Three Examples Of How Chaos Theory Affects Financial Markets
Chaos Theory – the idea that a butterfly in Thailand could cause a US hurricane – can actually create positive outcomes as well as mayhem. Consider that European banks, German long-term bunds and the offshore yuan are essentially the butterflies making for pleasant investment conditions just now. All have turned sharply in the last 2 months after previous discounting disaster. And all have more room to run.
Chaos Theory gets a bum wrap, and I think the reason is bad branding. The most common explanation of the phenomenon is the classic “a butterfly flapping its wings in Thailand can cause a hurricane in the Gulf of Mexico”. Initial conditions, in other words, can have outsized effects in complex systems like weather patterns. Fair enough, but one usually associates Chaos Theory with bad outcomes like cyclones and stock market crashes.
What about when initial conditions push their way through to create unexpectedly good outcomes? That’s Chaos Theory as well, but no one talks about the mayhem created by a lovely day… Bad branding, that, or at least misleading packaging…
Turning to the current sunny spell in global risk markets, three examples of why Chaos Theory can work to investors’ benefit as well as harm.
Exhibit #1: European Bank Stocks:
- In early August, the EURO STOXX Banks Index looked like it was about to implode. At 77, it had not been lower since the 1990s. We wrote about it, highlighting that several market bears thought the group was destined to go into chaotic (there’s that word again) free-fall.
- But then the group found its footing as Eurozone long-term interest rates bottomed (more on that in a minute).
- From August 15th to now, the index is up 20%. Disaster averted, at least for now.
