“Physicists like to think that all you have to do is say, these are the conditions, now what happens next?” — Richard P. Feynman

What follows are random headlines from the front cover of Futures Magazine:

• How will grain prices fare?
• Will the fed hike a third time?
• Sky high: will grains come back to earth?
• Will metals heat up in the cooled economy?
• The fed effect: what’s the market to do?
• Top ten trading systems of all time!
• How will stock market react to Fed over next 12 months?
• Gore vs. Bush: who will corner the market?
• Will energy markets heat up?
• Stocks: will the bears return?
• Should you trade on government statistics?
• How to navigate the currency maze?
• Bull or bust: where are softs headed?
• How sentiment moves the market.
• Bears to crash stock market’s party?
• Will the U.S. dollar keep chugging?
• Is the bull back?
• How to profit in a modernized Europe.

How many questioned the prediction folly of these headlines at the time?

Not many. Each headline promises insight into where a market is going. Each one implies that the answer is knowable, that the right analysis will crack the code. None of them does. The question “will the Fed hike a third time?” may produce a correct answer by chance. The question “how will the stock market react to Fed policy over the next 12 months?” cannot produce a reliable answer by any method. The market is a nonlinear dynamic system. Its future state is not computable from its present conditions with any degree of accuracy. Every headline on that list is selling the illusion that it is.

Prediction Impossible

The headlines above all imply that market prediction works. They seem to back the ruse that a crystal ball will help see the chaotic future. Trend following food for thought from Manus J. Donahue III, An Introduction to Chaos Theory and Fractal Geometry:

The world of mathematics has been confined to the linear world for centuries. That is to say, mathematicians and physicists have overlooked dynamical systems as random and unpredictable. The only systems that could be understood in the past were those that were believed to be linear, that is to say, systems that follow predictable patterns and arrangements. Linear equations, linear functions, linear algebra, linear programming, and linear accelerators are all areas that have been understood and mastered by the human race. However, the problem arises that we humans do not live in an even remotely linear world; in fact, our world must indeed be categorized as nonlinear; hence, proportion and linearity is scarce. How may one go about pursuing and understanding a nonlinear system in a world that is confined to the easy, logical linearity of everything? This is the question that scientists and mathematicians became burdened with in the 19th Century; hence, a new science and mathematics was derived: chaos theory.

The stock markets are said to be nonlinear, dynamic systems. Chaos theory is the mathematics of studying such nonlinear, dynamic systems. Does this mean that chaoticians can predict when stocks will rise and fall? Not quite; however, chaoticians have determined that the market prices are highly random, but with a trend. The stock market is accepted as a self-similar system in the sense that the individual parts are related to the whole. Another self-similar system in the area of mathematics are fractals. Could the stock market be associated with a fractal? Why not? In the market price action, if one looks at the market monthly, weekly, daily, and intra day bar charts, the structure has a similar appearance. However, just like a fractal, the stock market has sensitive dependence on initial conditions. This factor is what makes dynamic market systems so difficult to predict. Because we cannot accurately describe the current situation with the detail necessary, we cannot accurately predict the state of the system at a future time.

Stock market success can be predicted by chaoticians. Short-term investing, such as intra day exchanges are a waste of time. Short-term traders will fail over time due to nothing more than the cost of trading. However, over time, long-term price action is not random. Traders can succeed trading from daily or weekly charts if they follow the trends. A system can be random in the short-term and deterministic in the long term.

What Chaos Theory Confirms About Trend Following

Donahue’s framing from chaos theory arrives at the same conclusion trend following practitioners reached empirically: short-term price action is effectively random, but long-term price action exhibits trends. A system that is random in the short term and deterministic in the long term is precisely the system that trend following is designed to exploit. It does not attempt to predict the next tick, the next day, or the next week. It identifies a directional movement that has been sustained long enough to represent a genuine trend rather than noise, enters a position in that direction, and holds it until the rules say to exit.

The fractal nature of markets that chaos theory describes is also directly relevant. If the structure of price action looks similar across monthly, weekly, daily, and intraday charts, then the same approach, following the trend at whatever time scale you are trading, applies consistently. The TurtleTrader rules used 20-day and 55-day breakouts as their entry signals precisely because they were operating at a time scale where trends are more deterministic than random. Short-term traders working intraday are fighting the noise. Long-term trend followers are working in the range where the signal begins to dominate.

The Feynman quote at the top of the page is the physicist’s version of the same problem. “These are the conditions, now what happens next?” For a linear system, you can answer that question. For a nonlinear dynamic system with sensitive dependence on initial conditions, you cannot. Markets are the latter. Every Futures Magazine headline asking “will X happen?” is posing a question about a nonlinear dynamic system as if it were a linear one with a predictable answer. It is not. The trend following answer to that question is not a prediction. It is a rule: if price moves in a defined direction past a defined threshold, enter a position. If it reverses past a defined exit point, close it. No forecast required. More on why price is the only input that matters at the price page and the broader TurtleTrader story.

Frequently Asked Questions

What is chaos theory and how does it relate to markets?

Chaos theory is the branch of mathematics that studies nonlinear dynamic systems, systems that do not follow predictable linear patterns and that have sensitive dependence on initial conditions. Markets are classified as nonlinear dynamic systems. This means their short-term behavior is effectively random and unpredictable, but their long-term behavior exhibits trends. Chaos theory confirms that predicting specific short-term market moves is impossible, while following long-term trends is viable.

Why does trend following work if markets are chaotic?

Because chaos theory distinguishes between short-term randomness and long-term determinism. A chaotic system can be random in the short term but exhibit trends over longer time horizons. Trend following operates at the time scale where the trend signal begins to dominate the noise. It does not try to predict the next tick or the next day. It identifies sustained directional movement and follows it.

Why are financial magazine headlines about market predictions misleading?

Because they frame questions about nonlinear dynamic systems as if they have predictable answers. “Will the Fed hike a third time?” might be answerable by chance. “How will the stock market react to Fed policy over the next 12 months?” cannot be reliably answered by any method. The magazine’s business model requires the illusion of predictability. The market’s behavior does not support it.

What does the fractal nature of markets mean for traders?

That the structure of price action looks self-similar across different time scales: monthly, weekly, daily, and intraday charts share a similar appearance. This means the same general approach of following trends applies at multiple time scales. It also means that no single time frame is uniquely privileged. Trend followers operating on daily or weekly charts work where long-term price action is more deterministic. Intraday traders work in the range where randomness dominates.

What did Richard Feynman’s quote mean for market traders?

Feynman described the physicist’s instinct: given initial conditions, compute what happens next. For linear systems, this works. For nonlinear dynamic systems like markets, it does not. Because initial conditions cannot be described with sufficient precision, and because small differences in those conditions produce dramatically different outcomes, the future state of the market cannot be computed from its present state. Trend following acknowledges this by abandoning prediction entirely and responding only to what the market is actually doing right now.

Trend Following Systems
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