Quote of the Day: Blinded by Science

Even some from the mainstream gets it.

Finance is often said to suffer from Physics Envy. This is generally held to mean that we in finance would love to write out complex equations and models as do those working in the field of Physics. There are certainly a large number of market participants who would love this outcome.

I believe, though, that there is much we could learn from Physics. For instance, you don’t find physicists betting that a feather and a brick will hit the ground at the same time in the real world. In other words, they are acutely aware of the limitations imposed by their assumptions. In contrast, all too often people seem ready to bet the ranch on the flimsiest of financial models.

Someone intelligent (if only I could remember who!) once opined that rather than breaking the sciences into the usual categories of “Hard” and “Soft,” they should be split into “Easy” and “Difficult.” The “Hard” sciences are generally “Easy” thanks to the ability to perform repeated controlled experiments. In contrast, the “Soft” sciences are “Difficult” because they involve trying to understand human behaviour.

Put another way, the atoms of the feather and brick don’t try to outsmart and exploit the laws of physics. Yet financial models often fail for exactly this reason. All financial model underpinnings and assumptions should be rigorously reviewed to find their weakest links or the elements they deliberately ignore, as these are the most likely source of a model’s failure.

That’s from GMO’s James Montier (source Zero Hedge).

Mr. Montier also discusses the psychological aspects of people’s predisposition for mathematical or science based models: particularly “complexity to impress” (The penchant to signal “intelligence” to acquire social acceptance—my opinion) and “defer to authority”.

And here is the warning against being blinded by science from the dean of the Austrian school of economics the great Professor Murray N. Rothbard,

Not only measurement but the use of mathematics in general in the social sciences and philosophy today, is an illegitimate transfer from physics. In the first place, a mathematical equation implies the existence of quantities that can be equated, which in turn implies a unit of measurement for these quantities. Second, mathematical relations are functional; that is, variables are interdependent, and identifying the causal variable depends on which is held as given and which is changed. This methodology is appropriate in physics, where entities do not themselves provide the causes for their actions, but instead are determined by discoverable quantitative laws of their nature and the nature of the interacting entities. But in human action, the free-will choice of the human consciousness is the cause, and this cause generates certain effects. The mathematical concept of an interdetermining "function" is therefore inappropriate.

Cartoon of the Day: Damned Lies, Statistics and Correlation-Causation Explanations

Manipulation of statistics to generate causation-correlation explanations is shown below in a spoof.

From Businessweek/Bloomberg

Our pattern seeking instincts has been shaped by our quest for certainty. This has rendered us highly vulnerable to misinterpretation of events and the subsequent distortion of our expectations. Pattern seeking plays well into our cognitive biases. Yet many seek comfort in the confines of statistics, which unknowing to many could be manipulated or skewed to fit into the bias of the presenter for whatsoever purpose/s (often politics).

And this is why we should cautiously be screening or filtering data and opinions for their validity than just to accept them as irrefragable reality or truth.

As Mark Twain once said,

There are three kinds of lies: lies, damned lies and statistics

Global Markets: A Wild, Wild October!

Floyd Norris of the New York Times put out some great market statistics backed by impressive charts. (Charts From New York Times, Emphasis on quotes all mine)

Here are Mr. Norris’ observations on October’s rollercoaster period:

-October was the worst month for the Standard & Poor’s index of 500 stocks in 21 years — since the 1987 stock market crash.

-The final week was the best week for the market in 34 years.

-The most volatile in the 80-year history of the S.& P. 500.

-The huge gains of the final week were reminiscent of the sharp recoveries from bear market lows in 1974 and 1982. Both of those moves came while the economy was mired in recession, as it almost certainly is now.

Mr. Norris’ observations on market volatility or number of days in which an index closes up or down at least 4 percent:

-In normal times, the market goes years without having even one such day. There were none, for instance, from 2003 through 2007. There were three such days throughout the 1950s and two in the 1960s.

-In October, there were nine such days.

-The accompanying chart shows the months, from 1928 through the present, when the S.& P. 500 had at least five days with 4 percent moves. Most of them were during the 1929 crash and the Great Depression. (oops!-my comment)

-Until now, September 1932 held the record for the most days with big moves, at eight. (more oops!-my comment)

-Two days during October ended with the index leaping more than 9 percent, something that had happened only nine times in the previous 80 years.

-For the week, the S.& P. 500 was up 10.5 percent, the best weekly gain since a 14.1 percent rise in the week that ended Oct. 11, 1974.

-For the month, the S.& P. 500 was still down 16.9 percent, the worst showing for the index since it fell 21.8 percent in October 1987. The Dow fell 14.1 percent, and the Nasdaq index lost 17.7 percent…

-All of the big days in September and October came after Lehman Brothers was allowed to fail. That Lehman was not deemed important enough to save signaled to investors that there was risk where they thought there was none and caused a sharp tightening of credit for many borrowers, despite efforts by central banks to push interest rates down.

On Global Contagion:

-Many countries, among them Britain, Japan, India and Brazil, also showed more volatility than the United States.

-That volatility was so high everywhere was an indication of how linked markets have become in the age of globalization. It is not just that most industrial countries appear to be in recession, or close to it. Another factor is that investors now own portfolios of shares from around the globe, and in times of stress may sell what they can, instead of just what they want to unload.

On a Possible Bottom:

-If Monday’s stock market lows prove to be the low prices for this cycle, the bear market will have ended with the S.& P. 500 down 46 percent from the peak it reached in October 2007. That would make the bear market almost, but not quite, as bad as the 1973-74 bear market, which ended with the index down 48 percent.

-In the 2000-2 bear market, the fall was 49 percent.

-If the rebound this week indicated that the bear market of 2007-8 had ended, it lasted just over a year and hit bottom on Monday, at 848.92. It recovered to 968.75 by week’s end. There were similar moves in most major indexes. The Dow Jones industrial average ended the week up 11.3 percent, at 9,325.01, and the Nasdaq composite climbed 10.9 percent, to 1,720.95.

My Additional Comments:

It’s a mixed message from the market, although definitely representative of bear market violence.

On the optimistic note, last week’s sharp recovery could be reminiscent of the 1973-1974 “bottom” paradigm.

BUT, from the pessimist side, looking at the market volatility aspect, it could also signify the movements during the Great Depression especially IF we see MORE of the same degree of intense gyrations in the coming sessions.