What is Fractal Markets Hypothesis (FMH)
Fractal Markets Hypothesis (FPH) is an alternative investment theory to the widely utilized Efficient Market Hypothesis (EMH). FMH analyzes the daily randomness of the market and the turbulence witnessed during crashes and crises.
BREAKING DOWN Fractal Markets Hypothesis (FMH)
The framework of the Fractal Market Hypothesis proposes a clear explanation of investor behavior throughout a market cycle, including booms and busts. The FMH was formalised in 1991 by Edgar Peters as a way of creating a foundation for the technical analysis of the pricing adjustment of assets under the central premise that history repeats itself. As such, the fractal markets hypothesis dictates that financial markets, particularly the stock market, follow a cyclical and repeatable pattern.
Major components of the theory focus on the investment horizons and liquidity of markets given a certain amount of information. The market is considered stable when it is comprised of investors of different investment horizons given the same information. Conversely, leading into crashes and crisis, FMH asserts that investment strategies converge to shorter time horizons. As a result, markets become less liquid and more inefficient.
Falling into the framework of chaos theory, FMH explains markets using the concept of fractals. Fractals are fragmented geometric shapes that can be broken down into parts which replicate the shape of the whole. With respect to markets, one can see that stock prices move in fractals. Due to this characteristic, technical analysis is possible: in the same way that the patterns of fractals repeat themselves along all time frames, stock prices also appear to move in replicating geometric patterns through time.
How Fractal Market Hypothesis Works
Investment hypotheses rely heavily on the prevalence of information with investors. During stable economic times, information does not dictate investment horizons and market prices. There are various numbers of long term investors who balance the numbers of short term investors. However in bearish markets, investors trend towards short term horizons, reacting to price movements and information. As a result, the market becomes unstable and inefficient. Unlike the Efficient Market Hypothesis, Fractal Market Hypothesis clearly defines investor behaviors in all market conditions.
Perhaps the most glaring problem with quantifying and utilizing the FMH is deciding the length of time that the “fractal” pattern should be repeated in a market leading projection. A pattern could be repeated on a daily, weekly, monthly, or even longer basis. Therefore, it's extremely difficult to accurately project the time period of repetition, despite it likely being closely related to the investment horizon, and it is also worth noting that the pattern would likely not be identically repeated.