Phisix: Holiday Abridged Sessions Unlikely an Obstacle to the Year End Rally

Methodological Individualism Applied to Holiday Shortened Trading Sessions

Trading sessions will be limited to just three days in the coming week as two days have been declared as public holidays by the Philippine government in the tradition of paying homage to the dead.

Since not everyone practices the tradition, others have used such occasion for leisure and travel.

Yet such extended holidays are likely to divert the attention of market participants on how and what to do during the mandated respite from work.

When markets are on a vacation mode, I expect trading activities to slowdown which may be reflected on Peso volume (excluding block and special block sales).

But lethargic trading does not necessarily reduce volatility.

For the past two years, holiday abbreviated weeks with three day trading sessions have posted substantial over 1% moves

*Aug 29 and 30 in 2011, Eidul Fitr and National Heroes Day[1]

**August 20 2012 Ninoy Aquino Day (Replaced to Monday)[2]

The same goes with All Saint’s Day week celebrations since 2007.

The natural intuition for the mainstream would be to impute from the above facts statistical correlations and or to seek out patterns from which to project into the future.

For instance, it would be easy to deduce of the dominance of negative returns by simple observation and the employment of heuristics without examining the operating conditions which had led to such outcomes

Let’s say, the -1.43% from November of 2011 came amidst the oversold bounce from the flash September market meltdown, as most likely an offshoot to the US Federal Reserve chairman Ben Bernanke’s jilting of market’s expectations of QE 3.0[3]

The other instances have shown to be responses to what seems as short term overbought conditions (in April and August 2012 marked by blue arrows) following new highs.

Thus, losses from Holiday shortened week have most likely accounted for profit taking.

Nonetheless the losses from the above incidentally marked the interim bottoms which eventually led to milestone highs.

Or how about the negative output during November’s of 2007 and 2008? The unfolding bear market cycle during the said period can serve as convenient explanation.

Today, considering that the Phisix has just been marginally off the record highs, along with the ASEAN peers, this means that price volatility can go in either direction.

On the downside, profit taking, possibly to fund vacations, leisure or traditional activities, could partly explain why the proclivity for negative returns.

On the upside, aggressive participants may take advantage of any new information that could eclipse such profit taking activities that may push the market higher.

In essence, there are no linear and clear cut answers to such short term events

What this implies is that even if the week’s results should turn out negative, this may not be suggests of an inflection point as the general market trend remains on the upside. This is unless of course, exogenous tail risk events may rattle the highly interconnected and intercorrelated global markets and gets transmitted to the ASEAN equity markets and to the Phisix.

The bottom line is that it would signify a serious mistake to perceive history as mechanically repeating itself for the simple reason that history is a complex phenomenon.

History as factual episodes represents heterogeneously embedded unique circumstances as consequence to “multiple causes” where “none of the factors are in constant relationship with the others” [Rothbard 1976[4]].

This also means that historical facts, according to the great Austrian Professor Ludwig von Mises[5], “cannot be used as building material for the construction of theories and the prediction of future events. Every historical experience is open to various interpretations, and is in fact interpreted in different ways”.

This also implies that while history can give us some clues, it is the understanding of science of human actions which is most important.

Again Professor Mises from the same material[6]

The subject matter of all historical sciences is the past. They cannot teach us anything which would be valid for all human actions, that is, for the future too. The study of history makes a man wise and judicious. But it does not by itself provide any knowledge and skill which could be utilized for handling concrete tasks.

Author Samuel Langhorne Clemens popularly known as Mark Twain[7] nailed it when said ‘history does not repeat itself, but it does rhyme’.

Financial Markets Are Now About Bernanke Put

Some have expressed alarm over the recent downside volatility seen in the overseas markets.

It’s all about framing, I’d say.

This week’s retracements (blue bar) seem to be in response to last week’s gains (red bars). While the degree of price changes has been different from last week to the other week, the scale of volatility has been evident. Heightened volatility from market distortions brought about by interventionism has been the crux of the current market environment.

Yet for some, declining US markets serves as a reason for concern.

The S&P 500, which I use as a key benchmark for the US markets, have lost 1.48% this week. Add to such loss the current level of the S&P 500, which represents nearly 4% loss from the most recent or September peak, we have a short term bear market story.

But there is the other view; year-to-date the major US benchmark has still been robustly up 12.27%. This remarkable advance by the US markets as exemplified by the S&P 500 has lubricated the outperformance of the Philippine Phisix and Thai’s SET and an animated global equity markets.

There are also those who claim that declining earnings will drive US markets lower.

But this concern seems valid when markets operated on merely the platform of the barrage of promises by the FED.

Expectations of the FED’s coming steroids provided the shot in the arm that produced a risk ON environment despite material signs of disconnect with the real economy or in terms of declining earnings and of the weakening of the economy[8].

Since promises are subject to diminishing returns, they are unsustainable. Rising markets based on empty talks simply increased the sensitivity to enormous downside risks or that this represents a recipe for a market crash.

Either trapped by their own policy signalling measures, or in the realization that failed expectations could bring chaos and relive the September 2011 flash meltdown, the FED and the ECB HAD to deliver.

And they DID. Both will be flooding the world with money to the preliminary tune of $2 trillion.

Add to this that this fact that it will not just be the FED-ECB but other major central banks as well. The Bank of Japan (BoJ) just joined the bandwagon with additional stimulus[9] while the Bank of England (BoE) has once again signaled its intent to expand her balance sheet further[10].

And most importantly, the US Fed Chairman Ben Bernanke made explicit that QE Forever/QEternity has been meant to sustain asset prices[11].

Many seem to forget that it is central bank actions that really matters since the market’s price mechanism has been skewered by their repeated interventionism.

Today’s risk environment has dramatically shattered conventional thinking. In a recent “Bagehot” lecture at the Buttonwood in New York City, PIMCO’s chief Mohamed El-Erian poignantly remarked[12]

What we are ultimately talking about is an “unusually uncertain” distribution of potential baseline outcomes, as well as unusually shaped tails. This inevitably undermines the robustness of lots of conventional wisdom, as well as a range of historical contracts and entitlements. It also challenges the agility of institutions in both the public and private sectors.

If corporate earnings have hardly been a factor in driving up market prices, then why should corporate earnings become a factor in marking down prices?

Earnings have recently become a matter of concern only after central bank’s rescue mechanism has been put in place. What this really shows is of the market dynamic of “buy the rumor sell on news”.

And given the reality of the slated expansion of money supply from central banks via asset purchases, this will also mean that sales revenues of enterprises will rise faster than the costs of business, where the latter has been incurred during the time prior to additional money infusions.

This implies that inflation creates the illusion of greater ‘corporate profits or earnings’, where the more the inflation, the greater the profit margins.

As financial analyst Kel Kelly explains[13] 

Another way of looking at it is that, with more money being created through time, the amount of revenues is always greater than the amount of costs, since most costs are incurred when there is less money existing. Thus, because of inflation, the total monetary value of business costs in a given time frame is smaller than the total monetary value of the corresponding business revenues. Were there no inflation, costs would more closely equal revenues, even if their recognition were delayed…

Since business sales revenues increase before business costs, with every round of new money printed, business profit margins stay widened; they also increase in line with an increased rate of inflation. This is one reason why countries with high rates of inflation have such high rates of profit. During bad economic times, when the government has quit printing money at a high rate, profits shrink, and during times of deflation, sales revenues fall faster than do costs.

This profit mirage from monetary inflation represents the ephemeral boom phase of business cycle.

Also as previously noted, the seeming recovery in the US real estate sector[14] will likely to be used as pretext to boost stock prices.

So far, the Dow Jones US Real Estate ($DJUSRE) and the iShares Real estate (IYR) along with Regional Bank Index (KRE) and the Philadelphia Bank Index (BKX) have all backed off from the recent highs. Although there has been little signs of any material deterioration,

Finally given the explicit goal by the FED to support asset prices via the “Wealth Effect” or Portfolio Balance Channel[15], any adjustments to the newly instituted QE Forever policies will likely be in accordance to the conditions of the financial markets.

In short, the Bernanke Put is in motion: conditions of the financial markets will dictate on the FED’s actions.

This also implies of the policy of redistributing resources from main street into the financial sector.

And any attendant tail risks will likely come from rising consumer prices (inflation risk) or the escalation of political squabbles e.g. the risks of growing secession movements in Europe[16] (political risks) or the recognition of insolvency of crisis afflicted nations or the lack of capital (credit risks), all of which will be manifested through interest rate channel.

How Interest Rate Regimes Affect Asian Stock Markets

Current easing policies by developed economies have translated into a boom through most of Asia.

That’s because most of Asia has mimicked their developed economy counterparts but from a lesser aggressive stance.

In the region, interest rate regimes can be categorized as[17]

-rate cuts in 2012: These include China, South Korea, Singapore, Thailand, Philippines, India, Pakistan and Australia

-previous rate changes prior to 2012, but remains on hold through 2012: These includes New Zealand who cut in 2011, Taiwan increased in 2010 until July 2011, Vietnam raised rates in 2010 until early 2011, Indonesia cut rates from last quarter of 2011 until January 2012 and Malaysia increased rates in mid 2011.

-increased rates in 2012: Bangladesh, Sri Lanka, Mongolia 

The relationship between interest rates and equity market performance has been striking.

Countries who cut rates in 2012 mostly outperformed: Pakistan, India, Philippines and Thailand. For those whose rates were unchanged, e.g. Malaysia, Indonesia and Taiwan, the benchmark equity performance has largely been the median.

The losers or the laggards are economies that have been raising rates: Bangladesh, Sri Lanka and Mongolia.

The Philippine central bank, the Bangko Sentral ng Piliipinas (BSP) appears to have succumbed to pressures from the external agents during the recent IMF-World Bank annual gathering by raising interest rates for the fourth time this year last week[18].

The BSP announced through Mr. Amando Tetangco that such measures were meant to “help ward off risks associated with weaker external demand by encouraging investment and consumption.”[19]

Consumption does not emerge from a vacuum. Consumption would need to be satisfied through exchange via division of labor that arises out of production.

This means production has to come from capital good investments which are financed by capital or through savings, and not from printing of money or digital creation of money.

As a reminder all economic growth stems from savings. According to the great Professor von Mises[20],

At the outset of every step forward on the road to a more plentiful existence is saving--the provisionment of products that makes it possible to prolong the average period of time elapsing between the beginning of the production process and its turning out of a product ready for use and consumption. The products accumulated for this purpose are either intermediary stages in the technological process, i.e. tools and half-finished products, or goods ready for consumption that make it possible for man to substitute, without suffering want during the waiting period, a more time-absorbing process for another absorbing a shorter time. These goods are called capital goods. Thus, saving and the resulting accumulation of capital goods are at the beginning of every attempt to improve the material conditions of man; they are the foundation of human civilization. Without saving and capital accumulation there could not be any striving toward non-material end

Inflationism, thus, only dilutes the purchasing power (even Lenin and Keynes recognized this[21]), as well as, creates economic imbalances that promote bubbles and social instability.

The BSP further admits that there has been increasing risks of price inflation through “impending electricity rate increases and rising global prices for some grains could upset the inflation outlook” but recklessly assumes that “subdued global demand should temper the overall picture by easing price pressures on oil imports”

But price inflation has been creeping upward[22] in spite of “subdued global demand” and falling Philippine exports[23]. Perhaps local monetary officials have yet to discover that there exists an economic phenomenon called stagflation—high price inflation, high unemployment and economic stagnation[24]--which dominated the 1970-80s

Nonetheless with diminishing recession risks from the US despite the recent corrections in the equity markets, explicit policy support from global central bankers led by FED-ECB on the financial markets, the still “benign” domestic price inflation, the deepening domestic negative real rates regime and the recently established momentum from the breakout, we should expect domestic financial markets (the Phisix, the Peso) to outperform at least until the year end unless external shocks will derail the above dynamics

We should also expect that sluggish commodity prices in the environment of near coordinated monetary easing implemented by almost every major economy to make an eventual rally, not entirely because of ‘consumption demand recovery’ but because of reservation demand[25] or the “demand to hold stock” or “hoard” out of anticipation of higher prices or greater use of the good or more exchange opportunities of the good for other goods.

Applied to the local stock market, stocks will rise barely because of conventional wisdom of earnings or economic growth, but because of the growing urgency to chase for yields, to gamble and to punt which all represent as products of the policy regime of negative real rates. And proof of such progression has been the growing incidences of miniature bubbles[26].

---

[1] PublicHoliday.org Philippines 2011 Holidays Calendar

[2] PublicHoliday.org Philippines Holidays 2012 Calendar

[3] See Bernanke Jilts Markets on Steroids, Suffers Violent Withdrawal Symptoms, September 22, 2011

[4] Murray N. Rothbard Praxeology: The Methodology of Austrian Economics Mises.org

[5] Ludwig von Mises 1. Praxeology and History Chapter II. The Epistemological Problems of the Sciences of Human Action, Human Action Mises.org

[6]Mises, Ibid

[7] Wikipedia.org Mark Twain

[8] See ECB-China Stimulus: Has the Risk ON Environment Returned? September 10, 2012

[9] see Bank of Japan Adds More Stimulus October 27, 2012

[10] Bloomberg.com King Says BOE Is Ready to Add to QE If U.K. Recovery Fades October 24, 2012

[11] see FED-ECB’s Nuclear Policies: Risk ON is Back! September 17, 2012

[12] Mohamed El-Erian Mohamed El-Erian's Bagehot Lecture From Buttonwood Minyanville.com October 24, 2012

[13] Kel Kelly How the Stock Market and Economy Really Work September 1, 2012 Mises.org

[14] See US Federal Reserve Policies Re-Inflate US Property Bubble October 20, 2012

[15] See Phisix-ASEAN Bellwethers at Fresh Record Highs October 8, 2012

[16] Atlantic Sentinel Secessionist Movements Threaten Foundation of Europe, October 17, 2012

[17] Asian Bonds Online Asia Bond Monitor September 2012

[18] ABS-CBNNEWS.com BSP ready to ease policy rates anew – Tetangco October 14, 2012

[19] Inquirer.net Philippines trims key interest rates again October 25, 2012

[20] Ludwig von Mises 2. Capital Goods and Capital XV. THE MARKET Human Action

[21] See IMF’s Christine Lagarde Inflationist Delusions October 20, 2012

[22] Danske Bank Brighter global outlook but every rose has it thorns, Emerging Market Briefer October 15, 2012

[23] See I Told You So Moment: Philippine Exports Hit in August October 12, 2012

[24] Wikipedia.org Stagflation

[25] See Are Surging Oil Prices Symptoms of a Crack-up Boom? February 24, 2012

[26] See Will Frothy Bond Markets Drive the Phisix Higher? October 22, 2012

Quote of the Day: The Limits of Experience

what we know about our action under given conditions is derived not from experience, but from reason. What we know about the fundamental categories of action—action, economizing, preferring, the relationship of means and ends, and everything else that, together with these, constitutes the system of human action—is not derived from experience. We conceive all this from within, just as we conceive logical and mathematical truths, a priori, without reference to any experience. Nor could experience ever lead anyone to the knowledge of these things if he did not comprehend them from within himself.

This is from the great Austrian school of economics professor Ludwig von Mises

Nobel Prize of Economics and the Penchant for Math Constants

The announcement of latest winners of the Nobel Prize in economics, particularly Alvin Roth and Lloyd Shapley seems a yawner.

Critiques Andrew Coulson at the Cato Institute Blog (bold mine)

As the Nobel organization’s website explains, the original algorithm was developed by Shapley and David Gale to optimally match pairs of individuals who could only each be matched with one other person. For instance, optimally marrying-off 10 men and 10 women based on their relative levels of interest in one another. Over the past decade, it has come to be used to match students to places in local public schools (by Roth).

The problem is that this approach to “school choice” correctly assumes that the better public schools have a fixed number of places and cannot expand to meet increased demand. So it’s about finding the least-awful allocation of students to a static set of schools—a process that does nothing to improve school quality.

Meanwhile, there is something called a “market” which not only allows consumers and producers to connect, it creates the freedoms and incentives necessary for the best providers to grow in response to rising demand and crowd-out the inferior ones. It also provides incentives for innovation and efficiency. But instead of advocating the use of market freedoms and incentives to improve education, some of our top economists are spending their skill and energy tinkering with the increasingly inefficient, pedagogically stagnant status quo.

Forehead… meet desk.

I am reminded of the great Professor Ludwig von Mises who rebuked mainstream economic practitioners for their penchant to falsely model human action into a subset of natural science.

Professor Mises (From Theory and History): (bold mine)

But it is not permissible to argue in an analogous way with regard to the quantities we observe in the field of human action. These quantities are manifestly variable. Changes occurring in them plainly affect the result of our actions. Every quantity that we can observe is a historical event, a fact which cannot be fully described without specifying the time and geographical point.

The econometrician is unable to disprove this fact, which cuts the ground from under his reasoning. He cannot help admitting that there are no "behavior constants." Nonetheless he wants to introduce some numbers, arbitrarily chosen on the basis of a historical fact, as "unknown behavior constants." The sole excuse he advances is that his hypotheses are "saying only that these unknown numbers remain reasonably constant through a period of years."  Now whether such a period of supposed constancy of a definite number is still lasting or whether a change in the number has already occurred can only be established later on. In retrospect it may be possible, although in rare cases only, to declare that over a (probably rather short) period an approximately stable ratio--which the econometrician chooses to call a "reasonably" constant ratio-prevailed between the numerical values of two factors. But this is something fundamentally different from the constants of physics. It is the assertion of a historical fact, not of a constant that can be resorted to in attempts to predict future events.

Well such so called ‘prestigious’ recognitions have seemingly been directed to the ideas and symbolisms (e.g. European Union as awardee for Peace) which promotes the interests of the establishment.

Is Financial Knowledge Key to Successful Investing?

The public doesn’t know how to manage their finances, that’s according to a study commissioned by the US SEC.

From the Wall Street Journal Blog,

Good news for those intent on committing fraud. Bad news for most everyone else. American investors apparently don’t know much about anything financial.

According to a review released Thursday of years of surveys of individual investors, they are presumably ripe for the picking by fraudsters because they don’t have much knowledge to counteract any outlandish offerings.

Here’s the key and rather astonishing quote: “These studies have consistently found that American investors do not understand the most basic financial concepts, such as the time value of money, compound interest and inflation. Investors also lack essential knowledge about more sophisticated concepts, such as the meaning of stocks and bonds; the role of interest rates in the pricing of securities; the function of the stock market; and the value of portfolio diversification…”

That is from the Library of Congress, which conducted the review on behalf of the Securities and Exchange Commission. The SEC, for its part, needed to study Americans’ financial literacy and assess what investors wanted to know about investments and advisers and how they wanted to receive the information. The SEC had a mandate for all that from the 2010 Dodd-Frank Act.

This generalized lack of knowledge (there certainly are plenty of exceptions) is particularly worrisome since more and more people are responsible for their own investment decisions as part of defined-contribution retirement plans, usually 401(k)s.

The Library of Congress said: “If employees do not have the requisite knowledge, they will not be prepared to make informed decisions regarding the management of their financial affairs, including investing for a secure retirement.”

The public (not limited to Americans) may not be technically sophisticated in the realm of finances but to claim that they are “not be prepared to make informed decisions regarding the management of their financial affairs” looks outrageously untrue.

This misleading assertion presupposes that government should play a role to compel people to get educated "financially".

In reality, America’s standard of living has been higher than most of the world because of capital accumulation.

As the great Ludwig von Mises wrote,

The average standard of living is in this country higher than in any other country of the world, not because the American statesmen and politicians are superior to the foreign statesmen and politicians, but because the per-head quota of capital invested is in America higher than in other countries. Average output per man-hour is in this country higher than in other countries, whether England or India, because the American plants are equipped with more efficient tools and machines. Capital is more plentiful in America than it is in other countries because up to now the institutions and laws of the United States put fewer obstacles in the way of big-scale capital accumulation than did those foreign countries.

Americans not only knew but appropriately acted to manage their state of affairs through the productive balancing of savings and investments which resulted to such high levels of capital accumulation

Moreover, having financial knowledge does not necessarily translate to having the expertise for “investing for a secure retirement”

In reality, financial knowhow does not make one infallible from loses.

In debunking the idea that financial success comes out of high IQs, I recently wrote,

The landmark bankruptcy by Long Term Capital Management in 1998 had been a company headed by 2 Nobel Prize winners. The company’s failure has substantially been due to flawed trading models.

In 2008, the 5 largest US investment banks vanished. These companies had an army of economists, statisticians and quant modelers, accountants, lawyers and all sort of experts who we assume, because of their stratospheric salaries and perquisites, had high IQs.

When Queen Elizabeth asked why ‘no one foresaw’ the crisis coming, the reply by the London School of Economics (LSE)

"In summary, Your Majesty," they conclude, "the failure to foresee the timing, extent and severity of the crisis and to head it off, while it had many causes, was principally a failure of the collective imagination of many bright people, both in this country and internationally, to understand the risks to the system as a whole."

Imagination had been scarce because the same army of experts heavily relied on mathematical models in dealing with investments. They did not follow the common sense advise by the real experts.

These people had all the supposed “expertise” yet they all burned investor's money.

The failure of pseudo financial mastery explodes the idea that “generalized lack of knowledge” will not enable people “to make informed decisions”.

To add, if one looks at the list of the victims of fraud committed by scam artist Bernie Madoff, they had hardly been about financial ignorance

Again I wrote,

Thus, it is no different when Bernard Madoff bamboozled $50 billion off from the who’s who list which includes top rated financial institutions among them banks, (e.g. BNP Paribas,Banco Santander, Fortis Bank Netherlands, HSBC Holdings, Nomura Holdings, Royal Bank of Scotland and etc.) insurers (CNP Assurances, Clal Insurance, Harel Insurance) and Hedge funds (Tremont Group Holdings, Fairfield Greenwich).

To consider, these institutions account for as supposedly smart money outfits since they are backed by an army of “elite professionals”, e.g. economists, accountants, risk managers, quants etc…). Yet at the end of the day, smart money seemed like everybody else; they got what they deserved because they substituted prudence with fad

In reality, inflationist “bubble” policies, which obscures price signals and whets the speculative or gambling appetite, have been the principal influence to fraud.

As a side note: even the most successful stock market investor Warren Buffett admits of occasional investing mistakes.

In Manias, Panics and Crashes Charles Kindleberger’s insight has been highly relevant, (I quoted from my previous article)

Commercial and financial crisis are intimately bound up with transactions that overstep the confines of law and morality shadowy though these confines be. The propensities to swindle and be swindled run parallel to the propensity to speculate during a boom. Crash and panic, with their motto of sauve qui peut induce still more to cheat in order to save themselves. And the signal for panic is often the revelation of some swindle, theft embezzlement or fraud

Bottom line: having financial knowledge is necessary but not sufficient reason for securing financial success.

Relevant theory backed by quality information from the desire to profit (stakeholder's dilemma) has to be used as framework for such analysis.

Morris Cohen in his 1944 book, A Preface to Logic provides a useful insight (quoted by Professor Don Boudreaux)

There can be no doubt that statistics deals with actuality, and that knowledge of actualities is always empirical, i.e., that we cannot obtain knowledge by purely a priori methods. There is, however, no genuine progress in scientific insight through the Baconian method of accumulating empirical facts without hypotheses or anticipation of nature. Without some guiding idea we do not know what facts to gather. Without something to prove, we cannot determine what is relevant and what is irrelevant.

And this should be complimented by emotional intelligence and self-discipline.

Quote of the Day: Economics is a Display of Abstract Reasoning

Economics, like logic and mathematics, is a display of abstract reasoning. Economics can never be experimental and empirical. The economist does not need an expensive apparatus for the conduct of his studies. What he needs is the power to think clearly and to discern in the wilderness of events what is essential from what is merely accidental.

That’s from the great Ludwig von Mises from his magnum opus Human Action. (hat tip Mises Blog).

Quote of the Day: Mathematics Diminishes Economics

Mathematics, seemingly so precise, inevitably ends in reducing economics from the complete knowledge of general principles to arbitrary formulas which alter and distort the principles and hence corrupt the conclusions.

That’s from the great Murray N. Rothbard, who discussed the origins of the methodology of praxeology or human action from J.B. Say.

Outside the promotion of self-esteem, mathematics via econometrics and or statistics serves as intellectual cover to what is truly heuristics based biases.

Video: Economics is Fun: Why Economics Isn't (Natural) Science

Dr Madsen Pirie of Adam Smith Institute does a great job in explaining vivaciously why economics isn't (natural) science, which conventional practitioners try to mold them into--through statistical or econometric models.

Here's a good quote [1:07]

When an economist tries to simplify it by leaving out stuff by, so that a small model can be created you have assumed away the real world.

(hat tip Greg Ransom)



Economics is the youngest of all sciences to quote the great Ludwig von Mises.

And it is important to note that the science of economics represents a subdiscipline to the science of human action. Again Professor Mises in his magnum opus Human Action,

The scope of praxeology is the explication of the category of human action. All that is needed for the deduction of all praxeological theorems is knowledge of the essence of human action. It is a knowledge that is our own because we are men; no being of human descent that pathological conditions have not reduced to a merely vegetative existence lacks it. No special experience is needed in order to comprehend these theorems, and no experience, however rich, could disclose them to a being who did not know a priori what human action is. The only way to a cognition of these theorems is logical analysis of our inherent knowledge of the category of action. We must bethink ourselves and reflect upon the structure of human action. Like logic and mathematics, praxeological knowledge is in us; it does not come from without.

All the concepts and theorems of praxeology are implied in the category of human action. The first task is to extract and to deduce them, to expound their implications and to define the universal conditions of acting as such.

And the difference between the science of human action from natural science in the words of Mises (emphasis added)

WHAT differentiates the realm of the natural sciences from that of the sciences of human action is the categorical system resorted to in each in interpreting phenomena and constructing theories. The natural sciences do not know anything about final causes; inquiry and theorizing are entirely guided by the category of causality. The field of the sciences of human action is the orbit of purpose and of conscious aiming at ends; it is teleological.

Both categories were resorted to by primitive man and are resorted to today by everybody in daily thinking and acting. The most simple skills and techniques imply knowledge gathered by rudimentary research into causality. Where people did not know how to seek the relation of cause and effect, they looked for a teleological interpretation.

Mainstream Analysts Capitulates on Bear Market Views

From Bloomberg,

Strategists at the biggest banks are capitulating on their bearish forecasts after the best start to a year for global stocks since 1994 and gains of more than 7 percent in emerging-market currencies.

Just two weeks after saying that investors should “remain cautious,” Larry Hatheway, the chief economist at UBS AG (UBSN), raised his recommendations on global shares and high-yield bonds in a Jan. 23 note to customers entitled, “Wrong, but not too late.” Royal Bank of Scotland Group Plc (RBS), and Benoit Anne, the global head of emerging-markets strategy at Societe Generale (GLE) SA, said their estimates for developing nations were proven wrong.

The MSCI All-Country World Index (MXWD) climbed 5.7 percent in January, surprising strategists at Bank of America Corp. (BAC),Goldman Sachs Group Inc. (GS) and Barclays Plc (BARC) who had forecast first-half losses because of Europe’s debt crisis. JPMorgan Chase & Co. (JPM) and Citigroup Inc. (C), which predicted the rally in stocks, say it will continue as the U.S. housing market rebounds and China eases lending restrictions to bolster economic growth.

Another instance where the mainstream admits to have gotten their analysis, and subsequently their predictions, all so wrong. Independent (usually contrarian) thinking pays. And most important is adhering to the methodology taught by Professor Ludwig von Mises.

There is only one way of dealing with all problems of social organization and the conduct of the members of society, viz., the method applied by praxeology and economics. No other method can contribute anything to the elucidation of these matters.

Video: Study Praxeology

Learn the fundamentals of Austrian Economics. Start with the science of human action, see video below: (hat tip: lewrockwell.com)

Flaws of Economic Models: Differentiating Social Sciences from Natural Sciences

David Freedman of the Scientific American asks “Why Economic Models Are Always Wrong?”

He gives the answer,

The problem, of course, is that while these different versions of the model might all match the historical data, they would in general generate different predictions going forward--and sure enough, his calibrated model produced terrible predictions compared to the "reality" originally generated by the perfect model. Calibration--a standard procedure used by all modelers in all fields, including finance--had rendered a perfect model seriously flawed. Though taken aback, he continued his study, and found that having even tiny flaws in the model or the historical data made the situation far worse. "As far as I can tell, you'd have exactly the same situation with any model that has to be calibrated," says Carter.

That financial models are plagued by calibration problems is no surprise to Wilmott--he notes that it has become routine for modelers in finance to simply keep recalibrating their models over and over again as the models continue to turn out bad predictions. "When you have to keep recalibrating a model, something is wrong with it," he says. "If you had to readjust the constant in Newton's law of gravity every time you got out of bed in the morning in order for it to agree with your scale, it wouldn't be much of a law But in finance they just keep on recalibrating and pretending that the models work."

We can’t simplify, through mathematical models, what truly is a highly complex environment. Repeated “recalibrating their models” or “calibration problems” only exposes on these structural analytical errors.

The ultimate reason why economic models are always wrong is that investigations have been patterned after natural sciences. Yet analyzing natural sciences isn’t the same as social sciences. That’s what modelers and their disciples cannot seem to grasp.

The great Ludwig von Mises draws a clear distinction between the two sciences, (bold emphasis mine, italics original)

Since the elements of social cognition are abstract and not reducible to concrete images one would like to have metaphors. First there were biological metaphors, now mostly mechanistic ones. These are based in positivist view of social science that holds that social science should be built up by experimental method as ideally applied in Newtonian physics. Economics becomes experimental, mathematical and about measurement. This is all wrong:

1. Social sciences cannot be based on experience like the natural sciences. Social experience is of a complexity and cannot be experimented with

2. Therefore the social sciences can never use experience to verify their statements. Every fact and experience is open to multiple interpretations (but see Kuhn. KS)

3. The impossibility of experimenting implies the impossibility of measurement. In human behavior there are no invariable relations like there are between physical properties, which means that it is pointless to mathematize them in order to make predictions. Statistics merely studies history.

4. Mathematics does not deal with actual operations of human actions but with a fictitious concept, static equilibrium (tomorrow is like today, no uncertainty), that economists build up for instrumental purposes. But not only is this unrealistic, it is also inconsistent for lack of uncertainty and change implies lack of actions. The only purpose mathematics can have in economics is the study of the nature of relations between costs and prices and thereby of profits.

5. Mathematics cannot tell us how the market arrives at a static equilibrium.

6. Mathematicians are prone to consider the price either as measurement of value or as equivalent to the commodity. But prices are neither; they are simply the amount of money exchanged for a commodity and there is reversed valuation.

Economics deals with human action, not with objects (as physics does) such as commodities, economic quantities or prices. Therefore economists do not consider their subject matter from without, but from within, through our own understanding of what it is to be human and to act. What makes natural science possible is the power to experiment, what makes social science possible is the power to grasp the meaning of human action….

Social sciences have a distinct method, praxeology and verstehen, due to the special character of their objects, and owe their progress through it and do not have to and cannot use the method of the natural sciences.

Praxeological concepts refer exactly and with certainty to the reality of human action because both the science of human action and human action itself have their toot in human reason. The quantitative approach would not render them more exact.

Nobody denies that economics is not perfect yet, but:

1. the present unsatisfactory state of social and political affairs is not due to deficiencies in economic theory, but in policy. People just don’t use economic theory enough.

2. even if economics needs to be drastically reformed someday it cannot take the direction proposed by those who use the model of the natural sciences. This idea has been thoroughly refuted forever.

Again many people seem to find comfort in models, for many possible reasons such as social signaling, conversation, career, politics and others.

But in terms of the predictive value, as the Scientific American article’s inquiry as indicated by the title, economic models have always been wrong.

Numerical Probabilities as Metaphorical Expressions

In an earlier post I argued that assigning numerical probability to what has been a constantly changing environment can be a dangerous undertaking because this either depends on presumptive omniscience or requires heavy reliance on unrealistic assumptions that replaces people’s choice.

I would like to add the allegation where numerical probabilities serve as “framework for communication” does not improve the efficacy of numerical based probabilities because the basis of such communication would be ABSTRACTION.

Professor Ludwig von Mises calls this metaphorical expression(bold emphasis mine)

It is a metaphorical expression. Most of the metaphors used in daily speech imaginatively identify an abstract object with another object that can be apprehended directly by the senses. Yet this is not a necessary feature of metaphorical language, but merely a consequence of the fact that the concrete is as a rule more familiar to us than the abstract. As metaphors aim at an explanation of something which is less well known by comparing it with something better known, they consist for the most part in identifying something abstract with a better-known concrete. The specific mark of our case is that it is an attempt to elucidate a complicated state of affairs by resorting to an analogy borrowed from a branch of higher mathematics, the calculus of probability. As it happens, this mathematical discipline is more popular than the analysis of the epistemological nature of understanding.

There is no use in applying the yardstick of logic to a critique of metaphorical language. Analogies and metaphors are always defective and logically unsatisfactory. It is usual to search for the underlying tertium comparationis. But even this is not permissible with regard to the metaphor we are dealing with. For the comparison is based on a conception which is in itself faulty in the very frame of the calculus of probability, namely the gambler's fallacy.

In short, 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.

Applying Methodological Individualism to the Financial Markets

I recently received a suggestion for me ‘quantify’ the probabilities of my risk scenarios.

While this may represent the conventional practise by the mainstream, I see this as a foolish undertaking.

Putting numbers assumes that I KNOW the nitty gritty or the minutest details of the risk events that I have been investigating. It also means that I KNOW how people think and their corresponding responses to the changes in the economy, the environment or the financial marketplace. Otherwise, I would be making irresponsible assumptions that may be out of touch with reality.

Besides, I don’t see the need to ‘signal’ or project my expertise just to get plaudits from any institutions. All I aim to do is to excel at my current undertakings in order to survive.

Anyway the prediction markets such as Intrade.com exhibits the probabilities of specific events based on actual risk money or bets and not merely from mathematical models.

For instance, the odds of a US recession in 2012[1] has been quite volatile.

The odds of a recession began to recede since the last quarter of 2010 and began to bottom out in the first quarter of 2011. But this trend reversed to the upside and currently stands at the highest level since the last quarter of 2009.

As of this writing, the odds of a recession by the betting public is at 43.6% and constantly changes depending on the risk perception of the betting public.

The above simply shows that there is NO constancy in people’s actions or that the only thing constant in the real world is change.

Therefore to apply probabilities based on math or econometric constructed ‘models’ from faulty and flawed assumptions would not be only ridiculous but dangerous, especially to our management of portfolio.

Class and Case Probabilities

A better option would be to apply what the Austrian School of economics calls as Class and Case Probabilities.

Class probability, as the great professor Ludwig von Mises defined is[2]

We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.

We know, for instance, that there are ninety tickets in a lottery and that five of them will be drawn. Thus we know all about the behavior of the whole class of tickets. But with regard to the singular tickets we do not know anything but that they are elements of this class of tickets.

On the other hand, Case probability according again to Professor Mises means:

We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.

Case probability has nothing in common with class probability but the incompleteness of our knowledge. In every other regard the two are entirely different.

Let me apply these probabilities to the recent typhoon that hit Metro Manila. [As a caveat I don’t know exactly the details of the typhoon but am comparing the major hits from a typhoon in the metropolis.]

Class probability means that we know some generalized information of the risk event.

-Typhoons can result to loss of lives, injuries or damage to properties as a result of flooding, strong winds and other related or ancilliary consequences (landslide, health hazards as leptospirosis, snake bites, E. coli and etc..).

-We can predict the path of typhoons using satellites.

-We know for instance that around 19 cyclones or tropical storms enter the Philippine area of responsibility every year[3].

From the above, we can even parallel class probabilities or “the behavior of a whole class of events or phenomena” to former US secretary of defense Donald Rumsfeld theory of uncertainty called ‘known knowns’[4]

Yet if there are ‘known knowns’ then the antipode would be the ‘unknown unknowns’.

This would represent as the Case probabilities or fragmented, dispersed and localized information on specific risk events.

Back to typhoons, we don’t know the exactitude and the variability of the typhoon’s strength (only estimates) and or its impact to particular affected localities.

While the Typhoon Nesat[5] [code name: Pedring] recently hit Northern Luzon’s Aurora and Isabela provinces the hardest, in Metro Manila, the famous Manila district of Roxas Boulevard got slammed by a barrage of extremely high storm surges that caused flooding at a public hospital, a five-star hotel and the US embassy.

This is in contrast to Typhoon Ketsana[6] [code name: Ondoy] in 2009 where strong continuous rains basically submerged Metro Manila’s Marikina City that led to many fatalities.

Think of it, about 19 typhoons hit the Philippines every year, yet we hardly know much about the prospective destruction or the scale of calamity these typhoons would bring about and where they will hit for us to apply precautionary measures.

But if you listen to the self-righteous blarneys of prominent media broadcasters, who base their comments on ex post analysis of ‘case’ events, you’d bear the impression that if the government only does as they propose the next typhoon won’t have an impact to the nation at all. Duh!

Yet fallacies from such presumptive omniscient gibberish can be applied to the most recent triple whammy calamity of Japan: the 2011 Tohoku earthquake, tsunami and the nuclear reactor meltdown[7].

Japan’s geographical location[8] makes her exceedingly vulnerable or prone to earthquakes. Thus Japan has lavished in putting up scientific prediction models, which only has proven to be a massive failure in predicting the latest catastrophe[9].

The moral: While it would seem as intellectually comforting to be guided by math based models in predicting the probabilities of the markets or the economy or of any people based risk events, unfortunately, they almost always fail to achieve their goals. The problem is that the social science isn’t physics or natural sciences that are quantifiable and work on some constants.

As Professor Mises wrote[10],

People would like to find in an economics book knowledge that perfectly fits into their preconceived image of what economics ought to be, viz., a discipline shaped according to the logical structure of physics or of biology. They are bewildered and desist from seriously grappling with problems the analysis of which requires an unwonted mental exertion.

Another notable example would be how the 2008 crisis exposed the travesty of quant[11] models[12]. UK’s Queen Elizabeth even questioned the economic profession[13] on why they haven’t seen the crisis coming.

To insist on applying something that doesn’t work is an exercise of self-deception or delusion.

Using Methodological Individualism on Uncertainty

The best methodology will always be to apply the understanding of human action or methodological individualism on social problems

Again from Professor Ludwig von Mises, (bold highlights mine)

Praxeological knowledge makes it possible to predict with apodictic certainty the outcome of various modes of action. But, of course, such prediction can never imply anything regarding quantitative matters. Quantitative problems are in the field of human action open to no other elucidation than that by understanding.

We can predict, as will be shown later, that — other things being equal — a fall in the demand for a will result in a drop in the price of a. But we cannot predict the extent of this drop. This question can be answered only by understanding.

The fundamental deficiency implied in every quantitative approach to economic problems consists in the neglect of the fact that there are no constant relations between what are called economic dimensions. There is neither constancy nor continuity in the valuations and in the formation of exchange ratios between various commodities. Every new datum brings about a reshuffling of the whole price structure. Understanding, by trying to grasp what is going on in the minds of the men concerned, can approach the problem of forecasting future conditions. We may call its methods unsatisfactory and the positivists may arrogantly scorn it. But such arbitrary judgments must not and cannot obscure the fact that understanding is the only appropriate method of dealing with the uncertainty of future conditions.

Understanding of how individuals interact with one another and with the environment should give us a better insight than sloppy thinking based on hypothetical numerical aggregates which attempts to substitute for people’s choices.

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[1] Intrade.com The US Economy will go into Recession during 2012

[2] Mises Ludwig von Uncertainty Mises.org

[3] Wikipedia.org Typhoons in the Philippines

[4] Wikipedia.org There are known knowns

[5] Wikipedia.org Typhoon Nesat (2011), Philippines

[6] Wikipedia.org Typhoon Ketsana

[7] Wikipedia.org 2011 Tōhoku earthquake and tsunami

[8] Wikipedia.org Seismicity in Japan

[9] See Science Models Fail To Predict Japan’s Earthquake, March 12, 2011

[10] Mises Ludwig von Blue-Collar Anticapitalism, Mises.org

[11] See How Math Models Can Lead To Disaster, February 25, 2009

[12] See Beware Of Economists Bearing Predictions From Models, May 27 2009

[13] The Telegraph The Queen asks why no one saw the credit crunch coming, November 5, 2008