Feb

11

The moves in markets often seem to imitate the kinds of things we see in nature: in gas; in water; and in electricity. For example, the gentle back and forth of the stock market last week, gradually building up pressure and then exploding on the downside, is like a cork bursting from a bottle of champagne, or a volcano erupting.

In electronic circuits we often see a signal gently oscillating between set points, then gathering a slight bit of amplitude on one side or the other, and finally tripping the set point thereby triggering a major change in the output. In capacitor resistor circuits, we find the same buildup of charge, with little change in the output until the time constant of the capacitor is fulfilled and the output suddenly and dramatically changes.

The reason for these similarities is they are all results of various energy conservation laws. Energy coming into a system cannot just disappear. One major conservation law in electronics is Kirchoff's Current law. It holds that current going into the confluence of two wires equals the current coming out. Another major law is Kirchoff's voltage law. It states the voltage that's input to a closed circuit is equal to all the voltage used up in work in the circuit.

I find the major applications of conservation laws in markets relating to some input from outside a system. Usually, some information or money flow gets distributed to the various components, companies, and markets of the system. A major merger announcement affects not just one company but all companies related to it. An increase in liquidity in the system gets distributed according to market's laws similar to Kirchoff's laws in electronics.

Click here for information on Kirchoff's laws.

To be continued.

Philip McDonnell adds:

Two summers ago, in Central Park, the Chair said something to me which was at once profound yet seemingly too simple. "There is only so much money." That was all that he said. To someone who did not understand, it would seem rather sophomoric or even downright cryptic. But it was all he needed to say because I had read his books.

The statement referred to a simple conservation law much like the conservation laws of physics. In physics energy and mass are the most significant variables in most mechanical systems. So we have laws such as the Conservation of Energy, Conservation of Mass and Conservation of Momentum. In financial markets a similar law applies. Money is conserved. At any given time 'there is only so much money'.

Let us imagine an island economy where there are only two stocks X and Y. There is only so much money on the island. When the traders on the island decide they want to invest in X they need to figure out how to pay for the purchase. The only liquid source of money is stock Y. So they sell Y. The price of X goes up and Y goes down.

Let us draw this on an X-Y coordinate plot and assign some real numbers to it. The relationship between X and Y would show up as a line from high up on the Y axis sloping downward to some point of a large X value. Suppose the amount of money were $100. If everyone wanted to own Y and no one wanted X then we would have Y=100, X=0. Conversely if everyone wanted X and not Y then Y=0 and X=100.

We can think of the distance of the current market valuations as the distance from the origin that is equal to the buying power of the money. It is a simple conservation law on our island. The $100 defines a radius from the origin. It thus defines a circle. It is easy to draw on a two-dimensional chart or even in 3D. Drawing a 5000 dimensional sphere for the 5000 actively traded stocks is a project still in progress.

Charles Sorkin adds:

Is it not the beauty of Eurodollars that since there is no reserve requirement (being out of the country and not under the auspices of the Fed), foreign banks can create and loan as many dollars as they want? 

Gregory van Kipnis adds:

Not quite. After the Eurodollar blew up in 1974, central bankers convened at the behest of the Bank of England to put a lid on the runaway growth of the Eurodollar market. It was agreed that each CB would be responsible for defaults of the banks they regulate even if the default were in the Eurodollar market. Following that, each foreign CB put reserve requirements on Eurodollar deposits.

From: George R. Zachar:

Not quite. After the eurodollar blow up in 1974 of Bank Herstadt, central bankers convened at the behest of the Bank of England to put a lid on the runaway growth of the eurodollar market. It was agreed that each CB would be responsible for defaults of the banks they regulate even if the default were in the eurodollar market. Following that, each foreign CB put reserve requirements on eurodollar deposits. /Gregory van Kipnis/

Given

1) That central banks are increasingly players themselves,

2) The clubby incestuous relationships within the govt/bank community in places like Italy,

3) The fact that one major central bank has had a high official murdered by someone he regulated (Russia),

4) The asset explosion in nations whose financial infrastructure hasn't been tested (the Gulf States),

5) The nil possibility that govt bankers grok the array and scope of derivatives…

I would not assume the central banking clerisy is on top of things. They might be, but there's reason for doubt.

Easan Katir writes:

The moves in markets often seem to imitate the kinds of things we see in nature… VN

To continue the Chair's analogy, it would seem the next practical question is how do we predictively discover the impedance of that market capacitor which discharged on February 8, provided the "3 of a kind," then tripped another point of capacitance and surged in the opposite direction for the past 4 days? What voltmeter can we use to measure the current passing through?

Or is this market more like a big kid bouncing on a "40-day moving average" trampoline for the past seven months?
 


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