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Friday August 10, 2007 - 11:20:47 GMT
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Crash dynamics

Key News
• China's trade surplus surged 67 percent in July to the second-highest on record. (Bloomberg)
Key Reports Due (WSJ):
8:30a.m. July Import Prices. Expected: +1.0%. Previous: +1.0%.
2:00p.m. 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,” 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.  Mr. Sornette is a professor of Geophysics, not economics.  But, even so, I found it at times fascinating, as Mr. 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 magnitudes, ranging from individuals to gigantic professional investors such as pension funds.  Structures at even higher levels, such as currency influences spheres (US$,Euro, Yen…), exit 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, critical phenomenon, called ‘log periodicity,’ in which, for instance, the probability or the hazard rate are not monotonously accelerating but are 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 every day 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) which links these structures into a hierarchical pattern. 

Here’s a basic example:  If we consider trend following strategies, which seems to be common in all markets at all levels by many different actors, we know it provides 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 effectively 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 (i.e. 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. 

Sornette tries to make the point that the oscillation of market structures moves in every increasingly tightly wound spiral patterns, building more and more pressure, which leads to a critical point or price level. 

“Crashes occur as possible outcomes of long preparation [years], 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…We propose that the origin of the crash is much more subtle (than most other theories) and is constructed progressively by the market as a whole. In this sense, this could be termed systemic instability.”

Maybe in real life we refer to this as the point at which some actors, and soon all, realize that prices have overshot their fundamental values to such a large extent, the only path left is to run.  It takes years to reach this level.  It takes credit to allow speculative urges to be satiated.  It takes massive levels of credit to push the majority of the market structure into extreme complacency.  Have we seen all that?

Are some possible hierarchical system beliefs about to be smashed?

1) The dollar can only go down
2) Gold is a safe haven
3) The European single currency is stable
4) Other countries have decoupled from the US
5) Derivatives packaging spreads credit risk
6) Corporate earnings determine stock prices

We still like short $-yen, short SPU, long Treasuries, and short NZ$--we mentioned these a while back not because we can forecast the market, we can’t.  But we liked them simply based on a view they represented good global risk-reduction trade bets.  It seems they are still in play.  And if we are near one of those “critical points” as Mr. Sornette defines, we are likely much closer to the beginning than the end of these trades. 

Stay tuned.  And be careful out there.

Jack Crooks

 

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