Icarus Descending?
In 2004 Benoit Mandelbrot, the inventor of fractal math, wrote an interesting book titled The Misbehavior of Markets. In a nutshell, his theory says that the standard deterministic model of cause and effect (Newtonian thinking) does not apply to financial markets.
He notes, “The precise mechanism that links news to price, cause to effect, is mysterious and inconsistent.” Like the weather and other complex dynamic systems, randomness is the rule.
We see examples of this in the paradoxical response of the market to seemingly good or bad news. In hindsight, the chain of cause and effect can be reconstructed to fit any model, but this armchair exercise is pointless when attempting to forecast real world developments. We are simply entertaining ourselves seeing faces in a cloud.
Even so, traditional market models still tend to see the financial markets through orderly Newtonian glasses. That means they underestimate risk because they minimize the influence of human factors in price action. Consequently, in the real world, price will move further and faster than traditional models suggest. Just look at China.
If you are an active trader, therefore, it might benefit you to factor in the psychological state of mind of the participants in the market you are trading. (Are they happy, indifferent or worried?) One way to do this is to analyze volume at price.
For example, I recently published volume profile charts of Netflix and Apple on Trader Planet showing that the largest volume nodes are sitting very far below current prices: $48 for NFLX and $75 for AAPL. This means that these stocks, like Icarus, have little internal support if price begins to fall. Consequently, at some point, that circumstance is likely to spark panic selling, i.e., a liquidation event.
If you are a potential investor in these wonderful companies, it might be prudent to wait for the panic to develop. Value is temporarily created by the emotions of other traders and exploited by those with sufficient mental discipline to take advantage of it.
