Mar

18

The amazing moves this week are consistent with my 50 year old studies as to what happens following cardinal panics like airline crashes, and presidential assassinations. A terrible move down, and then by the end of the week, right where it was before. It happened to i s p and the grains and oil and the dollar yen. What else? How to generalize?

Jon Longtin responds: 

"…how to generalize?"

One thought would be to do a simple curve fit on an instrument of your choice after each event in history. Since the events themselves are unique and relatively short in duration (earthquake, assassination, terrorist bombing, etc.) and also very well defined in time, the trigger point (or time t=0) is well known almost immediately after the event happens.

In general a cusp-like response is observed (very rapid decline, followed by a well-defined apex, and then a rapid ascent (although probably not as sharp as the descent) to some threshold pre-event point (say 80%).

The underlying argument would be that people's mass reaction to any catastrophic event is similar (panic, confusion, and uncertainty followed by the gradual realization that the world is not ending, and things work back to normal). Since the underlying behavior is the same, it's not unreasonable to expect that the financial instrument's response should similarly be the same across different events. One could then try to form a single curve by appropriate scaling (so-called self-similar behavior). Then, when a new situation presents itself (hate to sound so detached when speaking of disasters), one could chart the instrument's history against the curve, and as soon as enough points were collected, match/scale it to the master curve and make an estimate as to the turn-around point and recovery and go from there.

One could further classify events into separate categories, e.g., natural disasters, political events, financial events, etc., and prepare appropriate curves for each, since the nature of the event will be similarly well defined and knowable very soon after it happens.

The engineering analog is somewhat along the following lines: a standard technique to test a system is to apply an impulse response and see how the system responds. Examples include tapping an automobile frame with a hammer and measuring how the structure responses in time, or using a gunshot to measure the acoustics in a large hall. In these measurements, the initial driver (the hammer hit or gunshot) happens so quickly that it has come and gone before the system has had a chance to even begin to respond. As a consequence the resulting measurement is only the response of the system and is not contaminated by the initial response.

In contrast, drivers that that are longer in time have a more complicated interaction with the structure, because the structure will start to respond to the first part of the driver, but the system is still being driven. The analog would be grabbing onto the car frame with your hands and shaking it repeatedly for a few minutes to get it to vibrate: the car frame will begin to response as soon as you start shaking it, but then as you continue to shake it, that further alters the response, which affects the response, etc. etc. = much more complicated to analyze and predict.

 In financial terms, disasters are often very short in duration (seconds and minutes), and subsequently they behave like an impulse response, with the system being society. In contrast, an event such as the wave of unrest in the middle east is a much longer time-frame event (weeks and months): the event and the response become highly coupled, making their analysis more complicated.
 

Anatoly Veltman writes:

Not sure if it's a separate topic, but there are sometimes dangers when you generalize. For example, the level of EUR currency (and its perceived trend) is significantly higher today than at this sample's outset. To what degree did this influence most commodities' comeback?

Another layer that could be added to this sample's analysis: what to make of the relatively lagging instruments? Sugar, Platinum and Palladium haven't made up their losses…

The President of the Old Speculator's Club, John Tierney, responds: 

How does one make generalizations from the recent events outlined by the Chair? I have no doubt that his 50-year study shows similar market reactions. However, I'm reluctant to adopt any new theories or adjust my current investment outlook due to these studies. The current environment, and one that has existed at least since the Fed initiated QE1, is the involvement of government agencies.

I and others have suggested this surreptitious presence in the past. We have been (rightly) put in our place because we failed to fulfill the Chair's mandate: "stats on the table" (something, by the way, which Rocky was very, very good at).

In the current situation and that which has existed for several years now, we KNOW that our government (and others) have been manipulating the "invisible hand." We may not be aware of the extent of the presence, or where it is being applied, but that it exists is an established (and self-confessed) fact.

With that in mind, I'm left to "guess" whether the current scenario is an accurate re-enactment of past events, or whether it has been manipulated to seem so. For years we on the List have been leery of the efficacy of any government interference in the markets. With that in mind, it's difficult to make a legitimate extrapolation from past events - the new, big, player makes any surmise questionable.

My reluctance to revise my pre-existing view of the market's course is only enhanced by the numerous television experts who are outlining a "bounce-back" scenario based on past bounce-backs. It may well occur but will it endure or will it vanish with the exit of the interference? I'm currently betting (and that IS the right word) against it.

William Weaver shares: 

Check out this interesting abstract:

Behavioral economic studies reveal that negative sentiment driven by bad mood and anxiety affects investment decisions and may hence affect asset pricing. In this study we examine the effect of aviation disasters on stock prices. We find evidence of a significant negative event effect with a market average loss of more than $60 billion per aviation disaster, whereas the estimated actual loss is no more than $1 billion. In two days a price reversal occurs. We find the effect to be greater in small and riskier stocks and in firms belonging to less stable industries. This event effect is also accompanied by an increase in the perceived risk: implied volatility increases after aviation disasters without an increase in actual volatility.

Found via the Empirical Finance blog


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