I've Seen Deja Vu
Vol #86: June 24th, 2022
If it feels like you’ve seen this movie before, why isn’t the next scene obvious?
With pattern recognition baked deep into our DNA, we’re constantly prognosticating on what’s going to happen next. “The bottom is in,” “there’s another leg down,” “we don’t bottom until the dealers say uncle.”
It’s easy to boast a deep confidence in how the narrative will obviously play out, but our batting average for predicting what’s going to happen next barely gets a ride on the bus. After a 100 point drop, a next day rally feels like a sure thing. But there’s no free money in simply buying the upside calls.
The miracle of market efficiency ensures that this will not be the case. The options pricing model has no directional bias, but even if there were an exploitable pattern it would either already have been or shortly be squashed. (That and the nuances of spot:vol correlation and theta decay.)
Patterns and what feels like the most obvious cases self-similarity can be deceiving. Because we want to see a pattern, the goal posts constantly get shifted to align with our expectations. Deja vu is in the eye of the beholder.
Benoit Mandelbrot is the inventor of fractal geometry and one of the godfathers of chaos theory. (We talked a bit about his theory on market time and clustering of activity last year.) When he was asked how long the coast of England was, he famously answered “how long is your ruler?”
With a mile long ruler, measuring a coastline will miss the many nooks and crannies. A foot long ruler will accurately describe each bay and jetty, and at a micron scale each pebble will be accounted for. The smaller the ruler gets, the longer the coastline will measure.
To my disappointment, much of chaos theory isn’t colloquially “chaotic”, but based around patterns and how they scale up and down. The coast of England is the real world example of what mathematicians model with the Koch Snowflake.
Chaos starts with a simple seed or algorithmic rule - the metaphorical butterfly’s wings. For the snowflake, start with an equilateral triangle, and divide each side into three equal segments. Now use the middle segment as the base of another equilateral triangle. Continue ad infinitum.
As we zoom in further and further on the snowflake, the pattern seems to repeat itself endlessly. At scales both big and small a coastline will also look strikingly similar. In fact the fractal dimensions (a measure of the roughness of a pattern) of the Koch snowflake and the British perimeter are both about 1.26.
The more we zoom in on the markets, the more patterns we start to see. Daily charts look strikingly similar to weekly and monthly charts; and without prices or time frames even different asset classes are difficult to parse. This is where technical analysis really starts to look like astrology. There’s an emergent pattern on some time frame that will fit any hypothesis.
At the finest degree, markets are nothing more than a series of orders and trades. Candles and bars form on the charts because orders arrive at exchanges and interact with each other based on the microstructure of matching engine logic. This organic process unfolds in strikingly similar ways across the boom and bust cycles of human emotion.
Our engagement with the markets is a function of how we perceive them. Day traders that are trying to capture every Fed statement swing, and buy the dippers looking at long term value are watching the same movie through totally different glasses.
A fundamental prerequisite for giving investment advice is understanding the client’s horizon. Combine this with risk tolerance and you quickly narrow down the scope of appropriate products and strategies. We should probably also be asking what the measuring stick is.
Being correct every day requires a different approach than being correct over a decade. The scale of these two patterns looks deceptively similar though, and plays tricks on our egos and limbic system.
Fuzzy predictions on indeterminate time frames (“the market will rally after yesterday's sell off”) combined with generous mental accounting make it tempting to start buying 0 days to expiration calls. If that siren starts calling, tread carefully, and remember how long your ruler is.