The Physics of Markets: Synergy of Cavitation and Financial Bubbles

As COVID-19 uncertainty starts normalizing, social investing subsiding (post-stimulus checks), and stock market appreciation stalling (compared to mid- 2020 and early 2021 levels), many investors began to seek answers to the most coveted questions in finance: “When is the next market bubble?”, “What is the catalyst of this market bubble?” and “How do we (investors) profit or avoid its shockwaves?”

Though the answers to these questions remain subjective and open to contrary opinions, parallels to one of the oldest academic disciplines can potentially be the key to uncovering the characteristics of a market bubble and the potential areas of contrarian profit-generating approaches to a dynamic situation. Thus, “physics” may be the key to uncovering the inner metrics and catalysts that devise a market bubble.

Ironically, physics can actually be attributed with the actual term “market bubble.” Specifically, the phenomenon of “cavitation” in water concerning fluid flow machines can directly be linked to the term “market bubble.” “Cavitation” is the rapid formation and collapse of vapor bubbles within a liquid caused by the decrease in static pressure (below vapor pressure). These cavitation “bubbles” naturally flow towards a normal pressure environment, causing (as do most bubbles), cavitation bubbles to “pop” or “collapse at its weakest point. Over time, multiple collapses create surface erosion as seen below:

For example, when a boat propeller functions underwater, it creates cavitation bubbles as it moves through the water. The pressure decreases on the outer lip of the propeller generating bubbles under the water that flow away from the propeller, eventually dissipating into the normal pressured surrounding water (while also eroding the propeller over time) as seen below:

How does this apply to markets?

Now, financial market bubbles have many similarities to the dynamics of cavitation. Historical economics resemble machine-like repetitions with increases and decreases in debt loads and borrowing demands correlated to the strength and recovery of economic conditions and Fed interventions (quantitative easing and quantitative tightening) rooted in short-term and long-term debt cycles. Debt swings and human nature may lead to the situation where debt is used to over-consumer. This inappropriate but unfortunately common usage of debt can become problematic over time. Additionally, as the debt burden increases, the loan or debt collateral can subsequentially lose value. As in the 2008 Great Financial Crisis (subprime mortgage bubble), institutional loan requirements (in cavitation similar to static pressure) fell below the economic (investing) loan/debt expectations (in cavitation similar to vapor pressure), forming a market bubble (similar to a cavitation bubble). However, as spending retreats, borrowing slows, incomes start to fall, and asset values slide, social tensions and the innate human nature to overreact can become exaggerated. This dynamic potentially causes the stock market to pull back. As a byproduct of the natural economic deleveraging, a market bubble can form and implode as the financial and market dynamics shift towards economic expectations (or higher pressure). Therefore, the shockwaves and “micro-jet” (or, in financial terms, “lasting market connotations”) will have a fundamental impact on markets and the procedures/dynamics of the financial system’s underpinnings (or cavitation erosion). Thus, the phenomenon of cavitation bubbles and the hypothetical terminology of a market bubble have many similarities.

Currently, on the surface, our economic recovery appears to be slowing amid historically low rates, a weak U.S. dollar, negative real rates, falling U.S. home sales (as higher prices stunt demand), and sinking consumer sentiment and consumer confidence as inflation concerns and elevated unemployment overshadow (making a case for the stagflation argument). However, a deeper look shows that economic growth could continue beyond expectations. Last Thursday’s Leading Economic Indicators, LEI (forward-looking bias), grew 1.6% MoM, outpacing March by three basis points. Optimistic, forward-looking data is poised to normalize market conditions from the pressures that have the potential to weigh on economic growth such as the concoction of early-stage economic cycle dynamics, an uncertain economic path forward post-COVID, and stale backward-looking data. Therefore, an economic recovery appears to still have legs as forward-looking data (LEI) grows, vaccine inoculation/mobilization continues into the summer, and business operations return to pre-COVID restrictions. In short, investors must look past the surface level monthly backward biased economic data and focus on the optimistic trajectory of forward-biased economic data rooted in LEI growth.

However, that does not mean that the cavitation of financial markets has stalled. Instead, they form at a thousandth of a fraction’s pace of natural cavitation bubbles in flowing water (though with similar characteristics). The mechanisms weighing on financial systems take decades to adjust the figurative pressures lower to form an economic bubble. It also takes years for that financial bubble to approach a market situation where the bubble implodes due to normalized underpinnings.

Many financial system gaps have the potential to create market bubbles. The most discussed potential causes of the next financial bubble are: the onslaught of passive investing inflating asset prices and creating illiquid market dynamics, excessive increases and continued increases in student loan debt, the federal budget deficit increasing, complex derivative products that package poorly represented securities in a safe wrapper (similar to 2008), thematic ideologies that become overdraw or remain too early for current innovations (similar to the tech bubble of 2000), poorly conducted economic and government policy implementations (causing aspects like high inflation) or an aspect we have yet to uncover.

Therefore, investors should be aware of the inner workings of a financial bubble to avoid unexpected losses. Additionally, investors need to understand that specific investment strategies deeply conceptualize the physics of market bubbles and appropriately architect their strategy to accommodate for thematic or mechanical dysfunctions in the financial systems. For instance, some equity strategies take a tactical approach with an options overlay to limit downside, create a floor on losses to shield investors from exaggerated drawdowns, or incorporate machine learning and proprietary algorithms to calculate economic dislocations mathematically. On the other hand, fixed income strategies can become even more creative. Some limit duration and interest rate risk by keeping the duration of the core bond holdings short-term. Others have cash reserves in Gold to limit exposure to increases in inflation, decreases in purchasing power, and negative real rates. Or alternative fixed income strategies can utilize special situation holdings analysis to find illegitimacy discounts and other strategies can find arbitrage in legacy non-agency RMBS which have historically low correlations to financial markets (as most of these positions survived the 2008 Great Financial Crisis).

With this said, as technology innovation progresses, as explained in “The Next Stage of Disruptors: Part 1” and “The Next Stage of Disruptors: Part 2″, and the accessibility of investing becomes more widespread, psychological and cognitive micro-foundations of human decision making has the potential to be the pressures that can create the next market bubble (though remain exceptionally difficult to hone in on one specific decision influencing trait). Even though social investing has subsided from the GameStop and Reddit craze, it did highlight the impact that the masses can have on the financial system. It also displayed the irrational decision-making that coincides with the innate nature of human decisions. Whether it is the desire for “quick money schemes,” “free” things or the arbitrary coherence, theory of relativity, nudge theory, or prospect theory (as explained in “Behavioral Economics: The Psychological Shifts Driving the Current Financial Ecosystem“), human behaviors remain a mystery beyond what most academics or scientists can uncover. The reliance on game theory’s use of backward induction to deduce an inevitable outcome or the increasing implementation of neuroscience theory to understand the mysteries of the decision matrix remains collectively inconclusive. The low degree of uncertainty that runs havoc on everyday decisions and daily investment decisions creates short-term illegitimacy discounts (“arbitrage opportunities”) that can compound into market dislocation or a bubble over a long-time horizon. Therefore, understanding markets’ physics and the behavioral underpinnings that put pressure on the financial system remains vital components to continue to generate attractive returns while limiting the downside from market bubbles.

All in all, investors can accommodate their innate risk aversion with alternative investment strategies as their strategy complexity to navigate through financial cavitation (the natural application of physics) supersedes that of unitary investment strategies.