Joseph Effect

What Is the Joseph Effect?

The Joseph Effect is a term derived from the Old Testament story about the Pharaoh’s dream as recounted by Joseph. The vision led the ancient Egyptians to expect a crop famine lasting seven years to follow seven years of a bountiful harvest.

Understanding the Joseph Effect

The Joseph Effect is a term coined by mathematician Benoit Mandelbrot and postulates that movements over time tend to be part of larger trends and cycles more often than being random. Mandelbrot drew his theories from the Old Testament story of Joseph recounting the Pharaoh’s dream of seven fat cows being devoured by seven lean cows. The interpretation was that following seven good years of crop harvesting, seven bad years would follow.

Seven good years are known as the Joseph Effect, while the seven bad years are known as The Noah Effect. Interestingly, the seven-year cycle is commonly found in modern economic analysis as a predictor of recession timing.

The Joseph Effect and the Noah Effect are early examples taken from history showing that man was attuned to cycles in nature and wanted to become better able to predict future outcomes from recent experience. Human behavior is affected in great part by recent experience, with a tendency to forget some of the more random, and disruptive, lessons of the distant past.

Mathematicians set out to quantify these observed cycles into predictable formulas, and Mandelbrot quantified The Joseph Effect using the Hurst component. The Hurst component quantifies regression toward 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 an area of the world has been in a drought, the odds are high it will remain in drought for some time to come. A baseball team that has been winning recent games is likely to continue winning. If a stock price has been rising steadily, the likelihood of this continuing is strong. Technical analysts use trend lines to show this persistence principle.

The Joseph Effect and Leading Indicators

The Joseph Effect and the Noah Effect are just two of many mathematical trend analyses used by savvy investors. For example, chart analysis is an important tool in predicting future stock price movements. Investors look at volume trends, price ranges, momentum indicators, leading indicators, and lagging indicators.

Leading indicators and lagging indicators are especially important to classify and understand. Commonly used leading indicators include the Consumer Confidence Index, the Purchasing Managers Index, and movements in bond yields, especially when an inverted yield occurs. Corporate hiring plans are also a significant leading indicator.