2006 = 1987? Impending Doom or False Connection?
May 22nd, 2006With the recent slide in the stock market, including the DOW's 200+ point loss last Wednesday, financial entertainment TV has begun to trot out anyone and everyone who will compare this market climate to that of 1987. This notion has also begun to filter into the blogging world as I have noticed comments about it far and wide.
We, as human beings, have an uncanny desire to control and explain almost every event we experience. This is especially true of events that have a dramatic impact on so many people. The October 19, 1987 20%+ stock market crash is one such event. The truth is, we still do not even know what (if anything in particular) "caused" the crash of 1987. Many people point to the prevalence of computerized trading, some point to the large foreign debts of some Asian nations. Whatever catalysts we create in our minds to describe that event, none can be proven to be THE cause of the crash. That event was most likely the confluence of any number of forces and its result could have just as likely been attributed to chance as to any overriding issue created by man.
In my simplified discussion of chaos theory and the markets I mentioned how the tiniest of events can cause great avalanches of other events. There does not have to be any crazy NEW event never before witnessed that causes something like Black Monday. No, this could merely have been caused by a few chance occurrences that happened to effect very unstable parts of the market and caused a ripple effect throughout.
Let us revisit the sand pile game for a better idea of what I am talking about. When you randomly drop sand into an area you inevitably end up with some very tall and steep piles and some other very flat areas. The economy is no different. The economy is comprised of so many small parts and variables that some of them will inevitably organize themselves into very steep and unstable areas (think housing or commodities now). A grain of sand falling on an unstable area could cause an avalanche of massive proportions to ripple across the entire pile. Likewise, a small event "dropped" into an unstable portion of the economy could also ripple throughout. This organization is called the critical state. It essentially means that at any point in time we have no way of knowing if the next grain of sand will cause a massive avalanche or if it will simply fall onto a flat area and be inconsequential. This is primarily because it is hard to see all the underlying networks of instability (seeing the large piles is relatively easy).
I wanted to bring this up again in an attempt to help you understand that it does not always take some outrageous event to cause market crashes (or bull market runs for that matter). All it takes is a single event happening in a "finger of instability". You do not have to come up with outlandish reasons to explain them. We want a reason for what has happened so that we might possibly have control over that in the future. If we know a cause we can prevent that from causing further pain again. This is not always the case.
Whenever I mention Chaos Theory to most people they shun me and think I am off my rocker. The truth is that we can find lots of useful information in the application of science to capital markets. The ideas behind Chaos Theory have some extremely valuable insights about behavioral finance and the ebb and flow of markets. I will certainly have more to say on this in the future. For now I will leave you with a paragraph from Ubiquity: Why Catastrophes Happen
"But mathematical research over the past decade tells a very different and less comforting story. According to the numbers, sudden upheavals are very far from being highly unlikely, and may indeed even be inevitable. In direct conflict with everything the efficient market hypothesis stands for, large fluctuations in market prices seem to result from the natural, internal workings of markets, and so flare up from time to time even if there aren't any 'sources of structural fragility', or sudden alterations of the fundamentals to set them off. And the reason may be quite simple: markets are not even remotely close to being in equilibrium."
Trying to compare 2006 to 1987 is no different than attempting to forecast how much impact the next falling grain of sand will have on the pile. One cannot tell until it has already happened. The fingers of instability today are much different than they were in 1987. To even believe you know what they are NOW is unrealistic. To try and say they are equivalent to a past pile is ludicrous.
"The battlefield is a scene of constant chaos. The winner will be the one who controls that chaos, both his own and the enemies. "
-Napoleon Bonaparte
Disclaimer: this post is for informational purposes ONLY. Please read the disclaimer before even thinking about relying on me to make a financial decision!
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