Heteroscedasticity of deviations in market bubble moments – how the goods and bads lead to the ugly

ABSTRACT

We conjecture that market bubbles may be the results of the interplay of Goods and Bads (toxic products) which develop through three interlocking moments – herding, swarming and stampeding, with deviations marked by heteroscedasticity. We use our stylized model of financial predation, the Consolidated Model of Financial Predation, and data we have accumulated through in-the-field eight-year research and the study of 30 years of U.S. market history in order to explore the foundations of market crises. We find that blind trust (or the positivity bias) and of the fear to miss out on an opportunity to enter/exit a market impacts the investors’ decisions to invest or retract. We show how markets are driven towards a make-or-break predatory dynamic that creates winners and losers due in part to weak regulations and identify a constant k that permeates market behaviours.

KEYWORDS:

• Bads
• goods
• financial predation
• consolidated model of financial predation (CMFP)
• crisis
• regulation
• ‘badfare’

JEL CLASSIFICATION:

• A10
• D81
• G41

Disclosure Statement

No potential conflict of interest was reported by the authors.

Notes

¹ See also Bekaert and Hodrick for a discussion on the US subprime crisis (2012, pp. 7–9).

² http://www.mainelegislature.org/legis/bills/bills_124th/chappdfs/PUBLIC230.pdf. Accessed 13 May 2017.

³ https://supreme.justia.com/cases/federal/us/509/209/case.html. Accessed 3 June 2017.

⁴ If bounded rationality is to exist, there must necessarily be some boundaries. Our model is drafted after this conclusion.

⁵ Note that our framework is represented in a static fashion, unlike the phase diagram used in the Hamiltonian framework. For an introduction to the latter, see (Lambert 1985), pp. 172–197. For a standard macroeconomic analyses of steady states and dynamics using phase diagrams, see e.g, (Blanchard and Fischer 1989), 46.

⁶ This is often referred to as a positivity bias.

⁷ In this system, the operating area (where the decisions to invest occur) is considered to be constrained by 2.3 × 2π/4 or equivalently (1 + k) (π/2) or equivalently: (1 + k) / 2(k – 1).

⁸ Our past research has shown that this is the case for economic behaviours.

⁹ The CMFP (e.g. Mesly 2013a, 2013b; Mesly 2014a, 2014b, Mesly 2015a, Mesly and Bouchard 2016; Mesly and Racicot 2017) studies has shown that the budget line of the consumers is expressed by B(x) = 2.2–0.9x. The same logic applies to the seller. This means that their budget lines cannot actually parallel each other in an Edgeworth box: a perfect, stable equilibrium is impossible. Only a dynamic equilibrium can prevail and the information each receives is necessarily asymmetric. Furthermore, the consumers’ satisfaction (expressed by S(x) = x + 2k/x – 2k^1/2) is suboptimal at the perfect point of equilibrium and this is true for the sellers as well; hence, each has an incentive to depart from and move further away from the point of equilibrium. In short, consumers and suppliers realize they can fare better by being a little bit more deceitful (Mesly 2014a).

¹⁰ Bernard Madoff is an exemplary case (e.g. see Gregoriou and Lhabitant 2009).

¹¹ According to the U.S. Government Accountability Office (https://www.gao.gov/. Government Accountability Office 2004, 3. Accessed 13 June 2017), predatory mortgages are transactions that ‘contain terms and conditions that ultimately harm borrowers’.

¹² A disproportionate number of victims of market fraud are 65 years old or more (Tongren 1988; Yoon et al. 2005); these people see a decline in their cognitive capabilities with age (Charles and Piazza 2009; Moschis, Mosteller, and Fatt 2011).

¹³ In natural ecosystems, predator and prey populations maintain an equilibrium and this guarantees the survival of both (Bonsall and Hassell 2007).

¹⁴ Most notably, the hypothalamus is the centre of predatory (lateral) and prey (medial) behaviours. It controls all major homeostasis-related activities which ensure the survival and equilibrium of the body; it has a one way (instead of a bidirectional) link to the pituitary gland, which forces hormones produced by both to travel through the entire body before returning to the hypothalamus with bodily information (Squire et al. 2003; McCullough et al. 2007; Berthoud and Münzberg 2011; Hinds et al. 2010). This is in line with the CMFP which has an unidirectional link between perceived risk and trust. Furthermore, the fear ‘network’ includes the amygdala (Aue et al. 2013; Dilger et al. 2003; Amaral 2002; Schaefer et al. 2014) of course, but also the orbitofrontal cortex involved in decision-making (Cardinal et al. 2002; Dolan 2002), the anterior cingulate cortex (responsible for error detection – Paulus et al. 2004), the periaquiductal grey (Gray and McNaughton 2000, 31) and the insula. The Ventral tegmental area is the centre of reward. In other words, the CMFP has some neurobiological correlates. Fore more on predatory behaviours and the brain, see Appendix 2.

¹⁵ Blind trust can affect all market agents (Loughran and McDonald 2011).

¹⁶ ‘People trust others even when there is no guarantee that the trustee will respond benevolently’. (Fetchenhauer and Dunning 2009, 264).

¹⁷ The extensive form is a more in-depth representation of a game. For a detailed discussion on this, see Varian (1993, chap. 15).

¹⁸ An example of such dynamic is the Wal-Mart’s 2008 Black Friday. Overexcited consumers lined up over night (for Goods they thought they needed desperately), swarm the stores when the doors opened early in the morning and stampeded each other in their fight to access Goods that, in the end, they did not really need. Consumers turned a blind eye to the fact that Wal-Mart prides on ‘everyday low price’ anyway, and on the fact that their time and efforts boosted the actual price of acquiring the Goods, so that in the end, these Goods were actually more expensive than if they were sold at the regular price.

¹⁹ The (k + Ψ^φ) indicates the make-or-break situation: When the second part of the equation (Ψ^φ) equals 0 (there is no variance σ_t), it is a make. When it equals to 1 (complete blind trust), so that the total (k + Ψ^φ) equals 2.3, the limit of the system is attained and it breaks.

²⁰ Our model is analogous to the well-known build-up approach (Pinto et al. 2015, 75).

²¹ As expected, vulnerable people make more mistakes than those in control. For example, older people make more mistakes in estimating rate changes that affect the marketplace (Agarwal et al. 2008).

²² As expected, vulnerable people make more mistakes than those in control. For example, older people make more mistakes in estimating rate changes that affect the marketplace (Agarwal et al. 2008).

²³ As seen when discussing equilibrium, consumers and sellers have an incentive to become more deceitful. But the DI function indicates that as each one become so, the other retaliates by becoming in turn more deceitful. Each engage further into the trap of the other. The market, of course, longs for equilibrium amidst various momentums. Thus, equilibriums and momentums are critical in market dynamics.

²⁴ The formula recognizes the importance of emotions, such as regret, in decision-making (Damasio 1994; Zeelenberg et al. 1996; MacGregor et al. 2000; Sevdalis, Harvey, and Bell 2009; Seiler, Seiler, and Lane 2012).

²⁵ Neurobiologically, nocive stress induces a reduction in the perfomance of critical functions with leads to the make of more decision-making errors (more variance). Under nocive stress, the amygdala, the centre for emotion and anxiety located in the brain, increases, while the hippocampus (critical for learning and memory) and the prefrontal cortex (responsible for decision-making) shrink (Bear, Connors, and Paradiso 1996; Lupien et al. 2009). It has been found that emotions such as fear affect judgement (Angie et al. 2011).

²⁶ This is equivalent to the ‘option to exit’ used in real options analysis. For more, see Mun (2006).

²⁷ Mometum here is referred to the term as used in finance (e.g. Pinto et al. 2015).

²⁸ As mentioned, we found some neurobiological correlates to the CMFP. This is normal: What appears in the market is generated by humans, who are controlled by their brains.