Discourses on financial markets: Mainstream models, Chaos, Panic and Mania

Markets, Cycles and Risk

Models of market analysis, risk and forecasting The Fundamentalists The Chartists The Efficient Market modelers The Chaos theorists The Historians

The fundamentalists Oldest way to handle “risk” and understand how markets operate If a stock is rising or falling seek the cause in a study of the company or the economy behind it. Postulate: the price of a stock, bond, derivative or currency moves because of some endogenous (or most of the time exogenous) event. Implicit assumption: if one knows the cause, one can forecast and manage risk

Problems with the models of the fundamentalists –In reality causes are often obscure and not predictable –Information can be concealed or misrapresented (internet bubble, Enron, Parmalat) –The market mechanisms that links news to price (cause to effect) is often inconsistent (threat of war => some times dollar rises or some time dollar falls. Ex post link is clear, but ex ante there are arguments for both ways) –Investment strategy based on fundamental is grounded on dubious principle “I know more than everybody else”.

Enter the Chartists Second oldest form of analysis, also called “technical”. Back in favour in the 1990s and thriving in currency markets Chartists are technicians who look for trend indicators in graphical charts, usually depicting price as a function of time, but often including information on intraday highs & lows as well as closing price. A chartist typically will want to buy into an uptrend, sell into a downtrend and stay out of the market for a sideways trend ("momentum investing").

Problems with the chartists Thay are all doing it Everybody knows that everybody else know about this or that technical aspect of the chart (“support points”, “trading range” etc.) Hence bets are placed accordingly Financial astrology is not a basis for understanding financial markets

Enter the efficient market modellers What business schools call “modern finance”. It emerged from maths of chance and stats Basic concept: –Prices are not predictable,HOVEVER –their fluctuations can be described by the mathematical laws of chance –HENCE: their risk is measurable, and manageable.

Which chart is real? Plotting changes in stock prices Real EMH generated Real Fractal Model –(Mandelbrot)