Several years ago, when I was living in New Mexico, I had a girlfriend who used read very esoteric books about cutting edge theories on biology, evolution, and astronomy. We were talking about “what-if” scenarios one day and the conversation drifted to some called “punctuated equilibrium.” It was explained to me, at the time, that species evolve slowly in an environment that’s in equilibrium. A sudden leap in a species evolutionary development happens when a catastrophic internal or external event occurs. The example she used was the asteroid wiping out the dinosaurs theory. The dinosaurs lived and evolved in a relatively state of equilibrium until an asteroid killed them suddenly and allowed mammals to evolve rapidly.
Wikipedia defines it as:
Punctuated equilibrium (also called punctuated equilibria) is a theory in evolutionary biology, which states that most sexually reproducingspecies will show little change for most of their geological history. When phenotypic evolution occurs, it is localized in rare events of branching speciation (called cladogenesis), and occurs relatively quickly compared to the species’ full and stable duration on earth. [via wikipedia]
I understand that some of these theories have changed over the years but its premise stayed with me for years. Can the upset of punctuated equilibrium (PE) or something similar explain the sudden emergence or death of trends? Although we like to believe in market equilibrium (PE?) and slow evolution of prices when new fundamentals occur, I’m a firm believer that the markets themselves are not always seeking equilibrium. Sentiment and fundamentals drive a trend and then the trend in turn drives the sentiment and fundamentals of that market. Trends become reinforcing and suck more and more capital into them until they crash. Then the crash becomes self reinforcing as the sentiment and fundamentals change and a new trend emerges downward. Where’s the equilibrium in that?
What truly interests me in trend following is the moment a financial asteroid hits the trend. What are the events or sudden changes in the financial environment that will allow some trends to die and cause others to evolve? Was it single event or several smaller events together that killed a trend or caused financial havoc? The first example that comes to mind was the Russian domestic debt default in the late 90’s that led to Long Term Capital Management (LTCM)’s sudden demise.
I know I don’t have all the answers, all I have is an interesting brain tease, and an interesting biological theory that I’m trying to superimpose on existing trends, hoping to uncover future financial asteroids.