Market Phase Change Risk Analysis

One of our core assumptions is that financial markets function as complex adaptive systems. One of the key features of such systems is their ability to pass through so-called "phase transitions" that materially change their character once certain variables exceed or fall below critical thresholds. In our September 2009 issue, we reviewed a paper on one of critical variables, "Leverage Causes Fat Tails and Clustered Volatility" by Thurner, Farmer and Geanakoplos. This paper more formally demonstrated the importance of a factor that has been associated with booms and busts throughout financial history: the expansion of the supply of credit at a pace well in excess of real economic growth. In the past we have also noted that rising uncertainty and the changing connectedness and strength of social networks that influence investor decision making may also be critical variables driving phase transitions in financial systems (see, for example, "Asset Pricing in Large Information Networks" by Ozsoylev and Walden, or "Dragon Kings, Black Swans, and the Prediction of Crises" by Didier Sornette). As a practical matter, the challenge for investors has been to identify variables or statistics that can be used to identify the strengthening of networks (and consequent alignment of opinions, which may or may not reflect irrational herding) that is often associated with phase transitions. It was with this in mind that we recently read an excellent paper by Lisa Borland, of the asset management firm Evnine and Associates in San Francisco ("Statistical Signatures in Times of Panic: Markets as a Self Organizing System"). Using the phase transition approach, Borland searched for statistical signatures of market panics, and proposes a new order parameter that is easy to calculate and appears to capture the changing dynamics of asset return correlations and the underlying social network phenomena that give rise to them. The parameter equals the number of financial markets or assets that have positive returns over a given interval, less the number that have negative returns, divided by the total number of financial markets or asset classes evaluated. If the value is zero, the markets are in a disordered state and far from the potential phase change point. However, as the parameter value approaches one or negative one, the markets are in an increasingly ordered state. In this state, networks are more extensive, and presumably social influences have a greater impact on investor decisions. Under these conditions, a market may be close to or at a phase change point, and therefore subject to a sudden, and potentially violent, shift in its previous trend. We have calculated this order parameter for the 38 financial markets (excluding foreign exchange) we evaluate each month. Here are the results so far for 2009:

As you can see, in 2009 global financial markets appear to have swung from a relatively ordered and negatively oriented state early in the year, through a period of disorganization during the spring and early summer, then into a period of stronger positive orientation by August that began to reverse in September.

| Table: Market Implied Regime Expectations and Three Year Return Forecast | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Table: One Year Asset Class Valuation Conclusions and Recent Momentum | Market Phase Change Risk Analysis | October 2009 Issue: Key Points | October 2009 Economic Update | Product and Strategy Notes: Challenges Facing Investors in Venture Capital Funds; Improving Warning of Future Financial Crises; A New View on the Fundamental Drivers of Equity Market Returns; and The Long-Term Impact of the 2007-2008 Crisis on Financial Advisers' Compensation | Feature Article: Equal Risk Weighted Portfolios in 2007 and 2008 | Global Asset Class Valuation Updates Detail | This Month's Letters to the Editor: Oil and Gas Partnerships - Do they fit in your portfolio?; What's the best Asset Allocation Today; Is it Possible to Over-diversify a Portfolio?; PIMCO Heavy Weighting for Emerging Markets, II's thoughts?; Timber Followup |