The Physics of Price Discovery: Deconvolving Information, Volatility, and the Critical Breakdown of Signal during Retail Herding

Sungwoo Kang

Papers from arXiv.org

Abstract: Building on the finding that Market Cap Normalization ($\SMC$) isolates the ``pure'' directional signal of informed trading \citep{kang2025}, this paper investigates the physics of how that signal is transmitted -- and how it breaks down. We employ \textbf{Tikhonov-regularized deconvolution} to recover the impulse response kernels of investor flows, revealing a dual-channel market structure: Foreign and Institutional investors act as ``architects'' of price discovery (positive permanent impact), while Individual investors act as liquidity providers (negative total impact). However, using \textbf{Multivariate Hawkes Processes}, we demonstrate that this structure is fragile. We find that individual investor order flow exhibits near-critical self-excitation (Branching Ratio $\approx$ 0.998). During periods of high retail herding, the market undergoes a \textbf{phase transition} into a ``critical state.'' In this regime, the signal-to-noise ratio collapses, causing the price impact of sophisticated investors to reverse from positive to negative. These findings suggest that retail contagion acts as a physical barrier that temporarily disables efficient price discovery.

Date: 2026-01
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