Earthquakes and the Mind-Bending Laws of Markets

March 19 (Bloomberg) -- Like the devastating Japaneseearthquake of 2011, the stock market crash of Oct. 19, 1987,came as a total shock to most people. Yet the crash wasn’tentirely without warning. Five days before, the Dow JonesIndustrial Average dropped 95 points, which was then an all-timerecord. Two days later, it closed down another 108 points. Justlike others crashes -- 1929, for example -- and all majorearthquakes, the 1987 crash was preceded by significantrumblings.

The comparison of tectonic and market shocks goes farbeyond metaphor and analogy. Consider, for example, how much theprices of stocks and other financial instruments change over acertain time interval -- say a few minutes, a single day, or aweek. In the early 1960s, French mathematician Benoit Mandelbrotcarried out a landmark study of such changes in the prices ofcotton and found that the statistics of large market returnsfollow an inverse power law very much like the Gutenberg-Richterlaw for earthquakes. More than 30 years later, physicists foundthat this law-like pattern holds for intervals varying from asecond up to a month and in different kinds of markets --stocks, foreign exchange, futures -- as well as in manydifferent countries.