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A bifurcation model of market returns

a b
David Nawrocki & Tonis Vaga
a
Villanova School of Business , Villanova University , 800 LancasterAvenue, Villanova , PA
19085 , USA
b
Independent Scholar
Published online: 25 Jun 2013.

To cite this article: David Nawrocki & Tonis Vaga (2013): A bifurcation model of market returns, Quantitative Finance,
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 Quantitative Finance, 2013
http://dx.doi.org/10.1080/14697688.2013.772651

A bifurcation model of market returns

DAVID NAWROCKI*† and TONIS VAGA‡
†Villanova School of Business, Villanova University, 800 LancasterAvenue, Villanova, PA 19085, USA
‡Independent Scholar

(Received 27 July 2007; in final form 17 January 2013)

We propose a bifurcation model of market returns to describe transitions between an ‘over-reac-

tion’ mean regressive state and ‘under-reaction’ trend persistent states. Since July 1929, the Dow
Jones Industrial Average has exhibited non-stationary state transition behavior, including: (1)
mean regressive behavior during crisis situations during the Great Depression of the 1930s and
again in the crisis of 2008 when the availability of credit was interrupted; (2) strongly bifurcated,
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or trend persistent behavior from the 1940s through 1975; and (3) more efficient behavior since
1975. The bifurcation dynamic evident in the pre-1975 era is somewhat enhanced by conditional
volume and moderate volatility. The bifurcation model is used to develop a quantitative measure
of the degree of market efficiency, which indicates that the market has become more efficient, i.e.
less trend persistent, since 1975 with the advent of negotiated commissions and computerized
trading techniques. Similar findings are presented for the S&P 500 index and the CRSP Value
Weighted Index, which represent large capitalization markets. Results for the CRSP Equal Weight
Index are found to be significantly less efficient and more trend persistent than the larger capitali-
zation CRSP Value Weighted Index.

Keywords: Bifurcation; Adaptive systems; Complexity in finance; Disequilibrium macroeconomics;

Market dynamics; Empirical finance; Evolutionary finance; Nonequilibrium systems
JEL Classification: B5, B52, G1, G14, N2, N22

1. Introduction move in response to the business cycle. Nawrocki (1995,

Studies concerned with nonlinear serial dependence in stock
returns date back to Alexander (1961). The reason for the
nonlinear serial dependence is that the speed of information
dissemination is finite and noisy (Black 1976, Grossman
and Stiglitz 1976, Beja and Hakansson 1977, Beja and
Goldman 1980). Morse (1980) argues further that the speed
of information dissemination, while finite, is not constant,
and varies with the amount of new information. With the
arrival of new information, the greater the disparity between
the equilibrium price and the actual price, the more inves-
tors want to trade, and increasing trading volume increases
the market’s speed of information dissemination. Because
of the aforementioned restrictions affecting the speed of
information dissemination, greater dependence in security
returns also occurs during this period. Morse’s results indi-
cate a positive relationship between trading volume and
serial correlations for daily data for a mixture of NYSE,
AMEX and OTC stocks.
The nonlinear nature of stock market returns has been
found in studies of the business cycle. Whitelaw (1994)
reports that both expected returns and conditional volatility
1996) and Chauvet (1998a,b) propose and find a dynamic
relationship between stock market fluctuations and business
cycles. Perez-Quiros and Timmermann (2000) find asymme-
tries in the conditional mean and volatility of excess stock
returns around business cycle turning points. Chauvet and
Potter (2000, 2001) suggest a nonlinear risk measure that
allows for the risk–return relationship not to be constant
over Markov states (bull or bear) or over time. Perez-Quiros
and Timmermann (2001) also find support for a Markov
switching model with time-varying means and variances.
Finally, Avramov and Chordia (2006) find that business
cycle variables can help predict stock market returns.
The purpose of this study is to develop a quantitative
measure of market efficiency and to assess different market
states. Nicolis and Prigogine (1977) utilize bifurcation the-
ory and find that stable states exist far from equilibrium in
physical systems. Here we find empirical evidence of
dynamic market return equilibrium states far from the mar-
ket’s long-term average daily return (0.024% from July,
1929 to December, 2010). Market equilibrium states with
returns much greater than the long-term average return are
designated ‘bull’ states while states with much lower than

*Corresponding author. Email: david.nawrocki@villanova.edu

Ó 2013 Taylor & Francis
 2 D. Nawrocki and T. Vaga
average returns are designated ‘bear’ states. In addition to
bull and bear states, we also find mean regressive behavior,
often in crisis market situations when the normal flow of
credit may be interrupted.
The relevance of bifurcation theory to economic pro-
cesses has been noted by Boulding (1981a,b) and Nawrocki
(1984, 1995). The use of concepts such as entropy theory
and bifurcation theory is extensive in the finance and
economics literature (Murphy 1965, Georgescu-Roegen
1971, Cozzolino and Zahner 1973, Majthay 1980). Vaga
(1990) proposed a state transition model for the financial
markets based on Weidlich (1971), Callen and Shapero
(1974) and Haken (1975) where markets may be in equilib-
rium states of true random walk, periods of instability, or
coherent and chaotic markets in which there are trend per-
sistent drifts toward bull or bear states far from the market’s
long-term average return. The empirical evidence of trend
persistent drifts towards bull and bear states far from
equilibrium confirms that the market has not always been
efficient, although since 1975 the market has become more
efficient.
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In recent years, many questions have been raised regard-
ing the assumptions underlying the Efficient Market Hypoth-
esis (EMH) in work such as Shiller (2000) and Schliefer
(2000). Alternating trending and mean reverting investor
sentiment models have been proposed by Barberis et al.
Figure 1. Bifurcated equilibrium states (nonlinear force and quartic potential function).
Figure 2. Single equilibrium state (linear force and quadratic potential).
(1998). Hong and Stein (1999) suggest that positive correla-
tions in returns are due to the slow dissemination of informa-
tion. Wyart and Bouchaud (2007) propose that feedback
dynamics among a subset of market agents are sufficient to
create trends in the anticipation of correlations. Dopfer
(2005) offers unifying principles to the evolutionary
approach to economics, and includes contributions by Haken
and Prigogine. It should be noted that it is the bifurcation
process between trending and mean regressive states (Barbe-
ris et al. 1998) that is of main interest to this paper.
The structure of the paper is as follows. First, Haken’s
general evolutionary model of state transitions is used to
describe bifurcations in market return states. Then, empirical
evidence in support of the bifurcation model is presented and
discussed. Finally, summary and conclusions are offered.
2. A bifurcation model of market equilibrium
A simple bifurcation model of equilibrium states in a wide
variety of complex systems from various disciplines outside
of finance is provided by Haken (1975). Haken’s approach
is based on the Fokker Planck equation, a nonlinear exten-
sion of the Langevin equation for Brownian motion. Haken
employs a double bottom (quartic) potential well to illus-
trate transitions from a single equilibrium state to bifurcated
 A bifurcation model of market returns 3

equilibria in complex systems. Weidlich (1971) uses a simi-

0.50016
–0.17%

3.50%
lar approach based on the Ising Model to describe states of
polarized opinion in social systems. Nicolis and Prigogine
(1977) utilize bifurcation processes to describe their theory
of dissipative structures whereby stable states exist far from

0.47597
0.14%

3.00%
equilibrium.
To apply Haken’s approach to financial markets, we
model the market return Rðt þ 1Þ following a prior return

0.19457
0.20%

2.50%
RðtÞ as

Rðt þ 1Þ ¼ k½RðtÞ þ f ðtÞ; ð1Þ

0.77585
0.00%

2.00%
P
where k½RðtÞ ¼  i ai RðtÞi is a deterministic function of
prior return RðtÞ while f ðtÞ represents the random new
information arrival process. We assume the random forces

0.39520
0.06%

1.50%
are standard, independently distributed Gaussian noise and
concentrate on the deterministic term. The function k½RðtÞ
is the amount of undisseminated information after a prior

0.00028
return, RðtÞ, that may either ‘push’ the market return,

0.11%

1.00%

⁄
Rðt þ 1Þ, in the same direction as the prior market return
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RðtÞ, representing a trend persistence effect following

under-reaction by market agents, or it may be a mean

0.00114
0.08%

0.50%
Table 1. DJIA Conditional Return Map (CRM).

⁄
regressive force moving the returns back towards the mean
after over-reaction to prior news.
Following Haken (1975) we define a quartic potential

0.94472
function, V ðRÞ, such that kðRÞ ¼ @V ðRÞÞ=@R, and for

0.03%

0.00%
kðRÞ ¼ a0  a1 R  a2 R2  a3 R3 ; ð2Þ

0.00119
–0.04%

–0.50%
the potential function is the integral of kðRÞ as follows:

⁄
Z
V ðRÞ ¼  kðRÞdR 0.00069
–0.08%

–1.00%

¼ a0 R þ 1=2a1 R2 þ 1=3a2 R3 þ 1=4a3 R4 ; ð3Þ

where the constant of integration has been set to zero.

0.00586
–0.14%

–1.50%

Equation (3) is essentially the same as the phase transition

⁄

model of Vaga (1990), Wyart and Bouchaud (2007) and

Schoebel and Veith (2006). The parameters of the model
determine the conditions under which market equilibrium
0.37907
–0.05%

–2.00%

bifurcates from a single state to bimodal states.

Figure 1 illustrates kðRÞ and V ðRÞ for the case when the
control parameters ða3 ¼ 168:18; a2 ¼ 2:2316 and a1 ¼
0:1355R and a0 ¼ 0:0002Þ are in a range where market
0.58042
0.10%

–2.50%

stability bifurcates into two equilibrium states. Equilibrium

occurs where the conditional return map crosses zero with a
negative slope. Note that the force, kðRÞ, is zero at the
potential function minima and local maximum points.
0.24291
0.25%

–3.00%

Figure 2 illustrates both kðRÞ and V ðRÞ for the case when
the control parameters (a0 ¼ 0:0002; a1 ¼ 0:1037 and the
other parameters are all zero) produce a single equilibrium
0.16585

point and the market force is mean regressing toward this

0.47%

–3.50%

equilibrium.
In general, the coefficients a0 ; a1 ; a2 , and a3 can be deter-
mined by a third-order polynomial regression analysis of
>95% Not Null
Return, R(t)

the conditional return map for a market of interest. These

<R(t+1)|R(t)>
Conditional

parameters can then be used in equation (3) to determine

Prior Day
Return,

the potential function associated with the force, kðRÞ. The

T-Test

coefficients also determine stable states far from the

 4 D. Nawrocki and T. Vaga
Figure 3. Conditional return map and potential function for the Dow Jones Industrial Average exhibits bi-stable, trend persistent
behavior for July 1929 through December 2010.
long-term average rate of return, and the values of RðtÞ
where conditional returns are at a maximum or minimum.
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In equation (2) (when a3 [0 and a1 [0) the slope of the
deterministic force, kðRÞ is everywhere negative. This
implies that negative returns are followed by positive
returns and positive returns are followed by negative
returns, i.e. regression towards the long-term mean. A tran-
sition occurs when a1 ¼ 0, a bifurcation point, where the
market’s long-term average return is no longer a stable
equilibrium point.
The bifurcation results in two new equilibrium states. For
small values of a0 , one new stable state is at
1=2
Rbull ¼ ½a2 þ ða22  4a1 a3 Þ =2a3 ;
while the other stable state is at
Rbear ¼ ½a2  ða22  4a1 a3 Þ
1=2
=2a3 :
In general, these states may be far from the market’s
long-term rate of return and may be affected by the
prevailing economic and market conditions. Empirical
evidence suggests that markets do in fact transition
between mean regressive and bifurcated trend persistent
states.
3. Empirical evidence
We examine conditional market returns, Rðt þ 1 day), as a
function of prior day returns, RðtÞ. The average conditional
return \Rðt þ 1ÞjRðtÞ[ is expected to be proportional to
the deterministic ‘force’ or residual undisseminated informa-
tion after a prior return, RðtÞ, following equation (2). The
daily mean return has been 0.024% for the Dow Jones
Industrial Average since July 1929. If there is a single sta-
tionary equilibrium state, conditional returns should regress,
on average, towards the long-term mean. If the market
behaves more as a bifurcated, bi-stable equilibrium system,
then conditional returns would exhibit a persistent drift
towards either the bull or bear state, which may be far from
the long-term average return.
The conditional returns for the DJIA from July 1929 to
December 2010 are summarized in table 1 as a function of
prior day returns for fifteen 0.5% increments in the range –
3.75% to +3.75%.† Table 1 summarizes the mean next day
return after prior day returns in each 0.5% increment and a
t-test, which compares the conditional return sample with
the total sample to rule out the null hypothesis. For simplic-
ity of notation, prior day returns, RðtÞ, within an interval,
e.g. 0.75%\RðtÞ\1:25%, are listed in the table as 1.0%,
the center of the interval. The data show statistically signifi-
cant (at the 5% level; T -test, p  0:0003) trend persistent
ð4Þ behavior, on average, for the DJIA over the sample period
in the regions of moderate positive and negative returns
(within the –1.25% to +1.25% region). This region includes
83.9% of all the data. Moderate positive returns are fol-
ð5Þ lowed, on average, by further positive returns; moderate
negative returns are followed, on average, by further nega-
tive returns. It should be noted that a null (insignificant p-
value) result is expected for the conditional return map in
the neighborhood –0.25% \RðtÞ\ þ 0:25% for either a
single equilibrium market or bifurcated market states. A
null result is also expected at bifurcated Rbull and Rbear
states far from the long-term equilibrium point at RðtÞ  0.
Figure 3 illustrates the conditional return map for the
data summarized in table 1 for the region –3.75% to
+3.75% (which includes 98.6% of the data). A polynomial
fit to the data is also shown in figure 3, which has the form
expected from equation (2) for conditional returns for
bifurcated market states. The polynomial fit ðRðt þ 1Þ ¼
152:46R3 þ 1:6554R2 þ 0:1035R  0:0001Þ to the data
shows an r-square of 0.851. Using the coefficients of the
polynomial fit to calculate equations (4) and (5) yields
Rbull ¼ þ3:20% and Rbear ¼ 2:1%. The persistent drift
towards the bull and bear equilibrium states (rather than the
simple mean regression) is evidenced by the positive slope
†The analysis in this paper was also performed on the S&P 500
and CRSP indices, which also exhibit bifurcated state behavior.
 A bifurcation model of market returns 5

of the conditional return map in the region near the mar-

0.63031
–0.09%

3.50%
ket’s long-term average return.
The maximum and minimum of the polynomial fit can
be found by setting the derivative of the polynomial with

0.14198
respect to R to zero and solving for R. The maximum trend

0.31%

3.00%
persistence for moderate positive returns, Rmax ðtÞ, occurs
after prior returns of 1.91% with an average daily return on
the subsequent day of slightly more than 0.142%. Trend

0.27745
0.18%

2.50%
persistence for moderate negative returns, Rmin ðtÞ, is great-
est after prior day returns of –1.19% at –0.084%. For large
returns in either direction (beyond the stable bull and bear
0.54809
0.07%

states, respectively), conditional returns become regressive

2.00%

towards the bull and bear equilibrium states. The r-squared

statistic, the regression coefficients and state characteristics
ðRbull ; Rbear ; Rmax and Rmin Þ are summarized, where applica-
0.00270
0.16%

1.50%

ble, for each of the conditions specified in tables 1 through

⁄

20 in table 21.
It is noted that a null is expected in the T -test p-values in
0.00001
0.14%

table 1 when the conditional return map crosses zero, indi-

1.00%
⁄

cating an equilibrium state. This occurs in the long-term

equilibrium region (–0.25%\RðtÞ\ þ 0:25%) for each of
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the cases evaluated and may also be expected at bull and

0.00055
0.09%

0.50%
⁄

bear equilibrium states. It is further noted that when a1

Table 2. DJIA CRM with Conditional Volume > 0.

approaches zero, the conditional return map is expected to

flatten out over a wider range for RðtÞ, and the T -test
0.44553
0.04%

0.00%

p-value in table 1 would not be expected to rule out the

null hypothesis. Finally, all cases are limited to conditional
returns after prior day returns within the region of –3.75%
0.01621

to +3.75%. Returns of magnitude greater than 3.75% are

–0.04%

–0.50%

considered outliers. Conditional returns for RðtÞ\  3:75%

⁄

are 0.095% with a standard deviation of 3.97%; returns

following RðtÞ[ þ 3:75% are +0.027% with a standard
0.01122
–0.10%

deviation of 2.64%. Neither result rejects the null hypothesis.

–1.00%
⁄

3.1. Conditional volume

0.00172
–0.20%

–1.50%

Table 2 and figure 4 present the conditional return map

⁄

for market periods following prior day rising volume.

A polynomial fit ðRðt þ 1Þ ¼ 155:42R3 þ 1:3192R2 þ
0:1427R  5E  05Þ to the data shows an r-square of
0.10707
–0.10%

–2.00%

0.785. Using the coefficients of the polynomial fit to calcu-

late equations (4) and (5) yields Rbull ¼ þ3:48% and
Rbear ¼ 2:64%. Thus the bifurcated bull and bear equilib-
0.57997

rium states have widened (moved further from equilibrium

–0.05%

–2.50%

at R  0Þ based on positive conditional volume. The market

has met the rising volume condition 50% of the time.
The polynomial fit in figure 4 suggests that the peak in
0.81880

trend persistence for moderate positive returns, Rmax ðtÞ,

0.07%

–3.00%

occurs approximately after prior returns of 2.06% with an

average daily return on the subsequent day of more than
0.209% and the drift is towards a stable bull state near
0.43854
0.36%

–3.50%

+3.48% where the positive side of the conditional return

map passes through zero. Trend persistence for moderate
negative returns, Rmin ðtÞ, is greatest after prior day returns
of –1.49% at –0.137%.
Prior Day Return, R(t)
Conditional Return,

Table 3 and figure 4 present the conditional return map

T-Test (p of Null)
>95% Not Null

for periods following a prior day decline in volume. The

<R(t+1)|R(t)>

conditional return map is consistent with a single equilib-

rium, mean regressive market. A polynomial fit ðRðt þ 1Þ ¼
158:7R3 þ 2:44189R2 þ 0:0252R þ 0:0003Þ to the data
 6 D. Nawrocki and T. Vaga
Figure 4. Conditional return map following prior day volume change >0% enhances bifurcated, trend persistent states which vanish with
declining volume.
shows an r-square of 0.794. Using the coefficients of the
polynomial fit to calculate equations (4) and (5) yields
Rbull ¼ þ2:25% and Rbear ¼ 0:71%. The peak in trend
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persistence for moderate positive returns, Rmax ðtÞ, occurs
approximately after prior returns of 1.4% with an average
daily return on the subsequent day of 0.010%. Trend persis-
tence for moderate negative returns vanishes as it is greatest
after prior day returns of about –0.38% at –0.035%. The
T -test p-values in table 3 also suggest that the data may not
be significantly different than expected from the null
hypothesis, so we conclude that trend persistence and the
bull and bear equilibrium state structure contract with
declining volume over the period examined. This result is
consistent with the concept of the market being an open
system that requires a flow of energy (money) to maintain
its dynamic structure. Declining volume is an indication
that the flow of money has dropped below levels needed to
dynamically maintain a bifurcated structure. The market has
met the declining volume condition 50% of the time. This
result is consistent with the results obtained by Morse
(1980).
3.2. Volatility
Tables 4 and 5 and figure 5 present the conditional return
maps for market periods following 200-day annualized vol-
atility of less than 25% and for periods when volatility was
greater than 25%. Polynomial fit r-square statistics are sum-
marized in table 21 along with state variables as applicable.
The bifurcated bull and bear equilibrium states are clearly
evident for volatility below 25%. However, above 25% vol-
atility the bifurcated bull and bear state structure vanishes
and gives way to a mean regressive dynamic.
The result that the market’s bifurcation structure vanishes
with increasing volatility is consistent with phase transitions
in physics. For example, the ordered magnetic state of a bar
of iron vanishes above a critical temperature as the random
thermal forces become larger than the cooperative forces
that tend to align individual molecules. In general, the posi-
tive feedback forces that create the dynamic equilibrium
states must be larger than the random disordering forces. In
financial markets, the random disordering forces are
apparent as annualized volatility increases beyond 25% for
the Dow Jones Industrial Average.
3.3. Bifurcation parameter and unstable transition
threshold
We examine the slope of the conditional return map for
moderate returns around the neighborhood of long-term
equilibrium, at RðtÞ  0, to define a bifurcation parameter.
If the market is in a mean regressive equilibrium state, the
slope near zero should be negative ða1 [0Þ while if
bifurcated, trend persistent states exist, the slope near zero
should be positive ða1 \0Þ. To specify a bifurcation
parameter, we use a 200-day sum of the conditional returns
in the region of moderate positive prior day returns
(0:025%\RðtÞ\2:25%) and subtract the 200-day sum of
moderate negative prior day returns (0:025%[RðtÞ[
2:25%). If the slope of the conditional return map near
zero is positive, as expected in bi-stable, trend persistent
markets, then the sum of returns after moderate positive
returns should also be positive. Moderate negative returns
should be followed, on average, by further negative trend
persistence. Therefore a positive bifurcation parameter indi-
cates a bi-stable market and a negative bifurcation parame-
ter indicates a single equilibrium state market.
By using the sum instead of the average conditional
return, we also have a metric of an idealized, cost-free, trad-
ing strategy that is long after positive prior day returns and
short after negative prior day returns. The bifurcation
parameter can therefore be viewed as a diagnostic test of
market efficiency. The larger the bifurcation parameter, the
greater the degree of trend persistence or coherence in the
market while the closer the bifurcation parameter is to zero,
the more efficiently the market is discounting the arrival of
new information. A negative value for the bifurcation
parameter means that a strategy that takes advantage of
mean regressive conditional returns would be profitable.
Hence the further the bifurcation parameter moves from
zero in either direction, the less efficient the market.
Figure 6 summarizes the bifurcation parameter for the
Dow Jones Industrial Average since 1929. The most signifi-
cant periods of ‘mean regressive state’ with negative
 Downloaded by [173.49.92.104] at 15:37 25 June 2013

Table 3. DJIA CRM with Conditional Volume < 0.

Conditional Return,
<R(t+1)|R(t)> 0.67% 0.80% 0.45% 0.03% –0.06% –0.06% –0.03% 0.01% 0.06% 0.06% –0.16% –0.16% 0.25% –0.17% –0.40%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.17212 0.15446 0.19695 0.97986 0.42319 0.04989 0.01279 0.56489 0.10610 0.41298 0.06426 0.33962 0.36212 0.51238 0.64545
⁄ ⁄ ⁄
>95% Not Null

Table 4. DJIA CRM with Volatility < 25%.

Conditional Return,
<R(t+1)|R(t)> 0.44% 0.13% 0.03% –0.08% –0.19% –0.09% –0.04% 0.03% 0.09% 0.12% 0.11% 0.19% 0.18% 0.29% 0.13%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.13125 0.59145 0.99272 0.19439 0.00002 0.00001 0.00028 0.85794 0.00003 0.00001 0.02205 0.00794 0.10362 0.12378 0.81577
⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄
>95% Not Null

Table 5. DJIA CRM wiith Conditional Volatility > 25%.

Conditional Return,
<R(t+1)|R(t)> 0.49% 0.37% 0.24% 0.01% 0.07% 0.03% 0.00% 0.00% –0.06% 0.03% –0.20% –0.50% 0.22% 0.01% –0.29%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.34239 0.30233 0.47007 0.93764 0.83092 0.95238 0.87704 0.88040 0.56858 0.96276 0.25111 0.02487 0.50300 0.95936 0.37505
⁄
>95% Not Null
A bifurcation model of market returns

Table 6. DJIA, Bifurcation Parameter > 5%.

Conditional Return,
<R(t+1)|R(t)> 0.46% 0.28% 0.13% –0.07% –0.28% –0.12% –0.05% 0.03% 0.12% 0.15% 0.11% 0.24% 0.09% 0.22% 0.00%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.26384 0.33788 0.50224 0.39670 0.00000 0.00003 0.00010 0.76611 0.00000 0.00000 0.07303 0.01881 0.58987 0.38531 0.92147
⁄ ⁄ ⁄ ⁄ ⁄ ⁄
>95% Not Null
7
 8 D. Nawrocki and T. Vaga

bifurcation parameter occurred following the crash of 1929.
During the 1930s there was also a great deal of volatility in
this indicator. In contrast, for many decades after the 1930s
the market enjoyed strong bi-stable, trend persistent behav-
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ior. Beginning in the mid-1970s the bifurcation indicator
decreased, on average, from prior decades. This suggests
that the markets have become more efficient since the
advent of negotiated commissions and computer trading

Figure 5. Conditional return map with moderate annualized volatility enhances bifurcated, trend persistent states which vanish with high
volatility.

Figure 6. Dow Jones Industrial Average bifurcation parameter for July 1929 to December 2010.

Figure 7. Dow Jones Industrial Average conditional return map with transition between mean regressive state and bifurcated trend
persistent states.
 Downloaded by [173.49.92.104] at 15:37 25 June 2013

Table 7. DJIA, –5% < Bifurcation Parameter < 5%.

Conditional Return,
<R(t+1)|R(t)> –0.11% 0.01% 0.08% –0.10% 0.02% 0.00% –0.02% 0.04% 0.02% 0.06% 0.12% 0.10% 0.86% 0.59% 0.77%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.80334 0.96527 0.83322 0.45002 0.97207 0.62653 0.23733 0.52735 0.93905 0.51145 0.25461 0.61594 0.08208 0.10520 0.52154
>95% Not Null

Table 8. DJIA, Bifurcation Parameter < –5%.

Conditional Return,
<R(t+1)|R(t)> 0.61% 0.33% 0.04% 0.02% 0.14% 0.01% 0.04% –0.02% –0.02% 0.01% –0.12% –0.61% –0.03% –0.19% –0.49%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.32550 0.42868 0.96050 0.99834 0.50797 0.86528 0.86450 0.33168 0.44013 0.88410 0.30579 0.00360 0.83256 0.48690 0.34482
⁄
>95% Not Null

Table 9. DJIA CRM 1929 – 1975.

Conditional Return,
<R(t+1)|R(t)> 0.64% 0.31% –0.07% 0.02% –0.20% –0.15% –0.09% 0.01% 0.11% 0.17% 0.00% –0.04% 0.24% 0.13% –0.15%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.132213722 0.260073989 0.639377383 0.933545434 2.10E–02 2.85E–04 4.91E–05 0.980012312 1.16E–05 2.26E–05 0.9192948 0.693437299 0.336948775 0.64723712 0.634654425
⁄ ⁄ ⁄ ⁄ ⁄
>95% Not Null
A bifurcation model of market returns

Table 10. DJIA CRM 1975 – 2010.

Conditional Return, <R(t
+1)|R(t)> 0.06% 0.13% 0.31% –0.13% –0.08% 0.00% 0.03% 0.04% 0.04% 0.06% 0.11% 0.04% 0.15% 0.15% –0.22%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.961217394 0.715573376 0.20451759 0.114365839 1.20E–01 3.04E–01 8.59E–01 0.842268979 9.33E–01 5.16E–01 0.127594679 0.99490159 0.320484075 0.575910093 0.636356396
>95% Not Null
9
 10 D. Nawrocki and T. Vaga
techniques. More specifically, for the period from 1940 to
1975 the bifurcation parameter had a high degree of coher-
ence with a yearly mean of 20% and standard deviation of
9%. In contrast, the post-1975 period exhibited a yearly
mean of only 5% with a standard deviation of 15%. The
1929 to 1940 period had a yearly mean of –6% with a stan-
dard deviation of 28%. A t-test of the difference of yearly
means for the 1940–2010 and 1975–2010 periods is signifi-
cant at the 5% level ð p ¼ 0:016Þ. This result indicates that
the market became more efficient after 1975.
We examine conditional returns for three cases of the
bifurcation parameter. Table 6 and figure 7 present the con-
ditional return map for the DJIA from May 1929 through
December 2010 for the case of the bifurcation parameter
(BP > + 5%). For this case the conditional return map is
clearly bifurcated.
Table 7 and figure 7 present the conditional return map
when the bifurcation parameter is within a narrow interval
around the bifurcation transition threshold (–5% < BP <
+5%). For this case, the map flattens out and the magnitude
of conditional returns is very small, producing an efficient
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market state over a wide range of RðtÞ. However, the bifur-
cation point is a singularity or critical point at which large
fluctuations may occur. Some evidence of critical fluctua-
Figure 8. Conditional return map indicates increased efficiency in the post-1975 period.
Figure 9. The conditional return map for the CRSP S&P 500 index indicates a significant bifurcation process over the period from 1962
to 2010.
tions appears at high positive RðtÞ where the return map
shows unstable trend persistence. In this transition area,
both bifurcated and single equilibrium points become irrele-
vant and the market may become globally unstable.
The case of a negative bifurcation parameter (BP < –5%)
is summarized in table 8 and shown in figure 7. This
includes the crisis of 2008. When the BP < –5%, the market
is in the over-reaction, mean regressive equilibrium state.
Volatility is very high in this state and large negative rever-
sals after positive RðtÞ are evident. The DJIA entered an
over-reaction, mean regressive market state as the crisis of
2008 unfolded. The conditional return map suggests that
the market over-reacts during crises and that a strategy of
shorting after a price rise may be effective.
3.4. Post-1975 market efficiency
Tables 9 and 10 and figure 8 present the conditional return
maps for the Dow Jones Industrial Average from the period
from May 1975 to December 2010 and the period before
May 1975. The period since 1975 corresponds to the advent
of negotiated commissions and increasing use of computer
trading techniques and the bifurcation parameter suggests
that the markets have been more efficient and less coherent.
 Downloaded by [173.49.92.104] at 15:37 25 June 2013

Table 11. S&P 500, BP > 5%.

Conditional Return,
<R(t+1)|R(t)> –0.38% –0.05% –0.15% –0.11% –0.21% –0.20% –0.04% 0.04% 0.08% 0.20% 0.18% 0.17% 0.52% 0.32% 0.54%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.465569163 0.850182644 0.468101308 0.255030671 8.40E–04 1.45E–08 5.14E–03 0.533650169 1.43E–02 9.79E–07 0.015488728 0.061459084 0.002947042 0.218701009 0.290454935
⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄
>95% Not Null

Table 12. S&P 500, –5% < BP < 5%.

Conditional Return,
<R(t+1)|R(t)> 0.29% 0.17% 0.14% 0.05% 0.17% 0.09% 0.06% 0.02% –0.03% –0.11% 0.14% –0.09% –0.28% 0.35% 0.41%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.4940146 0.91416457 0.382454112 0.317622251 8.22E–01 9.65E–01 3.04E–01 0.13142042 9.87E–02 2.25E–01 0.658726652 0.651555806 0.403768482 0.626617478 0.108967501
>95% Not Null
A bifurcation model of market returns

Table 13. S&P 500, BP < –5%.

Conditional Return,
<R(t+1)|R(t)> –0.01% 0.27% 0.23% 0.16% 0.16% 0.09% 0.13% 0.02% –0.06% –0.21% 0.18% –0.18% –0.21% 0.29% 0.41%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.957190455 0.769614286 0.514378109 0.665594769 2.74E–01 6.38E–01 1.45E–01 0.865307352 1.29E–01 1.24E–02 0.253786288 0.258471131 0.368277134 0.235703193 0.525281481
⁄
>95% Not Null
11
 12 D. Nawrocki and T. Vaga
It is noted that the T -test for cases examined in the post-
1975 period shown in tables 9 and 10 does not meet the
95% confidence level except in isolated situations. This is
consistent with the observation that the market has become
more efficient and the bifurcated state structure less evident
than has historically been the case.
3.5. CRSP S&P 500 (1962–2010)
Other market averages also show deviations from the
efficient market state. Figure 9 illustrates the data in tables
11, 12 and 13 for the conditional return maps for the S&P
500 from 1962 through December 2010 for three cases of
the bifurcation parameter corresponding to bifurcated,
transition and mean regressive states. The trend persistent
state with positive bifurcation parameter is highly statisti-
cally significant for moderate returns. The transition state
has a flat map within the range of moderate RðtÞ as
expected in an efficient market state. The mean regressive
state exhibits a conditional return map with negative slope,
but the high volatility and modest slope suggest that the
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efficient market state cannot be ruled out.
It is noted that, for large values of RðtÞ, there is relatively
little data and outliers can have a large effect on the
estimate of bull and bear equilibrium points. Therefore,
the main determining factor for the trend persistent state is
the statistically significant slope of the conditional return
map in the region of moderate RðtÞ. For the S&P500 over
the period shown, the trend persistence extends to relatively
large RðtÞ so an estimate of bull and bear state equilibrium
points must be based on extrapolation of kðRÞ using the
regression parameters summarized in table 21, which yield
Rbull ¼ 5:2% and Rbear ¼ 3:2%. Since these equilibrium
points are beyond most daily returns, we conclude that this
market is trend persistent for virtually all values of RðtÞ.
The maximum positive trend persistence of 0.372% occurs
at Rmax ¼ 3:1%, while the minimum or negative trend per-
sistence of –0.172% occurs at Rmin ¼ 1:8%.
A trading strategy to take advantage of trend persistence
can be specified as follows: hold long when the bifurcation
parameter is greater than +5%, annualized volatility is less
than 25%, and RðtÞ[0:5%, and short under the same con-
Figure 10. The conditional return map for the CRSP Equal Weight Index Including Dividends (EWIID) indicates strongly bifurcated
states but no significant mean regressive states over the period from 1926 to 2010.
ditions except when RðtÞ\  0:5%. These conditions
occurred for the S&P500 index 45% of the time and
yielded a pre-cost daily return of 0.166% with standard
deviation of 0.987% compared with a buy and hold over
the same period of 0.029% with a standard deviation of
1.023% ð p ¼ 7:34E  13Þ. Trading costs may substantially
reduce the net return and this trading specification may not
necessarily be effective in the future.
3.6. CRSP Equal Weighted Index Including Dividends
(EWIID)
The CRSP All Three Market Index includes all companies
trading on the NYSE and AMEX from 1926 to 1972 and
NYSE, AMEX, NASDAQ from 1972 to 2010. The equal
weight favors small capitalization companies. Figure 10 pre-
sents the conditional return maps in tables 14 and 15 for
the CRSP EWIID from 1926 through December 2010 for
two cases of the bifurcation parameter corresponding to
bifurcated and transition states. The EWIID does not have
enough data in the single equilibrium, mean regressive state
to provide a meaningful conditional return map. The trend
persistent state with positive bifurcation parameter is highly
statistically significant for moderate returns. The conditional
return map is also trend persistent for large returns. This is
a potentially unstable situation where large moves in either
direction are followed by further large moves in the same
direction.
The EWIID shows by far the greatest degree of trend
persistence and the least mean regressive behavior among
the indices examined. It is again noted that, for large values
of RðtÞ, there is relatively little data and outliers can have a
large effect so we limit the plots to moderate RðtÞ values
for the transition state. The main determining factor for the
trend persistent state is the slope of the conditional return
map in the region of moderate RðtÞ. Over the period shown,
the trend persistence extends to relatively large RðtÞ so
there are no bull and bear state equilibrium points for the
EWIID, suggesting that the smaller capitalization stocks are
trend persistent for virtually all values of RðtÞ. There is also
no peak in trend persistence as the coefficient of the cubic
term (summarized in table 21) is negative and adds to trend
 A bifurcation model of market returns 13

persistence for large RðtÞ rather than acting as a stabilizing

6.37365E–06

0.69929
–0.34%

3.50%
1.43%
factor.

⁄
3.50% A trading strategy to take advantage of trend persistence
can be specified as follows: hold long when the bifurcation

0.36400
parameter is greater than +5%, annualized volatility is less

0.68%

3.00%
0.000443268

than 25%, and RðtÞ[0:5%, and short under the same con-
1.42%

ditions except when RðtÞ\  0:5%. These conditions

3.00%

occurred for the CRSP EWIID 32.5% of the time and

0.62861
–0.32%

2.50%
yielded a pre-cost daily average return of 0.313% with stan-
0.00006
0.72%

dard deviation of 0.948% compared with a buy and hold

2.50%
⁄

over the same period of 0.087% with a standard deviation

0.01373
0.95% of 1.053% ð p ¼ 1:72E  64Þ. Trading costs may substan-
2.00%
⁄
tially reduce the net return and this trading specification
0.00006
0.49%

2.00%
⁄

0.19606 may not necessarily be effective in the future.

0.38%

1.50%
0.00000
0.43%

1.50%

3.7. CRSP Value Weighted Index Including Dividends

⁄

(VWIID)
0.78658
0.05%

1.00%

The CRSP All Three Market Index value weighted indexes

0.00000
0.36%

1.00%

are weighted by company market capitalization. This index

⁄

favors large capitalization companies while equal-weighted

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Table 15. CRSP EWIID, –5%< Bifurcation Parameter <5%.

0.68398

indexes give every company an equal weight regardless of

0.05%

0.50%
Table 14. CRSP EWIID, Bifurcation Parameter > 5%.

0.00000
0.20%

size. Figure 11 presents the conditional return maps in

0.50%
⁄

tables 16, 17 and 18 for the CRSP VWIID from 1926

through December 2010 for the same three cases of the
0.04100
–0.08%

0.00%

bifurcation parameter corresponding to bifurcated, transition

0.00001

⁄
0.04%

0.00%
⁄

and mean regressive market states. The trend persistent state

with positive bifurcation parameter is highly statistically
0.53522

significant for moderate returns. For large negative returns,

0.00%

–0.50%
0.00000
–0.13%

–0.50%

there is evidence of mean regression towards a bearish

⁄

equilibrium point. However, for large positive RðtÞ there is

only evidence of trend persistence. It is again noted that,
0.04480
–0.35%

–1.00%
0.00000

for large values of RðtÞ, there is relatively little data and

–0.21%

–1.00%

⁄
⁄

outliers can have a large effect on the estimate of bull and

bear equilibrium points. Therefore, the main determining
factor for the trend persistent state is the slope of the condi-
0.81480
0.00000

0.22%

–1.50%
–0.30%

–1.50%

tional return map in the region of moderate RðtÞ.

⁄

Over the period shown, the trend persistence extends to

relatively large RðtÞ so an estimate of bull and bear state
0.27631
0.00290

equilibrium points must be based on extrapolation of kðRÞ

–0.25%

–0.34%
–2.00%

–2.00%
⁄

using the regression parameters summarized in table 21,

which yield Rbull ¼ 6:6% and Rbear ¼ 2:4%. Since the bull
equilibrium point is beyond most daily returns, we
0.00170
–0.41%

0.86128
–2.50%

0.12%

–2.50%

conclude that this market is trend persistent for virtually all

⁄

positive values of RðtÞ. The maximum positive trend

persistence of 0.568% occurs at Rmax ¼ 4:1% while the
minimum or negative trend persistence of –0.131% occurs
0.014998755

0.21254
–0.53%

0.99%

–3.00%

at Rmin ¼ 1:3%.
–3.00%
⁄

The transition state is evident in the flat conditional

return map when the bifurcation parameter is within 1.5%
of zero. This corresponds to an efficient market state over a
0.07507
0.000682072

2.96%

–3.50%
–1.01%

wide range of RðtÞ. The mean regressive state exhibits a

–3.50%
⁄

conditional return map with negative slope, in the region of

moderate RðtÞ. However, the high volatility and modest
Prior Day Return, R(t)

slope suggest that the efficient market state cannot be ruled

Conditional Return,
Prior Day Return, R(t)

T-Test (p of Null)

out in the over-reaction case.

Conditional Return,

>95% Not Null

T-Test (p of Null)

<R(t+1)|R(t)>

A trading strategy to take advantage of trend persistence

>95% Not Null
<R(t+1)|R(t)>

can be specified as before: hold long when the bifurcation

parameter is greater than +5%, annualized volatility is less
than 25%, and RðtÞ[0:5%, and short under the same
 14 D. Nawrocki and T. Vaga
Figure 11. The conditional return map for the CRSP Value Weighted Index Including Dividends (VWIID) indicates a significant
bifurcation process over the period from 1926 to 2010.
conditions except when RðtÞ\  0:5%. These conditions
occurred for the CRSP VWIID 32.2% of the time and
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yielded a pre-cost daily average return of 0.18% with
standard deviation of 0.936% compared with a buy and
hold over the same period of 0.038% with a standard devia-
tion of 1.079% ð p ¼ 1:72E  26Þ. Trading costs may sub-
stantially reduce the net return and this trading specification
may not necessarily be effective in the future.
These results from the CRSP equal and market cap
weighted indexes support Groth (1979), who suggested
that there are information-rich (large cap) and information-
poor (small cap) markets (possibly depending on the
number of analysts following a company) based on market
capitalization.
3.8. Bifurcation parameter in the crisis of 2008
The behavior of the bifurcation parameter is presented in
figure 12 for the period 1995 to 2010. The DJIA was in an
over-reaction (mean regressive) phase throughout the
financial crisis of 2008. The DJIA Bifurcation Parameter
(DJIA-BP) reached negative levels not seen since the Great
Depression Era of the 1930s. The S&P 500 and the VWIID
were also in an over-reaction (mean regressive) phase
throughout the financial crisis of 2008. The S&P 500
Bifurcation Parameter (S&P500-BP) reached extreme nega-
tive levels, indicating a strong deviation from the rational,
efficient market state. The VWIID Bifurcation Parameter
(VWIID-BP) also reached extreme negative levels, suggest-
ing a strong deviation from the efficient market state.
However, due to the extreme volatility and fairly limited
amount of data, the null hypothesis (i.e. efficient market
state) cannot be rejected.
While the major market indices all registered over-
reactive behavior, the EWIID, which reflects the behavior
of small capitalization stocks, showed the least over-
reaction and mean regression. The small capitalization
stock index is clearly furthest from equilibrium (efficient
market state) with a strong predisposition towards trend
persistence.
4. Discussion of results relative to market efficiency
Within the context of the bifurcation model of conditional
market returns, an efficient market occurs at the equilibrium
points Rbull and Rbear . At these points the average condi-
tional return is equal to zero and, on a short-term basis,
conditional returns fluctuate in a random walk around zero
due to the new information arrival process. This is where
there is no undisseminated information. The market neither
over-reacts, nor under-reacts. It is neither mean regressive
nor trend persistent at these dynamic equilibrium points,
where conditional returns operate as a random walk in
response to new information arrival (zero mean). However,
an efficient market is not a binary concept, i.e. it is efficient
or inefficient. We do have information, transaction, and
analysis costs in the real world. As a result, when the mar-
ket is far away from these equilibrium points, returns exe-
cute a biased random walk where the mean return is
specified by the conditional return map. If this mean return
exceeds the associated costs, the markets may offer profit-
able trading opportunities.
The efficient capital market (ECM) hypothesis is consis-
tent with this world of costs. As long as the profits avail-
able from taking advantage of mispricing in the market
(market disequilibrium) do not exceed the costs (informa-
tion, transaction and analysis), then the market is efficient.
This is the concept that is embodied in the statement “you
cannot beat the market.” Within the context of the bifurca-
tion model of conditional market returns, as returns deviate
from Rbull and Rbear there is undisseminated information in
the form of over-reaction by market agents with returns
greater than Rbull or less than Rbear , and under-reaction
otherwise, resulting in predictable drifts toward these equi-
librium states. In this case, market efficiency and profitable
arbitrage opportunities depend on transaction costs relative
to the magnitude of the predictable component of condi-
tional returns. A summary of the bull and bear equilibrium
states along with the maximum and minimum rate of drift
toward these equilibrium points is presented in table 21.
These states only apply to bifurcated states; single equilib-
rium and unstable states are designated as N/A.
 Downloaded by [173.49.92.104] at 15:37 25 June 2013

Table 16. CRSP VWIID, Bifurcation Parameter > 5%.

Conditional Return,
<R(t+1)|R(t)> 0.30% 0.25% –0.07% –0.22% –0.15% –0.17% –0.07% 0.03% 0.15% 0.21% 0.25% 0.30% 0.16% 0.52% 0.64%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.35516 0.27803 0.46111 0.00509 0.00087 0.00000 0.00000 0.25008 0.00000 0.00000 0.00000 0.00162 0.39047 0.02488 0.01662
⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄ ⁄
>95% Not Null

Table 17. CRSP VWIID, –5%< Bifurcation Parameter <5%.

Conditional Return,
<R(t+1)|R(t)> –0.18% 0.81% –0.78% –0.38% –0.05% –0.01% –0.02% 0.02% 0.00% 0.06% –0.03% 0.17% 0.72% 1.85% 0.34%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.83775 0.22416 0.13950 0.28105 0.50893 0.54515 0.35767 0.55800 0.33202 0.77129 0.65974 0.29483 0.01700 0.41377 0.61615
⁄
>95% Not Null
A bifurcation model of market returns

Table 18. CRSP VWIID, Bifurcation Parameter <–5%.

Conditional Return,
<R(t+1)|R(t)> –0.42% –0.45% 0.37% –0.11% 0.18% –0.01% 0.15% –0.12% 0.00% –0.03% –0.10% 0.35% –0.24% 0.47% –0.01%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.47372 0.20246 0.16907 0.50265 0.30203 0.74316 0.22273 0.01531 0.51327 0.50152 0.30372 0.24279 0.26348 0.35135 0.93827
⁄
>95% Not Null
15
 16 D. Nawrocki and T. Vaga

Figure 12. The bifurcation parameter indicates increasing market efficiency for the major market indexes following the technology boom
of the 1990s and a severe over-reaction market during the crisis of 2008.
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Figure 13. The DJIA conditional return map exhibits a mean regressive state when the bifurcation parameter is less than –5% and
annualized volatility is above 25% as can occur in highly inefficient crisis markets.

If we allow arbitrage profits to exceed costs, then the
market may be described as an effective market. In this
market, arbitrage opportunities do exist that allow the inves-
tor to ‘beat the market’. This also means that somebody in
the market is foregoing the opportunity and is losing
money, which increases their costs. Why would people con-
tinue to participate in this market? They participate because,
overall, the market system provides a better allocation of
resources (allocational efficiency) at a lower operating cost
(operating efficiency) than any alternative system such as
barter or communism. When the mispricing costs become
too severe and people lose confidence in the market as a
viable way to allocate resources, then people will leave the
market causing it to collapse. As long as a market is able to
attract people and capital, it will be effective and will sur-
vive. If people perceive the market as being grossly unfair
to them, then they will take their capital and leave the
market. Without people and capital, the market will
collapse. Within the context of the bifurcation model of
market returns, the equilibrium states, Rbull and Rbear , col-
lapse under crisis market conditions (when the normal flow
of market capital is disrupted), resulting in a single equilib-
rium market state, sometimes with negative mean, as
market agents are willing to accept losses in order to leave
the market.
The over-reaction market is quite infrequent, highly vola-
tile and at times has been the least efficient market state, as
measured by the bifurcation parameter’s deviation from
zero. In order to further characterize this market state, we
consider the case of the bifurcation parameter less than –
5% and market volatility above 25%. Figure 13 summarizes
the conditional return map in table 19 for this combination
of conditions (which only occurs 5% of the time). It also
shows the conditional return map for the balance of the
time (table 20) when the volatility, or the bifurcation param-
eter, does not fall within the specified range. While there
are numerous ‘whipsaw’ periods of short duration, the three
longest periods for the DJIA in this state have occurred in
crisis market conditions, including two periods for a total of
29 months during the Great Depression and 11 months dur-
ing the crisis of 2008.
During the crisis market periods, reversals after positive
RðtÞ of any magnitude would have yielded a daily return of
–0.24% with a standard deviation of 2.47%. This return
occurred for 2.7% of the time and is statistically significant
ð p ¼ 1:35%). When these conditions are not in effect, the
return after any positive RðtÞ was 0.087% with a standard
deviation of 0.93%. This occurred 49.3% of the time and is
statistically significant ð p ¼ 2:45E  07Þ. The buy and hold
over the same period yielded 0.024% with a standard
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Table 19. DJIA, Bifurcation Parameter <–5% AND Volatility > 25%.
Conditional Return,
<R(t+1)|R(t)> 0.70% 0.44% 0.21% –0.11% 0.27% 0.01% –0.13% –0.20% –0.01% –0.04% –0.22% –1.45% –0.23% –0.31% –0.33%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.30929 0.40222 0.68027 0.69376 0.54380 0.95648 0.51622 0.19891 0.87998 0.79169 0.45104 0.00063 0.51590 0.37912 0.53771
⁄
>95% Not Null
A bifurcation model of market returns

Table 20. DJIA, Bifurcation Parameter > –5% OR Volatility < 25%.
Conditional Return,
<R(t+1)|R(t)> 0.34% 0.28% 0.07% –0.14% –0.30% –0.11% –0.05% 0.03% 0.10% 0.14% 0.10% 0.25% 0.15% 0.27% 0.11%

Prior Day Return, R(t) –3.50% –3.00% –2.50% –2.00% –1.50% –1.00% –0.50% 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00% 3.50%
T-Test (p of Null) 0.39264 0.28898 0.74523 0.10828 0.00000 0.00003 0.00007 0.97768 0.00001 0.00001 0.07425 0.00778 0.27153 0.21402 0.75992
⁄ ⁄ ⁄ ⁄ ⁄ ⁄
>95% Not Null
17
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18

Table 21. k(R) Parameters and State Characteristics.

r2 a0 a1 a2 a3 Rbull Rbear Rmax Rmax(t+1) Rmin Rmin(t+1)

Table 1. DJIA Conditional Return Map (CRM)

R(t+1) = –152.46R3 + 1.6554R2 + 0.1035R – 0.0001 0.85 0.0001 -0.1035 –1.6554 152.46 3.204% –2.119% 1.909% 0.142% –1.185% –0.084%
Table 2. DJIA CRM with Conditional Volume > 0
R(t+1) = –155.42R3 + 1.3192R2 + 0.1427R – 5E–05 0.78 5.00E–05 –0.1427 –1.3192 155.42 3.484% –2.635% 2.055% 0.209% –1.489% –0.137%
Table 3. DJIA CRM with Conditional Volume < 0
R(t+1) = –158.7R3 + 2.4418R2 + 0.0252R – 0.0003 0.79 3.00E–04 –0.0252 –2.4418 158.7 2.246% –0.707% 1.403% 0.010% –0.377% –0.035%
Table 4. DJIA CRM with Annualized Volatility < 25%
R(t+1) = –133.16R3 + 2.3638R2 + 0.1262R – 0.0002 0.92 0.0002 –0.1262 –2.3638 133.16 4.092% –2.316% 2.465% 0.235% –1.282% –0.115%
Table 5. DJIA CRM wiith Conditional Volatility > 25%
R(t+1) = –45.482R3 + 1.7673R2 – 0.0384R – 0.0005 0.59 0.0005 0.0384 –1.7673 45.482 N/A N/A N/A N/A N/A N/A
Table 6. DJIA CRM with Bifurcation Parameter > 5%
R(t+1) = -168.18R3 + 2.2316R2 + 0.1355R – 0.0002 0.84 0.0002 –0.1355 –2.2316 168.18 3.578% –2.252% 2.140% 0.207% –1.255% –0.122%
Table 7. DJIA CRM with –5% < Bifurcation Parameter < 5%
R(t+1) = 64.769R3 + 3.2245R2 + 0.0518R + 0.0001 0.81 –0.0001 –0.0518 –3.2245 –64.769 N/A N/A N/A N/A N/A N/A
Table 8. DJIA CRM with Bifurcation Parameter < –5%
R(t+1) = –84.409R3 + 0.7372R2 – 0.0332R – 0.0005 0.72 0.0005 0.0332 –0.7372 84.409 N/A N/A N/A N/A N/A N/A
Table 9. DJIA CRM 1929 – 1975
R(t+1) = –190.97R3 + 2.4032R2 + 0.132R – 0.0005 0.8 0.0005 –0.132 –2.403 190.97 3.332% –2.074% 1.994% 0.157% –1.155% –0.141%
Table 10. DJIA CRM 1975 – 2010
R(t+1) = –75.134R3 – 0.0126R2 + 0.0537R + 0.0005 0.25 –0.0005 –0.0537 0.0126 75.134 2.665% –2.682% 1.538% 0.105% –1.549% –0.006%
Table 11. S&P 500, Bifurcation Parameter > 5%
R(t+1) = –94.402R3 + 1.8522R2 + 0.1557R – 7E–05 0.88 0.00007 –0.1557 –1.8522 94.402 5.159% –3.197% 3.088% 0.372% –1.780% –0.172%
Table 12. S&P 500, –5% < Bifurcation Parameter < 5%
R(t+1) = 0.0064R + 0.0003 0.02 –0.0003 –0.0064 0 0 N/A N/A N/A N/A N/A N/A
Table 13. S&P 500, Bifurcation Parameter < –5%
D. Nawrocki and T. Vaga

R(t+1) = –0.0545R + 0.0004 0.17 –0.0004 0.0545 0 0 N/A N/A N/A N/A N/A N/A
Table 14. CRSP EWIID, Bifurcation Parameter > 5%
R(t+1) = 141.36R3 + 2.3172R2 + 0.175R + 0.0004 0.97 –0.0004 –0.175 –2.3172 –141.36 N/A N/A N/A N/A N/A N/A
Table 15. CRSP EWIID, –5% < Bifurcation Parameter < 5%
R(t+1) = 0.0979R + 0.0004 0.21 0.0004 –0.0979 0 0 N/A N/A N/A N/A N/A N/A
Table 16. CRSP VWIID, Bifurcation Parameter > 5%
R(t+1) = –89.839R3 + 3.7791R2 + 0.1419R – 0.0003 0.85 0.0003 –0.1419 –3.7791 89.839 6.600% –2.393% 4.091% 0.568% –1.287% –0.131%
Table 17. CRSP VWIID, –5% < Bifurcation Parameter < 5%
R(t+1) = 0.0157R – 4E–05 0.24 0.00004 –0.0157 0 0 N/A N/A N/A N/A N/A N/A
Table 18. CRSP VWIID, Bifurcation Parameter < –5%
R(t+1) = –0.0743R + 8E–05 0.48 0.00008 –0.0743 0 0 N/A N/A N/A N/A N/A N/A
Table 19. DJIA, BP <–5% AND Volatility > 25%
R(t+1) = –0.1493R – 0.001 0.48 0.001 0.1493 0 0 N/A N/A N/A N/A N/A N/A
Table 20. DJIA, Bifurcation Parameter > –5% OR Volatility < 25%
R(t+1) = –137.2R3 + 1.6602R2 + 0.1262R + 8E–05 0.79 –8.00E–05 –0.1262 –1.6602 137.2 3.698% –2.488% 2.200% 0.220% –1.394% –0.098%
 A bifurcation model of market returns
deviation of 1.16%. Therefore, the bifurcation model offers
a specific, testable trading strategy that can potentially out-
perform the market (subject to trading costs) by taking
advantage of either the over-reaction or under-reaction mar-
ket inefficiencies. However, there is no assurance that these
criteria for market inefficiency will be effective for all mar-
kets or future market conditions.
5. Summary and conclusions
Empirical evidence suggests that, historically, the stock mar-
ket has deviated from the efficient market state, primarily in
an under-reaction, trend persistent state, drifting towards
either a bull state equilibrium point or bear state equilib-
rium. A long-term positive bias in economic fundamentals
shifts the bull and bear state equilibrium points toward posi-
tive returns. Returns following days with increasing volume
and in periods of moderate volatility have, on average,
wider dynamic equilibrium points. Conditional returns fol-
lowing prior day volume declines or periods of annualized
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volatility greater than 25% do not exhibit significant trend
persistence. Under these conditions, the bull and bear state
equilibrium points converge back toward a single long-term
equilibrium state.
A bifurcation parameter, which is related to the slope of
the conditional return map in the neighborhood of moderate
prior day returns, illustrates that the bifurcation dynamic
may change over time. Therefore, markets can be viewed
as restructuring their information structure, both on a short-
term basis in response to volume and volatility and on a
longer time scale as a function of changing market condi-
tions such as the advent of negotiated commissions and
computerized trading. The bifurcation parameter may be
interpreted as a quantitative assessment of market efficiency
and indicates that the market has become increasingly effi-
cient since the advent of negotiated commissions and com-
puter-based trading.
Within the context of evolutionary, state transition theory
the efficient market state is poised at the critical transition
between bifurcated states and the disordered, mean regres-
sive market state. This transition state requires a critical
flow of money or credit. Not enough credit and liquidity
problems may occur and lead to an over-reaction, mean
regressive market inefficiency. Too liberal a credit policy,
on the other hand, can lead to an excessive trend persis-
tence market inefficiency where bubbles can develop and
lead to chaotic trend reversals.
Even as the major, high capitalization indexes indicate
increased efficiency, on average, in recent years, the High
Tech Bubble of 2000 and the crisis of 2008 serve as a
reminder that markets are vulnerable to both too liberal
credit availability as well as disruptions in credit and associ-
ated over-reaction responses by market agents. Even when
the credit issues are resolved, the efficient market state is
inherently a critical or singular state where price fluctua-
tions may become unstable.
The bifurcation model offers new insights into the mar-
ket’s information dissemination process. The linear random
walk theory is insufficient to explain persistent trending and
19
market equilibrium states far from the market’s long-term
average return. Empirical evidence confirms the relevance
of the evolutionary concepts of Nicolis and Prigogine
(1977) to the financial markets as noted by Nawrocki
(1984). The methods proposed by Haken (1975) provide
useful insights into financial market dynamics and empirical
evidence confirms the relevance of phase transition models
to the financial markets. Further research is recommended
to determine more precisely the economic and business
cycle factors that govern the bifurcation of market equilib-
rium states and the dynamics of bull and bear states far
from equilibrium.
Acknowledgements
The authors wish to thank William Carter, George
Phillipatos, Fred Viole, and anonymous referees for their
comments on this paper. All remaining errors are the
responsibility of the authors.
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