Stocks & Commodities V.

20:12 (79-86): Interview: Edgar Peters Talks About Chaos Theory by Jayanthi Gopalakrishnan
INTERVIEW

Butterflies In China, Market Corrections In New York

Edgar Peters Talks

About Chaos Theory
His work Chaos And Order In The Capital Markets ignited the imagination of traders and investors everywhere, and the way we viewed the
markets changed. As PanAgoras chief investment officer and co-chair
of its investment committee, Edgar Peters is responsible for ensuring
the integrity of the firms investment strategies and product array. His
insights into market dynamics and behavioral finance have not only
added value to client portfolios but also stimulated the development of
innovative investment technologies. An expert in tactical asset allocation strategies, he also manages PanAgoras asset allocation portfolio
managers.
STOCKS & COMMODITIES Editor Jayanthi Gopalakrishnan spoke to
Edgar Peters on October 3, 2002.

What happened after that?

Over the next few years, I read a
bunch of physics and mathematics papers. I applied some of that knowledge
to do empirical research on the markets
directly. In 1988, I wrote one paper for
the Financial Analysts Journal in which
I looked at fractal analysis, which Id

come across in a book by

Jens Feder. Rescaled range
analysis, which is what Feder
wrote about, has the ability
to determine whether a process had long memory. What
happens now influences a
process far into the future; it
doesnt just go away.
But thats not conducive to
traditional theories like the
random walk.
When they talk about marYou dont typically have a big
kets being random walks or
having short memories, it
capitulation selloff at the bottoms
means that what happens toof bear markets ... they just sort
day doesnt really affect toof peter out.
morrow that much, and it
definitely doesnt affect
things that happen a few days from now. write a paper, which was published a
Thats critical to traditional quantita- year later, as well as a book, Chaos And
tive techniques, because if you dont Order In The Capital Markets. I thought
have that, a lot of the analysis doesnt it was important for people to be aware
work, or at least it becomes unreliable. of the implications of the long memory
of the market, rather than having them
What did you do?
slog through all the physics papers. Then
I conducted a test on market returns, I got a request for a more technical
and found that the market did have a explanation, because the first book was
long memory. This prompted me to supposed to be a conceptual introducCopyright (c) Technical Analysis Inc.

CARMELO BLANDINO

ow did you get interested in

chaos theory?
As a quantitative manager,
I had all the traditional
schooling. As a practitioner, you find
that the only way to make quantitative
analysis work is to make a lot of adjustments, because there are a lot of problems with it. And also because I took
classes with Harry Markowitz when I
was in business school at Rutgers University, I knew a lot of the underlying
assumptions that go into traditional
quantitative management. After a while
you find that those are fairly significant
assumptions, and they can have significant problems. So in early 1987, when I
read an article that chaos theorist James
Gleick wrote for The New York Times
Magazine, I got interested in the topic.
I began to do research on my own.

Stocks & Commodities V. 20:12 (79-86): Interview: Edgar Peters Talks About Chaos Theory by Jayanthi Gopalakrishnan

tion. So I wrote the second book, Fractal

Market Analysis. In that one, I described
the fractal market hypothesis to explain
days of extreme volatility.
How do you use fractal analysis to
determine volatility in the markets?
Chaos theory and fractals allow you
to put a framework around how the
markets work, which I think is always
good to have. You use it as a guide in
order to avoid mistakes like, for example, the mistakes of Long-Term Capital Management. Youre assuming a
certain type of statistical process. [LongTerm Capital Management was a hedge
fund begun in 1993 by John Meriwether
and a collection of financial geniuses,
including two Nobel laureates. The fund
enjoyed huge success until 1998, but its
models failed when the Russian ruble
collapsed at the same time other financial pressures dramatically changed the
historical fluctuations on which LTCM
had risked $1.21 trillion. To prevent
widespread economic damage, LTCM
was bailed out by Wall Street creditor
banks in a deal arranged by the Federal
Reserve Bank of New York, and survived long enough to pay its debts, but
was liquidated early in 2000. Ed.] A
lot of people think of fractals in terms of
technical analysis, like Elliott wave
theory, but fractals applied to the market are not like that at all.
How would you define them, then?
Instead, fractals applied to the markets are mostly statistical functions. With
those, what happens is that you have
statistical processes with a larger probability of larger events happening than
the normal distribution suggests. All
the traditional quantitative management
and what most people think of the markets are based on the normal distribution, or the bell-shaped curve. The actual market distribution is different from
that. It has a high peak at the mean, and
fat tails.
What does that mean?
The fat tails mean two things: one is
that average events are more likely to
happen than people think, and the other
is that large events are also more likely

to happen than people think. This is true

across time scales, so it doesnt matter if
you look at daily returns, monthly returns, or annual returns. They all have
this characteristic. So what happens is
that certain things that are based on
normal distributions do not work.

o you have an example in

mind?
Again, the people at
Long-Term Capital Management. Say that the events that happened to them were like a 100-year
flood. But if you look at the actual
distribution of returns, the frequency
of those events happening is a lot
higher than once in 100 years. They
actually happen every few years. If
they were based on the normal distribution, the probability would be once
every 100 years but its not normally distributed.
Any other examples?
Another thing is portfolio insurance,
which was a popular strategy in the 1980s,
up until the crash of 1987. It was based on
the idea that if things are normally distributed, theyre also continuous. That
would mean that if the price of a stock
was falling from 50 to 40, it would pass
through all the prices in between 50 and
40. But in reality, what happens during a
crash like the one in 1987 is that the
market actually leaps over prices. It might
go right from 50 to 40, without going
through 49, 48, or any other prices in
between. Portfolio insurance was based
on the idea that you can rebalance as the
market is going down, but youd have
trigger points. But if the trigger point was
one that you were supposed to sell a
stock at 45, and the stock didnt hit 45
because it went immediately to 40, then
youd be left in the dark.
One of the characteristics of these
fat-tail distributions is not only that large
events are more likely to happen than
youd expect, but also when large events
happen, they tend to be abrupt and discontinuous.
When you say large events, do you
mean crashes and rallies?

Yeah, but it doesnt have to be a crash

like the one in 1987. It could just be a big
downturn. If you get several downturns,
the market just doesnt go through the
prices you want. It leaps over them in
both directions. It can open or gap up,
and then drop immediately. Theres no
continuous nature to the way the prices
move. Price continuity was critical to
portfolio insurance, because that was in
line with normal distribution.
So what happened during the 1987
crash?
The trades couldnt be executed fast
enough on the way down and traders
werent able to hedge their holdings,
which was the way it was supposed to
work. To overcome this, what we do is
make sure that when youre setting up
your strategy, you dont fool yourself
into thinking that youre just preparing
for something with a low probability of
happening. The probability is actually
much higher. When an event that will
negatively affect your holdings does
come through, it can wipe you out.
Youre quantitative in your approach.
You use a lot of quantitative models in
your analysis. But you also believe that
some of the conventional models, such
as the capital asset pricing model
(CAPM) and the efficient market hypothesis, are not reflective of actual
market conditions, correct?
Thats right. And as a matter of fact,
the people who created the traditional
quantitative models, the original
founders, know that. Bill Sharpe used to
call them toy worlds. When creating
these models you make a lot of simplifying assumptions to get to the truth.
Theres a lot of truth in CAPM and modern portfolio theory, and a lot of useful
things that we use, too. You just have to
be careful and not think that the world
always acts like that. It doesnt. It works
most of the time, but there are times
when it doesnt, and not acknowledging
that can wipe you out. Theres always
an element of judgment at certain points
in execution. If something were to happen that we thought was outside of the
models experience, we would take that
into account, but it rarely happens.

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Stocks & Commodities V. 20:12 (79-86): Interview: Edgar Peters Talks About Chaos Theory by Jayanthi Gopalakrishnan

What happens when it doesnt work?

Whats the critical factor?
Well, the big events happen more
often than you think, and things tend to
be abrupt, not continuous. One of the
problems with the Long-Term Capital
Management situation, again, was that
their basic assumptions were correct,
and things reverted the way they expected them to. But they didnt do it
soon enough, and LTCM was so leveraged they ran out of money. You cant
let that happen to you. You cant assume that just because something has a
small probability in a normal distribution that its not going to happen. And
when it does, youre not prepared for it.
So you just have to be sure to control for
that kind of risk.
When you see things happening outside the realm of your model, do they
take place during extreme conditions?
No. They usually revolve around
political events. One example is the
German reunification, something we
thought the model couldnt handle, so
we had to figure out what to do about
that. Things like that do happen. When
economic activity changes, the belief is
that the structure will change too. But
structural change to the economy
real structural change is extremely
rare. The actual mechanics of the
economy change all the time; thats the
nature of it, but people think that new
technology structurally changes the
economy. Thats not true, because were
always getting new technology.
Do global and local events affect the
markets differently?
If youre familiar with my work, I
usually make a distinction between chaotic systems and fractals. There are global characteristics, and there are local
details. I look at it as global structure
and local randomness. What that means
is that in the business cycle, there are
certain things that are common across
business cycles.
Then there is the story behind the
business cycle, which is always different. Every time we go through the business cycle, it seems like things are different, because they actually are. The

details are different but the net effects

are usually the same. So during certain
sum factors, we react to whatever is
going on in the economy, no matter
what the story is. Those are the types of
things we look for.
Can you give an example?
A basic one we look for is the slope of
the yield curve. The yield curve broadens and gets steeper. Interest rates go up
and down, but they do so for different
reasons. Ive been in the investment
business since 1978, so Ive watched it
go up and down. But whenever theres
something that makes the economy expand or contract, the yield curve steepens and drops. It doesnt matter what it
is. This kind of information is the sort of
thing I mean by a global structure. Its
not dependent on the details of whats
going on. The mistake a lot of people
make, either when theyre creating their
judgmental or quantitative models, is
that they model the details, and forget
that those things will never be repeated.
So if you were to create a stock market process, or a forecasting process,
either judgmentally or quantitatively,
and depended on the New Economy,
you would have failed miserably. But a
lot of people believed that was going to
be the future. Back in the late 1970s,
everybody looked at money supply,
because Paul Volcker, who was the Federal Reserve chairman then, was targeting money supply for Fed policy. You
could see the market reacting heavily.
So everybody sat around waiting for
money supply, and the market reacted
heavily to increases and decreases in
money supply. Now, of course, nobody
pays attention to money supply at all.
You also focus on complexity theory.
How do you apply that to the markets?
Chaos theory is a subset of complexity theory. Complexity theory says that
a process will hover on the edge of
chaos and fully ordered areas. Theyre
usually fractals, and theyre usually
networks, where things go across. So
the market is generally not actually chaotic, but complex. It becomes chaotic
when fluctuations become really huge.
Typically, though, its complex. What

that means is that you have a process

that is self-adapting, and it learns over
time or adjusts over time. Because of
that, you never completely know whats
going on inside of it.
One of the important characteristics
of complex systems is that theyre very
adaptive and resilient, and they evolve.
This is because they have, again, certain
global laws, but theres a lot of local
randomness. Those random elements
allow the process to search for solutions. For instance, during the late 1970s
and early 1980s, there was a lot of talk
about how the US economy was a hasbeen. It was behind the times, and Japan
was going to move ahead, and so forth.
And then Japan imploded.
But before that, there was an outcry
that we had to do something, which
usually means people look for some sort
of organized search for a solution. What
happened was that the people in the
economy were actually searching for a
solution, and when you have a lot of
people working on a solution independently, they tend to crossbreed with
their ideas, because information gets
around. Eventually, the solution pops
up without any sort of organized search.
Usually it pops up in a number of different places.
So what happened?
During the transition of our economy,
unlike Japans where they keep trying to organize a recovery the process jettisoned some industries, a number of companies, and reestablished new
technology, and revamped itself, all on
its own. It didnt do so with any significant organized effort; it just organized
itself spontaneously. Thats what keeps
a free market working. One of the dangers is that in times of crisis theres
always a hue and cry that someones got
to do something about it.
Which is happening right now.
Yes, its usually what happens. But it
usually turns out that whatever is organized inhibits what needs to be done.
You need regulations to make sure
abuses dont happen, but you dont want
to impose a structure on the economy,

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Stocks & Commodities V. 20:12 (79-86): Interview: Edgar Peters Talks About Chaos Theory by Jayanthi Gopalakrishnan

which will inhibit its creativity. Japan,

for instance, follows a quasi-socialist
structure. Everything has to pass through
certain bureaus and ministers. The problem is that there are only a few of those,
and thats why socialism failed, and so
did communism.
If you have a free market, you have
thousands of people working on problems, independently and interdependently. But if you have a more structured, governmental system, you only
have five or six people who are supposed to come up with the solution. As
we know, when people work in groups,
the IQ of the group tends to be lower
than the IQ of the individuals, which
leads to never finding an answer, and a
system that never really adapts. The
reason communism collapsed was because it wasnt able to adapt to changes
in the environment. It turned out to be
extremely inefficient. People feared that
the efficiency of communism would
overtake us, because they were organized and we werent. And we didnt
want to be organized like that, because
you had to give up freedom in order to
do so, which we didnt want to do. It
turns out that freedom, which is largely
a function of individual uncertainty, is
actually more resilient.
Living in a free society means we
have more individual responsibility.
That also means we face more uncertainty on an individual level. Ironically,
on a societal level, we actually face less
uncertainty than the structured environment. But individually, we face higher
uncertainty, because nobody tells us
what it is were supposed to be doing. In
a structured economy like the old Soviet Russian economy, you were pretty
much told what it was you were supposed to do. You didnt have to make
any individual decisions, so there was
very little uncertainty for you. There
was very little opportunity, too, but you
didnt have to worry about going out
and finding a job, because someone
would do that for you.
So you believe uncertainty is necessary for an economy to function efficiently?

Thats right. And at times like these,

theres actually great opportunity in
the middle of the uncertainty, because
thats what uncertainty generates
not only risk, but opportunity as well.
So its a matter of making sure that
when you impose regulations, which
theres a lot of talk about now, you set
boundaries for what people can do, but
you dont tell people what theyre supposed to do.

ow much of the uncertainty

and randomness of the
markets has to do with human behavior?
A lot has to do with human behavior
and how people interpret information.
Thats the biggest flaw in the rationale
for traditional capitalization pricing
theory. They make a lot of simplifying
assumptions, one of which is that the
value of information is understood, and
everybody agrees on what it means when
it comes into the market. In reality,
most information that comes into the
market is not very precise, as we found
out with the accounting practices. Not
everybody can agree on what it means.
So even though you may have a consensus, there will always be a group that
disagrees. Because of that, things will
not necessarily go to fair value. Because
of the different reactions to it, you get a
lot of movement in the marketplace
itself, and a lot of opportunity gets generated from that.
In terms of fair value and the valuation of the markets, where do you think
the markets are right now? Are they
still overvalued?
No, as a matter of fact we think the
market is severely undervalued right now.
I can say this because during the market
bubble I was a notorious bear. And just as
people were overly optimistic during the
bubble period, theyre now overly pessimistic. What we dont know is when its
actually going to come true. But based on
the relationship between stocks and interest rates, and a couple of other things,
stocks are pretty severely undervalued
unless a couple of very unlikely scenarios
unfold, which is always possible.

Such as?
One of the biggest unlikely scenarios
is deflation. In order to justify the current level of prices, its not so much that
earnings have to fall, its that you have
to say were going to be facing a deflation. Not necessarily a massive deflation, but just a deflation sometime in the
future. There are some worries about
that, but the chances of actually having
a deflation significant enough to make
the market overvalued currently are
pretty slim. Wed have to have worse
deflation than Japan has.
Were quite a long way from that.
I think so too. So the chances of that
happening are pretty unlikely. As far as
were concerned, the market is close to
the bottom if it hasnt already hit, and the
downside is pretty limited at this point.
Its mostly upside, but when the upside
will come through, though, is unknown.
You base a lot of your analysis on the
belief that the market has a memory.
Do you see a repeat of a situation from
the past in the current markets?
Its not that kind of memory, but what
we are seeing now is very similar to the
way things have ended for other speculative bubbles. Its less severe for the
economy than it has been in the past,
because weve learned a lot about what
to do. But speculative bubbles themselves have a number of defining characteristics. When we were in the middle
of the bubble, I used to point these
characteristics out to people. I would
even read from newspapers from the
1920s, and there would be things there
that were just like what was going on in
the present. You could go back even
further to the 1870s, when there was
another speculative bubble, and youd
see a similar scenario. Its very common, but you dont get them often, and
thats the trouble. If youre not a student
of the history of the markets, you are not
going to see any of this.
I remember a lot of comments about
the similarities, but of course, not many
people paid any attention.
Each story behind each speculative
bubble is different. In the 1920s, the

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Stocks & Commodities V. 20:12 (79-86): Interview: Edgar Peters Talks About Chaos Theory by Jayanthi Gopalakrishnan

productivity gains were not due to computers or the Internet, of course. They
were due to electricity, something we
now take for granted as a commodity. In
the 1920s, the high-flying technology
companies were the electric utilities,
which we now think of as commodities,
sleepy little companies. What Id point
out was that this would also be true of
technology and particularly the Internet
it will become a commodity, just like
all the others, because thats what ends
up happening. If its something really
important, then competition will eventually make it into a commodity. Another thing that is similar is that theres
always an element of truth to what causes
the speculative bubble. This usually ends
up not coming through, and thats what
causes so much distress for people.
Anything else?
Whenever the speculative bubble
bursts, theres always a bunch of people
who go to jail or commit suicide or
something like that. It always turns out
that a lot of people who were thought to
be geniuses just turn out to be crooks.
When everybodys making money, its
human nature to overlook those flaws.
You dont care how the other persons
getting his money, as long as you get
yours. But if you lose yours, you want to
make sure that those who kept it, and
kept it illegally, get whats coming to
them. Thats what always ends up happening. I thought for a while it wasnt
going to happen this time, until the
Enron scandal happened.
Then what follows is usually a period
where everybody gets disgusted, and
what has typically happened is that a lot
of people just leave the market. Market
participation goes back down to more
modest levels. Even during the crash of
1987, the number of people who participated in the market was much lower
than this time or the 1920s. This happens because during a market bubble,
people overreact and decide that every-

thing is just gambling. The truth is they

were just not being prudent.
I think we are seeing people pull money
out of the market.
Yes, we are. People are pulling money
out of the market and putting it in real
estate. You dont see CNBC playing in
bars anymore. These are the types of
things that are similar during all the
bubbles. As far as the market itself goes,
you dont typically even though
people have been waiting for this
have a big capitulation selloff at the
bottoms of bear markets.
What happens?
Bear markets always end with whimpers; they just sort of peter out. Everybody loses interest, and we are seeing
that now. Im hearing a lot of people
say, Well, we havent seen the big
capitulation selloff. The big capitulation selloff is a symptom of bull market
reversals, not bear market reversals,
where everybody just gets tired and
quits. Were also seeing that because
this is just a grinding, day-after-day
decline. Its been going on for a number
of years now, another typical factor of
bear markets, which is another reason
why I think we are close to the end.
Are you optimistic about the markets
generally?
Yeah, overall Im optimistic for the
long run. During the next couple of
years, its going to be similar to when
we came out of the last recession. When
we go through mild recessions, we also
have modest recoveries, so it takes a
while for things to gear up again. Plus
now, we have a lot of excess capacity,
due to those productivity gains that everybody talked about. In the 19th century when there was also a big surge in
productivity gains, there was a long
period almost 20 years of deflation and low profits, because there was
more capacity produced than there was

actually a need to consume. I dont

think well face 20 years of that, but we
may face a few years of it.
What are we going to be seeing?
What well end up with is that stocks
will outperform bonds an allocator
thats important to me but not by a
lot. Absolute returns in both cases will
not be that great. Current yields are
about 3.5%, so if stocks return 4% or
6%, then Ive done my job. But its still
going to be below the actuarial assumptions of institutions, or the kind of returns that people want to see for their
retirement nest eggs. We are going to
end up with a couple of years where
things are going to be pretty mediocre
on the return side.
Thank you for your time, Edgar.

SUGGESTED READING
Feder, Jens [1998]. Fractals (Physics
Of Solids And Liquids), Plenum Press.
Gleick, James [1987]. Chaos: Making A
New Science, Penguin.
Peters, Edgar E. [1991]. Chaos And Order In The Capital Markets: A New
View Of Cycles, Prices, And Market
Volatility, John Wiley & Sons.
_____ [1994]. Fractal Market Analysis:
Applying Chaos Theory To Investment & Economics, John Wiley &
Sons.
_____ [1999]. Patterns In The Dark:
Understanding Risk And Financial
Crisis With Complexity Theory, John
Wiley & Sons.
_____ [2001]. Complexity, Risk, And
Financial Markets, John Wiley &
Sons.

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