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8/16/04:
Sornette was Wrong; Review of the Fractalist Mandelbrot's Misbehavior of Markets

Now one year to two years removed from the Sornette threads, I have calmed down a bit but I see the name has arisen once again on the list so I just would like to point out how far wrong the old predictions by the good doctor of geophysics proved to be last few years - both earthquakes and markets. Not in the sense of who was right/wrong but rather to point out via an example, why, for those of us who believe in a probabilistic, indeterminate world the notion that one can "accurately" (Sornette's term) predict the timing AND magnitude of earthquakes, market crashes and floods much in advance is determinate snake oil in the worst sense....

Sure Mandelbrot was right when he saw all of these natural phenomena described by power/Weibull functions and one can readily demonstrate the same with survivor distributions of earthquakes, rainfall events, durations of economic expansions, and yes open market prices as a number of us have struggled with in the past. but as Vic was quick to point out several years ago on this list, the knowledge of this form in and of itself does not provide predictability in the timing of the next event- only the general form to which the long term record holds.

Fractals are descriptive, not predictive. anyway along the line of "its not the things you don't know but rather the things you think you do know for sure that get you into the most trouble" I just returned from another trip to Ennis where the geology is always interesting, the fish are smarter than me, and the beer is cold. .....analogies to markets left to reader and names modified to protect the not-so-innocent.

I just returned from a nice stay once again in Ennis Montana. it was really funny, when we lived in Montana I didn't spend much time in the Upper Madison River Valley - I did most of my fishing on the Big Hole, Jefferson, and Beaverhead Rivers with just one excursion to the Madison. So anyway, other than a brief drive through that valley when Wendy and I once visited Virginia City, I never really had explored Ennis. As usual, I booked the late flight and Delta was late leaving Salt Lake City. By the time I got to Bozeman it was past midnight and there was probably only one baggage handler left to unload the entire flight (which was full) because it took over an hour - and I am not kidding - an hour to get my bag. and I wasn't the last person waiting either. Bags were still coming when I left the airport at 1AM. Another example of a monopoly gone bad. Delta has a monopoly on all those northern cities and their service is terrible. It seems inevitable that a service monopoly always turns into the worst bureaucracy imaginable ala Nock.

As it turns out it's almost a new moon so I'm driving towards Ennis in the pitch dark, and yes, I'm hauling a$# on these back roads, and I'm beat, really tired. As I drive down into the Madison river valley I calculated that I better slow down because there are probably deer everywhere. And just then, I swear not 2 minutes after slowing down I came around this curve and what was sitting in the middle of the road? The largest owl I have ever seen. it was dining on some roadkill and despite hitting the brakes hard, he barely lifted off and went right over the windshield. I heard his talons scrap the top of the car. That was better than coffee I can assure you.

Anyway, I obviously managed not to kill myself and pulled into our motel on the south side of Ennis at 2:30 AM or so. Needless to say, I left my guy who had gone up before me a note to the effect that I wouldn't be getting up at 5:30 for breakfast which of course didn't prevent him from trying to wake me up either. But I slept in a little (till 7 AM a perk for being boss) and hiked myself down to the center of town for breakfast. This is Montana, so there is no Denny's, just locally owned businesses. I went to the Ennis cafe (where else?) and plunked myself down at the counter in between what was obviously the local ranch crowd to my left and a nice older looking couple to my right. I sat in the seat in-between them. The discarded Montana Standard had a front page story about a bear attack outside of Wisdom. As a recent victim of a bear attack on the 5th and 6th of august of a slightly different kind, I figured I had enough of bears so I put the paper down without reading.

So I'm getting my eggs and hash browns and the good old boys start making conversation, as most polite Montanans do. These are the salt of the earth types that get up at 5AM, feed the stock, fire up the tractor and such and then take a break around 7-8 to run into town for a cup of coffee and whatever they might need to buy at the hardware store across the street. Now I've lived in Montana long enough to know how to make conversation with my workboots on, so these guys hit me up for some conversation. I tell them that I'm up from Arizona to do some work for Luzenac and they start pumping me for questions like how things goin' and hey my cousin is a good backhoe operator and he needs a job and such. Anyway I tell them we are going to be studying earthquakes in the area this summer. then I notice the couple to my right has gotten very quiet and is listening very intently. She interrupts to tell me that they are from California - they know all about earthquakes - they're from Cupertino! And they just moved into Ennis to retire and boy are they glad that they don't have to worry about earthquakes anymore.....they chose Montana partly to get away from the earthquakes. (I'm assuming cashed in ORCL or CSCO options?) Of course I have no choice but to inform them that the area around Ennis is one of the most seismically active areas in the lower 48 and that two of the largest known historical earthquakes in the US are Hebgen Lake 1959 and Borah Peak 1983, both within 60 miles of Ennis.

This of course starts the old-timers to talking about past "shakes" in the area with all kinds of interesting stories of barns falling down and livestock walking in circles etc. I'm thinking to myself that I should be taking notes, but I have got to go so I pay and off I go. But you should have seen the look on the faces of those two Californians before I left! I stayed for the week and then left leaving the locals to deal with Drew nightly at the Silver Dollar saloon where the sign reads - "Ennis a nice little drinking village with a big fishing problem". Good burgers at that place and some microbrews from Bozeman too. Just goes to show you how important it is to do your homework though, that poor couple looked terrified as I left them to hear the ranchers telling their earthquake stories.

Montana is having a really great, mild summer and I decided to stick around awhile and it didn't disappoint this time - 70's in the day, 40's at night, partly sunny. I did some fishing in the upper Madison near Wall Creek and then went to the park for some hiking on Friday and Saturday. I caught lots of smaller rainbows in the gravely stretches of the upper Madison river. I tried and tried to fish the cut banks but with no success. Funny how that works sometimes as one's ability to predict the fish constantly undergoes changing cycles. But in the open water I had no problem catching small rainbows and some whities on a golden stone floating just below the surface ripples, especially around any bigger rocks, and contrary to conventional wisdom, I once again found bigger fish in front of large boulders rather than behind or in the tailwaters.

When it comes right down to it, I am the Billy Beane of fishing, as I am convinced that fishing in a big river like the Madison is a exercise in probability, rather than the romantic lore that is so often written about. Yes, it helps to have some skill when it comes to the cast, and yes it helps to have a fly on the leader that will interest the fish. But at the end of the day my counting clearly shows that [1] there are hi and lo probability targets in the river, and it pays to know which are which, and that [2] the more time your line spends in the water the more likely fish will meet with your hook. These two factors plus the weather trump concerns about the more romantic concerns of fly selection, angle of attack, method of presenting the lure, the type of line, and other myriad things that is such a part of the romantic lore that surrounds fly fishing. Of course that doesn't make for good books or movies about fly fishing but that's my take for what it is worth.

After awhile it was off to the park. The park wasn't "empty" but not crowded by any measure. Its been awhile since i was last in Yellowstone - before the fire. I went to monument geyser basin and I walked through a burn area. It was really neat, but a bit spooky. I'd say about 80% of the dead trees from the fire are down, but there are still some that are standing and that day the wind was blowing a fair bit so all these dead lodgepole pine trees, some of which are really big, were blowing back and forth making this creepy creaky sound. The trail had not been cleared so much of the time you have to climb over these downed trees to make any headway. and some of those downed tree stumps looked very fresh at the base. Like I said, it felt like a tree could fall on you any moment but I am the probability guy so I estimated the probability of a direct hit was low, probably lower than a head on collision on the park road from a tourist craning their head to look at bison. But then there are these zones where the pines are coming back, and they are just about 6-8 feet tall now, so whenever you would get into a stand of those you would lose all visibility since they are still so dense. Late summer, bears about, no visibility, hiking by myself, creaky trees overhead, it was actually a reasonable metaphor for my life. But the views were definitely worth it when I got to the top. Monument geyser basin is still very active, it's a neat spot. There were elk about 200 yards or so along the ridgeline from me and about 200 yards directly down below me I saw what I think was a bear move briefly at one point. All in all, a good time. Although the forest is still quite devastated it is good to see the forest rebuilding itself, it is actually very uplifting in a way to walk through those burn areas and see life coming back after such an apocalypse. It is truly amazing how life is so damn resilient. We should always remember that when we're down.

Review of Benoit Mandelbrot's Misbehavior of Markets

(Note:  Ever since Dr. Mandelbrot threw Vic out his office in Littauer Center 40 years ago for questioning Mandelbrot's then thesis that stocks were a random walk showing a infinite variance, the two have shared a similar skepticism about the other.)

I admit I have not purchased and read the book by Mandelbrot, but did peruse it for 15+ minutes at the local store when looking to acquire reading material for my trip last week. My overall impression is similar to Abe's, it is Edgar Peters lite. Also I understand that Mr. Sogi did not partake of the threads we had on the list two years ago regarding fractals, power laws, and Hurst. Yes we know that volatility clusters. One approach would be to assume, like Mandelbrot, that markets are Brownian motion and apply this to time scaling and price dependence. Given enough model factors and enough time, in such a model "events" will appear in the simulation but how useful is that in a predictive sense. An alternative hypothesis is that there is structure underlying the power or negative exponential distribution tail, for lack of better term, complex periodicity.

Let's use a natural history example. Here in southern Arizona the rainfall records appear to have a Weibull form. That is of course not unusual. However, what is unusual is that the top 10 extremely high precipitation events, ALL occur in September and October. Now that is a bit curious. The explanation is that in this region we have two sources of precipitation - storms arising from the Gulf of Alaska that sweep down through the western US during the period of September-May of each year, and a southern flow from the Gulf of California, commonly known here as "monsoon season" that occurs between July and October. Now we see a structure. As it turns out all of the extreme events occur in September and October because that is the time of year when the two systems overlap, and there is a probability in any given year, that an early winter storm front, strong enough to make it this far south, will arrive and collide with a monsoonal flow (e.g., El Nino years) that is similarly strong late into the season. This is why all extreme events occur in this particular season.

There is nothing random about it, it is simply that there is a complex periodicity with lower probability of occurrence creating the tail events. The tree ring posts I sent to the list are another example. There is clearly dependence exhibited from one year to the next. This leads one to test such things as the time expired between today and the last drought, and the conditional expectations for time expired since the last. These are the kind of calculations that I am finding to be useful rather than random simulations of multiple variables.

Part of the reason I am so negative on this book is I have seen him talk before, and he has written many letters like this one... Which is just filled with hubris. Give me some more research money and I will solve the question of why markets move the way they do. As if there isn't BILLIONS of dollars with extremely smart people trying to figure that one out for over a century. But he will figure it all out if only the powers at be would give him so more money.....And Vic had a personal experience with him that was similarly disappointing. It all strikes one as a bit of self serving pomp and circumstance a la the scientist at the institute in 'Atlas Shrugged.'