Capital Market Theory: Is It Relevant to Practitioners?

David Nawrocki
Villanova University

A more complete theory is Vaga’s(1990) coherent market theory. Vaga argues that the market is constantly changing over time and is a time-varying process. As technology, investor expectations, government policy variables and rate of financialinnovation change, the market can experience different states -- steady state random walk, coherent cycles, and chaotic dynamics. Statistics may be used to describe Vaga’s market states. The random walk has stable symmetric (normal) distributions. The coherent cycle stage has stable skewed (nonnormal) distributions. The chaotic state has unstable skewed distributions. What are the implications? A stable probability distribution (random walk and coherent markets) will exhibit persistence over time. In other words, the distribution provides reasonable expectations of future performance. In addition, a coherent market is going to exhibit regularities that make the market forecastable with simple models. An unstable chaotic distribution implies that simple models cannot forecast the future.

Studying Vaga’s market states provides the interesting insight that his states relate to the business cycle. Vaga’s approach is statistical. However, the business cycle can be approached from an economics perspective. Hunt (1987) and Stovall (1996) have done interesting work on the stock market and the business cycle. Both authors divide the business cycle into different phases. We can divide the business cycle into four phases with each phase corresponding to one of Vaga’s market states. Four possible states of the business cycle are:

1. Easeoff -- The Federal Reserve is trying to cool down a rapidly growing economy that is experiencing increasing rates of inflation. The rate of economic growth slows and reaches a peak in economic activity. Interest rates peak.

2. Plunge -- The Federal Reserve’s anti-inflation policies cause a decline in economic activity (recession). A bottom (trough) occurs during this period. Interest rates and inflation decline during this period.

3. Revival -- The economy starts a recovery with strong economic growth, low inflation and low interest rates.

4. Accelerate -- The economy continues strong growth, however, capacity utilization starts to reach its limits and the economy overheats increasing the inflation rate.