Have you ever realised that the rising connectivity of people, objects, and systems to more and larger networks could impact and change the financial markets?
Today's article explains how markets have transformed from simple operations to complex mechanisms that are potentially influenced by a long list of variables.
It also shows the four main expected future trends:
- Mechanical trading will become less important.
- It will be better to focus on price movement than explain why it moved (as it did).
- Financial markets will become more uncertain and volatile.
- Long-term investing will be riskier and trades will become shorter.
How increasing connectivity impacts markets
The world around us is continuously changing as people, objects, and systems are connected to more and larger networks.
This is not new — certain systems have always been complex. Human immunology and the Amazon rain forest, for instance, are difficult to grasp and dissect. The same holds true for the weather and climate, where a small movement in pressure can cause a larger weather effect (i.e. rain) one thousand kilometers away.
What is new?
The pace (high speed) and scope (people, objects) of the connectivity is rising quickly. Let us look at at the markets for an example, where complexity has risen over the ages:
- Local markets used to be relatively simple — food was produced for own consumption and any extra supply was offered at the local market around the corner.
- Each local market stood more or less on its own feet with its own supply and demand. These markets were hardly connected to each other, besides perhaps a few closely neighbouring markets.
- Trade and merchants changed this model as local produces were being offered in further and distant markets, thus making markets more complicated. As more and more sellers, buyers, and markets connected to the global trade routes, the entire system eventually evolved to become complex.
Now large parts of the world are connected to each in one way or another. Fruit, vegetables, oil, iron and many more base products and finished products are being shipped from one region, country and continent to the next without anyone blinking their eye.
This entire web of interactions is increasing its complexity as more people, objects and networks are becoming connected. According to John Holland, highly connected systems, such as futures exchange and webs of finance, share an ' evolving structure that never stay the same'.(*)
The author Ramo from the Seventh Sense explains that "as any system fills out with more actors and more types of connection, it becomes more complex and harder to predict." (*page 138)
Or in other words, increased complexity leads to higher risk and uncertainty because small changes or disruptions in a connection can disrupt or destabilise the entire system.
The main conclusion from this first part is that an increasingly connected world will produce accelerated changes - at least for the next upcoming decades. The next major question is how will this trend impact the world of trading? What does that imply for trading? And how does that impact the financial markets?
The 4 key lessons of connectivity for trading
The truth is that nobody knows for sure… but I will provide you with my best educated guesstimate. The below items are speculation but do represent what I consider most likely scenarios at the moment. Feel free to add comments, critique or questions at the bottom chat.
1. Mechanical thinking and trading will produce diminishing returns
This is the first major conclusion that I draw from a faster and more intensely connected world. Market cycles will keep changing with an accelerated pace, become more complex, and appear more chaotic.
Traders must be able to see a 'deeper level' of analysis than just simply go with and trade the 'obvious'. In my view, wave analysis, technical analysis, and price action patterns will offer traders a clear method to diagnosis the market structure and price cycles (see video in point 2).
2. The best strategy is to focus on price movement, not on the 'why'
The number of variables impacting the financial markets, Forex, CFD and commodities will be rising rapidly. The interconnection between markets will make it more difficult to understand why price moved the way it moved.
It will be much more effective to focus on understanding the market structure (see video below) and price cycles rather than analysing the why. Simply said, knowing why will become less or not relevant, because it will be very difficult to spot and locate what caused price to move:
"Linked to a whole system of constant evolution, even the most innocent-looking point becomes vulnerable to twitches, infections, or innovations" (* page 140)
3. Financial markets will become more uncertain and volatile
The acceleration of systems, people, and objects connecting to networks will increase the speed of everything - just think how fast items can be delivered to your home nowadays. Market trends will also become shorter and as a result, price will move up and down with more volatility.
A few stocks might escape this volatility rhythm and witness a 'winner take all' climb in their stock price. Some could be vulnerable for an implosion if they fail to see the next big trend, development, evaluation, or connection in an ever more connected financial market and world.
Here is one piece of good news Forex traders. They will welcome the higher volatility and larger expected up and down moves because it will offer a higher frequency of trading opportunities.
4. Long-term investing will be riskier and trades will become shorter
Long-term investments use to be the best way of capitalizing on rising assets. The 'buy and hold' strategy till you retire was a successful strategy for many people in the past 100 years. But will the same strategy prove viable for the next century?
In my view, no. Changes will occur more rapidly: trends will last shorter, price will make more twists and turns, and price patterns will become more complex. The buy and hold strategy for the long-term will - in my view - become less relevant in the future and successful trades will become shorter in length.
You can see this trend already emerging over the last eighty years. The average stock was held for around seven years in 1940, two years in 1987, and seven months by 2007 (** page 50). I don't expect this trend to reverse: "More complexity produces more interaction, as you would expect, and that means what lies ahead is going to be even harder, more challenging than what we've faced." (* page 142)
Cheers and safe trading,
Follow @ChrisSvorcik on twitter for the latest market updates
(*) The Seventh Sense by Joshua Cooper Ramo, publisher Little, Brown, and Company, 2016.
(**) Rewriting the Rules of the American Economy by Joseph E. Stiglitz, Roosevelt Institute Book, 2016.