Wednesday, February 07, 2018

Most probable theory of why the stock market tumbled.

The DJIA saw a big shift downwards. There was a lot of commentary about why it happened - most of it was political. I suspect there is some politics at play here, something Trump did make the market uneasy and that started this shift.

The market has recovered somewhat and there is hope that it is going to keep going back up.

Here is my take on what likely happened.

I think of the market as a kind of PID loop. This is the preferred way for guys like me to think about the market because it is a well understood control theory construct. A PID loop locks a system's response to a set of control or reference signals. As the reference signals are tied to the state of the system itself - the PID loop works on feedback.

There are three parts to any PID loop - an integrated gain, a proportional gain and a differential gain. For extremely slow changes relative to the reference, the PID loop keeps aggregating the changes and only responds when the aggregate change has gone above a certain value. For extremely fast changes in the system relative to the reference, the system looks at the derivative or the instantaneous rate of change and responds to that. For changes in the system that are in the Goldilocks' Zone (not too fast and not too slow), the loop responds in a fashion that is directly proportional to the signal.

In every PID loop, there is a dead zone where the change in the system is simply too slow or too fast for the loop to respond to. In those situations the system drifts and the loop can't do anything to correct the drift.

In every PID loop, there is a oscillation zone, where the change is happening is peculiar and rather than damp out the disturbance to the state of the system, the loop actually amplifies the disturbance. This is called a "positive feedback".

You can always tune the position of the integrator and the differentiator in a loop to determine where the dead zone and the positive feedback zone lie, but you CANNOT make these phenomena go away.

In the market, there are two types of loops - human traders who follow trends in the various indices or keep track of true value in a corporation's stock and performance, and mechanized/computerized algorithms that do the same thing.

Most of the computerized trading companies actually have humans in the loop that constantly tweak the position of the dead zone and the positive feedback zone to keep the system from becoming unpredictable.

As each of these loops (human and assisted AI) are operating on different mixtures of reference inputs from the market and each of them have different dead/positive feedback zones. The result is a stock market that is subject to multiple loops.

As long as the banking sector is able to pump debt into the market, the stock prices keep rising even if there is no real growth in the productivity of the underlying companies. Companies are able to buy back stock and keep their stock valuations high. This high valuation comes in handy when borrowing money to cover financial eclipse periods.

What seems to have happened some weeks ago is that a fluctuation occurred in the market that hit the positive feedback or dead zone of multiple loops. With a large number of these loops operating in a quasi automated way, the algorithmic trading entities began to ride the DJIA down. This caused what I believe was a type of "flash crash" at 3:30 on Tuesday Feb 6th 2018.

By Tuesday night, all the big algorithmic players sat down and moved the positions of the dead zones and/or positive feedback zones. The result is a miraculous looking recovery in the market.

My guess is that this recovery is an illusion. The underlying bubble which kicked into play after November 8, 2016 has reached a critical size. The flow of more debt into the system is shaky. Most of the humans in the loop are wondering if Trump himself will politically survive the next few months and it is not clear how much longer this bubble is sustainable without Trump to keep pumping up the confidence of his ethnic compatriots on Wall Street.

I feel beyond this point sudden unexplained fluctuations like the one that triggered this market slide two weeks ago will be quite common. As one can never create a PID loop that completely avoids dead zones and positive feedback zones, there is no way to escape the phenomenology that we have just witnessed.

In his recent comments Nouriel Roubini has pointed out that BTC is become a kind of sub-prime loan and the true exposure of the market to this BTC menace is difficult to quantify. I feel he may be on to something, with people borrowing money to buy BTC and now facing the prospects of "HODL when then they should have SODL..." - there is no limit to how bad this could be.   Nouriel believes that the BTC is being propped up in fashion that is blatantly illegal, so if that is correct, this problem we saw a few days ago will recur with alarming regularity.


1 Comments:

At 8:19 AM, Blogger Ralphy said...

all the libertarian ditto heads are joyously celebrating space xs's launch and denigrating nasa........except nasa nurtured space x, gave space x use of various facilities as well as the plans for the nasa developed lunar module descent engine which became the falcon merlin engine, etc.

space x was created by elon musk but could not have existed w/o nasa.........

 

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