Ruled by Chaos 1

Ruled by Chaos

Philip Saroyan

March 19, 2009 (Updated: September 20, 2010) (Updated: April 23, 2012)

Ruled by Chaos 2 Ruled by Chaos Many people understand what the stock market is and how it behaves; we attribute it as having ups and downs, therefore, giving us ability to profit in a period of changing prices. Conventional wisdom has little to say about the markets and one of the things it purports is that the market is speculative in the same way that a casino is speculative. That's to say that there is a probability of loss and that probability results in a change of wealth for the speculator. If you were a professional blackjack player and we went to Vegas you probably would know which table to play at if you had gone before, but for the most part it wouldn't matter, would it? The probabilities for blackjack are constant and therefore your ability to win is based on your skill as a blackjack player, but your probabilities of loss would remain the same; therefore, you become a speculator because you simply don't know what the next card will be; you might go bust. This is easy to understand; with the markets, it's not so easy. Conventional wisdom tells us that playing in the market is no different then us going to Las Vegas and playing blackjack: you might win or you might lose money. Also, because there is an understanding that if you are skillful then you may win more than you lose, you may become like a math wizard out of MIT who learned the ropes playing blackjack; a master speculator.

Without thinking twice about it, it doesn't seem so unreasonable to believe it, some people make money and some people lose money, probably a fifty-fifty split. But what you don't think to ask is "what does this imply"? And if this were true then surely you are being cheated by your broker/trader, or he/she is a master speculator like that math wizard from MIT. Perhaps he or she is a master speculator, but that's not the point. The main question is what do probabilities in the market imply? If you put your money in a managed account of some sort like a Fidelity mutual fund for instance, you are paying for a master speculator. Shouldn’t you forget about your own worries and doubts and leave it up to the sharp that aced all his math tests in high school and college? Yet you still worry, you still think about the oscillations of the market and doubt anything and everything because even the most qualified ace managing your money can't predict the future. You start to worry when your accounts lose value and see that surely now you have been cheated because the manager is

Ruled by Chaos 3 supposed to be a genius, he should have known what was in store for the future in order to make your portfolio money.

The reality is that the market isn't a game of probabilities as it relates to the movement in prices. We’ve heard in the following phrase in one form or another: “The stock market might go up based on variable ‘ x’ but it may go down given variable ‘y’.” That's like saying it might rain or it might be sunny, have you ever seen your local weather anchor tell you that on the 8:00 news? Of course not, because meteorologists generally know what the weather will be like in your area. Same thing with a stock broker, or commodities broker, or any financial advisor/analyst; there is a general consensus on what the markets have in store for the near term. But probabilities in the financial markets are not applicable as they are in basic card games.

What you should know is this: conventional wisdom says the market fluctuates based on probabilities, but the simple fact of the matter is that it is chaotic, there are no real probabilities. No one can say that there is a 75% probability that your fidelity mutual fund will make positive gains this year or next. Same way no one can say that the Dow Jones Industrial Average has a set probability of reaching target levels. Although there may be consensus on general levels or prices, there simply does not exist a real probability, or chance of outcome. The financial markets are ruled by chaos. Since chaos theory is a scientific term, it would be good to know the definition.

Chaos Theory What does it mean that the markets are ruled by chaos? Well, very simply, we know that markets move chaotically, but that doesn’t explain more than what’s obvious to us. To know that the markets, a complex social system, are ruled by chaos we have to understand the theory of chaos, scientifically. The definition is described as follows:

Ruled by Chaos 4 Chaos theory is a field of study in mathematics, physics, economics and philosophy studying the behavior of dynamical systems that are highly sensitive to initial conditions. This sensitivity is popularly referred to as the butterfly effect. Small differences in initial conditions (such as those due to rounding errors in numerical computation) yield widely diverging outcomes for chaotic systems, rendering longterm prediction impossible in general. This happens even though these systems are deterministic, meaning that their future behavior is fully determined by their initial conditions, with no random elements involved. In other words, the deterministic nature of these systems does not make them predictable. This behavior is known as deterministic chaos, or simply chaos (Wikipedia.org). One major point to take away, if nothing else is that chaotic systems can take on different forms and those forms can be probabilistic. Ultimately, they are deterministic. What does deterministic mean exactly? It means events are not a matter of chance, it is determined by the function of an unpredicted event. The catalyst, so to speak, is what drives the pattern. For example, the falling of a leaf is random, it may fall anywhere. However, where it lands is in fact not unpredictable, it’s the course it takes to float down which is unpredictable.

Going back to the Las Vegas example—when you find yourself out of luck on the blackjack table you call it quits and spend your well earned money somewhere where your enjoyment is guaranteed. But you don’t do that with investments, you hold on to them because you generally know that although the markets go down, over the course of history markets have gone up. This is the expected result before laying your money down; at least that’s your underlying premise. As you can see fairly simply, the day to day course of the markets is unpredictable but its end result is not: through the economic cycle of boom and bust there are up waves and down waves, but mostly up waves as the economy grows.

Through the Looking Glass The reason we lay down our underlying premise for investing is due to our perception or misperception. There is a huge element of perception for us as participants in this complex system. One way to understand this is through reflexivity theory:

Ruled by Chaos 5 Reflexivity is discordant with equilibrium theory, which stipulates that markets move towards equilibrium and that non-equilibrium fluctuations are merely random noise that will soon be corrected. In equilibrium theory, prices in the long run at equilibrium reflect the underlying fundamentals, which are unaffected by prices. Reflexivity asserts that prices do in fact influence the fundamentals and that these newly-influenced set of fundamentals then proceed to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. Because the pattern is self-reinforcing, markets tend towards disequilibrium. Sooner or later they reach a point where the sentiment is reversed and negative expectations become self-reinforcing in the downward direction, thereby explaining the familiar pattern of boom and bust cycles (Soros, 2008). Essentially, Soros takes a new paradigm to economics by facing the reality that market participants do not have perfect information or knowledge. This simple truth is what gives rise to a whole new ideology which Soros continues to explain by introducing the variable of perception and how self-fulfilling prophecies ensue. Touted as one of the world’s greatest traders in history, George Soros described reflexivity by applying it to the financial markets. A common way to understand this is in understanding the nature of self-fulfilling prophecies, and more precisely, the capitulations that drive the markets towards exaggerated ends. Because of the inherent behavioral aspect of the theory we can assume prices are not scientific and are rather a testimony or bid of collective confidence levels. A logical explanation for the reason markets are reflexive is as follows: Markets are complex systems built on a level of confidence (trust) of its participants. Participants have changing confidence levels. Therefore, markets have changing confidence levels. Some people will act on their confidence levels changing and some won’t. The trick is to understand what is causing a shift in this reflexive feedback towards a certain level; chances are it is a fundamental weakness or strength underlying, but not necessarily.

Ruled by Chaos 6 Describing it as noise, El-Erian explains this point rigorously in his book, When Markets Collide. Rather than dismiss the random movements, he suggests that investment managers should embrace them as traders do when making decisions. Noise can matter in so far as it contains signals of fundamental changes that, as yet, are not captured by conventional monitoring tools…Rather than automatically dismissing it, one should ask whether there are signals within the noise (Eli-Erian, 2008).

Researchers find certain manifestations in the market. It is easy to dismiss differing opinions as noise or volatility. Opposing signals create confusion and conflict to make a clear decision. It may be pure volatility or it could be a clash of fundamental opinion between participants. Whatever the case may be, researchers can unearth significant findings from the noise.

The Trend is Not a Loyal Friend Anyone beginning to trade in the markets has heard the expression, “The trend is your friend”. Many people have profited from this understanding. It’s used because it is simple, the price trend can aid any layperson to profit in any investment no matter how complicated the actual investment may be. The underlying idea is the market discounts every piece of news and information and reflects it in the price as it is disseminated.

A good rule of thumb when using technical analysis to make decisions is to extrapolate channel lines from historical prices, projecting future boundaries of the stock’s price path. If you are speculating on a rise in price you should buy when the price touches the low channel line as it continues to bounce back up to the high channel line in its ascent. It does work; try it for yourself. The trend is not a loyal friend; however, because it can’t always be following the historical trend. Out of 100 price charts how many do you think would follow this rule? If it were less than 50 it’s no sense even using it, if

Ruled by Chaos 7 it were close to 0 you would make consistent money doing the opposite, and if it were close to 100 it would become the only tool for money managers. You can transpose this logic to any technical analysis rule. Yet the fact remains, at times prices will be trending.

In the field of social science research, the trending of prices up or down is known as positive feedback. In the field of mathematics, trending can be tested as short term memory which makes applications to Markovian chains. These are not necessarily fundamental price movements, they are market cycle trends based on emotion or an exaggeration of some sort. The bottom line is that perception has the power to change our principled decisions.

Sales Psychology Have you ever thought about buying something window shopping at a mall or on a promenade and found out that the item was just put on clearance? Your first reaction was probably “how long can I still buy that item?” It didn’t matter the price, it’s just the fact that it was such a good clearance that you didn’t want to feel the remorse of missing out on a sale. When Circuit City was going out of business, the first week they had a 15% clearance discount for going out of business. That may have caused you to budge, unless you knew that a similar company had the same clearance sale and all the steepest discounts occurred after the third or fourth week. The second week they discounted the prices 25% or more, the third week the discount was 45% or more, etc. Imagine this happening in the stock market except you’re the one carrying the inventory, your stock portfolio is being slashed to bargain basement prices. If after the first discount it doesn’t grab your attention you may be gritting your nails when you see a full liquidation sale leaving your portfolio awash. Notice how your perception tempts you to sell your inventory with the fear that your stock may keep going lower at the most pessimistic time.

Ruled by Chaos 8 The Long and Short of it Now think of the perceptions on the debate on whether hard assets should outperform equities (stocks). When times are good GDP is healthy, the unemployment rate is down, and inflation is in check; investing in market indices for the long haul seems like a really good idea. But when times turn bad, GDP is negative showing signs of recession, unemployment is high, and inflation is rampant, investing in hard assets, such as gold, seems like a really good idea. So then which one will win over the long haul? That’s really not an issue of professional debate, but speculators tend to think along those lines. Like a horserace, if you are going to put my money somewhere, it better be on the fastest horse; or in this case, the most winning investment vehicle. Professionals understand this dilemma to be nonproductive for solid investing so there is much more interest on asset allocation, which is one reason we put our money with them. But why must this be such a dilemma? Looking back in time we must focus our eyes through the looking glass, so to speak. Imagine financial experts putting on foggy spectacles when looking at copious amounts of data. How do you analyze financial history, when the course of its history is still taking place? Looking back as far as the eye can see seems like a good idea. Unfortunately, all that does mostly is confirm your perception of the present. The spectacles that we wear can be very foggy during volatile times, or they can be freakishly clear when times are great. Note that rapid change changes our perception of not only the present but of history, and, invariably, of the future. Technical analysts don’t concern themselves with the fundamental facts; they simply look at the asset’s prices.

It’s better to know their cycles and how they behave. For instance, a wave of falling prices will happen quicker than a bullish wave of rising prices. Understand first that the down waves are not constant slides, they happen like floods (Schwager, 1995, p.588). What this means practically is that short sellers, make their money quicker but not for as long. In a bull market scenario, going long means your chances of making money remain for a long time. Going short means your chances of making money remain for a short time. And the opposite is true in a bear market scenario.

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