IF THERE was to be some cataclysm, and he could preserve just one sentence for future scientists, Richard Feynman would have made it about atoms. Tell them everything was made of tiny particles in constant motion, thought the great 20th-century physicist, attracting and repelling each other along the way. With a little imagination, they could then uncover the rest.
That was because the universe had a marvellous feature: though vast, it could be described by surprisingly few laws. Armed with the knowledge of atoms, Feynman reckoned his successors could work some of these out and then deduce far more.
At first sight, the less illustrious field of financial theory resembles Feynman’s. A popular destination for recovering physicists, it includes many people who would have studied his old lectures as undergraduates. Some of the equations look similar, too.
Were you to pick one branch of maths to teach a budding financial theorist, it would probably be stochastic calculus – the same one used to analyse the behaviour of Feynman’s jiggling atoms. Asset prices, after all, also jump around with seeming randomness. If you could specify how – and how they, too, jostle each other – you would have markets cracked for good.
But that is where finance and physics part ways, because the quest for the laws of markets is doomed. This is seldom as obvious as it has been recently, when the ground has been shifting and longstanding links between assets have snapped.
Rich-world currencies normally strengthen when bond yields rise; no longer for the US dollar and American Treasuries. Gold is supposed to do well when investors are panicking, and share prices when they are ebullient; now, both gold and plenty of stock markets are at or near all-time highs.
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The volatility implied by the options market is supposed to rise when things get riskier. It has been falling for months. Who, then, thinks markets have become safer – those dumping their US dollars or snapping up gold?
There are plausible narratives to explain all these developments. But the reason investors reach for them is that they lack anything more concrete. Even physical laws that are merely approximate govern multitudes: Newton’s concerning gravity and motion got men to the moon, as well as explaining why apples fall. By contrast, all the financial candidates are both limited and empirically dubious.
The efficient market hypothesis says that investors, in aggregate, perfectly and promptly incorporate new information into asset prices. It is an appealing thought, though not a convincing one if you have observed a crowd, a trading floor or a stock market bubble.
Arbitrage theory, which says portfolios of assets with the same pay-offs must have the same price, is more useful. It governs how derivatives (contracts with pay-offs dependent on some underlying asset price) are valued by specifying how traders can replicate them.
But the replication strategies it prescribes can come badly unstuck if prices jump sharply. Models relating risk to returns – such as the widely taught “capital asset pricing model” – usually make the maths tractable by assuming returns are distributed along a bell curve. Unfortunately, they are not.
None of these approaches the ideal theory of markets, which would fully explain how fundamentals move prices and how they sway each other. It is no surprise, then, that practitioners pursue narrower goals.
The bright sparks who work at today’s dominant quantitative hedge funds are not searching for a theory of everything. They want to find links between assets that have held in the past, will hold in the near future and from which they can make money.
One example is “trend following”, which does what it says after spotting a new pattern early. Another is “statistical arbitrage”, which searches for assets that usually move in a set relationship to each other, snapping back if they get out of line.
If that sounds unsatisfying to investors who are wondering what comes next, it is not the theorists’ fault. The complexity of markets is dizzying, and in complex situations even the iron laws of physics can produce surprising, unstable results (think of aeroplane turbulence).
More important still, finance is ultimately driven by people, not particles, and they do not always respond to similar stimuli similarly. They look at what happened last time, try to do better, anticipate what other traders will do and seek to outfox them. The absence of fundamental laws in markets is frustrating, disorientating – and what makes them so interesting.
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