THE MARKETS HYPOTHESIS

by

Fred Viole OVVO Financial Systems fred.viole@ovvofinancialsystems.com And David Nawrocki Villanova University Villanova School of Business 800 Lancaster Avenue Villanova, PA 19085 USA 610-519-4323 david.nawrocki@villanova.edu

Preliminary and confidential Do not quote without permission of the authors.

THE MARKETS HYPOTHESIS

Abstract Our modest research goal has been to define a durable investor utility framework, dismissing the decades old expected-utility maximizing economic agent assumption. This has enabled us to properly re-define and re-quantify risk, and part from a reliance upon explanatory ex post analysis for ex ante portfolio generation. Finally, we have expanded that analysis into our market structures from which we observe said agents in context of their utility and risk profiles. We propose new classification and weighting metrics of the participants. This market analysis focuses on the ensuing distribution of the participants corresponding with the prices for the security.

The Markets Hypothesis I am omniverbivorous by nature and training. Passing by such words as are poisonous, I can swallow most others, and chew such as I cannot swallow.
Oliver Wendell Holmes, The Autocrat of the Breakfast Table, 1858

Placing a conspicuous adjective in front of a market hypothesis seems a prerequisite to postulating a theory. Perhaps the market in its nonlinear, dynamic, chaotic form cannot be qualified by an all-encompassing adjective, such as efficient. At times the market appears to be efficient, while other times inefficiency is evident. At times the market appears to be chaotic, while other times quite orderly. At times the market appears to be coherent, while other times simply incoherent. At times the market appears to be rational, while other times it has been called irrational. At times the market appears to be adaptive, while appearing stagnant in periods between perceived adaptation. If the market is all of this (and more), the only descriptive word that seems to fit is omniverbivorous. Holmes could well have been describing the security markets in The Autocrat of the Breakfast Table in 1858. The zero-sum nature of the transaction process does not swallow per se, it merely displaces wealth among buyers and sellers (net of fees and transaction costs). It is this union of buyer and seller, each with their own utility and risk profile that constitutes the markets we observe. Our hypothesis will focus primarily on the distribution of the participants. Simply put, without people and capital, there is no market. People have to want to participate in the market because they will be treated fairly. However, the market only has to be more effective than any competitive system. If not, people will not participate in the market. Probably the best descriptor for a market theory would be effective. We will review historical linear random walk models and other central assumptions in the Efficient Markets Hypothesis, as well as the evolution into more behavioral models such as the Adaptive Markets Hypothesis while explaining the consistencies of entropy and bifurcations.

The Markets Hypothesis

EFFICIENT MARKETS HYPOTHESIS Central to the Efficient Markets Hypothesis (EMH) is the belief that prices are unforeseeable, that the future direction of the market is random based on the actions of always rational, expected utility theory maximizing agents. Samuelson [1965] supports his proof that properly anticipated prices fluctuate randomly with idealized stationary and non-jumping assumptions. The geometric random walk model is most commonly used to quantify this notion for stock market data. Mathematically the linear random walk model can be written as: () = ( 1) + (1)

Then applying it to the logged series yields the geometric random walk model,

log(()) = log(( 1)) +

(2)

This is the so-called "random walk" model - it assumes that, from one period to the next, the original time series merely takes a random "step" away from its last recorded position. (Think of an inebriated person who steps randomly to the left or right at the same time as he steps forward: the path he traces will be a random walk.) where X(t) is the current price of the security and is the average change one period to the next. These are autoregressive models. Autoregressive models represent a stochastic process that can be described by a weighted sum of its previous values and a white noise error. Figure 1 illustrates the generic random walk model with a stationary forecast.

The Markets Hypothesis

Figure 1. Stationary random walk model. SOURCE: http://www.duke.edu/~rn au/411rand.htm#growth

If the time series being fitted by a random walk model has an average upward (or downward) trend that is expected to continue in the future, a non-zero constant term is included in the model--i.e., assume that the random walk undergoes "drift." This has led to the construction of AutoRegressive Moving Average (ARMA) models. The inherent problem with ARMA models are their inability to predict inflection points in the drift. In fact, the drift term should be more dynamic and non-stationary then currently assumed from ex post observation.

() = + + 1 + 1
=1 =1

(3)

X(t) is the current value of a time series, is a constant, is white noise, is the order of the autoregressive component, 1 ,..., are the parameters of the autoregressive model, 1 ,..., are the parameters of the moving average model, , 1 ,... are white noise error terms.

The Markets Hypothesis

Figure 2. Random walk model with drift. SOURCE: http://www.duke.edu/~rn au/411rand.htm#growth

While visually more instinctive then Figure 1, Figure 2 is exactly the problem with modern finance. Benoit Mandelbrot coined the term Joseph Effect, alluding to the Old Testament story of seven years feast followed by seven years of famine for Egypt. However, an ARMA model would suggest years eight, nine and ten should be of equal or greater feast to year seven. The positive drift term that accounts for the observed trend is explanatory. The confidence intervals are derived from the standard deviation of the number of observations (explanatory) and make no predictive reference to the influence of Brownian motion which serves as an attractor, or long term mean reverting ballast to volatility's stochastic nature. Viole and Nawrocki [2011d] highlight the inherent shortcomings of optimized explanatory models in part due to the nature of their construction which challenges their ability to serve a predictive purpose on a nonstationary process.

The Markets Hypothesis We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.
Warren Buffett

This reliance on explanatory models and expected-utility maximizing agents is what impedes the EMH from exhibiting any shred of common sense during increased conditional volatility, which Whitelaw [1994] notes is dictated by a very simple variable, the overall business cycle. Lo [2004] notes, Therefore, according to the behavioralists, quantitative models of efficient markets - all of which are predicated on rational choice - are likely to be wrong as well. Anomalies such as bubbles and panics are nonexistent and are simply ignored by the EMH as they contend, the market is simply pricing in all relevant information at time t. Central to their notion is that agents in the market are rational, expected-utility maximizers. Viole and Nawrocki [2011a,b,c] reconcile Prospect Theory within Expected Utility Theory, and isolate the individual's subjective wealth level relative to their personal consumption satiation point. It is demonstrated that expected-utility is clearly not maximized for all wealth classifications. Market participants' dueling emotions, fear and greed, which impede expected-utility maximization simply cannot be ignored. Basic questions the EMH cannot answer include: Why are there observable trends in seemingly random data? How does EMH deal with distributions that are clearly not Gaussian? How does EMH explain the crash of 1987, WTI Crude Oil at $147, Nasdaq at 5000 or ABX at 2 cents?
Witness the tenacity with which almost all clung to the theory of efficient markets throughout the 1970s and 1980s, dismissively calling powerful facts that refute it anomalies. (I always love explanations of that kind: The Flat Earth Society probably views a ships circling of the globe as an annoying, but inconsequential, anomaly.)
Warren Buffett

In defense of these anomalies which are not explained we offer this rationale. An effective market that allows participants to create anomalies is efficient in the sense that there are no obstructions to prevent these occurrences. The markets themselves are not inefficient in these instances. The instances 7

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however, are clearly based on non-EUT compliant economic agents who the EMH assumes will always act according to a generalized utility theory. That is the inherent assumptive flaw. Is it inefficient to have a market that allows for uniform conclusions? No, we contend the inefficiency would rest in the

products traded. An equity market without short sale restrictions would also be an improvement upon efficiency like currently in place with the commodity and foreign exchange markets. The EMH also falls prey to an unavoidable summation error by projecting a heavily assumptive normative theory onto a group. Because human behavior is heuristic, adaptive, and not completely predictable-at least not nearly to the same extent as physical phenomena-modeling the joint behavior of many individuals is far more challenging than modeling just one individual. Indeed, the behavior of even a single individual can be baffling at times, as each of us has surely experienced on occasion. (Lo, [2004]). Quantified by white noise terms in its autoregressive models, these summation errors can be quite dynamic versus the implied complacency of the moniker white noise. AutoRegressive Conditional Heteroscedasticity (ARCH) models were developed to identify a dependence of error terms over a given time series, but as we know, dependence is explanatory and nonstationary. If not Gaussian, white noise does not imply boredom, white noise implies very often a very rough ride. (Mandelbrot, [2001]).

The Markets Hypothesis

ADAPTIVE MARKETS HYPOTHESIS The Adaptive Markets Hypothesis (AMH), postulated by Andrew Lo in 2004 has several implications that differentiate it from the EMH. Lo observes the dynamic, non-stationary relation between risk and reward. Viole and Nawrocki [2011a,b,c] normatively, mathematically, and

empirically define a robust utility theory which accounts for the nonstationary (path dependent) nature of a participant's utility function. They further illustrate that a participant's risk and reward

characteristics can be accounted for by using different intervals (essentially steeping or flattening their utility function at time t), creating a sum over histories phenomena when intervals are summed. Chauvet and Potter [2000, 2001] also suggest a nonlinear risk measure that allows for the risk-return measure to not be constant over Markov states (bull or bear) or over time. Another implication is

survival is the only objective that matters while profit and utility maximization are secondary relevant aspects. Viole and Nawrocki [2011a,b,c] also highlight how the certainty equivalence works

influencing some participants to accept exceptionally large discounts to expected value, effectively dismissing the notion of expected utility theory maximization. Another implication from the AMH is that contrary to the classical EMH, there are arbitrage opportunities from time to time. Flash trading enabled an ultra-high frequency strategy with co-located servers to minimize latencies. There was an arbitrage available to certain participants that the

exchanges had to eliminate through regulatory actions.1 These orders flashed for milliseconds to certain participants prior to being published on the exchange, enabling programmers to recognize the intention of a participant prior to the rest of the market and transact accordingly.

http://www.nytimes.com/2009/09/18/business/18regulate.html

The Markets Hypothesis

Investment strategies will also wax and wane, performing well in certain environments and performing poorly in other environments. This includes quantitatively-, fundamentally- and

technically-based methods. This realistic perspective on strategies highlights the correlation of survival with a positively skewed platykurtic distribution. Platykurtic infers less concentrated frequencies of success (conversely, the ability to be wrong), directly supporting Lo's notion. Viole and Nawrocki [2011d] have provided a framework to test for such distributions through their upper and lower partial moment analysis. Alternating trending and mean reverting investor sentiment models are also proposed in Barberis, Shleifer and Vishny [1998]. Innovation is the key to survival because as risk-reward relation varies through time, the better way of achieving a consistent level of expected returns is to adapt to changing market conditions. The only edge in the market is the ability to change. Perez-Quiros and Timmermann [2001] also find support for a Markov switching model with time-varying means and variances. Andrew Lo at the IMCA 2010 New York Consultants Conference offers further support for this notion: Alpha, over time, morphs into betait cannot remain alpha, Lo posits, when huge amounts of assets pile in and everyone starts to invest to replicate that alpha, and alpha evolves into beta. Hedge funds are a case in point for Localling them, the Galapagos Islands of financeyou can actually see evolution taking place. He says the clear trend over time, is that even though the unique skills of managers who generate alpha are valuable, returns diminish over time, alpha becomes beta.2 Warren Buffett also notes this in his 2010 letter to shareholders, due to the increase in overall size of his company, ...But huge sums forge their own anchor and our future advantage, if any, will be a fraction of our historical edge.

http://www.wealthmanagerweb.com/News/2010/2/Pages/Beta-Morphs-From-Alpha.aspx

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The AMH's non-random walk autoregressive model: = + 1 + where is the price of the stock at time t. is an arbitrary drift parameter is a random disturbance term. Upon inspection, Lo's model is not that different from the auoresgressive portion of the ARMA model in equation 3 we presented earlier. The only difference in variables between the two equations is Lo's model is missing the order summing of the autoregressive parameters. These models also fail to account for two very important notions of the market, entropy and bifurcation. They assume that the information is present in prior prices (entropy) and that prices can reach points quite varied from equilibrium (bifurcation) without specifically accounting for them.

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ENTROPY Viole and Nawrocki [2011d] prove the importance of conditional entropy analysis, by using it as a punitive parameter in their quantification of risk. When the explanatory data set exhibited low entropy, the securitys metric was penalized more than a corresponding security with a high entropy explanatory data set. This procedure resulted in significant ex ante efficiency in ranking investments. Below is a random walk proof from an information theory viewpoint. Assume It is the current information set. We know from perfect capital market theory that: Xt = f (It) Xt+1 = f (It+1) It+1 f (It) is a common expression in information theory. (Weiner, [1948]). Xt+1 f (Xt) We will explain in the subsequent section how our participant distribution model supports this notion. Market participants all fit on an entropic ladder. The top of the entropic ladder is the individual with immediate knowledge of a particular situation. When a participant enters the market, they represent their entropic position. A grotesque example would be a CEO who initiated merger talks with another CEO. At this point, the only two individuals in the world with this knowledge are the two CEOs. If the CEOs enter the market to buy stock in the target company (if the deal is being considered at a premium), there exists entropic arbitrage commonly referred to as inside information and transacting upon it is illegal. From that point of initial conversation, the CEOs would alert their counsel to work on the documents and the information would disseminate. Information dissemination is clearly not

instantaneous, thus enabling the ability of certain participants to earn excess returns. Grossman [1976] and Grossman and Stiglitz [1980] argue that perfectly informationally efficient markets are an impossibility, for if markets are perfectly efficient, there is no profit to 12

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gathering information, in which case there would be little reason to trade and markets would eventually collapse (Lo, [2004]).

There were no shares traded today on the New York Stock Exchange. Everybody was happy with what they owned. Saturday Night Live Skit.

Morse [1980] argues further that the speed of information dissemination, while finite, is not constant, and varies with the amount of new information. With the arrival of new information, the greater the disparity between the equilibrium price and the actual price, the more investors want to trade, and increasing trading volume increases the markets speed of information dissemination. Because of the aforementioned restrictions affecting the speed of information dissemination, greater dependence in security returns also occurs during this period. Morses results indicate a positive relationship between trading volume and serial correlations for daily data for a mixture of NYSE, AMEX and OTC stocks.

BIFURCATION Bifurcation analysis has led to ex post identification of long term mean regressive and trend persistent states (Nawrocki and Vaga, [2009]). These trend persistent states that are represented by large bifurcation parameters are the reflection of the convergence of expectations of the market participants. In some instances this can be executed by a small number of participants utilizing increasing leverage to augment their positions and account for a greater percentage of the market. A distorted example of this phenomenon was in 1970's and the Hunt brothers' silver market manipulation. At one point the Hunt brothers had 77% of the world silver supply. One market participant accounts for the bifurcation.

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Another example of a convergence of expectations creating an elevated bifurcation parameter was the dot com bubble of the late 1990's. Dubbed irrational exuberance by Alan Greenspan, the market went parabolic based on retail investors' insatiable new found demand for tech stocks. This bifurcation was caused by many, many participants, yet had the same effect of the single participant variety. Government is the largest market participant to offset a bifurcation when an overwhelming majority of participants derive similar conclusions. Federal Reserve actions during the latest financial crisis exhibit this stark realization. They took direct participation - Quantitative easing was enacted to provide an opposing force to the mortgage backed security market in order to dampen interest rate increases. And they took indirect participation via loss guarantees to certain participant portfolios. George Soros explains in his theory of reflexivity that a negative feedback process is selfcorrecting.3 It can go on forever and if there are no significant changes in external reality, it may eventually lead to an equilibrium where the participants' views come to correspond the state of affairs. (Soros, [2009]). This quote refers to the bifurcations and can be applied most notably to the state of affairs in the asset backed market index provided by Markit. Sub-Prime asset backed indices tracked by Markit for several years of issuance represent a market with relatively few market participants.4 Some of the tranches have traded at 2 cents on the dollar. Why is this? Fewer participants can come to a shared conclusion more quickly than a larger diversified market. These participants' views have clearly come to correspond with the state of affairs for sub-prime home equity loans originated in 2007.

3 4

http://www.ft.com/cms/s/2/0ca06172-bfe9-11de-aed2-00144feab49a.html http://www.markit.com/en/products/data/indices/structured-finance-indices/abx/abx-prices.page

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THE PARTICIPANT DISTRIBUTION Entropy and bifurcation are two important distinct market characteristics. However, they are bound by the individual participant, either acting as an individual or sharing expectations with the masses. Our hypothesis captures these dynamics through the individual participant and helps rectify why the linear random walk model is insufficient to explain persistent trending and market equilibrium states far from the market's long term average return. The above random and non-random walk models are cornerstones of market hypotheses. We differ in this distinction of a reliance upon an autoregressive model. We believe that focusing on prices rather than participants is and has proven to be a foolish endeavor. Since prior prices were transacted upon by prior participants, the source of those prior prices is the most compelling to us. These participants represent their information sets, (It) and this information is completely ignored when the process is modeled with past price and error terms. In a security market only 2 information sets can be processed simultaneously, the buyers and the sellers. While information is additive and consistent with the second law of thermodynamics, it is simply impossible for all available information to be priced into the market at time t. First-order autocorrelation analysis on historical market returns provided by Lo [2004] buttresses this notion as a completely efficient market would not exhibit any serial correlation. Nawrocki [1996] illustrates through a daily cross-sectional autocorrelation index, support for Ney's [1974] contention that specialists were manipulating the equity market during the early 1970s; hardly efficient.

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Figure 3. First-order autocorrelation coefficients for monthly returns of the S&P Composite Index using 5-year rolling windows from January 1871 to April 2003. SOURCE: Lo [2004]

However, our hypothesis does take a fundamentally alternative approach. All of the identified models identified utilize time as an interval qualification. The ARMA model uses not one, but two summation parameters, thereby increasing its probability of summation error. We postulate that

transactions are a better interval. It is akin to quantum physicists at CERN recreating the big bang and understanding our universe by observing the smallest particles arising from atomic collisions. Viole and Nawrocki [2013] derive a nonlinear correlation coefficient illustrating how the macro correlation coefficient is a linear sum of the weighted micro observations. The same principle

methodology holds here, namely to a) classify the participants; and b) weight the participants and the ensuing transactions. A quick example may help illustrate the ability of this methodology to observe the macro from the micro.

The Nasdaq composite index is at 3,000 in March, 2012. It is the same price as November, 2000 yet the constituent weightings are completely different. It is a market 16

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cap weighted index so AAPL will now exhibit more influence than all others - due to its linear aggregation of weighted constituents. There are 2,776 listings in March, 2012, versus 5,500 listings as of late 1997. This is consistent with individual participants exhibiting more influence than others in specific securities (a larger market coefficient, MC) and survivors exhibiting larger concentrated MCs when the number of participants declines. Thus, why would it be a nonlinear sum of the micro behaviors when the number of micro is not relevant to generate the same price, in this case 3,000? The weighting of the micro accounts for the inequality of each constituent.

Wealth has been previously suggested as a classification of participants. Markowitz [2010] notes when taking a sum over investors, weighted by investor wealth, that the market portfolio of the CAPM equation holds. We propose a more granular definition of wealth. In classifying the

participants, our proposed measure is % ownership of a security (i). The weight of that classification is expressed in equation 5, = Subject to,

(5)

= 1
=1

(6)

Where i is the percent ownership of the total shares outstanding times current price, in security with market capitalization x.5 Since short sales are borrowed securities from existing long positions, they have a dilutive effect to the number of shares outstanding. Thus, the sum of all factoring short positions will still sum to one. A quick example will clarify - If 2 investors (A and B) of a security

Ownership as a percentage of open interest can be defined for futures contracts, and FX markets would be classified by the wealth in the particular denomination of the investor.

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each owned 50% of the company, and a fund were able to short the entire float (subsequently counterpartied equally by investor A and B), each would still be 50% of the company. However, i (rather than investor wealth) can be extended from an individual security to the market as a whole. = Subject to,

(7)

= 1
=1

(8)

The sum of all investors market coefficients, for each security with market capitalization of x, equals one and the sum of all investors of all securities equals one. Transactions alter the participant distribution. Time series analysis in essence is the summation of the transactions between participants and substantial pertinent information is lost in that summation process. The error terms present in prior models reflect these negative effects. In explaining past prices (which is the goal of the autoregressive models of other market hypotheses) we are explaining the distribution of participants (Z). Any transaction will shift ownership from one participant to the other, directly altering the distribution. Our hypothesis captures these dynamics through the individual participant and helps rectify why the linear random walk model is insufficient to explain persistent trending and market equilibrium states far from the market's long term average return. If the price of a security rises or falls, the distribution of the participants cannot be uniform or stationary.6 Selling has to diminish one classification while buying augments the other. Thus, the

Viole and Nwrocki [2011d] thoroughly dismiss stationarity by utilizing data sets with surviving components, a

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kurtosis of that distribution cannot equal the kurtosis of the prior participant distribution (if classification bins are sufficiently specified). (+1 ) ( ) Thus, (+1 ) ( )

The only possible way information can equal prior information for extended periods is if all of the constituents are identical for the period under analysis. Given that information is equal to f(log 1/p) and every individual can assign a different probability p to an event, uniform information content is impossible in an open system such as the market where participants are free to enter and exit. One participant can account for a majority of the participant distribution, as evidenced with the Hunt Brothers. Conversely, many participants with similar holdings can replicate this histogram effect. In both majority participant instances, increasing their holdings will increase the kurtosis of the participant distribution.

% Ownership of the Company

90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

Figure 4. Hypothetical distribution of market participants.

% Ownership of the Company

prerequisite for a stationary process. The failure of all MPT and PMPT metrics out of sample rejects the hypothesis of a stationary process.

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The largest participant at the time of an initial public offering is the company itself, with its ability to offer more shares to the secondary market. Evidence of kurtosis effects of distribution Z rests in secondary offerings. A decrease in the largest will decrease the kurtosis of Z, thus lower the securitys price. Conversely, a stock buyback will increase the companys and raise the price.

% Ownership of the Float

60% 50% 40% 30% 20% 10% 0% % Ownership of the Float

Figure 5. Hypothetical distribution of market participants relative to the float.

DISCUSSION POINTS WITH MC IMPLICATIONS Why are there trends in random data? In retrospect, even the most ardent critics of LTCM and other fixed-income relativevalue investors now acknowledge that their spread positions were quite rational, and that their demise was largely due to an industry-wide underappreciation of the commonality of their positions and the degree of leverage being applied across the many hedge funds, investment banks, and proprietary trading groups engaged in these types of spread trades (Lo , 2004). Lo goes further by identifying these participants as species: By species, I mean distinct groups of market participants, each behaving in a common 20

The Markets Hypothesis

manner. For example, pension funds may be considered one species; retail investors, another; marketmakers, a third; and hedge-fund managers, a fourth. and references their status later by saying, In this context, natural selection determines who participates in market interactions; those investors who experienced substantial losses in the technology bubble are more likely to have exited the market, leaving a markedly different population of investors today than four years ago. These points by Lo illustrates how individual participants can have near identical MC's. The drift terms used by former random walk models can be explained by similar market participants or indeed the very same market participant executing a larger number of transactions, resulting in a net positive kurtosis change (trend) for an observed period of time, or sum of transactions. Coincidental increased

dependence readings will be a tell to this convergence of expectations. Typically species will announce their transactions ex post in order to continue / accentuate their MC via entropic manipulation in order to generate this convergence. Henry Blodget's actions during the dot-com boom were the most egregious of this manipulative activity.7 Convincing investors to purchase securities through nefarious research reports contradictory to his personal opinion of the securities (as evidenced in his personal communications) was entropic manipulation in its worst form, a lie. Blodget's recommendations generated the counterparties to which the trading arm of his firm could transact with, essentially passing a hot potato while enriching the manipulators.

How does EMH deal with distributions that are clearly not Gaussian? Viole and Nawrocki (2011d) provide an argument that supports Lo's (2004) investment strategy observation. A positively skewed platykurtic distribution is actually the ideal investment and has a direct correlation to an investment's survival. The fatter right tail of a positively skewed distribution enables a platykurtic luxury to the manager whereby their frequency can be diminished in order to

http://www.sec.gov/news/press/2003-56.htm

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generate the same mean as a leptokurtic distribution. In this instance, survival is correlated to the postively skewed platykurtic investment due to its realization of the waning of strategies and losses realized in the adaptation period. Negatively skewed or symmetrical leptokuric distributions do not have this ability to be wrong at times. The EMH Gaussian assumption cannot explain the empirical evidence of the correlation of a positively skewed distribution with survivability nor the existence of such distributions. If the prices of securities were Gaussian, then there would be no kurtosis effects noticed in the distribution of participants. Also, there would be 0 serial correlation present. This is just not possible unless all of the trading in a security occurs within the same classification between participants.

Why do bubbles and crashes exist? George Soros is an active participant in irrationality.8 He actually attributes this to his vast wealth.9 How can so much in excess returns be accumulated if the market is efficient? Because it is not efficient according to any of the forms of the EMH. Soros goes on to explain qualitatively how positive and negative feedback dynamics are formed from fallibility and reflexivity. I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants' view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity. (Soros, [2009]) Viole and Nawrocki [2011a,b,c] identify the seeds for reflexivity in their utility work. An important milestone in this was a convex utility for market participants' gains and a concavity for losses,

8 9

See Ellsberg [1961] for a complete argument on why individual actions should not be considered irrational. http://www.youtube.com/watch?v=MUEGC4btm64

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essentially risk seeking behavioral patterns for both outcomes instead of the historical relative risk aversion ideologies. Wyart and Bouchaud [2003] propose that feedback dynamics among a subset of market agents are sufficient to create trends in anticipation of correlations. This supports not only the utility work of Viole and Nawrocki [2011a,b,c] and risk seeking for gains of individuals, but the fact that bifurcations are endogenous.

CONCLUSION The market may be efficient, however, the supportive assumptions and dogma surrounding the EMH is clearly inefficient. It is also difficult to argue the adaptive nature of a market which has had two crashes in an eight year span (dot com and housing). The constant is the economic agent; the adaptation is in the products traded. Physics envy for this social science will be its ruin. While quantitatively defining flawed assumptions seems to be the direction this field has headed for the past few decades, perhaps a bifurcation is at hand. And we have learned that these bifurcations are endogenous, created from within by the very constituents of the system. It is okay to admit you are wrong, as the late Russell Ackoff noted that you only learn from doing something wrong, otherwise you already know how to do it. In doing so, we would hope that the immense cognitive resources available to this science will generate the only possible action to rectify a bifurcation, the opposite of what has been done. In the first paper to empirically link trading networks (a set of traders engaged in transactions within a period of time) that trace the execution of the limit order book with the dynamics of high frequency variables transaction prices, quantities and duration, Adamic et al. (2009) use an audit trail23

The Markets Hypothesis

level of detail. They uniquely identify two trading accounts for each transaction: one for the broker who booked a buy and the opposite for the broker who booked a sale. There were a total of 6.3 million transactions that took place among 26,950 trading belonging to 346 brokers. The underlying security analyzed was the E-mini S&P 500 futures contract and the transactions took place during August of 2008. We find that star-shaped or diamond-shaped patterns characterized by high centralization or assortativity and low transitivity (clustering coefficient) and connectedness are positively related to returns and volume and negatively related to duration and volatility. In contrast, less heterogeneous patterns those with centralization and assortativity close to zero (their averages), high transitivity and high connectedness are associated with average returns and volatility, and volume and duration above average. (Adamic, Brunetti, Harris and Kirilenko, [2009]) The information dissemination analyzed on a transaction interval (entropic time) provides an excellent foundation for further research and is fully consistent with our markets hypothesis whereby individual participant utility functions and risk profiles are not assumed away into obscurity due to fear of chaotic nonlinearity. These traits are represented within the distribution of the participants, Z. An efficient market allows for this distribution to change, and an adaptive market allows for this distribution to be comprised of different participants at any point in time. Just as Samuelson [1965] and Lo [2004], we leave the reader with more questions than answers, in hopes that future availability of transaction level data will provide us with the information needed to properly model this hypothesis.

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REFERENCES Ackoff, Russell (1999). Ackoff's Best: His Classic Writings on Management, John Wiley and Sons. Adamic, L., Brunetti, C., Harris, J., and Kirilenko, A. (2009). On the Informational Properties of Trading Networks. Available at the SSRN http://ssrn.com/abstract=1361184 . Ang, James and Chua, Jess (1979). Composite Measure for the Evaluation of Investment Performance. The Journal of Financial and Quantitative Analysis, Vol. 14, No. 2, 361-384. Ellsberg, D. (1961). Oliver Wendell Holmes, The Autocrat of the Breakfast Table, 1858 Lo, A. (2004). The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective, Journal of Portfolio Management, Vol. 30, No. 5, 15-29. Nawrocki, David N. (1984). "Entropy, Bifurcation, And Dynamic Market Disequilibrium," Financial Review, 1984, v19 (2), 266-284. Nawrocki, David N. (1995). "Expectations, Technological Change, Information and the Theory of Financial Markets," International Review of Financial Analysis, 1995, v4 (2/3), 85-105. Nawrocki, David N. (1996) "Market Dependence and Economic Events," Financial Review, 1996, v31 (2, May), 287-312. Nawrocki, David and Vaga, T., (2009) A Bifurcation Model of Market Returns. Ney, R., (1974). The Wall Street Gang. New York: Praeger Publishers, 1974. Post, T., Van den Assem, M., Baltussen, G., and Thaler, R. (2008). Deal or No Deal? Decision Making under Risk in a Large-Payoff Game Show. American Economic Review, March 2008, (98:1), 38-71. Samuelson, P. (1965). Proof that Properly Anticipated Prices Fluctuate Randomly. Management Review, 6, 41-49. Industrial

Viole, Fred, and Nawrocki David, (2011a). The Utility of Wealth in an Upper and Lower Partial Moment Fabric. Forthcoming, Journal of Investing (Summer 2011). Viole, Fred, and Nawrocki David, (2011b). An Analysis of Heterogeneous Utility Benchmarks in a Zero Return Environment. Forthcoming. Viole, Fred, and Nawrocki David, (2011c). Embracing the Cognitive Dissonance Between Prospect Theory and Expected Utility Theory. Forthcoming. 25

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Viole, Fred, and Nawrocki David, (2011d). The Quantification of Risk in an Upper and Lower Partial Moment Fabric. Forthcoming. Viole, Fred, and Nawrocki David, (2013). Nonl. Forthcoming. Weiner, N., (1948). Cybernetics, The Technology Press of M.I.T. And John Wiley and Sons, New York, 1948. (Second Edition, Cambridge, MA: M.I.T. Press, 1961.) Whitelaw, Robert F. (1994). "Time Variations and Covariations in the Expectation and Volatility of Stock Market Returns," Journal of Finance, 1994, v49 (2), 515-541.

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