CHAOS THEORY & MARKETS: DOWN THE RABBIT HOLE?

(Source: www.shutterstock.com/cartoonresource)(14 February 2016)

The Chaos Theory seems to have the answer for much of the market mayhem that we have been witnessing. To me, the Genesis seems to be the falling price of oil. 

 

How correlated are Oil Prices, Stock Prices & Inflation?

There is a definite positive correlation between oil prices and stock prices. However, the correlation is too random to be predictable. Currently, the correlation between oil prices and stock prices is between 0.9 and 1.0. This is an aberration. The normal range seems to be between 0.5 to 0.7. However, oil prices are positively correlated with inflation and also with inflation expectations. Consider the following: 

• In the worldwide ‘search for inflation’, the positive correlation between oil prices and inflation translates into a positive correlation between Central bank actions and oil prices. The lower oil prices go, the more hyper-active the Central Bankers get.

• Over the last fifteen months, as oil prices have kept falling, inflation expectations have vanished. Negative interest rates reflect the desperation of central bankers from falling oil prices. They have no control over the price of oil. As a result, they seem to be fidgeting with the other variable in the ‘inflation equation’.
• It all began with the OPEC (Organisation of Petrol Exporting Countries) in 2014. Their decision on 27 November 2014, not to cut supply and leave the oil market to rebalance itself led to a crash in oil prices. It eventually resulted in selling by Sovereign Wealth Funds (SWF’s), the Oil contagion, negative interest rates in Europe, debt defaults in the developed world, fears of European banks going bust, and recently negative rates in Japan. You can change the sequence any which way you want, except the starting point – the OPEC in 2014.

 

The Chaos Theory

 

In 1972 that American meteorologist Edward Lorenz wrote a paper titled Predictability: Does the Flap of a Butterfly’s Wings in Brazil Set Off a Tornado in Texas?. It inspired the ‘Chaos Theory’, also known as the ‘Butterfly Effect’. This four-minute YouTube video explains the Chaos Theory:

The Chaos Theory says that small changes in initial conditions can result in vast differences in the outcome. Consider the following:

• It was the self-immolation of a Tunisian man on 17 December 2010, that sparked off protests in Tunisia. After the death of Mohamed Bouazizi on 04 January 2011, the protests quickly spread to Egypt, Libya, Syria and the Arab world and led to what is now popularly referred to as the Arab spring. Moral of the story; the events that occurred were the ripple effects of one poor man being harassed by the police in Tunisia.

• It is a manifestation of the Chaos Theory that we are now witnessing in global stock markets. In the immediate context it means that if OPEC (Organisation of Petrol Exporting Countries) had not decided against going in for production cuts at their meeting on 27 November 2014, none of what we are currently witnessing would have happened. In other words, what I am insinuating is that OPEC action/inaction on 27 November 2014 led to the current negative interest rate regime.

 

How does The Chaos Theory apply to Oil & Stocks?

 

The Chaos Theory applies to systems which are both dynamic and nonlinear. We need to understand the meaning of these two words. Hence:

• Dynamic: something that is a subject of continuous change. The intensity of the change also varies. Dynamic systems are those wherein the output or assumptions in one process are used as inputs to the next process and so on and so forth. Effectively, a mistake at any one stage is compounded exponentially.

• Nonlinear systems are those whose effects are not proportional to their causes. In other words, they are chaotic.

In my opinion, the Chaos theory applies to both, oil and stocks. Not only are they both dynamic and nonlinear, the number of factors that can influence them is also very large.

Investing implications of the Chaos Theory?

 

The investing implications of the Chaos Theory are as follows:

• What Edward Lorenz and the Chaos Theory did was to shift scientific opinion towards the view that there are limits to the predictability of events. The reason: human behaviour is unpredictable. The Chaos Theory questions the premise that growing knowledge leads to greater accuracy.

• According to the Chaos Theory stock markets are inherently chaotic. Chaotic systems like stock markets work on feedback loops. A positive feedback loop leads to bubbles and a negative feedback loop to busts. We seem to be caught in a vicious negative feedback loop.

• Chaos and fear, resulting in even more chaos, is what seems to be happening in the markets. It is what George Soros called ‘the theory of Reflexivity’. Watch the two-minute video below to understand the theory of reflexivity.

How to navigate the chaos

The major takeaway from the Chaos Theory is that knowing and recognising the limitations in our ability to predict is more important than the predictions themselves. As a result, it is misguided to think that anyone can see very far into the future. Amidst all the chaos, the following thoughts might help:

• How much of all that has been predicted is predictable? The financial media is trying to predict the behavior of two dynamic and nonlinear systems. Is that possible? The verbiage is only exacerbating the negative feedback loop.

• Nothing has happened just yet.  Fear is justifiable; extrapolation is not. I think that all the predictions and forecasts need to be taken with a bagful of salt.

• Investing is a game of probabilities, not possibilities. Anything is possible. How probable is it? The Japanese Negative Interest Rate Policy (NIRP) was intended to weaken the yen. Nothing of the sort has happened. In fact, the Yen has strengthened. Their policy initiative has backfired. In such a situation, how probable is it that the Japanese NIRP would dive deeper into negative territory? It is possible, I agree. Is it probable?

• Negative interest rates were supposed to be a solution. The markets think they are the problem instead. It is not yet the case that, the proverbial Mrs Watanabe, the risk-averse Japanese housewife, who is having to suffer negative rates. In their desperation, Central Bankers forgot that investor human behaviour is sentiment driven and inherently irrational. As a result, what NIRP inadvertently does is that it exacerbates risk aversion. To rephrase a famous Yogi-ism ‘Markets are Baseball is ninety percent mental, the other half is physical’. 

• All the economists and analysts who predicted economic growth on the back of low oil prices, now expect none at all from even lower oil prices! I think this is a bit absurd. The consensus opinion that low oil prices are a ‘manna from heaven’ was wrong. It is the intuitive logic. Unfortunately, markets are counter-intuitive. Even if oil prices were to revert to their mean, it would alleviate market pain.

• OPEC now seems to be faced with an entirely different problem. They don’t want to quit when they are losing. I don’t blame them, none of us likes to quit when we are losing.

• While I am unable to comment on things like ‘global economic fundamentals’ and contagion, I do know that this stuff doesn’t happen with prior announcements. Black Swans as defined by Nassim Nicholas Taleb are those that are unimaginable and hence unpredictable. The Chaos Theory and Taleb are complementary. Imagined fears cannot black swans make, as simple as that.

• The jury is out on whether or not the world economy has gone down the rabbit hole. In the meanwhile, the markets have. It reminded me of a what now seems to have been a prescient post, written by me in April 2015, titled  Stray Thoughts – Like Alice in Wonderland.