Image Credit: Christophe Vorlet
By Jason Zweig | Nov. 3, 2017 11:23 am ET
Bill Miller isn’t always right, but he’s never boring.
The former manager of the Legg Mason Capital Management Value Trust mutual fund beat the S&P 500 stock index for an unprecedented 15 years in a row only to lose a bloodcurdling 55% in 2008. The largest mutual fund he now runs, Miller Opportunity Trust, has outperformed 99% of similar funds over the past five years, although it lagged badly in 2016. And a hedge fund run by Mr. Miller has made a bet on bitcoin, the digital currency.
Through it all, Mr. Miller has remained one of the most interesting thinkers in the investment world, fascinated by everything from the physics of baseball to the social dynamics of ant colonies. In his latest intellectual foray, he is exploring whether the science of earthquakes can help make investing smoother.
Mr. Miller hopes to use insights from geophysics to measure when stock prices will be calm, when they will fluctuate sharply and when to reduce exposure to the market. In effect, he is hoping to develop a financial seismograph that could identify market shocks — before they occur.
So far Mr. Miller is testing the idea only in a private fund he runs for his family, Seismic Value Partners 1, that had about $15 million last December, according to a Securities and Exchange Commission filing. He isn’t using the technique in any of the accounts his firm, Miller Value Partners LLC of Baltimore, manages for outside investors.
“What we’re hoping to do is to have a quantitative model that would add value when the market’s going up and when it’s going down,” he says.
Using market prices and other measures, the system seeks to predict when conditions will favor buying or selling, and how aggressively the fund should buy or sell. It typically trades exchange-traded index funds tracking a wide selection of securities.
Mr. Miller’s son, Bill Miller IV, a portfolio manager at the firm who oversees the seismic model, says it “has done exactly what we thought it would do” since its launch two years ago. That includes doing “okay” during the extreme turbulence at the beginning of last year, when U.S. stocks slumped roughly 10% in six weeks.
John Rundle, a geophysicist at the University of California, Davis, who helped design the forecasting approach, says earthquakes and market crashes “look so much alike that you can describe them both with the same mathematics.”
Both kinds of shocks are preceded by tremors; both are followed by aftershocks. Earthquakes reach a critical point at which all fluctuations, large or small, are correlated and synchronized; in a market crash, nearly all assets tend to fall in lockstep. Financial markets, like tectonic plates, can form what physicists call a “metastable state,” temporarily harboring latent energy that gets suddenly and violently released.
Investors have long sought a reliable technique for determining when to get out of the market before a crash and back in before a rise.
Unfortunately, that holy grail remains at least as elusive as it is precious. As Cliff Asness, Antti Ilmanen and Thomas Maloney of AQR Capital Management in Greenwich, Conn., have shown, contrarian investors who tried to time the market didn’t substantially outperform those who held stocks non-stop through the booms and busts of the past six decades, without even accounting for taxes and trading costs.
The search for connections between physics and finance isn’t new, either. In 1900, French mathematician Louis Bachelier likened the path of stock prices to Brownian motion, the random diffusion of particles throughout a liquid or gas. Decades later, financial economists Fischer Black and Myron Scholes borrowed an equation from thermodynamics to develop an influential method of valuing stock options.
Still, the science of predicting earthquakes is far from perfect. In 2015, an Italian appeals court acquitted six Italian scientists of earlier manslaughter convictions after they had failed to foresee the earthquake that devastated the town of L’Aquila, killing more than 300.
Perhaps the last word should come from the most famous of all physicists.
On April 20, 1720, when the rise in the South Sea Co., one of the hottest stocks of the time, already resembled a bubble, Sir Isaac Newton got out of the market. The great physicist dumped his South Sea shares, doubling his money by locking in a £7,000 gain, according to historian John Carswell.
A few months later, though, Newton jumped back in at a far higher price. He ended up losing £20,000, or at least $3.6 million in today’s money.
So far as I know, there’s no record of whether Newton used a mathematical formula to get out of — and back into — the market, or whether he was impelled by some metaphysical force. But the great man lost his breeches.
Predicting earthquakes is hard. Predicting human behavior, especially tens of millions of people at a time, is harder. As Newton is reputed to have said, he “could calculate the motions of the heavenly bodies, but not the madness of the people.”
Source: The Wall Street Journal, http://on.wsj.com/2iWCBmj
For further reading:
Definitions of BUBBLE, CRASH, FORECASTING, OVERCONFIDENCE, PANIC, RISK, TACTICAL ASSET ALLOCATION, in Jason Zweig, The Devil’s Financial Dictionary
Chapter Four, “Prediction,” in Jason Zweig, Your Money and Your Brain