June 23, 2016

Using Earthquakes to Understand Markets: Why and How

John Rundle is a Distinguished Professor of Physics and Geology at the University of California, Davis. We had the pleasure of meeting Professor Rundle through the Santa Fe Institute and were intrigued by his work on the dynamics of complex systems, specifically in the geosciences. His work on earthquake and hazard forecasting, and the similarities of these hazards to the financial markets expanded how we think about market movements and crashes. This is the first in a series of posts by Professor Rundle to share his research.

On July 31, 2010 the New York Times ran the story A Richter Scale for the Markets. This article was one of the first in the popular media to draw attention to recent research in the new discipline of Econophysics, showing that earthquake dynamics may have important similarities to market fluctuations. But the basic idea is not new. Financial analysts have used the earthquake metaphor for markets frequently in the past.

Books such as Raghuram Rajan’s Fault Lines, Robert Reich’s Aftershock, and Nouriel Roubini’s Crisis Economics all illustrate the idea that economic and financial influences on markets are analogous to the forces driving tectonic plates, ultimately leading to earthquakes. Economic cycles that proceed from recession to expansion and back, and intermittent market corrections and crashes, are modeled by earthquake-like events. Market crashes are followed by a series of lesser corrections, which are seen as aftershock-like events.

But just how appropriate are these analogies and models? And more importantly, can we learn about markets by studying the dynamics of other systems that are subject to sudden large changes?

While the jury is still out on detailed answers to these questions, what we can say is that there are tantalizing similarities. In the type of physics studied at the Santa Fe Institute in New Mexico, there is an important field of study focused on phase transitions. These are changes in the macroscopic state of a system as a result of external forces acting on the system.

We are all familiar with one type of phase transition, usually called a first order transition. These occur, for example, when a bottle of liquid water is place in the freezer for several hours. The liquid phase transforms to the solid phase we call ice, in the process releasing a quantity of energy we call the latent heat. The water molecules still exist as individual particles, but instead of being in the macroscopic liquid state they have transformed as a group to the solid state.

In our refrigerator experiment, this phase transformation usually occurs gradually. But it is also possible to conduct the experiment in such a way that the transformation from water to ice occurs suddenly. It is now known that these same sudden transformations also characterize earthquake faults. For this reason, earthquakes are now considered to be a type of first order phase transition of the earth’s crust, from the intact state to the fully ruptured state.

This type of sudden change is much like a market crash, which represents a sudden, macroscopic change in the character of the system. Phenomena such as hysteresis, persistence, correlations and states such as asset bubbles (or meta-stable equilibrium) are seen in both markets and earthquake systems.

First order transitions are non-equilibrium transitions. They occur spontaneously and suddenly in response to external conditions, and once initiated, they cannot be controlled. They are said to be irreversible transitions because even if the external conditions are reverted to their original values, the system can remain in the new phase.

Another type of phase transition is a second order transition. These are equilibrium transitions that occur gradually in response to slowly changing external conditions. They are reversible transitions. If the changes are subsequently reversed, the state of the system is reversed.

In second order transitions, and in some types of first order transitions, the changes in state are associated with the appearance of correlations in fluctuations of the system. For example, in second order transitions, there is a condition known as a second order critical point at which fluctuations of all sizes are perfectly correlated. This has obvious analogies to markets, in which the growth and decay of correlations is associated with changing market conditions. A particular example in 2016 is the growth of significant correlation between the price of oil (WTI) and other commodities, FOREX levels, and the Standard and Poors 500 index. An interesting question is whether these correlations may explain the period of high market volatility seen in early 2016.

In the case of earthquakes, the events and their correlations are driven by plate tectonic forces. In the case of markets, the events and their correlations are driven by FOMC rate-setting policies, leverage, and general economic conditions.

In future posts, we will explore more of the details of these ideas, and comment on the implications of phase transitions for anticipating market moves.

Read his second post: Earthquakes and Markets: Stability
Read his third post:Earthquakes and Markets: Hysteresis

The views expressed in this report reflect those of the author as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee dividends will be paid or continued.

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