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

In 2009, Stocks Over Bonds Means Inflation Over Deflation

This should be an interesting chart from Bloomberg's chart of the day.

According to Bloomberg,

``U.S. stocks beat 30-year Treasury bonds by a record 36 percentage points in 2009 as investors bet on a recovering economy and the government sold a record $2.11 trillion in debt.

``The CHART OF THE DAY shows the performance of 30-year bonds versus the Standard & Poor’s 500 Index since 1978, according to data compiled by Bloomberg and Bank of America Merrill Lynch. Last year, the debt lost about 13 percent, while the benchmark index for U.S. stocks surged 23 percent. Gold futures added 24 percent in New York.

``Stocks trailed bonds in 2008 as the worst financial crisis since the Great Depression drove investors to the relative safety of Treasuries. They switched places in 2009 as the yearlong contraction in U.S. gross domestic product ended and President Barack Obama raised money to fund economic stimulus programs."

I'd like to add to the perspective where 2009's outperformance of stocks over bonds essentially validates the camp of those who argued for inflation to prevail over the camp of those who advocated for deflation. And the difference hasn't been marginal.

Yet this serves as an example where a misread would have been devastating to the real returns of a portfolio.

We should see the same dynamics for the 2010.