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Money & Markets: Christmas sees the markets rally

Portfolio managers wanting to finish the year on a high cause the Christmas markets to rally. This is followed by another seasonal phenomenon as the first couple of days' trading set the tone for the year to come.

Christmas is famously a share-trading period where the market rallies, as portfolio managers buy into their existing positions to puff them up, buying more so they can flatter their performance with a year-end rally. This is called ‘window dressing.’

This runs against the rule underlying the market, that it is efficient and perfectly so. Clearly it is not perfectly so; perfection, as I assume any engineer would tell me, is unattainable. This seasonal effect underlines the sort of imperfection that lurks in the corners of the markets. Time is where many imperfections lie, nested in self-affinity and self-similarity. The daily opening and closing of markets is another period where inefficiencies created by time pressure and bounds mean prices can diverge from the ideal and where traders try to make their money by trading profitably to lessen these time-based glitches.

Where the market is inefficient you can run the numbers and see it, then trade against these mis-pricings and thereby pre-empt, lessen and ultimately destroy the inefficiency. As such, inefficiencies are rare and need to be driven by something systemically large to stay in existence for long.

After Christmas, another such inefficiency is said to lie in wait, so the first day or two of the year gives an indicator of whether the year will be a good or bad one. The reason for this is likely to be the re-entry of money into the market, having been safely parked during the Christmas break. If there is a thick slug of new money quickly re-entering the market then it bodes well for money flows for the rest of the year. Some say January is not an indicator, merely a good month because of this inflow, while others say it is already pre-empted away.

Without doubt, though, two things rally in January: dieting and investing interest, and both are likely driven by the same desire for a new beginning to an individual’s health and wealth. It seems that interest in stocks also wanes with self-control as levels of traffic on dieting sites mirror the new year’s usage patterns of share information sites.

Markets are very noisy and the more efficient they are, the more their changes represent noise. Engineers are in a particularly solid position to understand what this means. There are lots of different kinds of statistical noise and they have a huge impact on the performance of machines, whether that is the engine in a car or the engine of an economy. Most market participants have zero understanding of the implication that the stock market is overwhelmingly noisy, and will happily regale you with acres of narrative to explain away the hurricane of random noise which buffets a share hither and thither.

If there is a grinding noise coming from the economy, then most people will tell you who and why and only a few will explain the situation as something in the plumbing of the system that has shaken loose. In the main, however, it is signal and noise that drives markets, not who and when.

Claude Shannon, engineer and mathematician, is said to have made lots of money applying his genius in noise and information theory to make money in the markets from this noisy random walk and should motivate any engineer or technologist to apply their science to make a killing playing what remains a primitive game.

Efficiency and randomness are all very good but there are times when it all goes out of the window and it is debatable whether noise or a hidden variable is in play. These kinds of extreme events are often called ‘black swans’, once more a treatment of another kind of random ‘black noise.’ In black noise, you get a lumpy string of random events, like Nile floods that the hydrologist Harold Edwin Hurst studied. Hurst noise events are like ‘old-style’ buses, that never came alone and when they did, they came in threes. You can instead model this behaviour as the effect of a hidden variable. Instead of a random event, a variable is in play that grows and shrinks in immaterial ways, until one day it balloons into a big deal and wrecks the whole show. There is nothing random to it; it looks random because it was unexpected, but that of course it not the same thing at all.

 In 2007, this hidden variable was market liquidity. Until a sudden inflexion point everyone had liquidity and thought nothing of it, until suddenly there was no liquidity to be had and the whole system pitched into the abyss of the credit crunch.

It couldn’t happen again of course – except that it nearly just did and the US Federal Reserve had to restart its Quantitative Easing programme to save the day this very autumn. As liquidity is no longer a hidden variable the problem was nipped in the bud, but if the whole emergency was black noise we should be prepared to see several black swans pass by in swift succession.

Instead there is a reasonable chance that we are about to enter a different type of extreme event.

2020 might just be the beginning of a bubble. It’s a brave pundit indeed that makes such a non-random prediction, but if you see the market go vertical in 2020 you will know what is going on. Bubbles cannot be banned and are as inevitable as crashes, and it can be extremely profitable to get wrapped up in one. The only thing to remember if 2020 bubbles is that it’s a bubble making you money, not your brains, and that the only way to lose is to ride it all the way up and all the way down again.

If there is a bubble in 2020, don’t forget a crash is coming and that to win you have to jump off the wave near the top.

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