Interconnected, Irrational Markets
In light of recent volatility, the correlation between markets has received a lot of attention among bloggers, the stocktwits community, and even mainstream journalists. As traders, we see this in futures prices during pre- and after-market hours. If the US market closes significantly higher, the Asian futures will likely reflect that in their pre-market trading, possibly leading to a huge up-gap at the open. If the trading day in Asia continues this momentum, the same can be said for Europe, which in turn may lead to a gap in the following day of US trading. Of course, the reverse is also true for a big down day. As the markets feed off each other, the result is a high degree of correlation.
Take a look at the charts of the major indices around the world.
If it weren't for the weekend, the correlation between markets may be even higher! As our world has become increasingly interconnected, so have the markets!
This interconnectedness is very scary if you are believer in the theory of reflexivity, which by the way, wasn't first proposed by George Soros - Soros simply applied it to the financial markets. Nevertheless, I believe Soros describes it brilliantly in the context of financial markets,
The following is taken from Soros' speech to Congress:
The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy.
As a scientist, I know that, at any given time, our current state of knowledge is incomplete. In time, new theories will be proposed, and certain "facts" will inevitably be disproved. I believe that this extends to all industries and fields - finance and economics is no exception. I believe that equilibrium theory, and the assumption that markets are rational, is no longer true, if it ever was at all!
Traders should ponder this:
Who really cares if Europe starts unraveling, and if Greece goes under in the near future (likely, in my opinion)?
How will this affect not just my trading, but eventually, my daily life? It is obvious that the cost of food, gas, and energy may change, but the longer term implications may also affect the cost of healthcare, insurance, and even your childrens' education.
I don't know the answers to these questions, and won't pretend that I do.
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