Chaos Hits Wall Street The Theory, That Isby
Ronald K. Brandes is president of Braddis Associates, a consulting firm, and he is trying to explain the most fascinating new way to extract profits from the discordant forces of the financial markets--chaos theory. So he does what any chaologist would do under similar circumstances: He lights a cigarette and places it on an ashtray. "Look at the smoke," he says. "See how it rises." It starts off in a straight line, only to diffuse swiftly into turbulence. Disorder. Chaos.
"I'm going to tell you the secret of life," the beefy, 39-year-old Brandes confides. He leans forward in the basement-den-office of his Smithtown (N.Y.) home. "Existence is the struggle against entropy--the struggle against disorder."
GLAMOUR. Welcome to the world of chaos theory, the cutting-edge mathematical discipline aimed at making sense of the ineffable and finding order among the seemingly random. Not surprisingly, chaos theory has come to the kingdom of disorder, Wall Street.
Chaologists are hardly receiving a warm welcome on the Street, where they are viewed with near-universal bewilderment. Still, chaos theory is here to stay and is not likely to remain cloaked in obscurity for very long. For one thing, it is the only really new way of looking at markets since the mid-1960s, when academicians developed modern portfolio theory. Chaologists also have an aura of high-tech glamour because their complex computer programs frequently require the use of high-power computers and neural networks, which mimic the human brain.
But most important, chaologists have the potential to revitalize the money-management industry. That's because chaos theory turns portfolio theory on its ear by tossing out its central tenets--that investors act rationally and that markets are efficient. In place of those notions, it installs a more alluring idea: Investors can actually beat the market.
This controversial discipline is garnering a small but growing body of adherents, particularly among "quantitative" money managers, who are mathematically inclined and already use sophisticated computer models to guide their investments. Chaos theory also has a natural constituency among market technicians, who chart price and volume data in the belief that past trends suggest future action.
To chaologists, the patterns of the financial markets are akin to natural systems, such as a tropical typhoon or the flooding of a river basin. The reason for the similarity is almost self-evident but is notoriously difficult to quantify--human nature. Warren Buffett provided one unintended perspective on chaos theory when he observed, quoting famed teacher and investor Benjamin Graham, that the market behaved as if it were "a fellow named Mr. Market...a man with incurable emotional problems." At times, Buffett noted, "he feels euphoric and can see only the favorable factors," while at other times "he is depressed and can see nothing but trouble ahead for both the business and the world." Chaos theory tries to put numbers behind these sentiments.
Orthodox quants, of course, also use powerful computers, and they also build models of market behavior that take into account a host of relevant factors--price-earnings ratios, dividends, interest rates, and so on. The crucial difference between them and chaologists is in the theory used to construct these models.
GLITCH COUNTRY. Chaos theory came to Wall Street like many other financial innovations--via academia. Its intellectual underpinnings were set forth in 1963, when a mathematician at the Massachusetts Institute of Technology, Edward Lorenz, mused on the frustrations of weather forecasting in the Journal of the Atmospheric Sciences. Lorenz noted that weather predictions were almost invariably inaccurate because of tiny variations in the way data were measured. Over time, these tiny glitches were magnified tremendously. Lorenz' observations went unnoticed until 1975, when another mathematician, James Yorke, expounded on the subject in the American Mathematical Monthly. Yorke's work was the foundation of modern chaos theory.
Actually, the term "chaos" is a misnomer. To devotees, natural systems and the markets aren't chaotic in the sense defined by Webster: "a state of utter confusion." On the contrary, chaologists maintain that things that often seem random are really following their own set of rules. One of these rules is that they are, as Lorenz observed with weather, "feedback systems"--what happened yesterday is having influence today and, combined with what happens today, will influence tomorrow.
If the market is a feedback system--as chaologists maintain--standard portfolio theory is wrong. It holds that prices reflect all publicly available information. Any change in the stock price is caused by a change in the information. There's a direct chain of causality--what mathematicians refer to as a "linear" view of the markets. But chaos theory holds that, as feedback systems, markets are "nonlinear"--that is, things don't happen one by one in a chain of events. Markets, chaologists maintain, assimilate information in an inconsistent manner--in "clumps," so to speak.
To put these theories into practice, chaologists employ concepts of higher mathematics used to model complex natural phenomena as well as advanced computers with feedback systems. At F. Martin Koenig Advisors, a New Jersey money-management consultant, chaos theory is used to construct "matched" portfolios of long and short positions, a market-neutral strategy aimed at gaining a premium over the Treasury-bill rate of return. Koenig's head of tactical asset allocation, John W. Scott II, uses chaos theory to combine macroeconomic and monetary factors in constructing investment portfolios. The aim, he says, is to assess market risk accurately, not to predict the future.
WEAK SPOT. At Braddis Associates, a chaos pioneer, Brandes, too, is wary of claims that chaos theory can predict the markets--though his view that chaos theory can precisely gauge the present represents only a shade of difference. Although Brandes waxes rhapsodic on the theory of chaos investing, he quickly turns reticent when the conversation turns to practical applications. And what he is willing to say about the nitty-gritty of chaos investing seems far from compelling. For example, one of his indicators of the risk of investing is what he calls a "fractal-fill ratio"--apparently little more than a run-of-the-mill technical indicator. He boasts "advanced return strategies" to pick stocks, based on an undisclosed, "proprietary" system that analyzes the way companies use their cash flow. He has developed an agricultural index that, he says, demonstrates a perfect inverse relationship with bond prices. And his "core" portfolio is prosaic--a baker's dozen of large-cap stocks such as AT&T, Du Pont, and General Electric. "People should always be in the stock market," he notes, "and own important companies."
That's hardly a revolutionary sentiment. Indeed, translating theory into practice is one of the glaring weak spots of chaos theory. So it's not surprising that chaos theory has yet to prove itself to the satisfaction of the people who really count--chief financial officers, corporate treasurers, and the trustees of pension funds. The details of building quantitative stock portfolios with chaos theory--its most promising application--are excruciatingly complex, even for the mathematically astute.
Chaologists are trying to break down the investment community's resistance to their ideas. On Oct. 15, the New York Society of Securities Analysts sponsored a full-day seminar that brought together chaologists, analysts, and mainstream institutional investors. Some arrived brandishing copies of Chaos and Order in the Capital Markets, the recently published primer that is fast becoming the bible of the market chaologists.
`SPEAK ENGLISH.' If the goal was to sell chaos theory to the uninitiated, it appeared to be something less than a smashing success. Investment pros who had not been previously converted seemed unconvinced by the chaologists' presentations. Among other things, they seemed nonplussed by Brandes' refusal, in response to a question from one participant, to define his fractal-fill ratio as anything but "measuring an entropy that is a quiet before the storm." That prompted Gary L. Gastineau, a futures and options expert at Swiss Bank Corp., to observe later that "very few people, if any, are willing to accept a black box." After a complex, math-laden talk by one chaologist, participants expressed bewilderment. "If anyone understood 10% of what the speaker said, would he please stand up?" quipped John S. Brush, a leading quant who is president of Columbine Capital Services. And Arthur S. Bahr, executive vice-president of General Electric Investment Corp., observed at the end of the day's proceedings that "if this presentation were held up in GE corporate headquarters, some of the people would say: 'Now speak English to me.' "
Such skepticism is understandable. Fund trustees and fund managers who might buy computer models from chaologists are justifiably unwilling to sink money into chaos-based systems based on theories that they simply don't understand. At times, chaos theory presents itself as a kind of surefire money-maker. And that makes folks with conventional investment methods wary. "The assumption is that once you discover a nonlinear model, it will work better than the others," says Columbine's Brush, "and folks like us who have struggled for years with linear models will be put out of business."
As far as Brush and other quants see it, chaos theory is intriguing but unproven. Chaologists, he admits, have "powerful ideas" worth pondering. Much of the rest is dismissed by Brush as "more emotional than analytical."
As far as Brandes is concerned, some emotion is warranted. Japanese securities firms, he believes, take chaos theory seriously. He likens the situation to Star Wars--the competition with the Soviets, not the movie, although when Brandes speaks it's hard to tell the difference. "Lets start off by talking about good and evil and sin," Brandes exhorted the visibly unimpressed money managers. "Evil is disorder, and good is order."
Perhaps. But before chaologists can burst out of the realm of theory and into reality, they are going to have to show some results. They must persuade some pension funds to put money--and lots of it--where their theories are. And funds are unlikely to try out chaos until the chaologists have established a track record. That's what's known as a "Catch-22." Not as intellectually stimulating as chaos theory, but no less valid.
CHAOS THEORY AND PORTFOLIO MANAGEMENT: SOME KEY CONCEPTS FOLLOWING THE MARKET'S MOVES REQUIRES NEW MATH Market chaologists believe that since markets are a complex `nonlinear system,' they must be analyzed by using fractals--a mathematical tool that describes complex objects MARKETS ARE ANALOGOUS TO NATURAL PHENOMENA Chaologists are using statistical stratagems that have been developed over the years to study social and natural sciences-- principles used to gauge the timing of such natural events as overflowing rivers and sunspots THE STOCK MARKET IS NOT EFFICIENT Chaologists insist that the notion of `efficient markets,' in which market prices instantaneously reflect all public information, is a myth. The reason: Investors interpret information haphazardly and irrationally PRICES DO NOT MOVE IN A `RANDOM WALK' Under the efficient-market theory, prices change only because of new information. Chaos theoreticians believe the 'random walk' is wrong and that markets move in a more complex, but understandable, fashion