 The Riddle of the Nile
Chris Mayer
The
Daily Reckoning
March 14 2005
The Daily Reckoning PRESENTS:
What does
an English hydrologist, a Harvard economics professor, and the
Nile have to do with predicting the ups and downs of the stock
market? A lot more than one would thinkChris Mayer explores.
. .
In 1906, Harold
Hurst, who was a young civil servant at the time, came to the
ancient city of Cairo, Egypt, which was then under British rule.
While there, he solved one of the mysteries that had bedeviled
the pharaohs for ages - and also provided a sign for how financial
markets worked, a connection that was later uncovered in the
1960s by an ambitious Harvard economist and mathematician.
Hurst's problem
was to solve the riddle of the Nile's great floods. He was not
interested necessarily in why it flooded; he was interested in
predicting how much the Nile flooded from year to year.
It was a very
important question, in which the lives and wealth of millions
hung in the balance. The budding population in the Nile Valley
and their growing cotton industry depended on it. Their dams
were inadequate to the task of protecting them in times of flood.
And their reservoirs were incapable of sustaining them during
periods of extended drought.
The fickle,
wild and untamed nature of the Nile baffled them. While much
time and energy was spent investigating the Nile's floods, they
had yet to produce a practical answer. The people of the Nile
remained at the mercy of the majestic river's seemingly unpredictable
flows.
That is, until
Hurst tackled the problem. His contribution here would earn him
a lasting title of respect and it would bring him great fame.
The Egyptians called him Abu Nile, or Father Nile.
Hurst, the
son of a village builder, was a man of modest means and background.
Born in 1880, his family hailed from Leicester, England, where
his family had roots stretching back for some three centuries.
Determined
and dedicated, he left school at age of fifteen and worked as
a carpenter, and learned a bit of chemistry on the side. By the
age of 20, he had - against all odds - earned a scholarship at
prestigious Oxford, eventually winning honors in physics despite
no mathematical training.
When the precocious
Hurst left Britain and headed for Egypt, the Nile region had
just entered a period of relative peace in which economic prosperity
started to bloom and dam construction began in earnest as British
engineers attempted to harness and manage the power of the Nile.
The Nile was,
and remains, an immense river over 4,100 miles long. Hurst began
by mapping and studying the river and its tributaries. With the
help of other engineers, he sounded the river's depths and installed
flood level gauges in various spots.
The fluctuations
in the river ranged widely. In a particularly soggy year, it
displaced as much as 151 billion cubic meters. Yet, just as the
river proved overly generous in some years, it could be overly
stingy in others. In a particularly parched year, the river could
discharge as little as 42 billion cubic meters.
Hurst studied
these patterns and noticed how they tended to cluster. Hurst
abandoned many of the methods prior mathematicians used and started
to work out his own formula to describe their behavior. He also
looked at data from other rivers and discharges all over the
world - Michigan's Lake Huron, Sweden's Dalalven Lake, and lakes
in Russia, Canada and Norway.
More than that,
he looked at other experiences as well, searching for the footprints
of climate patterns in the tree rings of Flagstaff pines and
Sequuia, in the thickness of lakebed sentiment, in sunspot readings,
in temperature records - Hurst catalogued thousands of nature's
patterns, a menagerie of natural phenomena.
To all these
he worked out a formula, describing the patterns as functions
of a unique power law, a fundamental number that seemed to be
a fact of nature. Hurst's findings basically described the Nile's
flood cycles and showed that they did follow a pattern.
From 1951 to
1956, Hurst, then in his seventies, published a series of papers
describing his findings. These findings roiled the scientific
community and invited both criticism and praise.
But, the things
was, Hurst's formula worked. Other hydrologists working on other
rivers soon confirmed his findings.
Benoit Mandelbrot
made the connection with finance in 1960s, while he was a teacher
of economics at Harvard. Mandelbrot was working on a study of
cotton prices and worked out a power law to describe their behavior.
He published his paper and a colleague of his noticed the similarity
of his work with Hurst's.
Mandelbrot
studied the work of Hurst and connected it with his own work.
He thought that Hurst's floods were like big price jumps, and
that the droughts were like market crashes. He found that cotton
prices were similar to the Nile's pattern, that there existed
what mathematicians call "dependence" - which simply
means that what is going to happen next depends on what happened
before. Cotton prices trend. This view was in opposition to the
idea that price changes mimicked a random process, or a "random
walk" as economists described it.
Mandelbrot
measured the tendency of prices to trend and called his number
"H" in honor of Hurst. If the H factor was 0.5, then
the prices exhibited a random pattern. But, if the H factor was
greater than 0.5, say .75, then the prices had trends and that
they did not fluctuate randomly. Prices tended to persist in
one direction much longer than would be predicted by a random
process. If the H were less than .5, say .2, then this meant
that prices tended to hew closely to some mean; it meant that
they did not roam very far.
Other researchers
plowed into price data and found varying H factors for different
financial assets - more evidence that prices exhibited some trend.
Interest rates and inflation had high H factors, indicating persistent
moves in one direction. Later researchers studied the prices
of Apple Computer, Xerox and IBM - each had H factors of .7 or
better, again indicating trends.
This was a
radical idea. All of orthodox finance had been operating under
the assumption that prices behaved randomly, that they had followed
a random walk. The thinkers and theorists of finance had created
elaborate mathematical models and intricate theories that depended
on the assumption of randomness. Their works were celebrated
and the star theorists with feted with Nobel Prizes and prestigious
tenured chairs at the nation's finest universities.
If Mandelbrot's
findings were correct, then all of the models of modern orthodox
finance - the Efficient Market Hypothesis, the Capital Asset
Pricing Model, the Black Scholes Option Pricing Formula, and
more - were wrong!
Not surprisingly,
Mandelbrot's ideas have not yet gained widespread acceptance.
There is too much invested in modern finance as it is constructed.
Too many professors continue to try and patch up the existing
theories, like Ptolemaic astronomers trying to resist Copernican
theory. The evidence sits there right in front of them, but they
choose not to see it.
Regards,
Chris Mayer
for
The
Daily Reckoning
P.S. Much of
the story above is derived from Mandelbrot's excellent book,
The (Mis)Behavior of Markets. I highly recommend the book to
anyone interested in the flaws of orthodox financial theory.
Mandelbrot's
ideas remain on the cutting edge of finance. The mathematics
behind his ideas is very complex. However, there was another
visionary who observed the persistence of trends in markets.
He was born 80 years before Mandelbrot discovered the work of
Hurst. He died before Hurst even made his trip to Cairo, while
Hurst was still a teenager. The man I am talking about is Charles
Dow and his theory, a set of observations about the stock market,
form the basis of a powerful trading system that is used and
understood by a very small group of investors.
This system
is still used today, over 100 years since Charles Dow invented
itand many investors have since then honed and shaped this market-timing
strategy to pinpoint the crisis points that tell you exactly
when it's time to trade.
Editor's
Note: Chris Mayer predicts that the scandal at Fannie Mae will
have far greater economic implications that anyone is ready for...and
that's just one of the events he sees unfolding in our near future.
To find out all seven of his forecasts for this year, see here:
7 Stunning Predictions for 2005
Christopher W.
Mayer is a veteran of the banking industry, specifically in the
area of corporate lending. A financial writer since 1998, Christopher's
essays have appeared in a wide variety of publications, from
the Mises.org Daily Article series to here in The Daily Reckoning.
He is also the editor of the Fleet Street Letter.
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