The physics of investing

26 Feb 2020

Patrick Lawlor

Writer, Investec Wealth & Investment

Investment professionals like to use metaphors to convey some of the complex ideas of their trade, with the world of science providing plenty of material to do so.

According to John Wyn-Evans of Investec Wealth & Investment UK, physics provides a useful lens with which to view and explain market movements, especially when they move suddenly.
 
Wyn-Evans highlights four areas where physics explains markets well, notably:
 
  • Phase transitions
  • Critical states
  • Bubbles
  • Non-linearity
We will deal with each of these in turn.
 

Phase transitions

A phase transition is the process by which something changes from one state to another. We will know from our days in school about how substances will move from solid to liquid and to gas, depending on its temperature (the obvious example being water – when boiled it turns to steam; when frozen it turns to ice).
 
“The trouble with a phase transition is you don't necessarily know when it’s coming. For example you could see a bath full of water and you could jump into it but you have no idea whether it’s freezing cold or boiling hot, and sometimes that's the problem we face with financial markets,” explains Wyn-Evans.
“We don't actually know how hot or cold they are just by observing, for example, the level of markets and what the indices are, so we have to find ways of testing the temperature of the market.”
Wyn-Evans says we therefore need to test the temperature of the market using various analytical tools, such as value, in absolute terms or relative to other assets (eg price/earnings, price-to-book and other ratios).
 
Other measures are how well-traded the asset is (which will help us to know if we can trade in or out of a stock with ease), how over- or under-owned a stock or sector is by fund managers, or sentiment. Economic drivers can also provide indicators, such as GDP growth or manufacturing or retail data.

Phase transitions - taking the temperature of the market

Critical states

With any phase transition, there is a critical state (that temperature at which water freezes or boils). “For markets it’s obviously different: it will take lots of things to come together for a market to reach a critical point at which a big move will be made in one direction or the other,” says Wyn-Evans.
 
Wyn-Evans says it’s like a pile of sand, to use another metaphor. “You can build it up grain by grain very slowly and the pile of sand will seem exceptionally stable for an awfully long period of time, but sometimes it just takes one little extra grain of sand on it to start a cascade.”
 
“One example I like to look back to is the financial crisis. There were so many things that came together to create the financial crisis that you had lots of these fingers of instability in this big sand pile of the financial markets, which all started cascading and breaking over each other simultaneously.
 
“Everyone points towards the US housing market, how people were over-exposed to that, how there was too much debt in the market and how the housing market had become over-leveraged and over-expensive, but that was just one sort of small component,” he explains.
“Lots of things came together simultaneously, and add on to that human nature as well, and suddenly you’ve gone from a critical point into a big spillover and suddenly you had a financial crisis on your hands.
“But the extraordinary thing is that, like the sand piles, they collapse and then they stop collapsing, and it’s almost impossible to tell when they will reach an equilibrium again, and it’s the same with financial markets.”

What causes bubbles and where is the next one forming?

5 conditions for financial bubbles to form

The official physicist’s definition of a bubble is something that has infinite capacity but finite structural integrity, which is a fancy way of saying that a bubble will keep growing until it pops.
 
So what creates bubbles in financial markets? There are five particular things that make these happen, says Wyn-Evans. One is excess liquidity. “You very rarely see bubbles being formed in any asset class without there being lots of money available and people looking for a home to put it,” he says.
 
Another is a compelling narrative. “You need a good story,” says Wyn-Evans. “You need people to believe they’re buying into something which has  got a fantastic growth path in front of it, for example, or some great new technology which is going to take over the world.”
 
Incomplete knowledge is another one. The buyer of an asset won’t necessarily know the whole story. “The people who are the promoters of the asset usually know more about where the bad things are but they won’t necessarily reveal those to the buyers,” says Wyn-Evans.
 
The fourth is human nature, particularly the fear of missing out (FOMO as it is known colloquially). “Once people see that their friends and neighbours are making money, that their competitors in the financial markets are performing better than they are because they’re in this particular asset class, people feel they have to climb aboard that particular bandwagon,” says Wyn-Evans.
 
Finally, you have momentum. “Quantitative type funds, driven by computers and black boxes, see which things are performing best in markets and then latch onto those strong performers and start buying more of those. That tends to become self-feeding, so the more they go up, the more money they attract, until you reach the bursting of the bubble,” says Wyn-Evans.

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What causes a bubble to burst?

Various factors could contribute to a bubble bursting. The emperor’s new clothes factor is one – where a particular stock is revealed to not be as good or effective as what it was promoted as and there’s a knock-on effect on other stocks in the same class.
 
Another is tightening liquidity: “If liquidity is taken away, either by the central banks or by market forces, suddenly people don't have that excess money to play with and they’re drawing it back into their portfolios, so those bubbly stocks and assets can be sold off.”
 
Exogenous shocks are another, in the form of something like a natural disaster, an outbreak of a disease or war. Fraud is another good example, as is excess supply.
 
“In Canada you had a bubble in cannabis stocks as people were looking for the long-term investment potential of people switching away from alcohol to cannabis as a recreational use. But a lot of producers suddenly saw this opportunity as well and they’ve massively over-produced  cannabis, so now you can hardly give the stuff away.”
 
Finally, there’s innovation. Technology that may seem brilliant today can be superseded by a new technology. Good examples of this are Nokia and Blackberry, which were superseded by subsequent forms of smartphone.

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Are any bubbles about to burst?

Are there any potential bubbles in the market today? Debt markets are a candidate, says Wyn-Evans. “There’s an awful lot of debt in the world. People are taking out a huge amount of credit, not just recently but it’s been building up over decades. That’s not just in the developed world, it’s also in the emerging world.”
 
Some people think bond markets are a bubble too. “You’ve got negative yields on major bond markets, for example the German bond market.  Effectively you’re paying the German government to look after your money for 10 years,” says Wyn-Evans.
 
Some areas of technology are bubble candidates. “If you look at the recent collapse of the WeWork IPO for example, one day that was potentially going to be worth $60 or $70 billion, the next day it was worth less than $10 billion – that was a bubble that certainly burst, there was a valuation bubble there.”
 
Wyn-Evans doesn’t think the equity market is in bubble territory. “Yes, the indices have done well. Some markets are trading at all-time highs but that is not actually a reason to call it - a bubble. We think the valuations are fair in the current environment of growth and inflation that we’ve got and certainly relative to bond yields,” he explains.

Nonlinearity - why investments don't move in a straight line

The nonlinear nature of investments

Finally, there’s the concept of nonlinearity, where the change in the output is not proportional to the change in input, that is to say, things don’t always move in a straight line.
 
A good example is debt, explains Wyn-Evans. “You might think if you just keep on taking on more debt that things will continue to grow at the same rate, but what we discover is that debt becomes much less productive the more of it that you take on,” he says.
 
“When companies are taking on debt to pull on productive capacity, i.e. to invest in new, innovative plants or factories, put in robots etc, this can all be very productive. However, if they’re taking on debt just to leverage up the balance sheet, do things like share buybacks, it’s probably quite good for the earnings and for the incentives of management, but it doesn’t necessarily make the company any more productive and it certainly doesn’t help the overall economic level.”
Another element of risk and nonlinearity is in the so-called decumulation phase of people’s investing, when they’re taking their pension, says Wyn-Evans.
“Looking out over 20 or 30 years at your portfolio, we can try to give you 5% to 6% returns per annum perhaps over that period of time, but those returns do not come in a nice, straight linear line. If in the first two or three years of your decumulation phase, you see a big drop in markets then suddenly the end point is going to be much harder to reach because you’re always trying to claw back the losses you’ve made, particularly if you’re trying to take out the same sort of income from your pension fund.”
 
Wyn-Evans concludes that while physics metaphors can explain what goes on in financial markets, they won’t necessarily have predictive qualities
 
“I think physics is an exact science, but investing is not. It’s fair to say and we can’t make perfect predictions based upon using physics metaphors. What we can do however is prepare for a range of outcomes that we weight according to probability.
 
I think this is a more scientific way of trying to give some idea of the movements that we expect from markets and the returns that our investors can receive over a period of time.”