Is the Stock Market a Three-Body Problem?

Much like the weather, it seems that the stock market is entering March like a lion. Granted, there is a difference between high-variance pressure patterns and their effect on temperature, cloud development, and wind, versus a series of economic tire fires that almost seem like they’re being set by on an increasing set of dares. Volatility has jumped back into the discourse, and the latest drawdown has even made its way to the general populace. Now normally, hearing about a market event from people who rarely even discuss investing is a sign to take the opposite position, but that may not be the case this time. Or is it? That’s one of the main issues with the market: historical precedence can either be a sign for what’s to come, or it can be completely misleading, and damned if you can figure out which is which this time around.

Some of the stuffier shirts out there will scoff and point to their Efficient Market Hypothesis sign, ten feet tall and blinking in buzzing neon. All information is already baked into the price, so you can’t beat the market (…unless you have information that the general public doesn’t have…cough cough). It represents that concept that Economists love: a closed system that behaves rationally and is easy to model and/or describe. It has also been taking an absolute beating from the meme stock craze, which pointed out how absolutely irrational a market can distorted into with the proper cajoling. But what differentiates between those periods of calm where something like the EMH can make sense if you squint slightly, or when self-described diamond-handed autists from Wall Street Bets go absolutely HAM on the focus of their ire?

The theory that’s been swirling around in my head for a while is that we’re dealing with a three-body problem in markets. In physics, you can determine the impact that Body A has on Body B and vice versa, allowing you to determine the trajectories of each through space when given initial positions and velocities. That…all goes to hell when you introduce Body C into the mix. There is no closed-end solution for a three-body problem, meaning that the trajectories of all three bodies are unpredictable due to the drastically more-complex nature of the relationship between all three bodies at the same time. To describe something as a “three-body problem” outside of the technical definition is to suggest that the interaction of multiple factors and their importance at any given point is not predictable and subject to the whims of forces that we cannot account for.

The idea of the three-body problem is having a bit of a moment right now. It has been the initial catalyst for a very popular Chinese Sci-Fi trilogy (and middling Netflix adaptation) and has been hypothesized as the reason for the weird seasons in the A Song of Ice and Fire (aka the Game of Thrones book series) world. While neither of these examples hold a candle to the true GOAT book/TV series 1-2 punch, The Expanse, they do demonstrate that the idea is gaining more and more traction in the mainstream. Of course, with anything that’s becoming more and more accepted, we’re scrambling to find ways to clumsily apply to things that failed to be described simply before the concept came along. The concept itself was something I thought of before knowing about the three-body problem, namely in the context of…Ultimate frisbee. Typically, Ultimate defenses are based around man* defense, or one defender assigned to a specific member of the offense. You can switch or dip in to help for a moment, but for the most part you are sticking to your assigned opponent during the play. Now, in adverse conditions (wind, bad field surface, or even poor offenses), you can drop a zone defense where defenders are assigned to guard players in a specific place on the field. This can level the playing field, as it can force strong man-to-man offenses into sub-par offensive movement. While most man defenses are very similar, zone defenses can be very diverse, and having 2-3 solid zone options can really allow an underdog to take a run at a team that may be better at standard 1-on-1 gameplay. Understanding which defense to deploy against a certain opponent in certain conditions allowed for us to garner some upsets and nearly knock a few regional powerhouses on their asses back on my college team.

So, how does this apply to the market? Well, there seems to be three broad market environments that have occurred over the last few decades. The first, as described above, is a market where financials and the underlying metrics of a business are driving their pricing. A company with a solid profit margin, reliable client base, and good fundamentals will see its price hew extremely closely to these drivers in this sort of environment. This is where the unsexy, lunchpail companies shine: the example that was always given in my MFE program was Caterpillar (CAT). Let’s call this body the Fundamentals body.

The second environment is our bubble generator. This is when current fundamentals start to lose out to future potential. This is our bubble generator, our pie-in-the-sky hope and promise of a company’s future to be the rosiest edge of the outlook spectrum. This is where the numbers take a backseat to the story: they are there to give us a starting point, but there is a refusal to be tethered down by their restrictions when spinning a yarn. This is the Narrative body.

Finally, we get to the environment where we need to make moves in the market no matter what. Number only go up? Ok, I’m putting my wealth in anything I can get my hands on. The market is on fire and everyone is selling? I need to sell too because I don’t want to be the one left holding the bag! Invest in a shitcoin for the vibes? Yeah sure, why not! All numbers but returns are ignored, and you don’t even need a story behind the investment thesis outside of “everyone else is doing it, and you don’t want to miss out, do you?” This is the Emotion body.

Generally speaking, the market has a plurality in one of these three environments at any given time, if not a majority. We can be in a Fundamental market environment, but there can be Narrative and even Emotion pockets within it. We are not privy to when this balance will shift, how it will shift, and why. Despite knowing its state at a given point, we cannot know the market’s trajectory and where it will be in terms of Fundamentals, Narratives, and Emotions a month from now, a week from now, or even tomorrow.

This unknowability of the three-body market system is why buy-and-hold strategies tend to outperform more-active strategies in the long term, unless you have a technological advantage a la High Frequency Traders or have insider knowledge…or Ponzi schemes. Over a long enough time horizon, the market flux nets out toward growth, allowing a decades-long investor to be able to weather recessions and enjoy bull runs. Investing in progress is mostly correct over time, and even the best strategies are only right less than 55% of the time. Remember, you only need to be right slightly more than 50% of the time to have solid returns in the market.

This is what we’re working on with some of our strategies, namely the Global Anomalous Index Allocation (GAIA), the Executive Actions for Self-Enrichment (EASE) scores and its Near-term Response to Corporate Heuristics (NRCH) strategy pair, and our Country-Oriented Volatility-Enhanced Strategy (COVES) that seeks to hedge downturn risk with a volatility component. For instance, GAIA is focused on countries where strong fundamentals are currently driving returns, while EASE/NRCH look at US companies that are sacrificing long-term business health for short-term gains via executives selling off shares after stock buybacks. COVES takes a slightly different tack, instead applying a broad, momentum-based model to a market and its uncertainty in order to know when to deploy volatility-based countermeasures. All of these focus on flexibility to hone in on the parts of the market that adhere to the body that best suits the strategy, rather than a broad-based index that’ll take the good times with the bad but keep you moving with the market.

Ideally, we’d be able to come up with an uber-strategy one day that has three bodies of its own, and can sense when the winds of the market are changing and reweigh itself to capitalize. At the end of the day, the three-body problem in this context is only allegorical; the financial world is not a facsimile of the natural world, no matter how many concepts we attempt to carry between the two. The market may not be unknowable as a whole, but it can be understood in parts where a prevailing consensus can be modeled and understood. Approaching the market in this context may not explain it all, but it does provide a slightly askew view with which to understand it better.