Chasing The Big One
A few weeks ago, California was hit by two earthquakes. And almost every media covering the event started to speculate about “the Big One”, a catastrophic quake that might shake (and even destroy) the Golden State sooner or later.
Surprisingly, the same behavioral pattern can be observed on capital markets nowadays. Whenever risk aversion rises, commentators are wondering whether “the Big Crash” is coming or not.
But the similarity between finance and seismic activity is actually much deeper than that. Indeed, there is a scientific name to describe the way they both work: self-organized criticality (SOC).
Like many natural phenomena (earthquakes, floods, forest fires, solar flares, epidemics, mass extinction and so on) human interactions seem to be well-explained by SOC. Put forward by Danish physicist Per Bak, SOC is an amazing theory to understand how such complex systems naturally self-organize towards criticality. Once in a critical state, they become so unstable and vulnerable to even small shocks, that they might suddenly reverse. And the reversal process is called an avalanche.
Scale invariance and power laws
Self-organized critical systems have interesting properties like the fact that they display scale free behavior, and the fact that the size of avalanches is distributed following is a power law. For instance, consider the Gutenberg-Richter Law expressing the relationship between the magnitude and the number of earthquakes. It is a power law. Consider now a Pareto wealth distribution. It is a power law too.
What does it imply for investors? First, price corrections must be regarded as a necessary and natural adjustment process. What’s more, catastrophic events (like the 1987 stock market crash) are still possible and should not be treated as an anomaly. In other words, models based on Gaussian behavior assumptions will always fail when the market enters a transition phase, as already explained by Mandelbrot in 1963.
Another important finding of econophysics research is the fact that financial markets can be modeled as a network connecting investors to each other. And when the market moves towards criticality, the degree of connections between agents tends to increase dramatically. Said differently, the market tends to exhibit a macro-behavior that will embrace most of investors’ decisions (i.e. a “speculative bubble”), until it collapses due to any kind of external event or change in opinion.
Further work has been done to build signals that would help investors to anticipate imminent market crashes. But forecasting the next Big Short is not an easy task! It would be like anticipating upcoming earthquakes in California or in Indonesia…
Instead of chasing the next crash, investors could focus on what makes the market vulnerable in the near term. Which assets are mostly overweighed? Are there evidences of a macro-behavior driving the market? And how should portfolios be diversfied in order to resist in a complex and nonlinear environment?
In my opinion, a simple look at Shiller’s adjusted price earning ratio should be enough to understand where the biggest risk lies today.
This article was originally published on LinkedIn August 2, 2019