Why the markets are like an epileptic brain
An Israeli study shows that the stock market's behavior leading up to the 2008 financial crisis resembled the human brain during an epileptic seizure.
The U.S. stock market behaves like the brain of someone with epilepsy. That startling claim is the result of an academic collaboration no less startling - between Prof. Eshel Ben-Jacob of Tel Aviv University's School of Physics and Astronomy and Gitit Gur Gershgoren, chief economist of the Israel Securities Authority. (Ph.D. candidate Dror Kenett also contributed to the study. )
It was a student of Ben-Jacob's who combined physics, astronomy and finance with research that built on Ben-Jacob's work analyzing activity in various parts of the brain during an epileptic seizure. Ben-Jacob developed complex statistical models for analyzing correlations that, when applied to another field with complicated correlations - the stock market - yielded surprising results.
One of the biggest surprises was revealed by Ben-Jacob and Gur Gershgoren, who examined the roots of the 2008 financial crisis. They concluded that the roots were planted as far back as 2001. They identified a drastic change in the correlations between stocks on the New York Stock Exchange starting that year. This change caused the U.S. stock market to behave in a manner resembling the brain during an epileptic seizure from 2001 until the great seizure of 2008.
According to Ben-Jacob, in every stock exchange there are correlations between the behavior of the various shares; for example, between shares of energy companies and shares of car makers. These healthy, natural correlations in the U.S. market fell to near zero in 2001. They were replaced by a correlation with the stock index - the study used the S&P 500 index for comparison. The researchers found that the single strongest explanatory variable, beginning in 2001, lay in fluctuations of the index itself.
This meant that market risk was also very great: The market lost its flexibility and the natural disparate behavior of its various sectors. It began behaving like a herd. And in acting like a herd, the market resembled the brain during an epileptic seizure.
In the healthy brain, as in the healthy stock market, there are natural correlations among the various parts - some act in concert, others in opposition, still others totally independent of each other. But during an epileptic seizure, one part of the brain takes control and dictates behavior. Instead of natural correlations between certain sectors, each of which also functions independently, the brain falls under the sway of a single focus of correlation. The herd behavior of the stocks in the S&P 500 continued from 2001 until the great crash of September 2008.
The findings end here, but the researchers forged on in an attempt to explain the reason for the big change in correlation beginning in 2001. The main reason they found was the massive increase in index-linked trading - index funds, index-linked options and the entire world of derivatives, all of it based on indexes. This made playing the stock market much more a matter of playing the indexes than of focusing on the shares of individual companies.
It was the financial sector, of course, that was responsible for this lockstep behavior - the sector that issues all these index-based instruments.
The study's authors suggest that it was the decline in interest rates in the United States beginning in 2001 that drove investments away from low-risk channels into shares. Most stock investing is done through financial institutions. So there were two parallel trends: The financial sector increased in size and in its influence over the market, while investing more and more in index-linked instruments of all kinds. This created a cycle of low interest rates, an increasingly strong financial sector and investments in index-focused instruments that interrupted the stock market's natural behavior.
The "great epileptic seizure" of 2008 did not solve the problem, it exacerbated it. In an effort to end the crisis, interest rates were lowered, further accelerating the cycle by which the financial sector and the indexes increased their power at the expense of individual stocks. U.S. economic policy in the wake of the financial crisis speaks the language of change, Ben-Jacob writes, but the changes are in effect only cosmetic ones that forestall the painful, major operation needed to allow the markets to recover their health.