domino effect as the falling markets triggered more
stop-loss orders.” Concluding, “the same programs also automatically turned
off all buying, bids vanished all around the stock market at basically the
same time.”

As the NYSE began to spiral, other exchanges took notice, and a global panic
ensued. CNN Business Corespondent, Christine Romans, explains, “A crash
like that today would equal more than 5,000 points on the Dow.” However, it
was short-lived. In just two years, the markets involved regained the lost
value.

Market Liquidity
Liquidity is a measure of how easy it is for one to trade an asset. For an
exchange to function, there must be a buyer for each seller. There is a
designated position in modern markets called the market maker. Their job is
to buy and sell specific assets at a price they set. The goal for the exchange is
to have market makers representing every security listed.

Financial Journalist, Andrew Bloomenthal, explains, “The term market

maker refers to a firm or individual who actively quotes two-sided markets in
a particular security, providing bids and offers (known as asks) along with
the market size of each.” While making trades for their accounts,
Bloomenthal reveals, “Market makers provide liquidity and depth to markets
and profit from the difference in the bid-ask spread.”

Thie bid-ask spread is the policy that an asset is purchased for a lower price
than it is currently selling. While the difference is usually slight, the high-
volume trading by the market maker is most often very profitable. In current
markets, computer algorithms set the bid-ask spread. In essence, the price
level of the asset bought by the market maker does not matter since the bid-
ask spread usually protects it.

Asset Manager Joshua Kennon explains, “Without market makers, it would

take considerably longer for buyers and sellers to be matched with one
another.” Thus reducing market liquidity. In essence, the market maker gives
investors instant trading. Without the market makers, it would take several
days or more to close a position. Kennon explains, “This would reduce
liquidity, making it more difficult to enter or exit positions and adding to the
costs and risks of trading.”

Market Depth
A problem with exchanges is buying or selling large volumes of an asset
without affecting the price during the execution. Bank of Japan Analyst Jun
Muranaga et al. writes, “We define a liquid market as a market where a large
volume of trades can be immediately executed with minimum effect on
price,” in his 1999 paper “Market microstructure and market liquidity." Thus
providing an additional dimension to market liquidity in market depth.

Muranaga et al. details, “we consider “market depth,” which absorbs the
price changes accompanied by trade execution, as an important factor in
explaining market liquidity.” Determining, “market liquidity is an indicator
which represents market depth and shows the absorption power of risk
premium on trading execution.”

Market liquidity is one of the factors in the price discovery function. The
former head of research at Gain Capital, James Chen, declares, “Price
discovery is the overall process, whether explicit or inferred, of setting the
spot price or the proper price of an asset, security, commodity, or currency.”
Muranaga et al. explain, “in order to examine how market liquidity affects
the price discovery function in an actual market, not only should the static
aspects of market liquidity be examined, but also the dynamic.”

Price discovery is the primary function of any marketplace. CME Group

explains, “Price discovery refers to the act of determining a common price
for an asset. It occurs every time a seller and buyer interact in a regulated
exchange.” Chen eludes that price discovery is not new. “Ancient souqs in the
Middle East and market places in Europe, the Indian subcontinent, and
China brought together large collections of traders and buyers to determine
prices of goods.”

Market Seasons
According to Muranaga et al., the market indicators are: “probability of
quote existence, trade frequency, price volatility, bid-ask spread, gross order
book volume (buying order volume plus selling order volume), and net order
book volume (buying order volume minus selling order volume).” All of
these are affected by the behavior of market participants, be it humans or
machines. Muranaga et al. identify two parts to this behavior:

1. The Micro Stage or decision-making process.

2. The Macro Stage or price discovery process.

The economic definition of the decision-making process includes budget

constraints, a comparison of alternative behaviors, and expected gain.
Muranaga et al. clarify, “when an investor tries to decide whether or not to
trade in a specific market, the investor will, regardless of whether he
explicitly calculates or not, compare the costs and benefits of executing the
trade with that of other economic activities.”

In studying markets, the problem with the micro stage is that it occurs in
private. Investors’ thoughts and actions leading up to trade are rarely known
to the other market participants. Like a game of poker, no one wants to
reveal their particular method.

Thus most of what one discovers about a market is from the price discovery
process. According to Brummer, “Exchanges help determine the
equilibrium, or ‘market-clearing’ price of the traded instrument.” He
explains that the economic aspect of price discovery is supply and demand-
not just the ability to buy and sell quickly but the capacity to profit from the
transaction.

The third dimension to liquidity is market seasons. Naturally, every trade

will not be profitable. Sometimes an asset is in favor, and at others, it is not.
Like farmer’s markets, exchanges have periods where specific items are in
season. For example, savvy investors find correlations in measurable events
to make early trading decisions. Once enough activity ensues, other investors
follow and increasing the demand and price for the asset in question.

Once the correlated events deviate from the asset, the wise investors close
their positions. The followers, in turn, do the same, dropping the demand
and price. Thus the season for that asset has gone.

Memory
“Pain is the great teacher of mankind,” said Countess Marie von Ebner-
Eschenbach during the 1800s. However, it is still just as relevant today,
especially when it comes to investing.

For example, the investors who lived during the 1929 crash had died or
retired from trading by the 1980s. Mandelbrot observed that their memory of
1929 caused them to act with more caution. In 1987 the worse crash in sixty
years hit due to their forgotten wisdom.

A market’s memory comes from the person’s participation in it. Jean de

Carufel et al., in “A Topological Approach to Scaling in Financial Data,”
writes, “markets are a result of the interaction between participants with a
diverse set of investment horizons and views about current, and future asset
valuations.”

This memory decays with time but never disappears entirely. The results of
the sudden worldwide crash of 1987 impacted those investors with enough
fear to carry forward until 2007. Likewise, the pain of that experience
followed the next generation of investors. According to Swiss researcher
Wolfgang Schadner, the main driver of market memory is sentiment.
Defined by the Oxford Dictionary as “a view of or attitude toward a situation
or event; an opinion.”

Social Influence
Carufel et al. explain, “Financial market data provide some of the most
complete historical measurements reflecting human social interaction.”
Their 2017 paper uses topographical data analysis (TDA) to prove financial
markets are fractal. Concluding, “The scaling characteristics originate from
the diversity of these market participants.”

Johan Bollen et al. published “Twitter Mood Predicts the Stock Market” in
2010. Presenting “an accuracy of 86.7% in predicting the daily changes in the
closing values of the DJIA” by analyzing user sentiment on Twitter.
Economist Pablo Azar concludes, “We find that a tweet-based asset-
allocation strategy outperforms several benchmarks.”

What started with discussing sentiment toward or against exchange-traded

assets spiraled into meme investing. On August 28, 2020, Keith Gill (“The
Roaring Kitty”) decided to take a long position in GameStop. Motivated by
the short trades of significant funds, Gill utilized social media to attract a
crowd of stimulant wealthy twenty-somethings to pump up the stock’s value.
According to MarketWatch, “In late January, it hit $483. Its surge came
alongside gains among peers that would go on to be identified as meme
stocks.”

The result was an estimated $27 million for Gill and a new take on social
investing called meme stocks-making the private “Micro Stage” of Muranaga
et al. very public.

Economics Finance Data Science

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