Volatility in the Dow

The Dow is up a breathtaking 11.08% today (936 points at close). For me this is another reminder of Benoit Mandelbrot’s The Misbehavior of Markets. Mandelbrot is the mathematician who discovered chaos theory as well as fractal geometry. In that book he examines the stock market for mathematical patterns: a task that many mathematicians have tried to do and failed. Mandelbrot discovered that the market is far wilder than finance theory takes it for, and he also made some other interesting observations. 

For one, he discovered that volatility begets volatility. If one day had a wild swing up, the next day would tend to have another wild swing. It might be up, or (more likely) it might be down, but it would tend to be of far greater magnitude than the average market return. This disproves one of the tenants of the Efficient Market Hypothesis which assumes that each day is independent from each other day, and it is a principle that we are seeing in action today. Mandelbrot proved that, as he puts it, “markets have memory.” He further proved that markets are a bit like elephants in that they never forget. 

Last week the Dow was down far more than it ever had been in any one week period regardless of whether you measured it in percentage or nominal points. So I had figured that today at least we would probably see a large move to the upside, and what a move it was. As a betting man, I’d say that tomorrow might bring a rather large move to the downside, or it could be up again. But either way, the magnitude of the move should be much higher than we say the market moving just a few weeks ago. Volatility begets volatility and vice versa. Right now the movements of the Dow more closely resemble those of a high flying tech stock in the 99-00 market than that of the 30 most solid blue chip companies in America; I should point out that the Dow lost one of its member companies with AIG had to get a government bailout, so being a Dow Jones company is no guarantee against suddenly going bankrupt in this economy.

As I’ve stated before and in my book, the Dow will continue to lose ground against gold. It did well for itself today, but the long term trend is clearly for it to continue to lose against the yellow metal. The only money to be made off of these huge moves in the Dow is for traders: this kind of volatility is a traders dream come true, provided he or she is on the right side of the move! For all others, I’d encourage all readers to seriously reconsider leaving their money anywhere near the American stock markets. The worse is yet to come.