Jean-Philippe Bouchaud and staff at Capital Fund Management in Paris studied the news feeds from Dow Jones and Reuters that provide real-time reports of items of potential interest to investors. Looking at over 90,000 news items in a two-year period, they investigated how sudden movements in stock prices were linked to the ticker reports. The interesting thing is that they couldn’t find any correlation at all between the two (Report in this week’s New Scientist – unfortunately you’ll need to buy the magazine or get a subscription to read the full article). Here’s a link to the research paper (200 KB PDF file), but be warned – it is pretty technical!
The conventional economic theory is that stock prices move close their “fair” price based on the collective knowledge of the companies which issued the stock. If news about a strike at a factory is published, you would expect the stock price of the affected company to fall as they won’t meet their production targets, for example. So news ticker items are expected to influence stock prices directly – how often have we heard “The markets fell today on news that ….”? Well, it appears that the theory and practice simply don’t match.
The research by Bouchaud and his colleagues indicates that instead, market psychology places a large role – prices continue to rise or fall long after they have reached the “fair price” because of the prevailing expectations in the marketplace. When a correction does occur, it can be triggered by a random piece of news, which then becomes amplified by social feedback.
Another group of researchers has been playing with models which take account of the positive feedback effect between traders that occurs in the financial markets:
Things go smoothly until the amount of leverage reaches a certain threshold, at which point the model shows the market undergoing a sudden change, loosely akin to a physical phase transition, like water freezing into ice. Increasing levels of credit create stronger links between market players, heightening the chance that the failure of one can put an unsustainable burden on others, triggering further failures. In the simulations, once the level of leverage passes a certain threshold, it becomes overwhelmingly likely that a single chance failure will send waves of trouble through the entire market. Avoiding future crises will mean identifying where the real-world market’s “freezing point” is – and keeping levels of leverage low enough to steer clear of it.
Unless the central and national banks take these models into account, it is likely that the next crash is already waiting off-stage, waiting to catch us unawares when the current property crash has played out.
