Markets, Murmurations, and Machines
Chris Sheridan

Most have yet to realize it, but we are now in a very strange and different world—"virtually undetectable market manipulation" by thousands upon thousands of coordinated trades generated by supercomputers fiber-optically connected to the exchanges that run world trade have figured out a way to use complexity to their advantage and shape the market for brief moments like a flock of starlings reacting to an unseen and invisible force.

/merr'meuh ray"sheuhn/, n.

1. an act or instance of murmuring.
2. a flock of starlings.

What makes possible the uncanny coordination of these murmurations, as starling flocks are so beautifully known? Until recently, it was hard to say. Scientists had to wait for the tools of high-powered video analysis and computational modeling. And when these were finally applied to starlings, they revealed patterns known less from biology than cutting-edge physics.¹

I'm not sure if you've noticed or not, but over the past year or so there's been a surging interest in the flocking behavior of starlings. Why? Well, other than the awe-inspiring beauty of one of nature's most beautiful and mysterious phenomena (see video), it represents a steadily growing dynamic at work within our own society and financial markets—namely, the collective behavior of any highly interconnected system.

To be quite honest, there may be no better way of capturing the mysterious behavior of complex systems than the unpredictable and yet highly coordinated movements of a thousand or so starlings flying in mid-air. Thus, it is easy to understand why TED-talks, morning shows, or long-time market commentators have all been inspired by this amazing phenomena and, in the case of James Dines, create splashy headlines like "The Coming Worldwide Murmurations."

Whether we refer to it as herding, collective intelligence, mass psychology, or complex self-organizing behavior—this property of the markets is something that we as humans have a hard time perceiving since, well, we're often part of it. As Dines went onto explain in a recent interview:

It is very hard to see and it doesn't show up very often. All psychology today is vertical, so to speak. It's a combination of our genes and experiences individually, whereas I believe there is another level of mind that is horizontal. And it's a mass mind, and it grips us without us even being aware of it. And the examples of it in the market were the real estate craze of a few years ago. People buying real estate at way higher prices, way too high prices, [which led to] the excessive gloom...[this herding or collective behavior] shows roughly in the market sometimes. But a more visible one sometimes occurs in nature. And we called attention to a free video site that showed thousands of starling birds moving in fractal exotic shapes as if they were one unit. And my theory is that they are. The scientists studying them couldn't possibly have gotten a signal from those next to them because they were moving in tandem with birds hundreds of feet away. And I feel that this is a visible example of the "mass mind", which excites me because I watch it in the Stock Market. But I've never actually seen it. And it seems to be something, a ‘pre-birdness’ of some kind, such that the birds themselves are actually manifestations of it. I'm a trained scientist, so it's not easy for me to accept this kind of thing, but a real scientist has an open mind to everything.

From a person who wrote the classic book on How Investors Can Make Money Using Mass Psychology, it is interesting that Dines simultaneously admits "never actually seeing" the murmurations of the market. But this isn't a criticism of Dines—merely an observation of how limited we are in recognizing minute and ever-changing patterns as visibly we do with a group of starlings. Ironically enough, most of the financial world is continually operating at this level—just beyond human perception. Good investors or analysts then, simply detect patterns driven by the intrinsic value of an investment and/or by their technical behavior and then capture the results. At a fundamental level, this is all that separates those who make money from those who don't. The problem with this, from a scientific point-of-view, is that the results are highly reliant upon 1) the number of observable patterns/events and 2) the skill of the investor in capturing profit—neither of which can be easily controlled. A way around this, of course, has always been through the time-honored approach of diversification and buy-and-hold value investing.

If we step back for a second though, it should be noted that as the return on savings through bond yields began to steadily decline from their highs in the early 80's to their current all-time lows, one of the unintended consequences of pushing investors further out on the risk curve was the growing dependency on increasingly complex investment strategies created by financial engineers and "quants". Right after the initial peak in interest rates major financial institutions began hiring them in droves to use their newfound computer models to extract returns from the market. Then, similar to the flash crash of 2010, something devastating happened. As Benoit Mandelbrot—the father of fractal geometry—tells it, "On October 19, 1987, the worst day of trading in at least a century, the [Dow] index fell 29.2 percent. The probability of that happening, based on the standard reckoning of financial theorists, was less than one in 10⁵⁰."² Of course, 23 years later, Wall Street thought the world was on the verge of an absolute meltdown when a perfect storm of events led to a vicious feedback-loop of selling between algo-traders once again.

Beyond the similarities of what exacerbated the 1987 and 2010 crashes however, there have been a large number of changes since then. Where program trading was only a fraction of the overall market decades ago, today nearly 3 quarters—that is, 73%—of every single decision or trade being made on Wall Street is now from a machine.³ Similarly, the average holding time period for stocks has shrunk dramatically from just under two years to 22 seconds,⁴ which, from a machine's point of view, is still a lifetime since high frequency trading is clocked in microseconds, allowing around a million trades in just a matter of minutes.

With all these massive structural changes in the market, the traditional approaches to investing have almost been completely "swept aside", as explained in the The Marginalizing of the Individual Investor:

For decades, professional investment advisers have continued to teach reliance on “value investing” and “buy-and-hold” as long-term guides to successful investment...

Technology may now have overridden such investment concepts. High-frequency trading platforms are focused solely on ramping up speed and volume so as to maximize tiny gains per transaction. Computerized algorithms that are momentum-sensitive are increasingly high-frequency trading-driven, raising serious doubts about traditional concepts of how markets should work. Investment strategies based on fundamentals such as a company’s long-term performance have been swept aside by high-frequency trading algorithms hunting for inefficiencies in daily pricing and super arbitrage opportunities. In so doing, they open investors to a new form of risk that has not been accounted for in most “buy and hold” asset allocation models.

In effect, individual traders are confronted with overwhelming momentum-driven forces that are unrelated to performance of individual businesses. A “fair price” may exist, but high-frequency traders are not seeking fair prices—they are focused solely on immediate profit. They are seeking transaction volume boosted by any form of momentum they can generate. Unfortunately, high frequency trader interaction with computerized algorithms of large-cap financial institutions is providing opportunities for high-speed, virtually undetectable market manipulation. Where there is opportunity to “shape” the market for advantage, it is likely that such opportunity will be exploited.⁵ (emphasis mine)

Most have yet to realize it, but we are now in a very strange and different world—"virtually undetectable market manipulation" by thousands upon thousands of coordinated trades generated by supercomputers fiber-optically connected to the exchanges that run world trade have figured out a way to use complexity to their advantage and shape the market for brief moments like a flock of starlings reacting to an unseen and invisible force.

This is where we are currently. What about the future? If I told you my real thoughts, you'd think I was a quack. Let's just say I think we are seeing the beginnings of a huge paradigm shift in how we perceive our place in the world and how we define both intelligence and living systems. 

I'll leave with this final thought: many brilliant inventors came to the conclusion that flight was impossible since previous attempts to attach wings and mimic birds utterly failed. The true breakthrough came only when the underlying principles of flight were understood and applied to mechanical systems that not only look quite different from birds, but far exceed anything originally imagined—except, of course, a flock of starlings...for now.

p.s. For a bit of science-fiction fun, here's a Hollywood spin on collective machine intelligence: http://www.youtube.com/watch?v=DX3qLIwHoUo

Footnotes:

[1] The Startling Science of Starling Murmuration - Wired

[2] The (Mis)behavior of Markets: A Fractal View of Risk, Ruin, and Reward by Benoit Mandelbrot

[3] Yan Ohayon on the Impact of Algorithmic Trading - TEDx

[4] Ibid

[5] The Marginalizing of the Individual Investor: The inside story of flash crashes, systemic risk, and the demise of value investing

Cris joined PFS Group in 2002. He holds a B.S. in Mathematics from California State University San Marcos. His professional designations include FINRA Series 7 & Series 63; and he is also currently pursuing the designation of Chartered Financial Analyst.

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