Darwinian Speculations: Evolution & Markets

6/24/2004
Ecology of Markets, by Philip J. McDonnell

Pundits have often referred to market gyrations as a price discovery process. The mental image being one of seeking an optimal price via some inscrutable search algorithm. Economists also subscribe to this meme with their ever present assumption of price equilibrium. Implicit in this kind of thinking is that markets will settle down to some sort of stable price in the absence of news shocks. The flaw in both lines of thinking is that speculative markets are never stable - they always fluctuate. Rather the correct model should consider the ecology of the markets as suggested by the Chair. To that end what the markets are trying to discover is not price at all but rather volume. In effect the markets are searching for that price level which will maximize volume. It is volume and order flow which nourishes the fixed overhead of the industry which feeds on the the markets. The price is irrelevant to the industry as long as the volume is maximized. Fundamentally this is the reason that markets will always fluctuate. When the market moves up it stimulates sellers to sell who were waiting for their price. At the same time buyers who are trend followers or break out players will buy. The price can move up until volume fades. Then it moves down seeking a new volume peak. The down move brings out new buyers waiting for their price. Sliding prices also stimulate new sellers who are momentum players or simply cutting losses via stops. It is the movement of markets which stimulates volume and the ecology of the market will always seek to maximize volume.

6/23/2004
Corpse Flowers and Deception

Corpse Flower: The corpse flower uses Level 1 deception to pretend it's dead.  The predator comes in to get some nourishment but instead leaves with an empty bag while spreading the pollen of the flower. This appears to be an almost one-to-one correspondence with those who come in to buy companies that have been removed from an index. Studies show this is a profitable buy and hold strategy. But the numbers rely on catching such stocks as Enron at 2 cents, holding them just the right amount of time until they're 80 cents, a 4,000 % return. And then averaging this to create a very high and meaningless mean, which would have been computed on a base 4,100% smaller if a different and random base period was used. The net result is the same, giving nourishment to the deceptive companies that were removed from index.

But humans are so much better at deception than plants, since they learn from the environment and then can transmit the characteristic to subsequent generations a la Lamarkian inheritance rather than through the route of natural selection of traits with survival value in the genes. The extra twist is that some character or other will write a book saying that he's a predatory hedge fundist who uses this buying the dead to his advantage, thereby making it a second or third level deception as additional prey, a la the angler fish, are brought into play.

April 2003
The Tree Thread

4/15/2004
Evolution and the Fossil Record

In studying evolution, I have found this essay by John Poejta helpful in dealing with the idea that the fossil record is very amorphous and that "evolution is only a theory." http://www.agiweb.org/news/evolution/fossilrecord.html

4/13/2004 Convergent Evolution

The usual examples of convergent evolution are the development from independent species of flight in the birds, insects, and bats , or the streamlined shape of dolphins and whales both mammals that look like fish, the similar structure of eyes in species in different genera, and mimicry where a palatable butterfly or moth or spider grows to resemble an unpalatable species. I often think of this during the pre-opening in many markets where the price spikes below a pivot, as defined by Mr. X or other mystiques, numerous inflexible participants rush in to extend the extreme, there is a loss, and then the same thing happens during the main trading day. I also am reminded of this when a pattern that worked in one market like down Friday , own Monday in stocks, ( which stopped working 40 years ago when Frank Cross and I first discovered it ), starts working in another market like bunds or currencies. It is as if the Mistress of markets is never satisfied to leave any opportunity for energy of the slow moving, weak to support the continuity of the markets. -- Victor Niederhoffer

4/12/2004 Extremophiles

Nature's true extremophiles show some mind-boggling capabilities (above and beyond hibernation and tolerance for drought). Microscopic water animals called tardigrades can survive almost total dehydration for over a decade, while some bacteria can live in hot springs that are more acidic than vinegar. Their adaptations are the results of intense selection pressure, an extra rigorous weeding out that takes place in tough habitats.

I got a group of nepotistics working for me this summer and I intend to ask them to study this by looking at the performance of the 10 best companies on days when the market declined by more than x and the 10 worst when the market rose by more than y. Other ways of approaching this subject by testing rather than internalizing I would also think worth exploring. Hopefully, results will not appear in any much-suppressed book unless totally worthless. -- Victor Niederhoffer  

4/11/2004 Adaptive Radiation

One of the key insights of naturalists is that if two members of the same species are separated they will develop along similar lines, with the greatest differences between them varying directly with the length of time of separation. Within the differences that develop there will be species fit into each possible niche in the habitat that develops, which itself is the result of geological chance. Thus, the concepts of branching from a common forefather, or original organism, with the new branches replacing those that became extinct. Because of frequent extinction, Darwin suggested that instead of a tree of life the diversity of species be called a coral of life.

What are the key niches in the world of spec investment that have not been filled? Are there any where competition is so great and vigorous that we may expect extinction?

I started thinking about this after a certain famous derivatives expert told Laurel that he is bigger than ever, despite the current environment. One can only speculate about his success in an environment where volatility has receded to the lowest levels in six years, as he reportedly profits when volatility increases dramatically. But aside from the expert's remarkable performance, one yet might well ask which niches may experience a paucity of adaptive profit. -- Victor Niederhoffer

Tim Melvin, trader of distressed securities, comments: Niches in the investment world come in and out of style. The demise of a particular area seems to be very easy to track. Just watch the flow of new hedge funds and other investment vehicles established to compete in the area. A glance at the incredible sum of money raised in the distress and arbitrage areas has squeezed returns down below what I would consider reasonable levels. The established giants in distressed may do well as they continue to create new ways to wring equity out of the corpse. But smaller and mid-level players are in danger of being eliminated by the larger predators. Merger arb has reached the point of the ridiculous. Annualized deal returns are at sub-5% on a quality deal. As Vic points out the VIX trade -- wildly successful for the first few in...simply doesn't work well any more. As anomalies and opportunities are discovered, the rush of money eliminates them from existence.

Post-LTCM, there was tremendous opportunity in various types of arb as they unwound their book and a general distaste for the methodology took hold. The returns attracted enormous funds that have again pushed the returns down to unacceptable levels.

The forest is burned and lays dormant for a time. Grazing animals avoid the area as there is no food. Left to its own devices, the forest begins to revive and the ash of the previous fire fertilizes new growth. By misadventure or accident, some of the bottom layers of the food chain find the new source of plentiful food. The grazing herds return and grow fat. Eventually, predators return and feast mightily for a time until the new area is now old and the ecology is much the same as the rest of the forest.

Perhaps we need to look for the burned areas. Where did virtually all the money leave the field over past several years? Where now the first blades of grass are struggling to emerge from the ashes? to be the first predator in a area newly filled with game is to become the predator most likely to survive the next winter.
 

Darwin and Travel

Traveling around the world from 1831 to 1836, Charles Darwin was struck by certain facts on the distribution of species and the present and past inhabitants of the continents he visited. On his return home, he thought that he might be able to use his observations to come up with some ideas on the sources and causes of variability and origins of  ‘that mystery of mysteries’. I have traveled in the last year around the world twice to Africa and Asia and many of the countries of Europe. Over Christmas, for example, I studied in a short week, the volcanic eruptions in the Big Island of Hawaii and the tsunami museum in Hilo, as well as the earthquake region of San Francisco, then attended the Imperial Ball in Austria and stayed at a captured king’s palace in Istanbul. I just returned from a stay at Viterbo, a medieval city in the Etruscan area of Italy, without refraining from a visit to the Coliseum and the Sistine Chapel and other sites along the way. I certainly do not pretend to have the remotest resemblance to Darwin in my insights, creativity, or impact. But I do feel I am equal to him in his humility, and perhaps the laboriousness of his data collecting. And like Darwin, whose voyage was unified by his collection and love of beetles, barnacles, and corals ("I am dying by inches in not having anyone to talk to about the insects"), I too had a unifying interest in that I played and took tennis lessons in each of the places I visited. I solicit any communications from the learned readers of this site on their own take of what Darwin's books can teach us about the causes of variability and will transmit a few of my own humble observations on this subject in future missives. I can state here, however, that based on my observations and my reading of the very learned work of scholars in this field, that the market has evolved to generate certain varieties of movement for us, and that these varieties are related and correlated to all the other markets in the world, and that big variations in one market are soon adapted to and revealed in closely related markets. Vic

Comment from J.T :
The markets seem to follow natural selection so perfectly that Darwin would be impressed as much as he was with those finches he snagged and took home. I think Origin's insights on sexual and artificial selection apply to the variations seen in the markets we trade and invest in.

Sexual selection: So many times it seems that I am trying to court or mate with the Mistress of Markets and she plays the role "hard to get" so good she forces me to change my ways and the competition for her attention is so great I must change.

Artificial selection: Seems to be foremost of those with the (large piggy banks) that program their way to profits and yes add more to the variety pool. But the greatest thing that Darwin seemed to implant on my brain cells is that these selections and their manifestations in the markets happens "slowly and in small steps" even though oftentimes others to the contrary feel it has much more to do with 1/10th of a cent in contribution to the vig, the rapid-fire execution of a trade and the instantaneous relaying of such critical information.

Does anyone else feel that Aesop's fables ironically and with great humor are a good examples of Darwinism?
 

Comment by Steve Ellison, reader from Boise, Idaho:
Variability in the environment leads to variation of life forms. There are wet years and dry years, warm years and cold years.
 
In On the Origin of Species by Means of Natural Selection, Darwin stated that when the "conditions of life" change, "this would manifestly be favorable to natural selection, by giving a better chance of profitable variations occurring; and unless profitable variations do occur, natural selection can do nothing."
 
Variety of species increases as variability in conditions increases. Richard Koch, in The Power Laws of Business: The Science of Success, describes an 80-year study of a plot of land in the southwestern United States. He quotes ecologist Tony Burgess: "If conditions are variant, the mixture of species increases by two to three orders of magnitude. If you have a constant pattern, the beautiful desert ecology will almost always collapse into something simpler."

Comment by Tom Ryan:
It would seem that a common theme here is that specialization offers many benefits vis-a-vis competition, although there is often problems with long-term resilience when one becomes so specialized. However, in a protected environ, with few major changes, like Galapagos? U.S. bond market? Senior members of Congress? Federal Reserve chairmen? The benefits of specialization seem to outweigh the drawbacks.

Prehistoric and contemporary human populations living at altitudes of at least 8,000 feet (2,500 meters) above sea level may provide unique insights into human evolution, reports an interdisciplinary group of scientists.

Indigenous highlanders living in the Andean Altiplano in South America, in the Tibetan Plateau in Asia, and at the highest elevations of the Ethiopian Highlands in east Africa have evolved three distinctly different biological
adaptations for surviving in the oxygen-thin air found at high altitude. . .

The Andeans adapted to the thin air by developing an ability to carry more oxygen in each red blood cell. That is: They breathe at the same rate as people who live at sea level, but the Andeans have the ability to deliver oxygen throughout their bodies more effectively than people at sea level do.

Tibetans compensate for low oxygen content much differently. They increase their oxygen intake by taking more breaths per minute than people who live at sea level. . .

In addition, Tibetans may have a second biological adaptation, which expands their blood vessels, allowing them to deliver oxygen throughout their bodies more effectively than sea-level people do.
http://news.nationalgeographic.com/news/2004/02/0224_040225_evolution.html

2/10/2004
Ancient Indian ruins in the forest

"What a struggle must have gone on during long centuries, between several kinds of trees, each annually scattering its seeds by the thousands; what war between insect and insect --  between insects, snails, and other animals, with birds and beasts of prey -- all striving to increase, all feeding on each other, or on the trees, their seeds and seedlings, or on the other plants, which first clothed the ground, and thus checked the growth of the trees! Throw up a handful of feathers, and all fall to the ground according to definite laws. But how simple is the problem where each shall fall compared to the action and reaction of innumerable plants and animals, which have determined in the course of centuries the proportional numbers and kinds  of trees now growing on the old Indian ruins!"
-- The Origin of Species, Chapter 3, "Struggle for Existence."

And what a struggle went on after the complete lack of trust, and evidence of corruption among brokers and corporate executives, and regulators, that led to the present profusion of abundance on the investment landscape. And how great must be the shocks that operate on this system that would upset the order that has arisen. -- Vic

Big Al writes: (03/03/2004 9:23:38):
Looking at trading market noise over 10-day periods (S&P 500), I calculated for each day the % gain between Close T-zero, and maximum High T1-T10, as well as the % loss between Close T-zero, and minimum Low T1-T10. Then, just for fun, I calculated the gap by subtracting minLow from maxHigh, so that for each day I had a gap, expressed in % points between the High and Low of the succeeding 10-day period.

During the period January 1996 through May 2003, the average gap was 5.8 percentage points, with a standard deviation of 2.61 percentage points. Since June 2003, the gap shrank considerably to 3.6%, with a standard
deviation of .87.

However, from 1992 through 1995, the gap was only 2.76%, with a standard deviation of .93.

For some reason this reminds me of a study of moths (*not* the famous Kettlewell study) in which a biologist studying this moth population happened to study them over a span of years that included a very particular
anomaly: Normally, the moths were preyed upon by a bird species that migrated south each winter; but due to some climactic changes, one spring the bird population was either very late in returning or did not return at
all.

The moth population exploded. In his past study, the biologist had categorized about 5% of the population as "poorly adapted", e.g., had wings too small to fly, or coloring that was not effective camouflage, etc. This
5% level had remained relatively constant. After the population explosion, he found that 45% of the now much larger population fell into the category he had considered poorly adapted.

Species are constantly pushing out against the environment by having many offspring, by bestowing upon the offspring variability hidden within the genome, and by accumulating new variability through random mutation. When the environment relaxes, the species expands outward with increased variability.

Last summer, the market environment relaxed, and pretty much any long equity or commodity strategy has worked since then. Volatility declined and has been low ever since -- a measure of the declining pressure being applied to market participants to develop differentially successful strategies.

Spec Duo, in their recent volatility article, pointed out that big drops in the VIX in one year bode poorly for the coming year. Perhaps as the market environmental pressure relaxes, there is an explosion of variability in market strategies, most of which work just because of the relaxed environmental conditions. Then when the birds return, the poorly-adapted moths get eaten.

Kim Zussman responds (03/03/2004 9:30:54): 
Another biological analogy is the cycle of population explosion/extinction resulting from changing environments.

One could postulate that long period shifts of volatility regimes effect or cause subsequent regimes. In other words, periods of high volatility (related to macro events) might elicit flight of investors with weaker stomachs, effectively purging markets of such participants. Once markets are cleared by some critical amount, remaining participants (who are less excitable and slower to react) create periods with less volatility. Gradually, more and more investors are drawn back into the market, including the excitable boys. This leads to a return of volatility.

Guo's recent note pointed out that idiosyncratic volatility (stock vol not related to market vol ) has been higher over a period when volatility of macro-economy has down-shifted. He attributes this to "increased competition" in the marketplace. Perhaps also there is a component of the shifting nature of market participants.

Big Al responds (03/03/2004 10:39:15) 
Along the same lines, when the poorly-adapted segment of the moth population expanded from 5% to 45%, it happened in stages, as, for instance, moths born with too-small wings survived instead of being eaten, then bred to produce offspring more likely to have small wings, etc. The expansion happened up a curve.

Likewise, as market pressure/volatility relaxes, various strategies start to "survive" and "breed." Smith sees that his energy sector fund is doing well, so he tells Jones, who buys in. Money flows into funds, whose managers have to put it to work. Performance gets chased in specific niches by many who do not see the broad correlation of everything being up. It seems that sector funds and ETFs might increase this effect by eliminating the "middle-manager."

BTW, the end of the moth story is that the birds did come back, the moth population contracted to its normal level, and the poorly-adapted segment returned to its observed 5%.