Chaos theory

Kondratiev waves

The Kondratiev theory held that capitalist economies move in long cycles, typically 50–60 years. The upswings occur during periods of technological innovation and abundant investments followed by downswings as new investments dry up and old ones lose value. The brainchild of Nikolai Kondratiev, this theory is pooh-poohed by economists but is often ridden by the investment niche. We are currently in the 5th cycle, the last sub-phase — crisis (ending 2030). The 6th wave is to onset with transformative healthcare & its interaction with every other industry.

An interesting article about the upcoming wave goes:-

After examining R&D budgets from around the world, we can envision six major trends possibly emerging:

  1. Extreme robotization using Artificial Intelligence
  2. Extreme longevity using HET (Human Enhancement Tech)
  3. Extreme geographical dispersion due to the optimization of telecommunications
  4. Extreme mobility in new cars and airplanes
  5. New energy matrix with solar, wind, biomass, and shale (fracking)
  6. New raw materials coming from space

Bubbles

The technology bubble of the 1990s serves as a test that sophisticated traders (say hedge funds) can get pulled into an irrational mob mentality. Equity analysts usually value companies by looking at their earnings and their likely growth — these give a measure of the cash that will ultimately flow to investors. But the technology start-ups that flooded the market in the late 1990s had no earnings at all; by traditional yardsticks, their intrinsic worth was zero. Nevertheless, investors fell over themselves to buy tech stocks or even stocks that in some way seemed connected to the internet. For example, a start-up called Priceline.com gained 425% on its first day of trading, which meant that this untested website for selling airline tickets was deemed to be worth more than United Airlines, Continental Airlines, and Northwest Airlines combined. How would hedge funds respond to this insanity? If they were the efficiency-enforcing actors that optimists imagine, they would sell the internet stocks short until they brought their prices down to a more rational level. If they were trend followers, on the other hand, they would buy into the bubble and reinforce it. For believers in markets, it is hard to accept that intelligent investors would miss the opportunity to short something overpriced. Even the biggest hedge funds of the late 1990s, Tiger and Quantum, had just over $20 billion under management at their peaks; they could hardly challenge the momentum of the technology-heavy NASDAQ stock index, whose total capitalization topped $5 trillion. A bet against the bubble would come good only if others bet the same way, and a hedge fund could sustain heavy losses in the meantime. If those losses spooked investors into yanking their money out of the hedge fund, the fund would have to unwind its bet against the bubble before it paid off. The market can stay irrational longer than you can stay solvent.

Bets

In simple words, hedging is taking an opposite position(buy/sell) in a related asset and leverage means using borrowed capital to increase returns.

Suppose there are two investors, each endowed with $100,000. Assume that each is equally skilled in stock selection and is optimistic about the market. X, operating on conventional principles, puts $80,000 into the best stocks he can find while keeping the balance of $20,000 in safe bonds. Y, operating on principles of hedging & leverage, borrows $100,000 to give himself $200,000, then buys $130,000 worth of good stocks and shorts $70,000 worth of bad ones. This gives Y superior diversification in his long positions: Having $130,000 to play with, he can buy a broader range of stocks. It also gives him less exposure to the market: His $70,000 worth of shorts offsets $70,000 worth of longs, so his net exposure to the market is $60,000, whereas X has a net exposure of $80,000.

Now, consider this. If a fund has $100 of capital to support $800 of positions, a 5% loss will leave it with $60 [$100- ($800*0.05)] in capital and $760 worth of positions: Its leverage rockets up from eight to one to more than twelve to one. If there is another 5 % loss the next day, the leverage will triple, from twelve to one to thirty-three to one. A third 5 % setback will drive leverage to infinity since the fund’s capital turns negative. To hold leverage, the fund starts selling its positions. Funds with similar portfolios will follow suit & destabilize prices in the market. The resulting fright would force brokers to slap margin calls on the fund and investors to demand their money. Descent to death spiral to dust, all in a few days.

(Markets are a phenomenon & I strive each day to learn more. The above rambling is a small part of my thought train.)

--

--

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store