Financial Market Physics
In the past few years, a remarkable parallel can be seen emerging between financial markets and the laws which govern physical motion. In the world of science, we call this field physics. In most high schools and colleges familiar to me, even the word "physics" generates among students off all types pure fear and trembling, if not confusion and consternation. Without mathematics, chemistry, french, and physics, this here guy would have had a grade point average pulled to a much lower level. Heck, I loved physics, at least until we got to nuclear particles and fission crapp. There simply are not many fields where laws are inviolate. If you do violate, your airplane crashes, your kite fails to remain aloft, your space craft misses the window for orbit re-entry, your baseball does not reach the outer wall, you fall off the ledge when balance is lost, your thrown snowball misses your buddy John's back. People cannot override laws of physics, which is reassuring. We will eventually learn that Economic Laws cannot be violated for too prolonged a period of time either, engineering or not.
My favorite basic physics problem of all time pertained to a cannon. It fires a ball at an angle of Θ with respect to the ground. For a given fixed velocity, and ignoring friction, at what angle would the ball travel the farthest from the point of origin, where the cannon was located? At angle zero, the ball travels zero, as it hits the ground immediately. At a vertical angle (90 degrees), the ball travels zero after rising and falling at the original point. The same problem can be framed for tossing a ball by a person, or shooting a ball from a slingshot, or firing an artillery shell on a battlefield. In the world of baseball, a favorite pastime in the USA, the question relates to the best angle off the bat for the longest fly ball. In the real world we cannot ignore friction, as heavy humid summer air impedes the flight of the ball. In Colorado, the high altitude lighter air has led to historically high home run counts (fly balls hit over the outfield wall). Ground balls off the bat involve an angle closer to zero. Pop up fly balls off the bat involve an angle closer to 90 degrees. It turns out that the distance traveled by the ball is proportional to a certain trigonometric function of Θ. The function is “sin(2Θ)” for total distance traveled, for those with math curiosity after a raft of impressive computation. Bear in mind concern is for the optimal trajectory angle. The answer is 45 degrees to achieve maximum flight length, for a given initial velocity. This problem’s solution in high school sent pleasurable shivers down my spine in pure unadulterated inspiration. Call me strange, but be sure to know that other things also caught my fancy, like prisms, gyroscopes, spinning tops, a wicked curve ball, moons of Jupiter seen through a telescope, jet takeoffs, the rhyme of a poem, the turn of a phrase, clever symbols in a novel, lightning, rainbows, tornadoes, solar eclipses, the shape of a tree leaf, the leaning of a sprout toward the sun, the effect of a magnifying glass on ants under the sun, the parallel nature of blood and chlorophyll, the color in flowers, a child’s smile, a woman’s profile form, and especially a young woman’s returned gaze. In high school, we used to razz the mediocre students by writing on the blackboards “PHYSICS IS FUN.”
The appearances and evidence of physics is everywhere in financial markets. This should not be surprising, given how we in the United States constantly employ financial engineering. What seems to receive very little deeper attention are the physics concepts in this engineering. Sir Isaac Newton would shudder to observe how we pretend to have advanced a pretentious science. Charles Darwin might also shudder to observe how we as a nation might be ripe for the natural selection process. The US Economy has relied far too heavily upon inflation and leverage and financial machinery. Argentina collapsed in reaction to inflation and foreign flight, Darwinism at work.
For now, let's review some physics parallels in honor of the difficult field. A counter point of view might be told at a later date on whether our usage of engineering principles in the world of finance represents progress at all. Whether the immutable laws of physics are obeyed by the financial markets remains to be seen. If they prevail, we are in for a rough and deservedly unpleasant ride, a fate sure to be Mother Economic Nature's revenge and payback.
Resilience: A hickory stick will bend without fracture, a sign of strength. Check the gold price and the HUI goldbug index, which on Tuesday May 31 and Wednesday June 1 did not budge in the face of a rising USDollar and a falling euro currency. They used to say of the old Cleveland Browns, "they bend but don't break." Well, they do move to Baltimore. Gold will bend but won't break. Even if most new money goes toward unproductive purposes, gold will still thrive during the inevitable crises ahead. Copper, silver, and the Canadian Dollar are also showing resilience. Heck, the USDollar bent until DXY=80 was touched earlier this year. It did not break.
Momentum: Mass times velocity perpetuates motion in momentum, even in transfer of that motion to other bodies (like swinging metal balls or other share holders). We hear "the trend is your friend" to describe momentum. In finance, movement continues until, well, it is interrupted. A favorite technical chart pattern of mine is the momentum swing, which might show an upward move after a downward move of equal size after momentum is reversed. Notice the 7 point swing in 2004 for the Canadian Dollar, from a Jan04 high of 78 to a May04 low of 71, back up to a Nov04 high of 85. Also, see the momentum measure known as the stochastic indicator, which has crossed over positively. Click HERE for its chart.
Inertia: A body will remain moving in a pointed direction until disturbed. Investors will continue to employ the same trading strategies until they face too many losses. Tech traders kept it going until they ran over the cliff in 1999. A hedge fund will chase the same type of risky trades, play the same type of arbitrage, until it incurs painful losses which force change. Nowadays, the commodity bull market has strong inertia, and is nowhere finished.
Pendulum & Coiled Spring: Two common moving objects in the laboratory world attract much attention. A pendulum swings to the left then to the right in a fixed rhythm. A coiled spring loads its force, bound by obstruction, only to free the stored power. Financial market cycles are well studied, in patterns that swing a few years like with Fed tightening cycles, or swing for two decades like with paper securities versus hard asset commodities. Since summer 2004, the Fed has thrust a tightening cycle upon the financial markets, the effects of which have yet to be determined. Although some damage is clear with GM/Ford and hedge funds, the Fed might not be content with the damage to date. The success or failure of the Fed Reflation will reveal whether the commodity bull market continues or is sidetracked by the ravages of secular deflation and worldwide recession. A remarkable chart is the 80-yr ratio of commodities versus paper stock securities, as it swings from low ratios (like in 1990's) to high ratios (like now). The more dangerous object is the coiled spring, whose power is tightly wrapped, and its forces hidden. The pyramid of derivatives which contain bonds, currencys, and precious metals certainly qualify as a coiled spring. When and if Asia rejects their role to dole out credit welfare to the US Economy, many will be the projectiles hurled about our system, in the financial, political, and social arenas, perhaps even military.
Gravity: Without support, a body will fall to the earth under the force of gravity. The earth pulls a body toward its surface, whether to solid ground or liquid sea. A financial instrument (bond, stock, mortgage for house, contract for commodity) will be pulled toward its true ground level of value. Furthermore, Art Cashin of the NYSE claims "stocks will find their rightful owners" in clever style, which might mean those wise cold hands well grounded. Usually, forces exert the pull as the market seeks an equilibrium between supply and demand. At other times, like lately, forces come from clandestine corners. Government entities or the Working Group for Financial Markets or cooperative foreign central banks or powerful brokerage houses will tinker with certain indexes at critical moments so as to influence the tea leaf readers. It is not beyond the Federal Reserve to implore the participants to obey their whim, as hot air is used to talk down the market. In recent months, OPEC ministers have employed hot air to keep prices up or down.
Storm potential (hi-lo): Low pressure zones have been cut by secular deflation forces, as debt has been abused, defaults registered, big price adjustments enforced, and oversupply (from Asia or our own car sector or telecom sector) weighed down the balances. High pressure zones have been constructed by human reaction, in a concerted effort to intervene with monetary inflation, interest rate accommodation, and vendor financing in order to keep commerce moving, to deliver the products. When low pressure meets high pressure, a storm develops and unfolds, much like in nature with tornadoes and hurricanes. The competing forces mix to produce a whirlwind, complete with extraordinary electrical action in the form of lightning. In our case, the lightning might be political in nature, as Asia resists the urge to supply the US Economy continued easy credit with no strings attached to halt abuse. The potential grows in magnitude as financial markets are interfered with, leaving political lightning the release of pent-up energy.
Eddies: Few outside the sailing and marine world are very familiar with eddies, those odd swirls of seawater which disturb sailors and earn their dread of racers. Eddies are the liquid version of a tornado, and are rarely seen. The financial world is chock full of eddies, often called minefields. But a planted mine is hardly a natural event within the world of physics. The harmful swirls might be reduced Asian credit supply, reduced retail investor inflows into mutual funds, regular stock sector rotations, sudden shifts from stocks to bonds, changes to tax incentives, military budget announcements, whatever. The investor community has as much difficulty and challenge in recognizing eddies as the sailors do. The GM/Ford bond downgrade and associated fallout made for nasty eddies.
Meltdown: An ice cube will melt when on a stove top, the same as a clump of snow. The 1998 disintegration of the LTCM pyramid was tragic, although the public was spared the step by step breakdown. The term "meltdown" is one of the most feared in the financial world, as it connotes total systemic destruction, both among the money changers (stocks & bonds) and among the workers, households, residents of commerce. If and when the USDollar index penetrates the critical support level of 80, which it touched last December, look for a possible meltdown. Too much is geared among bonds, currencys, and gold.
Tidal wave: When the Indonesian tectonic fault line reverberated in autumn 2004, the world witnessed what happens when a large wave ripples through islands and wrecks destruction. In the early 1990 decade, in response to soured prospects in Japan following their total economic bust, at least $600 billion in capital migrated to the US shores in a fortuitous tidal wave. The climax to that migration met a gigantic wave of capital from Europe late in the same decade. Tidal waves leave massive damage in their wake. In 2002, a tidal wave of money, mostly financed by cheap US rates, flowed into commodities and the euro currency. This wave is nowhere finished in its course. Its regular whitecaps are easily identified. Its next are not.
Ebb & Flow tide: Nature provides us with a daily reminder of the earth's sheer power in hidden forces bound by the pull of sun and moon. The Bay of Fundy in northern Maine has a 70-feet differential from low tide to high tide, in the most amazing display of tide on earth. The most tracked in money flow is for mutual funds, cited even for sectors such as energy, technology, or pharmaceuticals. Inflows are tracked by TrimTabs and other groups. Other flow is measured in volume of trading, which follows sectors and even foreign stock markets. We all wish that hedge fund traffic could be better monitored. Commodity investments are well tracked by commitment of traders, as commercials are pitted against speculators. Note that signs have improved positively for the bullish energy position and gold position. When the tide is coming in, all boats will float. When the tide goes out, only the healthy stocks (boats) embark toward the sea, as the sickly damaged stocks (boats) are left aground. One need not be smart to profit from selection during inflows, leading many an investor to confuse bull market with genius.
Acceleration: When speed increases, by whatever force as means, an acceleration results for the body. It could be a falling object or a vehicle reaching a high speed. Since 2001, the money supply has accelerated at an alarming rate, mostly led by debt creation. In order to achieve a steady stable economic growth rate, a constant acceleration in new debt will be required. Most investors fail to comprehend this requirement. Actual annual data can be frightening. Just as difficult as it is for a car to reach 1000 miles per hour (1600 km/hr), it might be equally challenging to see the US Economy continue to grow in a sustained manner, with or without foreign infusions. Many forward thinking analysts observe changes in acceleration, hardly detectable to the casual observer. They indicate failing tops and reversals, and can be recognized with momentum indicators.
Traction: In winter, a car might struggle to become released from the trap of an icy patch of ground. A person walking might struggle to run to a bus on a slippery surface. Traction is required to transfer force with a grip into an object's movement. No problem on dry pavement or solid dry ground. Since 2001, the US Federal Reserve has attempted to throw easy money into the system in the hope that business activity would engage, new business would form, jobs be created, and wages grow. The outcome of the Grand Fed Reflation initiative is to date rather mediocre. What has lacked is traction in job hiring and wage growth, since so much reliance upon Asian labor has bypassed the formerly caged US system. The presence of China represents a gigantic leakage to money out of the US Economy. Leakage invites poor traction. Job growth is mostly fictional and statistical, as the April Challenger Grey & Christmas large site layoff exposes (over 82 thousand, vs March 58k vs February 86k) in a resumption of trend. Wage growth stinks on ice, where traction sucks.
Imbalance: If a person is burdened with a heavy load on one side, or loses balance to the point that the center of gravity is far to the side, then the person is very likely to fall down. The person is out of balance, in disequilibrium. The body seeks equilibrium and balance, even if flat on the floor or ground. The US Economy suffers mightily from gross imbalances, like a trade deficit 40% relatively greater than anything endured before, like the disappearance of its manufacturing sector (never endured before), like a debt ratio versus income or versus industrial output (never endured before). Our sickly economy is like a fat slob running on amphetamines, with one leg much longer than the other, weighed down by a cinder block in a backpack, whose blood requires transfusions every three laps. Nature seeks equilibrium even in the financial markets, to counter the growing stress. Accidents happen when the forces work to achieve balance while disorder grows. Look for future accidents. In fact, one can argue that regular and frequent accidents have become the norm, since 1971 following the anchor of money to gold. As the US Fed has tightened, imbalances have been exposed.
Vacuum & Black Hole: Clearly in April 2005, we saw a vacuum in the stock market as most every sector was hard hit. Without question, higher short-term interest rates combined with the effect of a big cash drain for income tax payments to state and the federal coffers. The stock market felt a vacuum, to be sure. Another strong vacuum was felt in the summer 2002 with stocks. On a grander scale, Japan faced and survived a bout on the edge of a black hole early in the 1990 decade, otherwise known as massive secular deflation. In such an environment, money velocity slows, bond yields are nil (like now in USA), assets fall in price (like soon in USA?), debt defaults, and governments stimulate like crazy. In many respects, the USA is following the Japanese lead, although unwittingly. There are some temporary advantages to owning and abusing the world reserve currency. The carry trade between Japan's ultra-low rates and US Treasury's declining rates is precisely the tight grip of a pull to a black hole.
Nucleus-electrons: We all remember our past training about atoms, right? Each contains a nucleus with a certain number of protons and neutrons which identify the element as carbon or oxygen or nickel or silicon or whatever. Surrounding the nucleus is a cloud of electrons of equal number, busily spinning around that nucleus. The atoms can join to make compounds, known as molecules. Here is a parallel to the economy, and not all that much of a stretch. The nucleus is the real economy, where things are built, farmed, mined, serviced. The core is under tremendous strain, as cost inflation has been the sour fruit of Fed Reflation, as job outsourcing continues unabated. The cloud of electrons is the financial sector, spinning their woven money off a counterfeit printing press and directly influencing the real economy. The electron spin has gone amok, and has taken undue control of the New Asset Economy via housing and rousing bond market bull markets. Mortgages and refinances and equity extraction from home equity loans represent the vast conduit by which the electron cloud has wrestled control of the nucleus, in tragic heretical fashion fully blessed by our national cadre of clueless economists.
Action vs Reaction: The aged old maxim of "every action invites an equal and opposite reaction" assures continued equilibrium. If bond support vanishes from one world locus, it usually is compensated by arrival of new bond support elsewhere. Note how Asia has pulled back even as the Caribbean source has appeared. Note how a stock like Fanny Mae might plunge, only to rebound somewhat from short covering. Note how sources of income were inhibited by job loss, but home equity extraction by whatever means came to the rescue. Lastly, note how massive outsourcing to China and India has resulted not only in huge increased liabilities for the US Economy generally, principally to Asians. The insane low-cost solutions directed by inept national economic policy has resulted in a replacement of income by debt, with little awareness of the tragic policy even yet to date. The consequent reaction might be motivation and ground work foundation for trade war. If national security is threatened, then political response is certain amidst financial market overrides.
Entropy - max randomness: The final items pertain to unusual but powerful laws. A system will tend toward greatest randomness and dissemination. Cigarette smoke, or a campfire, or an Italian dinner, or a pungent odor like onions, or rotten food, or rubbing alcohol, or smelly feet, or paint solvent, these will fill a room, fill a house, fill a neighborhood, or fill a forest. The stream of molecules (behind any scent) dissipates, as we call it, which enables nearby persons to smell it at all. "What is that!?" is the human response to the law's manifestation as recognition occurs when a person enters proximity, and walks nearby. In financial markets, we used to have more random behavior. In recent years and especially recent months, we have remained rangebound in a great number of sectors. Controlled steering of the odors has replaced allowance of them to waft and find their own paths. The most visible areas of lost randomness are the reduced volatility VIX index, the S&P500 index after 10am, the price of Microsoft, Cisco, and Intel, even the exchange rate of the Japanese yen, or perhaps the prevailing mortgage rates.
Enthalpy - min potential energy: This other powerful law dictates that objects or systems will tend toward minimum potential energy. Good examples are a ball will find its way to the bottom of the staircase, an unstable vase will find the floor (even more energy lost if it breaks), a tottering toddler will fall to the ground, a pile of papers will find the floor (even more energy lost if scattered), a weak pine tree will fall on its side during a storm. In financial markets, overpriced assets will seek a lower more stable price. We are not seeing this occur in numerous arenas. The Plunge Protection Team has been working overtime. The key is housing prices and mortgage rates and interest rates. The entire US Economy is dependent upon housing bubble price levels and favorably low interest rates, much like a man in prison depends upon food and water dispensed through a slot in the door.
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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 23 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com.