Joseph Effect

Asian Financial Crisis

What is the Joseph effect

The Joseph effect is a term derived from the history of the Old Testament on the dream of the Pharaoh told by Joseph. The vision led the ancient Egyptians to expect a seven-year harvest famine to follow seven years of a bountiful harvest.

Break the Joseph effect

The Joseph effect is a term coined by the mathematician Benoit Mandelbrot and postulates that movements over time tend to be part of wider trends and cycles more often than to be random. Mandelbrot drew his theories from the history of the Old Testament of Joseph telling the dream of the Pharaoh of seven fat cows devoured by seven lean cows. The interpretation was that after seven good harvest years, seven bad years would follow. The description of the good seven years is known as the Joseph effect, while the bad seven years are known as the Noah effect. Interestingly, the seven-year cycle is commonly found in modern economic analysis as a predictor of the time of recession.

The Joseph effect and the Noah effect are early examples from history showing that man was attentive to the cycles of nature and wanted to become better able to predict future outcomes of recent experience. Human behavior is largely affected by recent experience, with a tendency to overlook some of the most random and disruptive lessons from the distant past. Mathematicians set out to quantify these observed cycles in predictable formulas and Mandelbrot quantified the Joseph effect using the Hurst component. The Hurst component quantifies the regression to the mean over time for any number of price movements.

At the heart of each term is the notion that trends tend to persist over time. If a region of the world has been hit by drought, chances are high that it will remain so for some time. A baseball team that has won recent games is likely to continue to win. If the stock price rises steadily, the likelihood of it continuing is high. Technical analysts use trend lines to show this principle of persistence.

The Joseph effect and leading indicators

The Joseph effect and the Noah effect are just two of the many mathematical trend analyzes used by sophisticated investors. For example, analyzing charts is an important tool for predicting future movements in stock prices. Investors look at volume trends, price ranges, momentum indicators, leading indicators and lagging indicators. Leading and lagging indicators are particularly important to classify and understand. Leading indicators commonly used include the consumer confidence index, the purchasing manager index and movements in bond yields, particularly when a reverse yield occurs. Corporate recruitment plans are also a significant leading indicator.

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