Zain Jaffer is the founder and president of Zain Ventures, a family office that invests in real estate and proptech.
During the past few months, we have all likely read how artificial intelligence (AI) will replace different types of jobs, many of those typically done by skilled and intellectual workers.
However, one particular task has been elusive for AI, and that is accurately predicting market outcomes. In many ways, this is understandable since it involves guessing how a large and complex herd of investors and traders will decide to buy or sell, short or go long.
Recently a paper published last March 2023 showed that Chat GPT could actually predict and decipher “Fedspeak”—you know, the rambling indirect statements that people at the Fed make at the end of each FOMC meeting. It appears that Chat GPT has found the regular patterns and can actually decipher these speeches quite well. But predicting how the Fed will act still doesn’t predict how markets will react.
AI And Stochastic Probability
There are different types of AI. Some are rule-based, meaning they make decisions based on programmed rules. Others use something called neural networks, which are modeled after the way our brain works.
Current AI like ChatGPT uses large training data that is ideally precurated so that the AI learns as it picks up patterns. When it knows these patterns, it can then deduce how something may turn out, assuming that succeeding actions more or less follow the previous actions with some allowed randomness.
There is something in statistics called stochastic probability. It means that although you can’t predict the exact price or value that will come out each day, you know that at least it follows a random probability distribution, and you can more or less determine what the probability of a particular price is.
Individual Motivations And Approaches In Trading
Each trader and investor has an individual set of motivations. One might just be interested in making money off the daily price swings going either up or down. Another might want to invest long term and just care about the extended price trend, ignoring the volatility of daily price movements. Others want to short a particular stock or crypto just to see it go down. Motivations are as unique as the individual.
Technical Traders
Technical traders use many techniques like Wyckoff Analysis, Bollinger Bands, Elliott Waves and others. Pure technical traders do not really care about the news or external events. They only look at charts and price movements.
Fundamental Analysis
Still, others prefer fundamental analysis. They are interested in what is happening in the world in terms of news that can affect the supply and demand of commodities and how those developments can affect business outlook. Will there be a recession, inflation, deflation or stagflation? How high or low are the CPI, jobs outlook and other metrics like price-to-earnings (P/E) ratios?
Fundamental analysis involves trying to understand the world and how it affects a stock or crypto price. For example, if a stock retains its price at present despite a forecast recession, that will lower earnings estimates for discretionary purchases that the company makes. Then most analysts will probably short the stock if it continues to go higher.
Contrarian Investors
Complicating matters are contrarian investors who may be whales. Whales are investors who have a lot of money to buy or have a lot of stocks or crypto to sell. Contrarians want to oppose the herd. They might short the movement of a certain price, meaning they are betting it will go down if everyone is piling up. Or they can go long, meaning they are betting it will go up if everyone is selling. Any attempt to predict how a market will move will have to make those considerations.
While buyers and sellers might fall into specific categories, if the herd, which can be several thousand to millions of buyers daily, can fit a probability distribution, then you can make certain predictions.
Information Asymmetry
Modern trading software can actually show you the number of buy versus sell order volumes. From that alone, you or a team can visually decide if a stock is about to go up or down. An AI can also take that into account for short-term price movements, especially if oracles (software price feeds) are accurate and timely.
We can safely say, however, that most retail investors aren’t really expert technical or fundamental traders. There is often information asymmetry because ordinary retail traders and investors often do not know the complete picture about a crypto or stock.
Those in large hedge funds tend to know more about what they are doing. They may be more fundamental or technical traders. They may also be long-term hold investors like Cathie Wood of Ark Invest or short sellers like Michael Burry of The Big Short fame. Because of the large amounts they trade, buy or sell, they can move the markets somewhat, especially if there is low liquidity and there are few other traders.
Challenges For AI
It is when a whale trader moves against the typical patterns of how most buyers and sellers fit into a stochastic probability distribution that is most challenging for AI prediction.
Because of this, while the technology may improve, what, in my experience, cannot be predicted is if something breaks and fundamentally changes the equation—like finding out that FTX and Alameda were running a scam.
Black Swan factors are those strange events that happen and derail the markets. Even Warren Buffett said in their latest 2023 Berkshire Hathaway shareholders meeting that no one can predict every possibility.
In the end, the only way to be ready for these types of events is to be flexible in terms of things like mindset, skill sets and assignments. Sometimes you need to abandon your original plan and play the cards you are dealt with. It is like war. You can have all the simulations you want. But in the end, sometimes chance and circumstance give you changes you need to be ready for.
While I think AI market prediction can become more consistent, there will always be the Black Swan factors and whale traders, and these will likely never be predictable by definition.
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