Markets and the laws of physics

The motion of the markets overall, a downward trajectory, requires a compelling force to change direction. So far, no-one seems to be able to supply that force.

Physics wasn’t really my strength at school. I was too busy writing a history of the heavyweight boxing champions of the world. Joe Louis was my pin up boy at the time.

I am embarrassed that such a terrible sport caught my fancy in those days and was responsible for me knowing a hell of a lot about boxing while getting 10 out of a 100 for Latin.

Somehow or another I was weaned off boxing and finally secured a modicum of knowledge of physics, although my marks in Latin never caused more than a blimp on my term reports. (It did have an effect on my father who told me on receiving my report: “Ten for Latin! I’ll give you 10 for Latin”.)

Anyway, that is by the way. One thing I did remember about physics was something along the lines that a body travelling at uniform motion in a straight line will continue in that direction unless compelled by an external force to alter that direction. My physicist readers will be able to correct me if my memory has misrepresented the principle.

Joe Louis was superb, by the way. He just kept going and wiped his opponent Billy Conn off the map (they turned out to be great friends in later years). You see, Conn could not prevent the uniform motion of perhaps the best boxer that ever walked into the ring. Sometimes, uniform motion is unstoppable.

Have a look at the following graph. It is pre-history, being the situation in July of this year. But despite its age, it demonstrates something.

As the price of oil increased, the All Ordinaries Index (the index of major shares traded on the Australian stock exchange) generally decreased. Right at the end, there is a bit of a blip and you will see that the price of oil is declining and the All Ordinaries starts to rise.

There is a temptation to conclude that there is a correlation between the price of oil and the performance of the All Ordinaries. Indeed, one would think that as energy decreases in price, the economy would improve.

I can‘t lay my hands on any graphs, but we all know that at the moment, the price of oil is (forgive the term) “tanking” and the All Ordinaries is going in the same direction.

The question then becomes “what is it that has caused the uniform motion of oil and the All Ordinaries to reverse course at the same time? Is there a correlation or isn’t there?” Something funny is happening because the laws of physics are not working here. There must be something else that influences the alteration in direction of the All Ordinaries.

There is another important index that people look at from time to time, and it is called the Dow Jones. Following is a graph of its performance over the past five years.

It has suddenly altered course. It was travelling fairly uniformly in an upward direction and then suddenly turned around. If my statement of the principle of physics has any semblance of accuracy, we would have to conclude that something intervened to turn this momentum to negative. We know that it could not have been the price of oil because it has tanked at the same time.

Every investor wants to know what is going to happen in the future. If we look closely at this graph, it will be seen that investors are doing the most incredibly stupid things. Let’s look at the last six months of the Dow Jones.

While the direction is generally down, if you look more closely you will see that almost on a daily basis, there is volatility both up and down. It is up one day and down the next, but overall the trend is down.

Why do serious investors push the index up by a few hundred points one day and then send it down by the same or more the next day? There must be something causing the Dow to alter direction, otherwise it would continue in uniform motion.

Let us have a look at the Australian sharemarket and the All Ordinaries index. Here is a graph of the past five years, and while its upward trend has been more significant that the Dow Jones, the trends are roughly similar.

Once again, something has occurred earlier this year to alter the uniform motion of the All Ordinaries. Certainly, the price of oil spiked earlier in the year, but subsequently it has been going in the same direction as the All Ordinaries.

Once again, you will see the volatility of the market since late last year. Up one day by a lot and down the next, but with an overall tendency to go down. Why would someone buy shares one day when the market is up by say 4% when in fact the next day it is likely to drop by the same amount? Are investors crazy?

The market is tanking. Why would anyone buy in a tanking market? Is anyone stopping to think about what is causing the market to tank?

What is it that is preventing the market from continuing in a uniform motion? There must be an enormous force working in the market place that is putting the sharemarket off course.

If you look closely at this graph, you will see that it is not an overnight wonder. In 1987 everyone was spooked that the world was going to come to an end, and in one day the market crashed but, as you can see from the graph, it didn’t stay crashed for long. This time, the downturn seems to be more systemic. It seems to be going in a uniform direction. We know that unless an opposing force comes into play, that this direction will continue.

The market is going in uniform motion in the wrong direction, and historically the pattern is not too good.

So the question is “why is the market tanking” and what will be the force that will turn it around?

The simple answer is that no one knows, although it has a lot to do with the smart spreadsheet guys on Wall St and other so called “financial centres” around the world.

However, as the market is now acting irrationally (with the drop in oil prices and interest rates the markets should be going up) we have to ask the reasons for this irrational behaviour. We know that finance guys and bankers have been in this scandal up to their ears, so it is fair to ask whether they are still there having an influence on events.

One of the serious practices that was adopted with an increasing sharemarket was called “margin lending”. Shares went up in value and people used that apparent increase in wealth to borrow more money to buy more shares. Have you heard of this phenomenon before?

You are dead right; the sub-prime fiasco in which there was a belief that property prices would continue to increase, justifying reckless lending to people who borrowed on their supposed increase in wealth only to find at some point in time that they couldn’t make the payments on the loans.

Suddenly, the mortgage market tanked and everyone who was holding these pieces of paper headed for the door. Banks that were relying on the solidity of these securities were suddenly put in a position where their capital base was eroding before their eyes with the result that foreclosure after foreclosure hit the market and property prices started to follow those who were less and less reluctant to take on property. Property prices in the USA are still in uniform motion, in the wrong direction.

Margin lending on shares had the same effect. Banks suddenly became tight for liquidity and started to ask people to pony up with their money.

So, what did they do? They started to sell their shares. You know the end of the story. Everyone was suddenly heading for the exit.

After a wave of selling, the market would stabilise and those who had some stuff up their sleeve felt that it was time to off-load. Every time there was a lull in the market, those who had hung on up till then felt that it was safe to go into the market with the result that there was a fresh wave of selling.

The strange thing is that this phenomenon is not attracting the same attention as the sub-prime issue, and yet it must be resulting in enormously greater wealth reduction. If I am right, the force that is derailing the sharemarket is the exodus of people who are responding to margin calls from their broker.

We have known about the possibility of recession ever since George Bush took over the job at the White House. America now has low interest rates and low oil prices and yet the market is still going in the wrong direction.

The only force that can possibly be in play here is that of people who have their shirts on the line and we haven’t any idea of how serious this is.

Until this is worked out of the market, it must conform to the basic laws of physics and trend down until countered by a greater force that starts sending it in the other direction.

Until speculators have been cleaned out of the market, this is not going to happen. When they are cleaned out of the market, the usual forces will come into play and the market will stabilise.

However, all of this has a secondary effect. As there are more examples of people going to the wall, and more headlines about the market tanking, and more headlines about the inavoidability of recession with the possibility of the “D” word, anyone who has any money is reluctant to spend it. They start storing their credits in the babysitting club only to find that no one wants them to babysit and the credits remain in the bank.

Only when those credits start to free up will this uniform motion of markets correct. Will lower interest rates do it? I don’t think so. Will lower oil prices do it? I don’t think so. Will injecting billions of dollars of taxpayers’ money into the financial system do it? I don’t think so.

What has now happened is that fear has gripped the market place and Warren Buffett can shout from the roof tops that he is buying America (in fact he is screwing GE) and things won’t change until people have the confidence that somewhere, someone has their hands on the steering wheel, and that involves leadership.

At the moment, bankers and politicians are plugging up holes in sieves. Until confidence in the direction of western society can be restored, I fear that the uniform motion is not going to be altered.

Perhaps the next president of the United States can provide this leadership and instil confidence into the community. Perhaps my knowledge of physics is awry. Perhaps, the motion of things will self correct and then, perhaps ….. well!

Louis Coutts left law and became a successful entrepreneur. His blog examines the mistakes, follies and strokes of genius that create bigger, better businesses. Click here to find out more.

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