There was a time when financial analysts, quants, were recruited from high energy physics labs and university maths departments. Physicists were trained in analyzing large data sets and picking trends out of the noise. Why not recruit hungry physicists fresh from the hunt for quarks and Higgs Bosons into the world of stock market predictions? But then came the stock market crash, the bubble burst and quants became a dirty word. They should have been able to predict the crash with access to all that data and computing power, so what went wrong?
Chaos in the stock market is a lesson we are doomed to repeat. Every time the stock market recovers a new algorithm is formulated and high speed trading takes over. The perils of the next crash are ignored because we are drawn like moths to a flame in the belief that fortunes can be made by predicting short term trends in market behavior.
Benoit Mandelbrot developed a new mathematics to characterize chaos theory in his 1982 book The Fractal Geometry of Nature. The same mathematics that could describe jagged mountain ranges, he discovered, could also describe the precipitous price changes on the stock market. He followed up with another book in 2004, The (Mis)behavior of Markets: A Fractal View of Financial Turbulencewhere he showed the shortcomings of present day economic models for market theory.
The graphic at the top of this article is a detail of the strange attractor discovered by Edward Lorenz when he first analyzed mathematical models of chaos in weather patterns. The eddies and turbulence in the flow of winds and water currents have many similarities to the chaotic behavior of financial markets. Lorenz succinctly defined chaos as “When the present determines the future, but the approximate present does not approximately determine the future.”
It is one thing to forecast that chaos will occur, but another thing to predict exactly how and when. We all know an earthquake will one day hit the West Coast, and another giant hurricane will devastate the East Coast again, but it would be nice to know when and where. Some private hedge fund managers claim they can now forecast market downturns and hedge against the losses to protect their funds. Didier Sornette, professor of finance on the chair of
entrepreneurial risks at the Swiss Federal Institute of Technology, famously predicted the 1994 stock market crash and showed that there was money to be made for some in short selling stocks. There’s gold in them thar fractal hills! He gave an illuminating TED Talk on how we can predict the next financial crisis.
Predicting market swings tends to be proprietary information closely guarded by an elite few. After all, if everybody knew what was going to happen it would no longer allow the top fund managers to make a profit at the expense of the remainder of the market. It is sometimes better left to fiction to describe the ‘what-if’ scenarios in such a high stakes game. In the novel Sand Hill Road a mathematical physicist does come up with an algorithm for predicting market turbulence and making market maps of the whirlpools and eddies in the flow of money. The reaction of the venture capital world to his discovery may not be what you think when they are less than welcoming to his ideas. The action takes place on the famous center for venture capital from which the novel gets its name – and referred to by some as ‘the Wall Street of the West Coast’. It’s a very different lifestyle from Manhattan and gives a distinctively Californian flavor to the novel when the Stanford physicist is pitted against the magnates of the financial world.