In a box, two gases are separated by an airtight partition. If we remove the partition carefully, the two gases mix together with no external energy input. The opposite path is more difficult… a lot of energy would be required to restore the initial state and separate the two gases again. This experiment is one of the simple illustrations of the second principle of thermodynamics: with no contribution of external energy, a system’s disorder (its entropy to be more precise) can only increase.
In recent days, the markets have provided a more spectacular illustration of this second principle of thermodynamics. The market’s entropy – its disorder – is measured by its volatility. In this respect, the last week of August returned to record levels with the CAC 40 moving by around 2,000 points after adding together all the oscillations seen during the week. For an index worth around 4,700 points and gaining a modest 1% over the last week of August, this distance was extremely long. The ratio was fairly similar in the US, with the Dow Jones travelling 8,000 points in one week, explained by several factors including the slower pace of growth in China, low liquidity over the summer period, the influence of automated trading systems and the ETF’s unwindings. Questions concerning automated trading are nevertheless returning increasingly often, on the one hand since its usage is rising (more than 60% of daily orders are now sent by machines) and on the other hand, since these systems are often pro-cyclical, thereby accentuating market amplitudes. The CEO of US high frequency trading company Virtu, stated that historically high gains had been made at the end of this crazy week of trading. Somewhat triumphantly, he reminded that the company was “made” for this type of market. We could be tempted to inverse this message by stating that companies such as Virtu “make” these types of market highly erratic. No-one has the answer to the direction of causal links. One thing is sure however: once a certain threshold of agitation has been crossed, disorder increases in accordance with the principle of thermodynamics mentioned above. So what should those of us who are not ultra-frequency specialists do in this ambient disorder? Two benchmarks remain: valuation and the measure of ambient stress. Valuations in Europe are at standard levels and give no strong signal in either direction. Meanwhile ambient stress is quick to exceed usual thresholds. On Monday 24 August, the VIX (volatility measure for US equities) briefly reached the level of 50. In order to re-situate this figure, note that the VIX was at 12-15 at the beginning of the month and that 50 corresponds to the level of stress reached in…. September 2001 and a level that over the past 20 years, was only exceeded during 2008!
This is probably the most encouraging news at the end of August: in coming days, we cannot know for sure what the pace of Chinese growth will be, but the markets have already priced in a large share of this uncertainty.
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