Ovanes Oganisian
Analyst
Renaissance Capital
The stock market is all about information. Information and news are intangible things, like gases, in the air or space around us, mixing with other gases, changing their pressure and spread. Therefore, I posit that you need to know the laws that govern gases to invest successfully. Using the laws of thermodynamics, for example, you can see how the increased pressure from an increased positive news flow drives the stock price up.
Another case in which thermodynamics might be useful to you when investing, is if you suspect that you are dealing with something of a very high temperature, which gets hotter and then cools down rapidly. This is the case when you hear about hot prices, ballooning prices, and exploding, skyrocketing or plunging prices.
Finally if you hear about monstrous assets or debts, huge capital expenditure plans, multiple expansions, large profits and increased sales volumes, you may also suspect that to comprehend those terms properly, you need to know about rules that deal with volumes. Here, again, the field of thermodynamics is very relevant.
In thermodynamics, everything can be described with three parameters — volume, price and temperature. Using these three parameters, thermodynamics then goes on to explore other constructs such as work, heat, energy and entropy. With these tools in hand, scientists are then able to define thermodynamically favorable or unfavorable processes, define states of stable and unstable equilibrium, and know what pressure, temperature and volume need to be applied to make a substance liquid from illiquid.
The next step is to make the important connections between the different components in thermodynamics and finance. Hence, stock price can be defined as temperature; company assets, profit, net asset value and equity can be defined as thermodynamic volume; and finally, news flow and information disclosure about the company’s operating activities can be defined as thermodynamic pressure.
To repeat, price is like temperature, volume is like a balance sheet, and pressure is like news flow.
To make sure that the connection works, we need to check whether the simple laws of gases hold if instead we use our new terms of price, balance sheet and news flow.
The first test is Gay-Lussac’s law, which says that if you increase the temperature of a gas at constant volume, then the pressure will rise. In other words, to increase the price of the stock without any changes to the balance sheet, all you need to do is to increase the news flow around the stock. We know from experience this works quite well. Start talking about the stock on every platform, and the price will move up. This is how most people in our field get a good reach, by constantly mentioning that the stock they already own is very good.
The second test is Boyle’s law, which says the pressure and volume of a gas are inversely proportional if the temperature is kept constant. In finance terms, this means that if your balance sheet deteriorates, but you don’t want your stock price to drop, you need to be creative and ramp up the news flow. This is more of a problem for a company’s investor relations officers, who can sometimes find themselves having to compete with the best comedians on creativity to explain that hole in the balance sheet.
The third and final test is Charles’s law, which says that at constant pressure, gas expands as the temperature increases. For us, this means that at constant rate of information disclosure, if the balance sheet of the company improves, its stock price will rise. This is useful to know, especially since this is what most insider traders go to jail for: knowing too much about the balance sheet and buying the stock before the stock price goes up.
There are a few more definitions to make before we go on. Work in thermodynamics is done when the system expands against its surroundings. For finance people, the work is done when more investors become stockholders. A successful IPO is a good example.
Heat in thermodynamics is related to internal energy. For finance nerds, the heat is the stock’s average daily value traded on the exchange. Since the heat is related to the energy of the system, we can see that energy of the system in finance is described by the liquidity of the stock. This is how we distinguish between the high-energy blue chip Gazprom and the illiquid third-tier Rostovoblgaz.
Liquidity is also related to bid-offer spread, to the frequency of trading and so on, which could be compared to Gibbs free energy, enthalpy and Helmholtz energy in thermodynamics.
Entropy is also an easy concept. It is a froth in the stock price, much like the froth in a beer mug. The entropy increases when you ramp up the trading volume in the stock (the heat) and the stock price rises. Over longer time periods, entropy could be related to price inflation.
The first law of thermodynamics — the law of the conservation of energy — says the change in the internal energy of a system is equal to the amount of heat supplied to the system, minus the amount of work done by the system on its surroundings.
In other words, if you want to increase the liquidity of the stock, you need to have a good market maker who will make sure that the value traded in the stock is good, but you also need to market the stock to investors — and the more investors who own the stock, the better the liquidity of the stock will become.
According to the second law of thermodynamics, it is impossible to convert heat completely into work in a cyclical process. Or in a system, the process that occurs will tend to increase the total entropy of the universe. This explains why it is that the longer the stock is trading, the more froth is in the stock price. In other words, over time, prices tend to inflate.
We have seen here how the laws of gases directly relate to the laws surrounding stocks. So, all those people who, after 30-year careers, decided they had been selling gas, or those clients who think that they are buying air when they are sold the next stock idea, are not far from the truth. The laws of thermodynamics work when applied to the stock market. In other words, the structure of thermodynamics is isomorphic, or analogous, to the finance constructs. Go forth, and make money!