Most economists are like weather forecasters. They can explain disasters after they’ve happened but they’re no good at predicting them. But while no-one expects meteorologists to be able to stop hurricanes, economists often think the storm will be averted if we take their advice.
They tell you the markets are rational, which begs the question of why trillions of dollars can just disappear. They tell you the markets operate better on the basis of information flow, when all the evidence suggests it’s not information but lemming pheromones that impel wild rushes over the investment cliff-top, producing the recent ‘adjustment’ which, if it had happened over a few days, would have been a ‘crash’.
Of course the Speculator was laying down the law long before boom came to current bust. The first law of speculation is that bubbles always burst in the end. The second law is that if there is nothing holding up a stock price, it will eventually fall. By combining the two we get an accurate description of today’s reality. If stock prices kept expanding for companies with no revenues and no profits, they would come down and the bubble would burst. Even when Alan Greenspan stopped talking about irrational exuberance and droned on about new paradigms, the Speculator went right on puncturing the balloon.
So it is almost refreshing to read a book filled with equations and graphs showing how bubbles burst – and promising to predict when. Didier Sornette is a geophysicist by trade, and his book, Why Markets Crash, applies the mathematics of physical and biological systems such as earthquakes, cells and quantum physics to stock market variations in the US and worldwide.
In fact, Sornette and his team claim to have accurately predicted several market ‘singularities’, as they call those times when the buying has to stop. If you want cause to worry, and you are a young reader, they foresee something big and unspecified happening to the global economy around 2050. (On the other hand, you could discount the whole book for its lousy editing. Sornette is French, so even in these times of American Francophobia he can be forgiven for writing mouses instead of mice, but what’s his publisher’s excuse?)
Sornette points out that close up, the typical price variation looks like what he calls the ‘random walk’, which is what more sybaritic physicists used to call the ‘drunkard’s walk’. Later he compares the financial markets with the self-organization of slime mold, whose cells operate as Thatcherite individuals then occasionally combine to move off as one organism. The notion of a drunkard’s walk combined with a slime mold makes me suspect that Sornette has met pit traders in the commodities markets.
In fact, Sornette also likens the randomness of the price changes to DNA sequences, not to mention Keynes’s beauty contest analogy for the stock market, in which successful investors don’t necessarily pick the stocks they like but second guess those they think other investors prefer. Or as Sornette puts it, an ‘infinitely iterative loop.’
He also, however, stresses the difference between an economic universe and the real one. When you develop physical laws, such as moving from Ptolemy’s earth centered solar system to a sun centered one, it doesn’t affect the actual movement of the planets. But with financial markets, if you come up with a new and better model of how they work, then they really do shift in their orbits, because all the players will incorporate the information and use it to make decisions. If enough people know when the next crash is coming, they will sell together. Other traders will see what is happening and rush to bail out, creating a crash. It makes program trading seem quite reasonable.
But the idea of applying the same math to markets as to quantum physics offers a great opportunity to people on the practical side of economics at companies like Enron and Tyco. After all, quantum physics and the search for dark matter and missing mass in the universe have led to some really innovative concepts – extra dimensions, super strings and bubble universes. Sadly, it is too late for Arthur Andersen, but it cannot be long before equally innovative accountants use such concepts to explain why earnings, like dark matter, may really be there, but the act of observing makes them disappear. Revenues may in fact be bound up in other corporate dimensions that are infinitely long but infinitesimal in volume.
When the day of reckoning comes – which could be well before 2050 with the baby boomers now looking to retire – quantum physics could prove particularly important for explaining what happened to all those corporate pension funds that appear to earn 10 percent a year in the annual accounts, but quickly evaporate when the pensioners want payment.
The Speculator
