MARKETS / MODELS / CRISIS … WHO IS THE WINNER?

Walid BEHAR
Founder of TBS Finance
Entrepreneur,
Investment Analyst, Accelero Capital
a.walidbehar@gmail.com

Since the Great Depression*, History has shown us how important it is to understand the rationale behind those 3 key elements that will rule the future of Financial markets.

Understanding the synergy and link between them is like trying to know who has been engendered first, the egg or the chicken.
Every story has its beginning, let us begin by the foundation. It seems to be that markets are driven by a simple rule « the rule of bid and ask ». After a bloody battle between classics and Keynesians, the little child has grown up to become what economists call «The Efficient Market».

But as me you are wondering: is it so efficient? Not so much! A market is efficient if every relevant information is perfectly and at a time reflected on coted assets prices In fact, there are three versions of the efficient market hypothesis. In weak-form hypothesis futures prices cannot be forecasted by analyzing past trends from historical data. In other words, technical analysis will not be consistent and will not produce excess return.

In semi-strong efficiency, share prices should adjust to the available new information very rapidly. Thus, it implies that neither fundamental nor technical analysis methods will be able to reliably produce interesting returns. Finally, the strong form of efficient market stipulates that share prices reflect all information, public and private. In this situation no excess return can be earned. In other words, we cannot beat the market.

However, the real world is not as magnificent as the theoretical fairy tale. In fact, many barriers make the information (the insider effect) biased or not efficiently spread between actors of the market. Moreover, cost of acquiring information (research…) may limit discovery of inefficiency. All those elements have strongly shown us that markets are not efficient but are MOSTLY efficient.

This is a big step in our built in approach to try to understand the game we enrolled in!

Second player of the game, models!!! A model is not only a mathematical equation where we put inputs but it is primarily an interface communicating with the market. These two exchange and interpret signals with each other.
The story of models is strongly related to the story of markets. As we say in French « like father, like sun».

In A Random Walk Down Wall Street, Burton Malkiel, a Princeton economist explains how most of finance models are built on the assumption of a random move of capital markets. Since, the end of Bretton Woods, the school of continuity that uses the linear regression as a magic tool dictated the golden rules to build model. No matter how many variables mathematicians and Bankers added to the CAPM, the problem was not to find correlations but explain causality effects. However, the « ten glorious years » of Wall Street in the beginning of the nineties have unveiled a new element in the picture of the market, « self-fulfilment forecasts ». This systemic domino effect happens when due to information inefficiencies, rational investors believe on a model forecast after a continuous success (for example). They become simple followers of a move that empowers and, at the same time, destroys the model they believe in. This process remains till the lack of confidence bursts the bubble. This reasoning clearly demonstrates that if 99% of time we have bitten the market we strongly believe we have found the magic model. The 1% remaining risk that most of investors undervalue causes more impact on the market than any of other risks. This neglected lone risk is called by Nicolas Nessim Taleb « the black swan », an event that could disturb at any time forecast of our so complex models.

Benoit Mandelbrot a brilliant mathematician has taken this concept further by propelling The World of Wall Street to the universe of « fractals ». Fractals are those strange geometric forms that express how much the market moves in a random way that couldn’t be contained in a normal law. Outliers value that statisticians trying to eliminate through their blue estimators, became more important to analyze than the standard values.

Let’s go back to the efficiency problem! A wise man would say is it rational to develop models based on efficiency while markets and new economists show us the contrary?

On the one hand, the hurricane of finance discoveries I unveiled above push us to say NO! On the other hand, « Yes », because observing investors and models behaviour provides us with a precious knowledge about the market. The second answer has an expensive price, let’s call it « Crisis » (the third player).

The key question is: to what extent could we believe in a model that doesn’t work anymore and that becomes more and more out of control? If we try to keep it simple, most of time, a crisis happens when there is a difference between the real economy and the Finance world. The widest the gap is, the terrible the crisis is. In this context, derivatives amplify the process, because by exchanging risks between them, investors make it more difficult to match the financial risk with its project in the real world. Moreover, by transferring the risk from the hedger to the speculator, the loop closes on itself and generates a systemic dysfunction. We are not so far from the Ponzi arbitrage strategy...

I believe like you that Financial innovation (derivatives...) is as important as the economy is. Crisis will always be part of the game; no matter how deep is our level of understanding of the market. But WE as financiers shouldn’t we try to build a win-win game between those three main players?

I strongly believe that from this incompatible triangle, we can really save the added value we created by observing wisely those events and learning from history. A game is something that entertains us but shouldn’t govern our daily life. So let‘s turn this game into what it should be: a model of participatory development.