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Feedback Loops

December 25, 2008

Financial Markets are complex entities. Driven by greed, fuelled by fear, it one one hand allows excesses of Tulip Bubble scenarios and in the other hand takes away viciously in prolonged periods of pain and frustration.

But given the fact, that I am an electrical engineer, it eerily fits into some of the concepts which we were made to study in the early years.

Consider the Indian Markets. In the New Indian Economy, we saw two bubbles, the 92’bubble and the 2003-2007 bubble. Also, the great realty bubble, oil bubble etc.

What drives a bubble? To quote, the legendary speculator, George Soros, he said, “Stock market bubbles don’t grow out of thin air. They have a solid basis in reality,but reality as distorted by a misconception.”
THE BUILDUP

True and this misconception feeds on itself, continues to build. As the misconception builds, the greed associated with the instrument also increases, due to the crowd psychology. This greed creates deviation from the real value and pushes up the price.

If the buildup is in pace with the reality underneath, then there is a fair amount of reason behind the prices. But often because,greed is a virus, and it affects the crowd at a much faster speed than any tangible business can generate returns[except Ponzi schemes],hence the price of the instrument almost always belies the value underneath.

It should be noted that, this deviation from the real value increases with time, thus compounding the net disturbance from the value.

Hence in this regard we can consider a stock bubble formation as positive feedback loop.In nature, positive feedback loops are extremely rare, for the sole reason that they are unstable. The unstability comes from this fact, that the output quickly builds up into enormously high values, which becomes difficult to sustain for the forward function itself.

But this positive feedback loop has to collapse. In financial markets, its a very similar situation. Maintaining the same exuberance is extremely difficult for the market participants in themselves.

THE CORRECTION

And almost miraculously, the market self corrects the deviation. Again building from the situation, the short term financial market must be then encapsulated with a self correcting negative feedback loop.This feedback loop is weird in many ways because it does not maintain the usual nature of self correcting devices. Negative feedback loops ‘hate’ sudden changes[its a low frequency filter]

But this feedback loop vociferously, corrects itself. My speculation is,the correcting mechanism is more like a thermostat than a correcting block,perhaps a short circuit of sorts happen when the standard deviation from the value exceeds a certain multiple. Often this correction is so heavy, that the instruments are corrected even below their underlying values. And this is when the investors pick up the so called investment ‘gems’. Undervalued when compared to their minimum book value, even the most pessimistic estimate of the asset value in itself is calculated to have a  rate of growth, which beats the riskless growth %age.Investing posterboys Warren Buffet,Rakesh Jhunjhunwala etc. have perfected this art.

Canny speculators, ride the entire way up and down with trend following mechanisms and keeping their senses open for spotting trend reversal opportunities, just before the self- correcting mechanism ‘kicks in ‘. Bulls are bears are just the class who are separated with their bias.

Consider the recent case of oil. A self destructive bubble. It had a huge amount of speculation buildup inside it, making it costly for the general demand. As a result, demand falls. And so does the deviation. So almost $150/barrel to $30/barrel situation.

Although, this is an interesting perspective on the issue, but I am sure, this is not a new concept. Neither will this help you to make any serious money. But it just assuages the ego of academic purists.

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