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How Markets Really Work

Ted Schwartz | Tuesday, June 30th, 2009

The best explanation of the forces that are at work in markets comes not from  traditional economists but from game theorists. In Mark Buchanan’s book, Ubiquity, Why Catastrophes Happen, he examines a wide array of occurrences using theoretical physics. His chapter on equity markets uses the theories of Thomas Lux and Michele Marchesi. They propose that at any one moment the market can be divided into three broad groups. The first group is the fundamentalists. These people try to buy any stocks that are selling at less than their authentic value and sell any when they surpass their authentic value. Essentially, if they were the only players, we would have an efficient market as many believe exists. Unfortunately, there are other players in the game. Optimists are players who believe that market prices are going up, so they seek to buy stocks in order to profit from their investments. Pessimists are players who believe the market is heading down, so they seek to sell stocks in order to cut their losses (risk aversion is a whole other column, but a powerful motivator).

This is where their theory gets interesting and makes more sense to me than anything I’ve read that attempts to explain market fluctuations. Simply put, while the “game” has three kinds of players, all the players are able to change from one type of player to another type at any time and as often as they like. So, the pessimist at any time can switch his role and become either a fundamentalist or an optimist. The same is true of all the roles. Do you know some pretty rational fundamentalists who by the 2000 had given up and become optimists believing that the new economy was real? They numbered in the millions. How many optimists and fundamentalists had become pessimists by the November of last year? Think about how these shifts can become catastrophic in nature? As the market tumbles, more and more people give up and become pessimists. Falling prices induce more people to acquiesce and become pessimists, which causes prices to fall even more. A tidal wave of selling ensues. That is how you can begin to understand a market day such as we experienced in 1987. Such phenomena have nothing to do with efficient markets and rational pricing models. The markets function near a critical state and a tipping point can be reached which causes players to take on either the optimist or pessimist viewpoint.

Think of the fundamentals of our market and our economy this March. Were there huge fundamental changes that took place around March 9th? I don’t think so. What changed were the players and how they looked at events. Prior to March 9th, every event was viewed negatively and became a reason to sell assets. From March 9th through May, every event has been viewed through an entirely different lens. There has been hope and optimism. The people who sold everything (total pessimists) are coming back trying to get into the game to make big gains (optimists). Greed is beginning to replace fear in the markets.

In longer periods of time, we can expect people to return to being fundamentalists and markets to reflect authentic values of assets. This explains why the Baron Von Rothschild proclaimed that the best time to invest was when there was “blood in the streets”. If everyone in the game has become a pessimist, there are profits to be made for the fundamentalist.

Ted Schwartz is a financial consultant with Capstone Investment. He offers securities through Cambridge Investment Research, Member NASD/SIPC. Investment Advisory Services through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. This article is for informational purposes only and should not be used as the primary basis for an investment decision. Past performance does not guaranty future results. Any opinions listed are those of the author and are not necessarily those of Cambridge Investment Research, Inc.

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