The Likely Impact of US Presidential Elections on the Stock Markets

Thus elections, quite apart from who won them, performed a powerful cultural function for the elites. To the degree that -everyone had a right to vote, elections fostered the illusion of equality. Voting provided a mass ritual of reassurance, conveying to the people the idea that choices were being made systematically, with machine-like regularity, and hence, by, implication, rationally. Elections symbolically assured citizens that they were still in command—that they could, in theory at least, deselect as well as elect leaders. In both capitalist and socialist countries, these ritual reassurances often proved more important than the actual outcomes of many elections. Alvin Toffler, The Third Wave chapter 75

It’s the eve of the much awaited 2012 US national elections.

On November 6^th Tuesday many Americans will flock to their respective precincts to exercise their suffrage. The national elections will cover the executive (President-Vice President) and the legislative branches (Senate and House of Representatives) as well as some positions at the state level[1].

The Follies of Pattern Seeking Behavior

We are told that certain outcomes from the coming election may lead to specific results on the financial markets.

For instance, a Barclay’s survey on professional investors[2] proposed that a Romney victory would be good for stocks while Obama’s re-election will favor the bond markets.

Others suggested that the elected President’s political party matters. The median return for the S&P 500 favors a Democrat President over a four year period, as against a Republican President who may spur a short term rally. All these are based on statistics derived from historical data[3].

For me, surveys are hardly reliable measures of the tradeoffs between profits and risks.

What people say and what they actually do may be different. Many people talk to signal Social Desirability Bias or to say things in a matter that they will be viewed favorably[4]. 

People are also highly sensitive to changes in preferences due to many factors as new information, social pressures, and more. Besides, surveys can also yield distortive results based on the influence from how questions are framed by the pollster.

Further, candidness of the survey participants also account for as another important variable to be leery on.

On the other hand, statistical constructs based on historical events signify as veneer to people’s desire to seek patterns in order to deal with uncertainty or to simply tell stories again for social signaling purposes.

Yet historical events are complex phenomena that had been arrived at through multifarious causes. They cannot simply be oversimplified or seen or interpreted as homogenous replication of the current environment. Even Wall Street acknowledges this dynamic through the axiom: Past performance does not guarantee future results.

Thus assignment of numerical probabilities on partially similar episodes, are not only irrelevant in forecasting the future, but such accounts for a form of entertainment to its practitioners.

As I previously wrote[5],

numerical probabilities serve to gratify one’s cognitive biases which in essence is a form of self-entertainment rather than a dependable methodology for risk analysis

Pattern seeking behavior can also be representative of the gambler’s fallacy or the Monte Carlo fallacy, which Investopedia.com defines as[6]:

When an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.

Yet there has been no precedent in terms of the scale of policymaking for any meaningful comparison to be made with past US national elections.

Such distinction even holds true in terms of other social phenomenon such as technological advances or innovation and of the diffusion of voluntary exchanges expressed as globalization

Yet social policies, which shape people’s incentives to save, invest, produce and consume, implemented and enforced through the political spectrum, have reached extraordinary proportions.

Regulatory growth has morphed into a large scale bureaucratic quagmire. Notes Mises Institute President Douglas French[7],

The Federal Register, a publication with all the country’s (federal, nonclassified) rules is now over 81,000 pages long. President Obama’s Affordable Care Act is 906 pages. The Dodd-Frank Act totals 849 pages. Once upon a time, in 1913, the Federal Reserve was created with only 31 pages. The U.S. Constitution required only six pages.

It would account for as a glaring mistake to construe neutral effects from these new-fangled edicts or rules or decrees on people’s economic and social activities.

Moreover, systemic debt has been ascending to unsustainable levels.

Chart from Dr. Ed Yardeni’s Flow of Funds[8]

Financial analyst and fund manager Doug Noland recently observed of the political imperative to keep the system afloat[9]

After beginning 1990 at $12.8 TN, Total System Marketable Debt ended June 2012 at $55.0 TN.  And Washington politicians and central bankers are now doing everything they can to sustain the Credit boom and avert the downside of an historic Credit cycle.  Similar efforts are afoot globally.  

The accelerating erosion of America’s productive dimensions has been due to the escalating welfare state, ballooning bureaucracy and other state based expenditures which transfers scarce and valuable resources to non-productive political based spending and entitlements, which has also been crowding out the private sector. Chart from Heritage Foundation[10]

America’s social policies have also led to the unparalleled deployment of the US Federal Reserve as chief provider of funds for the US government.

In 2011, more than half or 61% of US debts had been monetized by the US Federal Reserve. US Federal holding of US treasury debts of all maturities has surpassed $1.8 trillion (lower window).

This represents the highly fluid debt economics of the US government, where the Fed has stepped up the plate relative on the declining interests from the private sector, as well as, foreign public and private investors (upper window).

As Mr. Lawrence Goodman, president of the Center for Financial Stability wrote at the Wall Street Journal early this year

The Fed is in effect subsidizing U.S. government spending and borrowing via expansion of its balance sheet and massive purchases of Treasury bonds. This keeps Treasury interest rates abnormally low, camouflaging the true size of the budget deficit. Similarly, the Fed is providing preferential credit to the U.S. government and covering a rapidly widening gap between Treasury's need to borrow and a more limited willingness among market participants to supply Treasury with credit.

The failure by officials to normalize conditions in the U.S. Treasury market and curtail ballooning deficits puts the U.S. economy and markets at risk for a sharp correction.

The point being: The current state of imbalances borne out of America’s political dynamics has been unmatched in scale and depth. This only means that America’s future will depend on the actions of political authorities which will either deepen systemic fragility or take remedial but highly painful measures.

Risk Reward analysis, thus, requires a focus on the actions of policymakers.

Campaign Promises Hardly Are Reliable Measures of Projecting Future Policies

It would be conceivably naïve to rely on political rhetoric of competing candidates as basis for examining and projecting prospective policies.

Politicians usually appeal to the views the median voter to ensnare votes. In other words, politicians, who are running for office, are predisposed to say what the public wants or expects to hear.

On the obverse end, people hardly vote for policies but for symbolisms which these candidates represent. Thus aspiring politicians work hard to project themselves as symbols to reinforce people’s biases.

And this is why politicians usually end up with unfulfilled promises or have usually gone against their rhetorical assurances made during the campaign sorties.

Voters become useful only to politicians when election season arrives.

Take for instance, the Reason Magazine enumerates[11] some of the unmet campaign pledges by presidential candidate Barack Obama in 2008:

1. Creating five million green jobs.

Unfortunately President Obama’s green energy industry has been suffering from a string of high profile bankruptcies[12], which includes the controversial Solyndra scandal.

The highly influential think tank Council of Foreign Relations recently noted that Obama’s creation of green jobs from the green energy sector have penalized taxpayers heavily relative to the other non-renewable energy industries[13]

2. Balance the budget

As of Monday October 29^th, the US is on path to reach its debt limits before 2013. According to the Reuters[14], the U.S. Treasury was $235 billion below the $16.4 trillion statutory ceiling on the amount it can borrow.

3. Refusing to raise taxes on the Middle class

The passage of Obamacare translates to 21 new taxes or tax increases affecting the middle class too.

4. Reforming Immigration 

The Reason.com says that the Obama administration has been deporting illegal immigrants like crazy, leaving Hispanic Caucus Democrats in the awkward position of changing the subject to health care, and otherwise blaming Republicans.

5. Restoring America’s moral standing in the world

President Obama has been expanding the theatre of warfare to include Pakistan, Yemen and Libya and from the backdoor, Syria[15].

So whether Obama or Romney, there will unlikely be any radical changes in the political structure to headoff the looming debt crisis.

This goes to show that elections have mainly been used to justify policies which benefit many entrenched power blocs operating behind the scenes.

Given the above conditions, the pricing dynamics of the markets will, thus, represent expectations from the feedback loop mechanism between policies and market responses to them.

The late illustrious French American mathematician Benoit Mandelbrot in his book The Misbehavior of Markets[16] dealt with the difference of economics with natural science.

Finance is a black box covered by a veil. Not only are the inner workings hidden, but the inputs are also obscured, by bad economic data, conflicting news report or outright deception…And then there is the most confounding factor of all, anticipation. A stock price rises not because of good news from the company, but because the brightening outlook for the stock means investors anticipate it will rise further, and so they buy. Anticipation is a feature unique to economics. It is psychology individual and the mass—even harder to fathom than the paradoxes of quantum mechanics. Anticipation is the stuff of dreams and vapors.

Anticipation is part of human action. People’s divergent expectations, anticipations, and responses are what differentiate economics from natural sciences.

Yet anticipation of the prospective polices, the actual policies, and of its attendant effects on the marketplace will most likely anchor on market dynamics post-election season.

Unlikely Change of Direction for Fed Policies in case of a Change of Administration 

A good test of these will be to assess the scenario of a Romney victory (Although I have big doubts of a Romney win. In a close battle, the incumbent have the edge. This is because they hold the political machinery which can be used to their advantage through whatever means).

Yet under a Romney victory, would the new President discharge on his vows to replace the incumbent chairman US Federal Chairman Ben Bernanke at the expiry of the latter’s term? Will Mr. Romney spearhead through his appointee a massive overhaul to the US Federal Reserve’s current policies? I don’t think so.

Given the reality or the fact that the US government’s huge budget deficits heavily depend on the US Federal Reserve for financing, it is unlikely that the Romney appointee to rock on the establishment’s boat.

I have predicted in the past[17] and have been validated that Fed Chairman Ben Bernanke would work to ensure Obama’s re-election through “stock market friendly” policies. This places an ethical issue of the agency problem or conflict of interests between Mr. Bernanke and his policies which affects the average Americans on the political table. 

To downplay the political bias from his recent action, Ben Bernanke has floated to media the possibility of his retirement even if Obama wins[18]. Of course, the re-elected President Obama can always “persuade” Mr. Bernanke to change his mind. 

Mr. Bernanke seems to be applying the same communications signaling strategy to the public for his personal affairs. This leaves a bad taste on the mouth for Bernanke apologists.

As an aside, all the blarney about “QE forever” designed as monetary policy to supposedly aid the economy through the spending transmission channels of the wealth effect, has really been a diversion, if not a subordinated priority, to the real or primary objective: the FED as contingent financier to the US government’s intractable US budget deficit as expressed through surging debt levels.

Yet candidates floated by the mainstream[19], particularly Glenn Hubbard, Greg Mankiw and John Taylor, to replace Mr. Bernanke have mostly been “dovish” or in favor of the Fed’s contemporary policies (This is with the exception of John Taylor, of the Taylor rule fame, whom I don’t think stands a chance). 

In addition, the composition of voting members of the FOMC has been, and will be, most likely leaning towards the “doves” or conformists.

Such would include the previously vacant seats which were recently filled (Jeremy Stein and Jerome Powers), aside from the replacement of the 4 voting regional Federal Reserve Presidents, as part of the customary rotational process, which again favors the “doves”[20]

At the end of the day, regardless of whoever wins, US policies will remain embedded to the interests of the political economic establishment. Changing personalities who runs the same show hardly accounts for a change in the system.

And as such policies will likely remain accommodative primarily to shield the US government from interest rate and credit risks, which should for the meantime, benefit the financial markets, particularly stocks, bonds and commodities (yes despite last Friday’s shakeout) whom have been the secondary beneficiaries.

After all, the main risks I believe will emanate from the market’s ventilation of the unsustainable imbalances from the welfare-consumption-debt based political system, which eventually will render politicians utterly helpless in the face of market-economic chaos. But it is unclear if the day of reckoning is sooner or will surface later.

For the highly interconnected and interrelated global stock markets, including the Philippines, the actions of the US Federal Reserve will have very important transmission implications, and this will be backed by the actions of other major central banks, as well as, from the auxiliary effects of domestic policies. As far as the Philippine BSP is concerned they have aligned their policies to ease along with the US and with most of the major central banks.

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[1] Wikipedia.org United States elections, 2012

[2] CSMonitor.com Stocks rise if Romney wins; bonds, if Obama does October 29^, 2012

[3] Frank Holmes Who Will Lead America Over the Next Four Years? US Global Investors November 2, 2012

[4] Wikipedia.org Social desirability bias

[5] See Numerical Probabilities as Metaphorical Expressions October 24, 2011

[6] Investopedia.com Gambler's Fallacy

[7] Douglas French Democracy Is a Terrible System, Period Laissez Faire Books

[8] Yardeni.com US Flow of Funds, October 29, 2012

[9] Doug Noland Sandy, Bernanke And Money November 2, 2012

[10] Heritage Foundation Entitlements and Interest Are Crowding Out Other Spending October 16, 2012

[11] Reason.com 5 Broken Democratic Promises from 2008, September 4, 2012

[12] See US President Obama’s Green Energy List of Failures October 26, 2012

[13] See CFR: US President Obama’s Renewable Energy Jobs Comes at High Cost to Taxpayers November 3, 2012

[14] Reuters.com UPDATE 3-U.S. gov't poised to hit debt limit before 2013 October 31, 2012

[15] Anthony Gregory America’s Unique Fascism Lew Rockwell.com September 6, 2011

[16] Benoit Mandlebrot and Richard L. Hudson The (MIS) Behaviour of Markets p.28

[17] See Phisix: The Correction Cycle is in Motion August 27, 2012

[18] Yahoo.com Bernanke probably won't stand for third term at Fed - NYT October 23, 2012

[19] New York Times Presidential Election Weighs on the Federal Reserve October 22, 2012

[20] Axel Merk and Yuan Fang Monetary Cliff? Merk Investments October 24, 2012

Quote of the Day: Financial Markets will Never Be an Exact Science

The factors that determine activity on the Exchange are innumerable, with events, current or expected, often bearing no apparent relation to price variation. Beside the somewhat natural causes for variation come artificial causes: The Exchange reacts to itself, and the current trading is a function, not only of prior trading, but also of its relationship to the rest of the market. The determination of this activity depends on an infinite number of factors: It is thus impossible to hope for mathematical forecasting. Contradictory opinion about these variations are so evenly divided that at the same instant buyers expect a rise and sellers expect a fall.

The calculus of probability can doubtless never be applied to market activity, and the dynamics of the Exchange will never be an exact science. But it is possible to study mathematically the state of the market at a given instant—that is to say, to establish the laws of probability for price variation that the market at that instant dictates. If the market, in effect, does not predict in fluctuations, it does assess them as being more or less likely, and this likelihood can be evaluated mathematically.

That’s from the opening lines of “Theorie de la Spéculation” by 20th century French Mathematician Louis Bachalier (1870-1946). Mr Bachalier has been credited with being the first person to model the stochastic process now called Brownian motion, which was part of his PhD thesis The Theory of Speculation, (published 1900). [Wikipedia.org]

Source: Benoit B. Mandelbrot and Richard L. Hudson, The (Mis) Behaviour of Markets p.51

Quote of the Day: Discontinuity

Financial prices certainly jump, skip, and leap—up and down. In fact, I contend the capacity for jumps, or discontinuity, is the principal conceptual difference between economics and classical physics. In a perfect gas, as molecules collide and exchange heat, their billions of individually infinitesimal transactions collectively produce a genuine “average” temperature, around which smooth gradients lead up or down the scale. But in a financial market, the news that impels an investor can be minor or major. His buying power can be insignificant or market-moving. His decision can be based on an instantaneous change of heart, from bull to bear and back again. The result is a far wilder distribution of price changes: not just price movements, but price dislocations.

That’s from the illustrious French American mathematician and author Benoit Mandelbrot (November 20, 1924—October 14, 2010) in his bestseller, The (Mis)Behavior of Markets: a fractal view of risk, ruin and reward (p.237).

It is important to note that a distinguished mathematician can spot the indispensable difference between ‘discontinuity’ as consequence of human action with that of the ‘averages’ as an output of natural ‘physics’ sciences.

How Reliable is the S&P’s ‘Death Cross’ Pattern?

Mechanical chartists say that with the recent stock market collapse, the technical picture of the US S&P 500 have been irreparably deteriorated such that prospects of a decline is vastly greater (which has been rationalized on a forthcoming recession) than from a recovery. The basis of the forecast: the Death Cross or ‘A crossover resulting from a security's long-term moving average breaking above its short-term moving average or support level[1]’.

First of all, I’ve seen this picture and the same call before.

In July of last year, the S&P also experienced a similar death cross. Many articles emphasized on the imminence of a crash[2] that never materialized.

Secondly, I think applying statistics to past performances to generate “feasible” odds on a bet based on the ‘death cross’ represents as sloppy thinking

To wit, betting based on a ‘death cross’ signifies a gambler’s fallacy or fallacy committed when a person assumes that a departure from what occurs on average or in the long term will be corrected in the short term[3].

A coin toss will always have a 50-50 head-tail probability distribution. If the random coin toss exercise would initially result to string of ‘heads’ outcome, the eventual result of this repeated exercise would still result to a 50-50 outcome or a zero average, as shown by the chart below.

As the illustrious mathematician Benoit Mandelbroit wrote[4],

If you repeat a random experiment often enough, the average of the outcomes will converge towards an expected value. With a coin, heads and tails have equal odds. With a die, the side with one spot will come up about a sixth of the time

Applied to the death cross, we see the same probability 50-50, because each event from where the ‘death cross’ appears entails different conditions (finance, market, politics, social, cultural, even time and spatial differences and etc), as earlier argued[5]. It would signify a sheer folly to oversimplify the cause and effect order and speciously apply odds to it.

Proof?

One would hear proponents bluster over the success of the death cross in 2000 and 2007. Obviously the hindsight bias can be very alluring but deceptive. The causal relationship which made the ‘death cross’ seemingly effective in 2000 and 2007 for the US S&P 500 had been mostly due to the boom bust cycles which culminated to a full blown recession or a crisis during the stated periods.

The death cross was last seen in July of last year (green circle above window), but why didn’t it work? The answer, because the death cross had been pulverized by Bernanke’s QE 2.0 (see green circle chart below). When Mr. Bernanke announced QE 2.0, the ‘death cross’ transmogrified into a ‘golden’ cross!!! This shows how human action is greater than historical determinism or chart patterns.

Many mistakenly think that chart patterns has an inherently built in success formula which is magically infallible, as said above, they are not.

Third, not all market crashes has been due to recessions.

The above illustrates the crash of 1962 (upper window) and 1987 (lower window)[6]. This is obviously unrelated to the death cross, however the point is to illustrate that not every stock crash is related to economic activities. The recent crash may or may not overture a recession.

Bottom line: The prospective actions of US Federal Reserve’s Ben Bernanke and European Central Bank’s Jean-Claude Trichet represents as the major forces that determines the success or failure of the death cross (and not statistics nor the pattern in itself). If they force enough inflation, then markets will reverse regardless of what today’s chart patterns indicate. Otherwise, the death cross could confirm the pattern. Yet given the ideological leanings and path dependency of regulators or policymakers, the desire to seek the preservation of the status quo and the protection of the banking class, I think the former is likely the outcome than the latter.

And another thing, we humans are predisposed to look for patterns even when non-exist, that’s a result of our legacy or inheritance from hunter gatherer ancestors’ genes whom looked for patterns in the environment for survival or risked being eaten alive by predators. This behavioural tendency is called clustering illusion[7]. A cognitive bias which we should keep in mind and avoid in this modern world.

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[1] Investopedia.com Death Cross

[2] The Economic Collapse Blog, The Death Cross: Another Sign That We Are On The Verge Of A Recession?, July 5, 2010

[3] Nizkor.org Fallacy: Gambler's Fallacy

[4] Mandelbrot, Benoit B The (mis) Behaviour of Markets, Profile Books p.32

[5] See The Causal Realist Perspective to the Phsix-Peso Bullish Momentum, July 10, 2011

[6] About.com Stock Market History

[7] Wikipedia.org Clustering illusion

Should We Chart Read Market Actions From QE 2.0?

``We can chart our future clearly and wisely only when we know the path which has led to the present." - Adlai E. Stevenson

Now we know that no trend moves in a linear fashion.

Yet we cannot be heavily reliant on chart actions to determine the “overbought or oversold” conditions from which to base our positions.

In any major trend (bear or bull cycles), overstretched markets or securities can last for an extended period.

Besides, chart actions greatly depend on patterns from past performances in the probabilistic assumption of a recurrence. The operating word is here probability.

But charting does NOT incorporate the prospective stimulus-response and action-reaction by the public to the ever fast evolving highly fluid environment nor does charting impute exactly similar conditionalities from which decisions had been shaped. This is despite some successful repetition of patterns.

For instance can charting say to what degree the markets will react to a sustained QE? The answer is NO.

And it is from such dimensions that I accurately debunked earlier claims by perma bears of the supposed repetition of the Great Depression, through the alleged similarities in the unfolding of chart patterns[1].

For most of the perma bears, whom have been influenced by some form of (political or economic or cultural) bias rather than sound analysis, they can characterized by the frequent use of post hoc fallacy and data mining to support their desired outcome.

This is why I also correctly disproved earlier notions of chart based bearish patterns which ALL failed to pan out.

I earlier wrote[2],

``They never seem to run out of materials to throw in, after the earlier “death cross” and the ERCI leading indicator, whose effects remain to be seen, now they point to the Hindenburg Omen as a reason to take flight.”

Now that the actions have been reversed and that all former bearish patterns have evaporated, chartists have been talking about the bullish “Golden cross”. Duh!

Yet even if one looks at the charts, the synchronous breakouts in global markets imply a tailwind effect or “momentum” in favour of continuity going forward. As charts have yet to signify distribution or exhaustion.

Also the assumption that charts impute all the necessary information is similar to the flawed premises of the Efficient Market Hypothesis (EMH) which ignores the role of the individual entrepreneurial activities that generate variable outcomes and the erroneous implication that all participants have the same homogenous ‘rational’ expectations[3].

And in learning from the recently departed Benoit Mandlebroit, the father of fractal geometry, on why not to trust charts, Mr. Mandlebroit wrote[4],

``And in the fun-house mirror of logic of markets, the chartists can at times be correct...But this is a confidence trick: Everybody knows that everyone else knows about the support points, so they place their bets accordingly. It beggars belief that vast sums can change hands on the basis of financial astrology. It may work at times, but it is not a foundation on which to build a global risk-management system.” (bold emphasis mine)

In other words, Mr. Mandlebroit shares the analysis disputing the homogeneity of rational expectations incorporated in charting, such that everyone employing the same pattern recognition techniques would render charting to be impractical and an undependable tool for investment or trade.

For me, chart patterns have higher probability of repetitions only when it treads on major trends.

Yet I find more value in identifying the stages of the trend or the cycle, where charts only serve as supplemental role or a guidepost for entry and exit points rather than for main reasons to anchor on a major investment or trading decision.

Hence, given the current market actions and fundamental based developments brought about by QE 2.0, I am unlikely to recommend any position that would fight the major trend.

Remember, QE 2.0 represents uncharted waters in modern central banking, unless we’d include Zimbabwe Gideon Gono’s approach as part of this.

So why use traditional or conventional tools to engage in something unprecedented?

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[1] See Seeing Patterns Where None Exist, February 17, 2010

[2] See The Importance of Peripheral Vision, August 23, 2010

[3] Shostak Frank, In Defense of Fundamental Analysis: A Critique of the Efficient Market Hypothesis

[4] Mandlebroit, Benoit B and Hudson Richard, The (Mis) Behaviour of Markets, Profile Books p .8

Analyzing Predictions

“I’ve been dealing with these big mathematical models of forecasting the economy…I’ve been in the forecasting business for 50 years…I’m no better than I ever was, and nobody else is. Forecasting 50 years ago was as good or as bad as it is today. And the reason is that human nature hasn’t changed. We can’t improve ourselves.” Alan Greenspan

Baseball legend Yogi Berra once quipped on a sarcastic irony on prediction, ``Prediction is very difficult, especially if it's about the future."

Nevertheless prediction has been hardwired into the mankind’s genes with the implicit goal to overcome risks in order to ensure existential continuity of the specie. As Peter Bernstein aptly wrote in Against The Gods, ``The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk…”

Predictions From A Historian’s Perspective

Well, prediction is a tricky business. Since the advancement of science, the scientific model (quantitative) approach has been frequently utilized to determine probabilistic outcomes given defined set of variables.

However, social science appear to be more complex than anticipated, given that people have different scale of values, which are likewise meaningfully influenced by the divergences in time preferences, and also influenced by sundry cognitive biases, which subsequently makes us respond differently even to the same set of conditions.

As mathematician and scientist Professor Benoit Mandelbrot of the Fractal Geometry fame said in a PBS News Hour Interview, ``The basis of weather forecasting is looking from the satellite and seeing the storm coming but not predicting that the storm will form, the behavior of economic phenomenon is far more complicated than the behavior of liquid and gasses” (underscore mine)

Since markets are essentially economic events, the complications is that they represent endemically a menagerie of action-reaction and stimulus-response feedback loop dynamics to which Professor Mandelbroit elucidated in The (Mis)Behaviour Of Markets as, ``prices are determined by endogenous effects peculiar to the inner workings of the markets themselves, rather than solely by the exogenous actions of outside events.”

So given that markets signify more of human action dynamics than the functional state of natural science then our choice in making predictions will be one similar to the work of historians. Murray N. Rothbard makes the appropriate analogy, ``The latter attempts to "predict" the events of the past by explaining their antecedent causes; similarly, the forecaster attempts to predict the events of the future on the basis of present and past events already known. He uses all his nomothetic knowledge, economic, political, military, psychological, and technological; but at best his work is an art rather than an exact science. Thus, some forecasters will inevitably be better than others, and the superior forecasters will make the more successful entrepreneurs, speculators, generals, and bettors on elections or football games.” (all bold underscore mine)

The point is: Markets are likely to exhibit the causal effects from precursory human actions than from math designed economic models that ignore the aspects of human decision making.

Unfortunately the mainstream appears addicted to apply models even if they’ve been proven to be repeatedly unrealistic, either for reputational (need to be seen as pedagogic) or for social affiliations (need to be seen talking the same language) motivations or due to ideological blindspots (dogmatic treatment of economic theories).

Predictions Based On Dumb Luck

Besides, predictions should be weighed from the angles of opportunity costs and the incentives of the forecaster’s standpoint.

When a forecast for a certain direction of the market is unfulfilled, but at worst, goes into substantially to the opposite direction, losses will be real for those who adhered to them.

For instance, many ‘experts’ who predicted the “crash of the stock market” in 2009, when the market soared anywhere from 20-50% based on G-7 and BRIC and key emerging markets, could have bled their customers dry or would have lost 20-50% in profit opportunities from such erroneous predictions.

Yet for them to bluster “I told you so!” because the markets sizably fell this week would signify as “even a broken clock is right twice a day”! This implies that they’ve been right for the wrong reasons or as indicated by Urban Dictionary “success obtained through dumb luck”.

Market predictions shouldn’t translate to an immediate or outright fulfillment but instead focus on mitigating risks and optimizing profits. When markets move violently against a touted position and the forecaster refuses to badge, then it isn’t about “mitigating risks and optimizing profits” nor is it about accuracy, but about being foolishly arrogant or about obstinately adhering to wrong analytical models.

Remember since markets move in only two directions (up or down)… they are going to be right somehow.

Nevertheless successful investing isn’t myopically about being theoretically right or wrong but about generating maximum profits from the right moves and reducing losses on the wrong moves.

Since as human beings we are susceptible to mundane lapses, then investing is about dealing with the magnitude or the scalability of the portfolio and not of the frequency of transactions. In addition, it is also about the allocative distribution of a portfolio pertinent to perceived risks conditions.

Furthermore, as we said in Reasons To Distrust Mainstream Economists, some forecasters have different incentives for making publicly based predictions.

Some are there for mere publicity purposes (celebrity guru such as Nouriel Roubini makes the spotlight anew with another wondrous shift by predicting a market meltdown in the 2^nd half! It’s amazing how media glorifies an expert whose calls have been repeatedly off tangent) or to promote certain agenda- e.g. promote political interventions-example Bill Gross [see Poker Bluffing Booby Traps: PIMCO And The PIIGS], sell newsletters, sell funds, etc...

For instance, some experts recently argued that the recent wobbles in Wall Street validates the state of the economy. Does this translate that markets only reflect on reality on when they conform to the directions advocated by these so-called “seers”? That would be utter crock.

The truth is that the current state of the global economy operates under a fiat money regime which perpetuate on the boom bust cycles, irrespective of the actions by regulators to curtail private greed but not on their actions-which have been the underlying cause of it.

Put bluntly, politically oriented boom bust cycles are the dominant and governing themes for both the global markets and the world economy. Therefore, market actions on both directions have been revealing these dynamics.

They don’t essentially validate or invalidate the workings of the economy, because they are `` endogenous effects peculiar to the inner workings of the markets themselves, rather than solely by the exogenous actions of outside events” as Professor Mandelbroit would argue.

Hence, the “desperately seeking normal” school of thought represents as a daft pursuit to resurrect old paradigms under UNSUPPORTIVE conditions- we don’t use radar to locate for submarines or any underwater objects!

Similarly ludicrous is to show comparative charts of the crash of 1929 as a seeming parallel for today’s prospective outcome. This is a brazen example of the cognitive bias known as the “clustering illusions” or seeking patterns where there is none.

Unfortunately, even professionals fall for such lunacy, which is emblematic of why mainstream analysis should be distrusted [see earlier discussion in Why Investor Irrationality Does Not Solely Account For Bubble Cycles].

These people fundamentally forget that 1920s operated on a GOLD STANDARD while today’s world has been on a de facto US dollar standard. Today we have deposit insurance when in 1929 crash we didn’t.

Today is the age of the internet or Web 2.0, where communications have advanced such that they are done by email, or conducted real time as voice mail, web based conferencing, digital cameras, iPods and etc., and where the cost to do business has substantially fallen to near zero and which has, consequently, attracted the scalability of globalization.

In the 1920s, communications were in a primal mode: stamped postal mails, the electrical telegraphs, manual based switchboard rotary telephones, and photography were based on celluloid film 35mm Leitz cameras. All these were emblematic that the 1920s had operated on an agro-industrial age.

Today we have niche or specialized markets when in the 1900s it was all about mass marketing. These are just a few of the major outstanding differences.

In short, the fact that the basic operating framework of the political economy has been disparate implies that the effects to the markets would be equally distinct. Think of it, fundamentally speaking, monetary policies in the pre Bretton Woods 1900s were restricted to the amount of gold held in a country’s reserves while today central banks have unrestrained capacity for currency issuance.

Columbia Business School’s Charles Calomiris makes this very important policy-market response feedback loop differentiation in an interview,

``From 1874 to 1913, there was a lot of globalization. But worldwide there were only 4 big banking crises…From 1978 to now, there have been 140 big banking crises, defined the same way as the earlier ones: total losses of banks in a country equalling or greater than 10% of GDP.” (bold highlights mine)

As you would notice, the emergence and proliferation of central banking coincided with the repeated and stressful occurrences of big banking crisis. Put differently, where central banking fiat currency replaced the gold the standard, banking crisis became a common feature. So to argue that market actions don’t reflect reality translates to a monumental incomprehension or misinterpretation of facts and theory.

Yet if markets should reflect on the same 1929 dynamics, this would be more the mechanics of dumb luck than representative of economic reality. Besides, to presuppose as engaging in “economic” analysis to support such outlandish theories, but without taking to account on these dissimilarities, would also signify as chimerical gibberish or pretentious knowledge.

Bottom line: I’d be careful about heeding on the predictions of the so-called experts, where I would read between the lines of interests of these forecasters, their way of interpreting facts and the theory used, aside from opportunity costs from lapses, and their forthrightness.

Yet, I’d pay heed to Benjamin Graham, the father of value investing when he admonished, ``If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market."

Nassim Taleb 'The Risk Maverick': We May Be Experiencing Something That Is Vastly Worst

This insightful PBS News Hour Interview with great thinkers in Nassim Nicolas Taleb (author of Black Swan: The Impact of the Highly Improbable) and Fooled by Randomness and Benoit Mandelbrot (The (Mis)Behavior of Markets)







Some noteworthy quotes from the interview:

From Nassim Taleb:

"The banking system the way we have it is a monstrous giant built on feet of clay and that topples we’re gone. Never in the history of the world have faced so much complexity combined with so much incompetence and understanding its properties.

"We live in a world that is way too complicated for our traditional economic structure it’s not as resilient as it used to be we don’t have slack it is over optimized."

"Let me tell you what is happening in the ecology of the banking system, there is swelling of large banks because it vastly more optimal to have one large bank than ten small banks. It’s more efficient. And that consolidation is putting us at risk because when one large bank makes a mistake, it’s ten times worst than a small bank making a mistake."

"I think we may be experiencing something that is vastly worst than we think it is."

"The network effect of globalization means that a shock in the system can have much larger consequences."

From Benoit Mandelbrot:

"The word turbulence is one which is actually common to physics, social sciences to economics, everything about turbulence is enormously complicated not just a little bit complicated not just one year more school it’s enormously complicated.

"The basis of weather forecasting is looking from the satellite and seeing the storm coming but not predicting that the storm will form...the behavior of economic phenomenon is far more complicated than the behavior of liquid and gasses."

"Tools have been developed which assume changes are always very small,...then nothing bad happens, if several of them come together bad things can happen and the theory does not take account of that. And the theory does not take account of very large and sudden changes in anything, the theory thinks that things move slowly gradually and can be corrected when in fact they may change extremely brutally."

My comment: Both Mr. Taleb and Mr. Mandelbrot seems to be worrying about the US dollar based global banking system which is getting to be "too big to fail".

With the US government's increasing influence in the consolidation of the banking sector, directly and indirectly, where deal making has surpassed $3 trillion, such risk concerns may not be exaggerated.

Courtesy of Wall Street Journal/dealogic

Could Mr. Taleb be referring to our Mises moment?