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21-May-2006
Ecology and Markets, by Victor Niederhoffer

One of the functions of ecology is to steer us to think of the interactions between species and the effect our habitat has on our behavior. A person familiar with ecology always looks in wonderment at the complex and changing web of interactions between all the forms of life and their environment and the mutual connections so necessary for their survival that they have with each other.

Interacting prices of markets play a similar role in shaping our behavior that the environment does. However, whereas the effect on form and behavior of a changing environment in species are often written over generations, the effects of markets often take place in seconds.

With these thoughts in mind, consider the landscape of markets that investors face this week versus the one about ten days ago. The situation two weeks ago was bleak with the dollar and bonds getting killed, the trend followers making new highs with momentum investing every day at 1150, and commodities at all time highs with newspaper articles each day proclaiming this the great wave of inflation. But, now compare the current landscape. Commodities and stocks have suffered their worst week in three years. Trend followers are down some 10% from their previous levels, and about 1/5 of the S&P 500 stocks are down at least 10%, with Freeport, Nvidia, JDS, BJ Services, Allegheny Tech, EOG Resources, Carnival, Nobel, Rowan, and Phelps Dodge all down 15%. Bonds and the dollar are at a one-month high, up about 2% from their low one week ago.

In short, the markets have played their function in redeploying goods from the future to the present, signaling the likely impact of current conditions, and correcting any imbalances that existed. As to whether this redeployment is finished no one knows. Obviously the bears, like Alan Abelson on October 26, 1987, will take the line that it's only a start and the bulls will say that the market has now gone thru a period of 1 1/2 years with merely a 4% rise during a period of some of the most bullish economics and earnings time and earnings price relative to bond yields in history.

The only way I know to answer such questions is to ask what is now more likely relative to Fed activities now versus one week ago. Are they really that behind the cusp that they're still going to be taking anti inflationary actions after commodity prices and other forward looking markets have suffered their worst one week decline in history? Perhaps there is ambiguity here. Thus, one turns to markets themselves to look what has happened in weeks similar to this, where the bond yields are way down and stock yields way up, with the dollar strong and metals weak. Fortuitously for the markets, but regretfully for the past statistics, only 20 observations over the last 10 years qualify as fitting the bill with the two salient characteristics, and one or two of the dollar and metals similarities. Such ecosystems show that the markets had a leading, signaling and salubrious forecasting impact on the next week's change, with median expected changes and standard deviations both of order of plus one or two percent.

 

 

 

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