Can Physics Explain Markets? A Look at EMH Through Four Forces

During their recent episode, Taylor, Carlisle, and Katsenelson discussed Can Physics Explain Markets? A Look at EMH Through Four Forces, here’s an excerpt from the episode:

Tobias: What do you think, JT? You want to sneak in some vegetables before the top of the hour? There’s lots of demands for the book of vegetables. I have also been pushing JT to do this. There are transcripts of all of these interviews. If someone wants to contact us and produce the Jake’s book of veggies?

Jake: A lot of other projects going on. So, maybe let JT get to it in good time.

Tobias: Well, I’m saying we’ll find somebody who’ll put it together for you.

Jake: Maybe. All right, well, this is trying to stick the 10.0, like triple backflip here today. So, we’ll see.

Tobias: Oh. Is that getting it back to investing?

Jake: Yeah. Well, that’s not going to happen. [laughs] But I thought it would be fun with Vitaliy on, just because I know that he understands a lot of this stuff. So, I think hopefully this is a good choice of trying to match up content with the guests. But I’m going to give a little history lesson on the efficient market hypothesis.

Vitaliy: Love it.

Jake: And also try to relate that together with the four fundamental forces in physics.

Tobias: All right, then. This would be good.

Jake: Yeah.

Tobias: Well, just in–

Jake: Yeah, buckle up. This could really blow up in my face. All right. So, the EMH, the quick history lesson is like it starts really with a 1900 PhD thesis by this guy named Louis Bachelier. And it was called theory of speculation. And he suggested that stock market prices are unpredictable and follow a random path, laying the groundwork for what would later evolve into the EMH. And this is where the term random walk came from.

So, if you imagine the thought process was imagine a drunk that’s fallen asleep at a lamppost. And every now and then he wakes up and he staggers a few steps in a random direction, you don’t know which way he’s going, and then he falls back down and it takes another nap. And then after many stages of this aimless wandering, how far away is the drunk from the lamppost?

Well, we can’t really say with any one drunk how far away he’s likely to be. But if we had like a million of them, we could start to actually look for patterns of how far away would we expect them to be on average. And it would be diffused outward in all directions. The average distance from the lamppost would increase with the square root of time. And so, that’s kind of the math that would come out of that. So, that’s what people have used then to back into prices moving around in random ways.

What I mean by that square root of time thing, so if you think if it takes one hour for him to wander one block, it would take four hours on average to wander two, and then nine hours to wander three, because there’s a lot of back tracing, wandering around in circles. All right. So, fast forward to the 1950s, and we start to get more of a foundation laid for EMH. The legendary economist, Paul Samuelson, ran with this concept and suggested the stock market was a glorified casino. And people who make fortunes there are basically just lucky. They’re not that smart. They’re basically lotto winners. Funny enough, Samuelson hedged his personal bets by putting his own money in Berkshire Hathaway.

Tobias: [laughs]

Jake: Fast forward, and then we have Harry Markowitz introduced the modern portfolio theory in 1952, and there he emphasized diversification and the relationship between risk and return, which set the stage even more for discussions on market efficiency.

1953, an economist named Maurice Kendall gave a talk indicating that wheat prices move around randomly supporting the notion that markets are unpredictable and by extension then efficient. And it was, of course, wheat and stocks. There’s not that much of a difference when you’re looking at the squiggly lines.

1960s, we get a much more formal introduction and development with Eugene Fama in his PhD thesis at the University of Chicago, 1965, formal introduction of the EMH. He defined efficient markets as one where prices are always the fully reflect available information. And it really categorized into three forms, okay? Weak, semi-strong and strong. So, let’s look at each one.

The weak version is you can’t beat the market by predicting a stock’s future prices just from knowing its past prices. It’s basically destroys all technical analysis as worthless at that point, when you say that the past is not prologue for the future. Semi strong is you say you can’t beat the market with any publicly available information. So, every past price, every press release, every filing, Bloomberg story, whatever, and however good you are at interpreting these things, there’s no room left over. It’s already all baked into the price, okay? And fundamental analysis then is completely worthless.

Tobias: I agree there.

Jake: Yeah, [chuckles] that’s been the lesson for the last seven years.

Tobias: [laughs]

Jake: It does leave room for private information in the semi-strong version. And then you have the strong form, which is private, is also then included in the mix. And basically, you can’t beat the market. Every piece of information, public and private, is already baked into the price. The implication is that basically insider trading is completely worthless.

Fast forward 1970s, more studies are done to validate with mixed results. The markets seem to reflect public information quickly, which might support the semi-strong version, but you can never really get all the way to fully strong version.

1980s, then we have a lot more challenges. You have anomalies such as the January effect. You end up with market crashes like 1987 that completely challenge EMH. Like, really, everything’s worth 22% less from a Friday to a Monday suggesting that maybe markets aren’t perfectly efficient. You get the rise of behavioral finance, led by psychologists Daniel Kahneman and Amos Tversky, which RIP Mr. Kahneman last week. Unfortunately, we lost a giant. And all that introduces this idea of cognitive biases which affect investor decisions, which lead to potential inefficiencies.

And then, of course, 1984, Buffett wrote The Superinvestors of Graham and Doddsville, which is a direct parry against the challenges of EMH. Then, of course, in the 1990s, you get technology, which this goes to what you guys were talking about with the diffusion of information. Now that we’re all connected on the internet, maybe markets are even more efficient. And yet, squared against that, we have the dotcom bubble in the 1990s, which companies you throw a dotcom on the end of the name, and it adds a billion dollars of market cap. Does that really make that much sense?

Late 2000s, some of the same problems. The GFC brings significant challenges to EMH. Failure to predict and prevent a bubble suggests that there’s limitations in this efficiency. So, anyway, like systematic mispricing of a lot of risk at that point. Since then, despite the criticism, EMH still remains a fundamental part of financial theory. It’s taught in every business school still, although there’s still a little bit more room now for behavioral finance.

Anyway, so, analogously now, we’re going to try to bring EMH together with the fundamental four forces in physics, which to remind you of your classes from back in the day. Number one is the strong nuclear force. Number two is the electromagnetic force. Number three is the weak nuclear force. And then number four is gravity, all right?

So, the first one, the strong nuclear force, let’s connect that together with market fundamentals. This strong nuclear force is the most powerful of the forces, and it acts as the glue that will hold nuclei of atoms together. Similarly, market fundamentals, earnings, debt levels, economic indicators, whatever, are kind of the glue that underpins the intrinsic value of securities. And just as a strong nuclear force operates at the smallest scales but with the most intensity, bundle and minimal analysis is at the core of the financial health of the company, and often revealing the most potential indicators of long-term value. It’s very powerful and up close, but it’s also short range.

So, then the next one is electromagnetic force. Maybe we can liken this one to the information spread like we were talking about. And this is like attraction and repulsion, is basically EMF. So, imagine it governs how particles are either attracted or repelled from each other. And in markets, information acts similarly, where investors can be attracted to a stock or repelled from it based on the nature of the news. You see everybody’s making money on Nvidia. You get attracted to it. Everyone hates oil companies. You would never buy that. You get repelled from it and you get these dislocations.

And then it influences over a distance. Unlike the strong nuclear force, which is very up close, electromagnetic force works over vast distances. And this mirrors how information, especially in the age of the Internet, can spread globally in an instant and affect markets worldwide.

Next up, weak nuclear force. Maybe this relates to market anomalies. So, the weak nuclear force is essentially the process of changing one particle into another. So, imagine radioactive decay. Analogously, like market anomalies, bubbles, flash crashes, things like that can be seen as markets radioactive decay, where the usual rules stop applying temporarily and challenging, I think, EMH’s notion of a perfectly always efficient market. They’re rare and unpredictable. The weak nuclear forces responsible phenomena that are really pretty uncommon and very unpredictable compared to gravity, and these other things, which are much more regular. And similarly, market anomalies are pretty rare and often unpredictable.

And then the last one is gravity, I would say, and interest rates. So, gravity is the force of attraction between all masses in the universe. And much like interest rates, it acts like the gravity of the financial universe, like, everyone. Buffett said that a million times that gravity is the– Or, sorry, interest rates are the gravity of the financial universe.

So, on an interest rates, they may seem weak and irrational on an individual company basis. Of course, interest expense makes sense. But on a macro scale, they have very profound and far-reaching impact. Like, they get into every little nook and cranny of the economy. So, the gravitational pull, it decays much faster the further you get away, and so the same kind of idea. Anyway, all of this is like the interplay of these forces. The universe operates under the influence of all four of these fundamental forces. And financial markets are shaped by complexity and the interplay of factors from hardcore fundamentals to market sentiment to these other things.

So, anyway, hopefully, maybe we got a little bit of EMH background that was interesting, the history of it, and then the four forces and tried to weave those together to talk about the interplay. I would give this a 6 out of 10 landing. I don’t know, we have a Russian judge on. [Tobias laughs] What’s the Russian judge put it at?

Vitaliy: Oh, nice. I like that. Okay. [Jake chuckles] Jake, your ability to come up with this mental models is just incredible.

Jake: Thank you. I appreciate that.

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