Market force, ecology and evolution

Markets have internal dynamics leading to excess volatility and other
phenomena that are difficult to explain using rational expectations
models. This paper studies these using a nonequilibrium price formation
rule, developed in the context of trading with market orders. Because this
is so much simpler than a standard inter-temporal equilibrium model, it is
possible to study multi-period markets analytically. The resulting price
dynamics have second-order oscillatory terms. Value investing does not
necessarily cause prices to track values. Trend following causes
short-term trends in prices, but also causes longer-term oscillations.
When value investing and trend following are combined, even though there
is little linear structure, there can be boom--bust cycles, excess and
temporally correlated volatility, and fat tails in price fluctuations. The
long-term evolution of markets can be studied in terms of flows of money.
Profits can be decomposed in terms of aggregate pairwise correlations.
Under reinvestment of profits this leads to a capital allocation model
that is equivalent to a standard model in population biology. An
investigation of market efficiency shows that patterns created by trend
followers are more resistant to efficiency than those created by value
investors, and that profit maximizing behavior slows the progression to
efficiency. Order of magnitude estimates suggest that the timescale for
efficiency is years to decades. Copyright 2002, Oxford University Press.