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Can We Forecast Financial Markets?

By 10th April 2019 News No Comments

If you are new to trading, you are probably wondering if predicting the financial market is possible. You’re probably wondering, can I really make money forecasting and trading the markets?

At University, you probably heard that a stock moves according to a random process, that making money – beating the market – is not a possibility.

To have an understanding as to why using heuristics such as technical analysis is vastly supported by scientific research, we need to distinguish between randomness, determinism, and complexity.

In classic economic theory, financial trading is seen as something not too dissimilar from playing casino games or betting on coin-tossing.

In other words, there is no way to make a consistent income from it.

If what academics used to think until the 90’s was right, we would not be traders, and we would not be dissimilar from people wasting their income in the lottery.

On the other hand, financial markets cannot be modeled like a deterministic process, where no randomness is involved, and having all the necessary data, making a100% accurate forecast is certain.

In engineering, for example, with a bunch of differential equations, it is possible to model how an engine works or to know how much fuel is needed to push a car to a certain speed.

In finance, we don’t have this luck, even if some naive quants, especially those who are new to finance, put an enormous effort into building super complicated models that would predict the markets. At a certain point, they will lower their expectations, being grateful if they could find something that at least, eventually, makes some money.

If we are close to the conclusion that buying or selling a stock belongs neither to the deterministic world nor to the randomness one, then to which world does it belong?

It is Finally Time to Speak about Complexity

A complex system is something that consists of many elements interacting in a disordered way, out of which a robust order is generated. There is no centralised control as to how things are behaving.

Does this ring a bell with you? Elements interacting in a disordered way, looks maybe like traders buying, selling, and influencing each other, doesn’t it?  And maybe this crowd tends generally to behave all the time, following some sort of pattern, generating a “robust order?”

I am not the only one, of course, thinking that financial markets are a complex system – there are many papers on this topic. But they are hard to understand if you are not familiar with this topic. I’ll try to make things simple and I’ll avoid using mathematics and game theory.

By observation of how investors behave it is evident that markets satisfy most of the essential characteristic of complex systems such as non-linearity, feedback, and spontaneous order.

Non-linearity

In a non-linear system, a change in input is not proportional to the change in output.

When markets are quiet, some people are buying and some are selling, nothing strange so far. If there are fewer sellers (bears) than there are buyers (bulls), they might not be able to push the stock price down. If they increase by five-times, their effect will be five times bigger. But after some critical levels, their effect can turn from linear to exponential and the stock might reach a limit down. The transaction might then be suspended. This is clear non- linear behavior.

Feedback

A system participant receives feedback when the way its neighbor’s interact with it later depends on how it interacts with them at an earlier time. Each member of a flock of birds takes a course which depends upon the proximity and bearing of the birds around it.

I am not saying that bitcoin buyers are a flock of birds influencing each other, or maybe I am saying exactly that.

You saw a friend a year ago showing a picture of his new car on Facebook. He bought it thanks to an early investment in a cryptocurrency. Not wanting to be left behind, you google “how to buy bitcoin,” and you are influenced to invest in cryptocurrencies for yourself. You are engaging in “group” or “flock” behaviour – following the crypto investors who came before you because you were influenced by them.

Any bubble bursting process in financial markets, (like the dot-com or housing bubbles we’ve seen in the past), happens in a very similar fashion.

Every trader (stocks, commodities, etc) can follow like a bird – the recent crypto guys are in good company. (Please note – I have nothing against crypto’s, you could have made money buy either buying or shorting them)

Spontaneous Order

Even if the order in a system comes from the interaction of many elements, there is often evidence of symmetry, periodicity, determinism, and patterns.

The latest few lines are very important to us because when we say that in a complex system there are patterns and some components of determinism, we open the door to the possibility of using pattern recognition (machine learning), technical analysis, or time series modeling to make forecasts.

The fact that complex systems are not random but also are not completely ordered, this is a big reason as to why it is so important – and why it’s gaining in popularity!

Robustness

The order in complex systems is said to be robust because, being distributed and not centrally produced, it is stable under perturbations of the system. The flock of birds largely stay together, even though some of them move erratically, get shot by a hunter, or chopped in an aeroplane engine.

If some big hedge fund goes bust, the financial markets would survive. Even in the worst case, we have ever seen like LTCM in 1998, the federal reserve rescued them, saving the financial markets.

Lack of Central Control

Traders and investors have the freedom to make their own decisions, even in a country where the government tells its people to buy more stocks to support the economy, the final decision is still in the hands of each individual investor.

Hierarchical Organisation

In complex systems, there are often many levels of organization, where there are many systems and sub-systems.

This can be seen in the financial markets in different ways. For example, there is a hierarchy in investors due to their dimension, such as mutual funds, which are bigger and have a more systemic impact than many individual investors.

Personally, the system/sub-system structure of markets makes me think about the self-similarity of financial time series.

If you watch a daily chart of any stock, you’ll notice it is similar to a smaller time frame. In other words, it is similar to itself. As Mandelbrot has extensively covered, financial markets are fractals.

CONCLUSION

At this point, you should be convinced that the complex characteristics of financial markets are essential to demonstrate that traders do have a chance to make money.

What do Ph.D.’s and scientists use when dealing with complex non-financial systems?  A lot of math of course, but also heuristics.

What do traders use when dealing with financial markets?  Heuristics! They don’t even know that any form of technical analysis they are using is a heuristic!

A heuristic, very simply, is proceeding by trial and error – by rules, employing practical methods, without any guarantee of optimality or even rationality.

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