Adaptive Markets and the Long Hot Summer

Author(s): Andrew Sheng

Date: Aug 2, 2012

Theme(s): Trade & Investment

Publications: Opinions & Speeches

Editor’s note: The adaptive markets hypothesis first posited in 2004 suggests that conventional wisdom about the efficiency of markets may turn out to be wrong over time. Fung Global Institute President Andrew Sheng concurs that, because everything is interrelated, it is necessary to draw lessons from biology, ecology and systems theory to understand market behaviour today and the interaction between the market and the state.

The summer heat wave in the US Corn Belt is going to hit grain production and has already raised food prices. So far, such price increases have not yet translated into global inflation, thanks to better food crop production in other parts of the world.

Commodity traders today use satellite maps to track global crop production and weather conditions to predict commodity prices. In 1878, English economist William Stanley Jevons (1835-1882) even suggested that economic cycles are related to sunspots because these phenomena affected the weather, which in turn affected crop production and the economy.

In many countries, the summer heat is also adding to political tension on top of the European debt crisis and the fear of the Chinese economy slowing, all adding to market volatility and uncertainty. The question is what is the best economic framework to make sense of what is happening around us? All we can say with some certainty is that the current efficient market hypothesis economic and risk management models are not working well at all.

In his December 2011 paper, “Adaptive Markets and the New World Order”, Massachusetts Institute of Technology (MIT) Sloan School of Management Finance Professor Andrew Lo suggests that we should view financial markets and institutions from the perspective of evolutionary biology rather than physics. He simply suggests that the current generation of efficient market hypothesis models is not so much wrong as incomplete. While these models worked reasonably well from the 1930s (the Great Depression) to the mid-2000s in the US financial markets, Lo argues that the past decade is really the beginning of a new world order marked by higher volatility due to larger populations and seismic economic shifts caused by technology, competition for resources among large countries such as China and India, and of course, rising financial leverage and global imbalances.

The adaptive market hypothesis is a behavioural theory of the interaction among market players, recognizing that efficient and irrational markets are extremes, with most market conditions somewhere in between. The market adapts to changes in the environment such as policy shifts. There are well known puzzles in economics that suggest market behaviour adjusts due to changes in regulations. For example, in his 1975 Journal of Political Economy article on seat belt safety in the US, University of Chicago economist Sam Peltzman showed that highway deaths did not decline that much because the seat belt regulations led people to drive more recklessly since they felt more safe.

The idea that the market knows best underpins current corporate governance theory that share prices reflect the market’s assessment of how good a company is performing. However, the rule change to allow share buybacks meant that a company can use its own cash to keep its share price up, at least delaying the signalling effect of weak share prices on performance.

The adaptive market hypothesis suggests that rather than rely always on the “wisdom of crowds” – the logical extension of the idea that markets are always right – we should think about the creative tension between the wisdom of crowds and “the madness of mobs”. In Europe, there is already a flight to quality. German bond yields are at record lows, whereas Italian and Spanish bond yields remain under pressure. European politicians keep responding to crisis by decisions at the brink. Markets are responding accordingly.

A very useful insight from the adaptive market hypothesis is that conventional wisdom can become wrong over time. Consider the notion of diversification. We are taught that we should diversify our risks, but increasingly most markets have become highly correlated to each other so moving money to emerging markets may not be a diversification if these economies and markets have not decoupled from the advanced economies.

Innovative analysis such as Lo’s is needed because we live today in a highly complex world, where the only way to comprehend it is to have a system-wide view that looks at the interconnectivity, the interdependence and feedback mechanisms between the parts and the whole. George Soros is right to point out that reflexivity – the feedback between the parts and the whole that creates new situations, which give rise to new opportunities as well as risks – may be more important an insight about the current world order than the idea that we will all eventually get back to equilibrium.

Climate change, ecology and economics converge because the issues are all interrelated and can no longer be thought of as independent of each other. What we have not understood is how to link these patterns of change into a new order. We can only do this when we see this graphically by using big data as well as micro-data, which companies and governments have not yet mined and analysed. This is now made possible by the rise of super-fast computers and new mathematics of complexity.

Biologists have long argued that organisms evolve through patterns, changing from one order to another through evolution. The big debate over using biological science to explain economic behaviour is whether collective human behaviour and human social order can imitate biological life, which belongs in the realm of natural science.

Social science has always differed from natural science because of human determinism – the fact that our species alone has been able fundamentally to re-shape (some people think destroy) our natural environment and impose social order to the extent we have. The fact that political leadership and order are being challenged throughout the world raises the question of whether we are as able to shape social order as we thought, or are we in the midst of a major move to a new order?

The study of the interaction between market and state (or control of markets) needs to draw lessons from biology, ecology and systems theory. Markets are about self-organisation, which in biology is the emergence of new structures and forms of behaviour in open systems far from equilibrium. Change is dynamically complex and feels like chaos.

So summer heat, political heat and market volatility are all interrelated. Sound familiar?