Weekender: Earthquakes, Power Laws, and Market Behavior

January 30, 2011
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Note — this was originally written May 2009.

I review this book with a specific message (and specific audience) in mind: The driving insight behind “Ubiquity” is of potential great worth to active traders and investors.

The book is excellently written — an easy and engaging read. I first read it many years ago, found it effortless to pick up and read again with fresh eyes a year or two on, and am only now returning to review it (in May 2009) having stumbled across an interesting market-related connection.

(The book touches on out-of-the blue market crashes, but I suppose it took the awe-inspiring volatility of Q408 and Q109 to really open my eyes to the point in question.)

To briefly summarize the key idea, no one knows how big an earthquake will be before it starts. This is so because the earthquake itself does not know how big it will be until events actually play out.

Earthquake energy feeds off a series of feedback loops, which are in turn driven by a chain of complex interlinked events (plate tectonics, geothermal pressures and whatnot) beneath the earth’s surface. If any event in the chain fails to sustain the feedback loop, the earthquake fizzles out.

The same idea applies to wildfires, flu pandemics, and other complex “catastrophic events” of unknown size and duration fueled by myriad complex inputs.

One can perhaps think of an earthquake or a wildfire, then, as the combined result of thousands of hidden domino chains. The ultimate size and destructive power of the event is determined by the combined manner in which all the domino chains fall, and there are far too many inputs (most of them hidden from the human eye) to track.

So the only thing that really governs the ultimate size of earthquakes, wildfires, pandemics, and other complex catastrophic events is something called a “power law”… a sort of linear inverse correlation between the size of an event and the probability of its occurrence.

The power law, in other words, cannot tell you how big the earthquake will be either. But it CAN tell you that the starting conditions for big and small earthquakes often look exactly the same… that big earthquakes occur relatively less often than small ones over time… and that this established relationship between size and frequency remains stable up and down the line.

The market insight that brought “Ubiqity” back to the forefront of my mind is as follows: Major market rallies and declines behave a lot like the phenomena discussed in the book. And thus we can hypothesize that:

1) No one knows in advance how big a rally or decline will be, because the market itself does not know beforehand…

and

2) Major market rallies [and declines] are ultimately governed by power laws.

This is why it’s so hard (if not impossible) to know how far a market will travel — in either direction, up or down — if conditions are suitably conducive to a wide range of possible outcomes.

In other words, there’s no effective way to predetermine the magnitude of a major market move, without first having a VERY clear sense of all the myriad inputs and all the ways they can combine.


In the case of the monster bear market rally that has been unfolding for nine weeks or so as I write this review, an improbably long chain of positive economic data points fed into a number of other supportive conditions… and thus the stock market equivalent of a giant bullish “earthquake” resulted.

This concept is valuable to traders and investors because it offers a tangible intellectual anchor for a critical market insight. Again, if rallies and declines follow power laws, it doesn’t make sense to try and anticipate magnitude ahead of time without a VERY clear sense of what could stop the movement in its tracks.

At the same time, power law governance is instructive in that, while traders and investors cannot reliably predict deeply complex outcomes, they CAN analyze the general conditions necessary for producing a significant outlier event, in the same manner that one can examine conditions conducive to “extreme” outcomes on the natural disaster front.

Just for fun, take the relatively recent (as of this writing) earthquake in Italy for example. There was a scientist who predicted a major earthquake around L’Aquila weeks before it happened. He was reported to the authorities for “spreading alarm” and forced to take his findings off the internet.

Afterwards the authorities (in deep damage control mode) said the scientist’s method of earthquake prediction (involving radon gas) was hopelessly unreliable, mainly because “earthquakes cannot be predicted.” And yet they were using the baseline belief that “earthquakes cannot be predicted” as a tautological first principle! Not unlike the way some say that significant market movements can’t be predicted… even though clear evidence shows that general conditions can most certainly serve as a “heads up” guide for those with eyes to see and ears to hear.

All that to say is, in some ways smart traders and investors are like geologists or forest rangers on the lookout for earthquake-prone / wildfire-prone conditions… persistent tremors, dry underbrush, extreme low humidity, and so on. And then as active market participants, they get involved with the phenomena as it gets underway… but with a healthy respect for catalyst points and potential / probable ranges of outcome, as opposed to an overly anxious fixation on pegging the size of the move.

If you’ve read this far, I hope I’ve inspired you to read the book.

JS

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One Response to Weekender: Earthquakes, Power Laws, and Market Behavior

  1. Anonymous on February 6, 2011 at 8:40 am

    teri maa ki choot

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