An Easy Way For You To Understand Complex Markets 1
After giving you some sense, and hopefully, an appreciation for how market outcomes are the result of complex phenomena, it is time to introduce the Iceberg model.
This model is an excellent tool to help you think through developments in complex systems, and react accordingly to them. Of course, for us, this would center on financial markets.
As with any iceberg, only a small percentage of the structure is visible above the waterline, with the rest of its massive bulk floating beneath. The same thing applies to Events in complex systems.
Events are the observable outcomes of multiple interactions within the complex system, hence their place at the top of the Iceberg model.
This would be, for example, the price of a stock moving sharply higher or lower on a headline. The price move is immediately obvious to all who are watching, which draws in a lot of traders who are keen to act, thinking the Event is all there is to the price move.
Of course, the Iceberg model tells us otherwise, and we must look at the submerged levels of the Iceberg to figure out what really is going on.
The second level of the Iceberg details Patterns of behavior in the system.
In financial markets, this would be how a market trends over time. Trends are the context behind price movements, and crystallize seemingly random short term gyrations in price over longer periods of time.
This is extremely useful in two ways, the first being it shows a trader whether to go long or short over a relevant time frame, with the trend being your friend and all. The second being that the long term trend hints at broader factors at play in the market; a clue, so to speak, asking the trader to conduct further investigation.
Next, we have the third level of the Iceberg, representing Systems structure.
This level calls for market participants to map out each component in the complex system in order to understand the relationships between each, and how these relationships influence systemic outcomes.
For example, on a broad level, the components of the US economy would be the labor market, Corporate America, the banking system, government fiscal policy, the Fed’s monetary policy, and to some extent, capital markets.
It is important to remember that the relationships between these components will change over time.
Government fiscal policy is very different depending on which party has control over the legislative agenda, and it’s policies can have far reaching effects on the rest of the economy’s components.
Whether or not the labor market can keep its skills up to date with what Corporate America demands is another example of a changing relationship, with direct effects on corporations’ costs and productivity.
Relationships between components can run both ways, adding another layer of complexity. Keeping with the US labor market, it is quasi dependent on the US government and what education policies it adopts. Hence Corporate America is also affected by what the US government chooses to do with education.
It is crucial to note that in this globalized world, no economy stands as an isolated system.
This means that the US economy is itself a component in the global system. Which makes the parts of the US economy sub-components of a much larger whole whose interdependency, interrelationships, scale, and complexity is truly mind boggling.
The final layer of the Iceberg is Paradigm, and it is key to understanding and changing all complex systems.
So important in fact, that it needs its own article to explain fully and properly.
To be continued…
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