The Link between Austrian Business Cycle and the Black Swan Theory

In a white paper published at Zero Hedge, Mark Spitznagel, CIO of Universa Investments LP has an insightful exposition of the critical linkage between the Austrian Business Cycle Theory (ABCT) and Nassim Taleb’s Black Swan theory.

Here is Mr. Mark Spitznagel at the Zero Hedge… (bold emphasis original)

Birds of a Different Feather

On Induction: If it looks like a swan, swims like a swan…

By now, everyone knows what a tail is. The concept has become rather ubiquitous, even to many for whom tails were considered inconsequential just over a few years ago. But do we really know one when we see one?

To review, a tail event—or, as it has come to be known, a black swan event—is an extreme event that happens with extreme infrequency (or, better yet, has never yet happened at all). The word “tail” refers to the outermost and relatively thin tail-like appendage of a frequency distribution (or probability density function). Stock market returns offer perhaps the best example:

Over the past century-plus there have clearly been sizeable annual losses (of let’s say 20% or more) in the aggregate U.S. stock market, and they have occurred with exceedingly low frequency (in fact only a couple of times). So, by definition, we should be able to call such extreme stock market losses “tail events.”

But can we say this, just because of their visible depiction in an unconditional historical return distribution? Here is a twist on the induction problem (a.k.a. the black swan problem): one of vantage point, which Bertrand Russell famously described exactly one-hundred years ago with his wonderful parable (of yet another bird):

The man who has fed the chicken every day throughout its life at last wrings its neck instead, showing that more refined views as to the uniformity of nature would have been useful to the chicken…The mere fact that something has happened a certain number of times causes animals and men to expect that it will happen again.

Bertrand Russell, The Problems of Philosophy (1912)

My friend and colleague Nassim Taleb incorporates Russell’s chicken parable as the “turkey problem” very nicely in his important book The Black Swan. The other side of the coin, which Nassim also significantly points out, is that we tend to explain away black swans a posteriori, and our task in this paper is to avoid both sides of that coin The common epistemological problem is failing to account for a tail until we see it. But the problem at hand is something of the reverse: We account for visible tails unconditionally, and thus fail to account for when such a tail is not even a tail at all. Sometimes, like from the chicken’s less “refined views as to the uniformity of nature,” what is unexpected to us was, in fact, to be expected.

II. Not Just Bad Luck: The Austrian Case

Perhaps more refined views would be useful to us, as well.

This notion of a “uniform nature” is reminiscent of the neoclassical general equilibrium concept of economics, a static conception of the world devoid of capital and entrepreneurial competition. As also with theories of market efficiency, there is a definite cachet and envy of science and mathematics within economics and finance. The profound failure of this approach—of neoclassical economics in general and Keynesianism in particular—should need no argument here. But perhaps this methodology is also the very source of perceiving stock market tails as just “bad luck.”

Despite the tremendous uncertainty in stock returns, they are most certainly not randomly-generated numbers. Tails would be tricky matters even if they were, as we know from the small sample bias, made worse by the very non-Gaussian distributions which replicate historical return distributions so well. But stock markets are so much richer, grittier, and more complex than that.

The Austrian School of economics gave and still gives us the chief counterpoint to this naïve vew. This is the school of economic thought so-named for the Austrians who first created its principles3, starting with Carl Menger in the late 19th century and most fully developed by Ludwig von Mises in the early 20th century, whose students Friedrich von Hayek and Murray Rothbard continued to make great strides for the school.

To Mises, “What distinguishes the Austrian School and will lend it immortal fame is precisely the fact that it created a theory of economic action and not of economic equilibrium or non-action.” The Austrian approach to the market process is just that: “The market is a process.” Moreover, the epistemological and methodological foundations of the Austrians are based on a priori, logic-based postulates about this process. Economics loses its position as a positivist, experimental science, as “economic statistics is a method of economic history, and not a method from which theoretical insight can be won.” Economic is distinct from noneconomic action—“here there are no constant relationships between quantities.” This approach of course cannot necessarily provide for precise predictions, but rather gives us a universal logical structure with which to understand the market process. Inductive knowledge takes a back seat to deductive knowledge, where general principles lead to specific conclusions (as opposed to specific instances leading to general principles), which are logically ensured by the validity of the principles. What matters most is distinguishing systematic propensities in the entrepreneurial-competitive market process, a structure which would be difficult to impossible to discern by a statistician or historian.

To the Austrians, the process is decidedly non-random, but operates (though in a non-deterministic way, of course) under the incentives of entrepreneurial “error-correction” in the economy. In a never ending series of steps, entrepreneurs homeostatically correct natural market “maladjustments” (as well as distinctly unnatural ones) back to what the Austrians call the evenly rotating economy (henceforth the ERE). This is the same idea as equilibrium, but, importantly, it is never considered reality, but rather merely an imaginary gedanken experiment through which we can understand the market process; it is actually a static point within the process itself, a state that we will never really see. Entrepreneurs continuously move the markets back to the ERE—though it never gets (or at least stays) there. Rothbard called the ERE “a static situation, outside of time,” and “the goal toward which the market moves. But the point at issue is that it is not observable, or real, as are actual market prices.”

Moreover, “a firm earns entrepreneurial profits when its return is more than interest, suffers entrepreneurial losses when its return is less…there are no entrepreneurial profits or losses in the ERE.” So “there is always competitive pressure, then, driving toward a uniform rate of interest in the economy.” Rents, as they are called, are driven by output prices and are capitalized in the price of capital—enforcing a tendency toward a mere interest return on invested capital. We must keep in mind that capitalists purchase capital goods in exchange for expected future goods, “the capital goods for which he pays are way stations on the route to the final product—the consumers’ good.” From initial investment to completion, production (including of higher order factors) requires time.

By about one hundred years ago, the Austrians gave us an a priori script for the process of boom and bust that would repeatedly follow from repeated inflationary credit expansions. Without this artificial credit, entrepreneurial profit and loss (“errors”) would remain a natural part of the process, except that, for the most part, they would naturally happen quite independently of one-another.

Central to the process is the “price of time": the interest rate market. This market conveys tremendous information to entrepreneurs due to the aggregate time preference (or the degree to which people prefer present versus future satisfaction) which determines it and is reflected in it. Interest rates are indeed the coordinating mechanism for capital investment in factors of production.

Non-Austrian economists typically depict capital as homogeneous, as opposed to the Austrians’ temporally heterogeneous and complex view of the capital structure. We see this in the impact of interest rate changes. Low rates entice entrepreneurs to engage in otherwise insufficiently profitable longer production periods, as consumers’ lower time preference means they prefer to wait for later consumption in the future, and thus their additional savings are what move rates lower; high rates tell entrepreneurs that consumers want to consume more now, and the dearth of savings and accompanying higher rates make longer-term production projects unattractive and should be ignored in order to attend to the consumers’ current wants. The present value of marginal higher order (longer production) goods is disproportionately impacted by changes in their discount rates, as more of their present value is due to their value further in the future.

Variability in time preferences changes interest and capital formation. If lower time preference and higher savings and lower interest rates created higher valuations in earlier-stage capital (factors of production) which initiates a capital investment boom, this newfound excess profitability would be neutralized by lower demand for present consumption goods and lower valuations in that later-stage capital. (John Maynard Keynes’ favored paradox of thrift is completely wrong, as it ignores the effect on capital investment of increased savings, and resulting productivity—and ignores the destructiveness of inflation, as well.)

But there is an enormous difference between changes in aggregate time preference and central bank interest rate manipulation. Where this is all heading: The Austrian theory of capital and interest leads to the logical explication of the boom and bust cycle. To the logic of the Austrians, extreme stock market loss, or busts—correlated entrepreneurial errors, as we say—are not a feature of natural free markets. Rather, it is entirely a result of central bank intervention. When a central bank lowers interest rates, what essentially happens is a dislocation in the market’s ability to coordinate production. The lower rates make otherwise marginal capital (having marginal return on capital) suddenly profitable, resulting in net capital investment in higher-order capital goods, and persistent market maladjustments.

Despite the signals given off by the lower interest rates, the balance between consumption and savings hasn’t changed, and the result is an across-the-board expansion—rather than just capital goods at the expense of consumption goods. What the new owners of capital will find is that savings are unavailable later in the production process. These economic cross currents—more hunger for investment by entrepreneurs seizing perceived capital investment opportunities, and consumers not feeding that hunger with savings, but rather actually consuming more—creates a situation of extreme unsustainable malinvestment that ultimately must be liquidated.

The only way out of the misallocated, malinvestment of capital, is a buildup of actual resources (wealth) in the economy in order to support it. This could result from lower time preferences (but as we know compressed interest rates actually inhibit savings)—or of course by accumulated reinvested profits over time (but of course time will not be on the side of marginal malinvested capital earning economic losses).

Credit expansion raises capital investment in the short run, only to see the broad inevitable collapse of the capital structure. Eventually the economic profit from capital investment and the lengthening of the production structure are disrupted, as the low interest rates that made such otherwise unprofitable, longer term investment attractive disappear. As reality sets in, and as time preferences dominate the interest rates again (even central banks cannot keep asset valuations rising forever), projects become untenable and must be abandoned. Despite the illusory signs from the interest rate market, the economy cannot support all of the central bank-distorted capital structure, and the boom becomes visibly unsustainable.

“In short,” wrote Rothbard, “and this is a highly important point to grasp, the depression is the ‘recovery’ process, and the end of the depression heralds the return to normal, and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom, then, requires a ‘bust.’”

Aggregate, correlated economic loss—the correlated entrepreneurial errors in the eyes of the Austrians—is not a random event, not bad luck, and not a tail. Rather, it is the result of distortions and imbalances in the aggregate capital structure which are untenable. When it comes to an end, by necessity, it does so ferociously due to the surprise by entrepreneurs across the economy as they discover that they have all committed investment errors. Rather than serving their homeostatic function of correcting market maladjustments back to the ERE, the market adjusts itself abruptly when they all liquidate.

What follows—to those who see only the “uniformity of nature”—is a dreaded tail event.

Read the rest below

Universa Spitznagel 5.21

I haven’t read the entire paper but the black swan-ABCT perspective has generally represented my analytical approach to the market.

And the complementarity of both theories is probably why Nassim Taleb endorsed Ron Paul, whose principles essentially represents the Austrian persuasion, for President.

“Pump and Dump” Policies Pumps Up Miniature and Grand Bubbles

A friend recently called to say that there have been numerous accounts of “miniature bubbles” in the local markets. Others claim that these have been brought about by unscrupulous people engaged in “pump and dump”.

In reality as I have been pointing out, miniature bubbles are symptoms of the ultimate bubble blower—central bank policies. Central bank policies distort people’s incentives towards money. Savings, investment and consumption patterns will have all been skewered. Where negative real rates punish savers, naturally people whose savings are being diminished through the erosion of purchasing power will seek higher yield, and thus, redeploy their savings into other activities which may include more consumption activities, speculation or high risk investments and or take up more debt to fund these activities. Even private sector Ponzi schemes has been flourishing under today’s environment[1]

In essence policies that tamper with money motivates the public to value short term over the long term.

Thus heightened price volatilities which are deemed as “pump and dump” or as “miniature bubbles” represent as symptoms rather than the cause. People will look for excuses to push up prices or speculate for the simple reason that policies have egged them to do so.

The easy money climate lures the vulnerable public to go for momentum and chase prices using any available tools (charts, corporate fundamentals or even tips[2] and rumors) to do so. And this is why pump and dumps happen.

Large price swings make some people think that stock market operators are culpable for such swing. But this would be mistaking trees for the forests. Absent easy money policies, bubbles and pump and dumps hardly has been a feature. Had there been mini bubbles or pump and dumps during the bear market of 2007-2008? No, because inflated assets were all deflating in response or as contagion to the real estate-banking crisis abroad.

Broken Markets

And as earlier pointed out[3], the US today has not been different, junk bonds or high yielding debt has been booming.

Writes the Buttonwood (Philipp Coggan) of the Economist[4]

Of course, the broader point is that investors are being pushed into these high-yielding assets because of the policy of the Fed (and most developed world central banks) of keeping interest rates close to zero. Similar reasoning drove the enthusiasm for structured products that financed the subprime boom.

Zero bound rates have prompted for yield chasing actions, here or in the US.

The mainstream finally comes to admit what I have been saying all along—that markets have been vastly distorted where one cannot use “fundamentals” in the traditional and conventional sense to evaluate investments.

The excessive price volatility in today’s markets does not match with the fluctuations of conventional metrics of financial ratios. Today’s price volatility has been incongruent with trends of corporate fundamentals. And thus as I earlier pointed out[5], anyone who believed in “fundamentals” would have sold as early as March.

Considering the huge jump in prices from the start of the year, we should be around at near the peak of 2007. So anyone who believes in this stuff ought to be shorting or selling the market. I won’t.

The left window from the chart above as I earlier posted last March has a time series that ended November of 2011. The right chart from DBS represents a more updated one albeit was updated until last March. Considering that the Phisix has now been drifting at over 5,150 which means valuations continues to climb higher away from these charts, the Phisix has become “priciest” stock market in Asia.

Yet leaning on earnings or conventional fundamental metrics, like the Heisenberg uncertainty principle, becomes a permanently moving target which is impossible to pin down, especially punctuated under today’s easy market climate.

Will I sell on the account of earnings/fundamentals? My answer is still no. Not until interest rates climb in response to consumer price inflation, or through heightened demand for credit, or questions over credit quality of government papers or the scarcity of capital becomes apparent[6]. Nominal interest rates are not a one-size-fits-all thing, and there are many measures (like real interest rates, CDS, yield curve et.al.) to gauge if the monetary environment has begun to tighten for one reason or another. This also should come in the condition that the hands of central bankers have also been shackled and would be unable to respond forcefully as they have been doing today.

For now central banks around will continue to find ways and means to push more easing measures in support of the asset markets which was highlighted by last week’s additional stimulus by the Bank of Japan (BoJ)[7]

The following excerpt from the mainstream loudly resonates on what I have been saying.

From the Financial Times[8],

Markets are broken. Accepted investment wisdom has been overturned and the basic tenets of value and diversification no longer work. The financial crisis put the market into a volatile “risk on, risk off” – or Roro – mode for which there is no cure.

For many investors, this has made stockpicking seemingly an impossible task. Markets once responded to their fundamentals. Now, disparate assets have a much greater tendency to move together, individual characteristics lost. Trusted strategies such as relative value and currency carry trades are nearly useless, overwhelmed by daily market-wide volatility.

“Assets now behave as either risky assets or safe havens, and their own fundamentals are secondary,” writes HSBC strategist Stacy Williams in a recent note. “In a world where most asset classes are synchronised, it becomes very difficult to achieve diversification. It also means that since most individual assets are dominated by a common price component, it becomes increasingly futile to invest in them based on their usual fundamentals.”

Though asset classes had been moving in closer correlation since the start of the financial crisis in 2007, the Roro trend became most apparent after the collapse of Lehman Brothers a year later. The uncertainty helped turn investing bimodal, where every price has been contaminated by systemic risk. Everything became a bet on whether we were closer to a global recovery or to deeper crisis.

So what recommendations do they offer for the public to deal with the state of “broken markets? They have three. One is to pick a position from the boom or the bust scenario, second is to chase momentum and third is to hedge positions through index futures.

I would like to emphasize on the second option, not because this is my preferred approach but because of its relevance to the conditions of the local markets, from the same article,

Another option is to seek out an investment strategy that still works. Momentum investing – in effect, buying the winners and selling the losers – is a method that HSBC analysts highlight as having been largely impervious to the risk trade. To chase a trend aims to harvest small but systematic mispricing of assets, and there is no reason to suppose these anomalies would disappear in bimodal markets, the broker argues. (In this context, the growth of high-frequency trading since the start of the crisis is unlikely to be coincidental.)

This simply means that the mainstream will largely be chasing momentum, by targeting frequency over magnitude through “harvest small but systematic mispricing of assets”. So in essence, high risk speculative activities or gambling (a.k.a “miniature bubbles” and “pump and dump”) has been recognized as the common or standardized feature of the current market place. So history will rhyme and a bust will be around the corner.

I would rather “time” the bubble cycle rather than go chasing prices. And this is why it is imperative for any serious investors to understand the bubble process or the boom bust cycle.

Stock Market is about Human Action

Finally financial markets signify a social phenomenon. There is a popular aphorism from former President John F. Kennedy, who said in the aftermath of the failed Bay of Pigs Invasion[9], which seems relevant to the financial markets,

Victory has a thousand fathers; defeat is an orphan.

Winning issues and or market tops tend to attract substantial participants as a function of easy money (get rich quick mentality), keeping up with the Joneses (bandwagon effect) or survivorship bias (focus on survivors or winners at the expense of the others) or social signaling (desire for greater social acceptance, elevated social status and or ego trips).

On the other hand market bottoms results to the opposite: depression, avoidance, isolation and animus behaviour for those caught by the crash.

Most people don’t realize that emotional intelligence or self discipline is key to surviving the market’s volatility, not math models or charts or any Holy Grail or Greek formulas. And this comes from the desire to attain self discipline than from advices of other people.

Yet self discipline is earned and acquired through knowledge and through the whetting of one’s skills based on these accrued knowledge. Alternatively, self discipline cannot be not given or inherited. And that’s why I vehemently opposed the suggestion by a popular religious personality, who had investments on a mutual fund, to get housemaids to invest in the stock market[10].

The incentive to acquire the desired knowledge and skills varies from individual to individual because they are largely driven by the degree of stakeholdings or the stakeholder’s dilemma or stakeholder’s problem[11].

Today’s information age has democratized access to information. What can be given are information relevant to attaining knowledge and skills. What can NOT be given is the knowledge that dovetails to one’s personality for the prudent management of one’s portfolio. Like entrepreneurship this involves a self-discovery process.

And most importantly, what can NOT be given are the attendant actions to fulfill the individual’s objectives.

Stock market investing is about people and their actions. That’s why this is a social phenomenon. No more, no less.

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[1] See After 5,000: What’s Next for the Phisix?, March 5, 2012

[2] See New Record Highs for the Philippine Phisix; How to Deal with Tips February 20, 2012

[3] See Self-Discipline and Understanding Market Drivers as Key to Risk Management, April 12, 2012

[4] Buttonwood Hooked on junk, April 27, 2012, The Economist

[5] See Earnings Drive Stock Prices? International Container Terminal and Ayala Land, March 6, 2012

[6] See Global Equity Market’s Inflationary Boom: Divergent Returns On Convergent Actions, February 13, 2002

[7] See Bank of Japan Adds More Stimulus, April 17, 2012

[8] Financial Times ‘Roro’ reduces trading to bets on black or red April 20, 2012

[9] Quotationspage.com Quotation Details John F. Kennedy, "A Thousand Days," by Arthur M. Schlesinger Jr [1965]., p289. Comment made by JFK in the aftermath of the failed Bay of Pigs invasion, 1961.

[10] See Should Your Housemaid Invest In The Stock Market? September 5, 2010

[11] See Knowledge Acquisition: The Importance of Information Sourcing and Quality, March 6, 2011

Phisix Should Outperform as Global Markets Improve

And right here let me say one thing: After spending many years in Wall Street and after making and losing millions of dollars I want to tell you this: It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! It is no trick at all to be right on the market. You always find lots of early bulls in bull markets and early bears in bear markets. I've known many men who were right at exactly the right time, and began buying and selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine - that is, they made no real money out of it. Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn. But it is only after a stock operator has firmly grasped this that he can make big money. It is literally true that millions come easier to a trader after he knows how to trade than hundreds did in the days of his ignorance. Jesse Livermore

Mechanical chartists will consider the present environment a sell.

That’s because the Phisix has joined her ASEAN neighbors (MYDOW- Malaysia, IDDOW- Indonesia and Thailand-SETI) into a transition towards the bearish “death cross”—where long term moving averages have gone above the short term moving averages.

As an aside, it’s a heresy for fanatic chart practitioners to know the fact that trading based on mechanical charting usually leads to needless churning, which benefits brokers, commissioners (like me) and governments (taxes) more than investors, due to the accumulated transaction costs that only hampers or diminishes on investor’s returns. Who cares about truth, anyway? For most people, belief is about social acceptance than of reality.

Never mind if trying to catch tops and bottoms of highly dynamic price actions of each securities driven by variable human choices under unique circumstances would seem like fictional heroine Alice—of the famed Charles Lutwidge Dodgson known under the pseudonym Lewis Carroll’s fable—who tries to ascertain if Wonderland was a reality.

To quote the legendary Jesse Livermore via Edwin Lefevre through the classic Reminiscences of a Stock Operator[1]

The reason is that a man may see straight and clearly and yet become impatient or doubtful when the market takes its time about doing as he figured it must do. That is why so many men in Wall Street, who are not at all in the sucker class, not even in the third grade, nevertheless lose money. The market does not beat them. They beat themselves, because though they have brains they cannot sit tight.

Feeding on emotional impulses and cognitive biases only deprives market participants of the needed regimen of self-discipline and importantly narrows a participant’s time preference in conducting risk reward analysis in the silly pursuit of short term “frequent” gains but at the risks of the magnitude of greater risk.

Again the legendary Jesse Livermore

Disregarding the big swing and trying to jump in and out was fatal to me. Nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end. To do this you must study general conditions and not tips or special factors affecting individual stocks.

It is important for market practitioners to realize that what counts is the magnitude of the effects of one’s action than of its frequency[2].

Frequency will mostly be about luck while magnitude will account for the impact of patience, discipline and mental rigor.

Going back to the big picture, given that the developed economies has once again embarked on undertaking policies to substantially ease financial conditions, which this time includes developed markets periphery and some emerging markets, e.g. Australia recently joined Turkey, Brazil and Indonesia to cut policy rates[3], we may be looking at the next leg of the boom phase of the present bubble cycle.

Outside another round of exogenous based political spooks, market internals in the Phisix appear to be showing meaningful signs of improvements.

While volume still lacks the vigor of a strong recovery, possibly due to the sluggishness brought about by the extended holiday from an abbreviated trading week, signs like average number of trades (computed on a weekly basis) seem to be holding ground and showing incremental improvements.

To consider this week’s losses in the Phisix seem to reflect on the weakness of the global markets.

My interpretation of last week’s action was one of natural profit taking following a strong push from the previous weeks. The correction of which only used the Greece political circus as an excuse to take profits.

For instance, the US Dow Jones Industrials saw a winning streak of 5 consecutive weeks which accrued gains of 12.92%, but gave back 2.03% this week for a retracement of 15% from the previous gains.

The Phisix seem to reflect on the same motions, the local benchmark racked up 11% over the same 5 week period where US markets went up, but lost 1.43% this week equivalent to a 13% retracement.

Yet over the broad market, except for the financial sector which was largely unchanged, the mining sector led the losses which weighed mostly on the local composite bellwether.

And this week’s losses have hardly dinted on foreign sentiments, which as stated last week, the present recovery appears to be accelerating.

Again one of the major surprises has been that foreign investors has hardly been affected even by the September shakeout.

Finally, the Peso’s performance again appear to reflect on the actions of the Phisix.

The gap generated the other week seeems as being filled, using the current profit taking mode as pretext.

Nevertheless, since the outperformance and the momentum by ASEAN bourses seem to have been spoiled by the recent exogenous contagion, an easing financial environment will likely spur the next leg up, barring unforeseen circumstances.

My bet is that the Phisix’s ‘death cross’ along with the ASEAN counterparts are likely false signals that will become whipsaws soon, another failed chart pattern.

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[1] Gold-eagle.com Wisdom of Jesse Livermore 6

[2] See Dealing With Financial Market Information, February 27, 2011

[3] FT.com Growth fears prompt Australian rate cut, November 1, 2011

Dealing With Financial Market Information

Ideas and only ideas can light the darkness. These ideas must be brought to the public in such a way that they persuade people. We must convince them that these ideas are the right ideas and not the wrong ones. The great age of the nineteenth century, the great achievements of capitalism, were the result of the ideas of the classical economists, of Adam Smith and David Ricardo, of Bastiat and others. What we need is nothing else than to substitute better ideas for bad ideas-Ludwig von Mises

Markets operate on a pricing system. And prices are manifestations of people’s actions guided and coordinated by information aimed at the efficient allocation of resources.

As the great F. A. Hayek wrote[1],

Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan.

The financial or capital markets (stock markets, bond, currency, derivatives, etc...) function the same way. They are information sensitive since they operate as intermediaries of savings and investments. Perhaps they even could even represent more information sensitivity than the real economy for the following reasons:

-Financial markets today are organized formal markets that are far larger than the economy

According to the table above from McKinsey Quarterly[2], despite the 2008 crisis, financial depth still accounted for 293% of the GDP (Here financial markets include equity, bank deposits, private and government debt)

-Financial markets are more globally integrated have been buttressed by the digital technology

-Financial markets are more liquid and volatile, and have been lubricated by the central banking based monetary system.

Of course not all information are equally useful or relevant.

There are information that are considered as useful or to quote Hayek anew “only the most essential information is passed on and passed on only to those concerned[3]” and that many information are not.

Furthermore information isn’t complete. They are dispersed, localized and account only for a portion of the system, writes author Peter L. Bernstein[4], (bold emphasis mine)

The past or whatever data choose to analyze, is only a fragment of reality. That fragmentary quality is crucial in going from data to a generalization. We never have all the information we need (or can afford to acquire) to achieve the same confidence with which we know, beyond a shadow of a doubt, that a die has six sides, each with a different number, or that a European roulette wheel has 37 slots (American wheels have 38 slots), again each with a different number. Reality is a series of connected events, each dependent on one another, radically different from the games of chance in which the outcome of any single throw has zero influence on the outcome of the next throw. Games of chance reduce everything to a hard number, but in real life we use such measures as “a little”, “a lot” or “not too much please” much more often than we use a precise quantitative measure.

Falsifying Popular Delusions

This brings us to the gist of what supposedly are useful information/ facts/ data sets for the financial markets.

Here is a great example, this isn’t being nostalgic for 2008 crisis but should be a thought provoking exercise

Information/Fact A

According to ABS CBN[5] (bold emphasis mine)

In a statement Sunday, the PSE reported that the combined net income of publicly listed firms dropped to P198.91 billion in 2008 from P281.54 billion in 2007, a banner year...

Lim noted, however, that revenues of listed firms grew 12.8 percent to P2.67 trillion from P2.37 trillion.

The recent data were culled from the latest financial statements submitted by 233 out of 246 listed companies. Of the 233 reporting firms, 159 posted net gains while the remaining 74 posted net losses.

Interpretation: Public listed companies were down from a RECORD highs in 2007 but remained overall positive. To add, 68% of publicly listed posted profits in 2008.

Information/Fact B

The above is the % change of the Philippine economy courtesy of tradingeconomics.com[6]

Interpretation: Like corporate profits, the Philippine economy slowed but did not suffer a recession in 2008.

Information/ Fact C

The Phisix closed at the end of 2007 at 3,621.6 and at the year end of 2008 at 1,872.85

Interpretation: The Phisix fell 48.28% in 2008!

Analysis:

Fact A partly reflected on Fact B because Fact A is part of the computation of Fact B, or corporate profits are part of the computation for the GDP[7]

Where the conventional wisdom is to generalize

Fact A (corporate profits) + Fact B (economic growth) = Fact C (rising stock markets),

then we see that three facts tells us the contrary

A+B ≠C

The conventional wisdom of A+B=C has been demonstrably falsified.

Let me add Fact D

According to Bloomberg at yearend of 2008[8],

The S&P 500 decreased 38.5 percent, the most since the 38.6 percent plunge in 1937, to 903.25 and sank to an 11-year low of 752.44 on Nov. 20. Volatility increased, with the index rising or falling 5 percent in a single day 18 times. The Dow Jones Industrial Average slumped 34 percent to 8,776.39 for the steepest drop since 1931.

Additional analysis: The Phisix did not suffer a recession or a crisis, yet the local stock market endured MORE losses compared to the epicentre or the source of the crisis—the US markets.

In short, there has been no meaningful correlation or even an established causation nexus between corporate profits and the economy relative to the stock market under the local setting.

Asymmetric Risk Taking

Why this matters?

Because any serious or prudent investors would attempt to pursue information or assimilate knowledge that are relevant or one that works, something which Nassim Taleb calls as “positive knowledge[9]”, and presumably ignore those that don’t.

Not every individual engaged in the stockmarket or the financial markets share the same incentives: instead of the primary pursuit for profits or returns, many are there for the adrenalin (thrill or the gambling tic) or to stimulate the dopamine “brain’s pleasure centers” (intellectual or ideological strawman), some are merely active for social purposes (signalling via talking points) or possibly to simply to keep busy.

The deviance from the pursuit of profits makes risk taking activities largely asymmetric.

Thus the demand for workable ‘positive’ knowledge in the financial markets would be proportional to the desire to generate real returns. We increase our profits by dealing with information or knowledge that will give us profits.

The famous Wall Street maxim, ‘bulls and bear make money but pigs get slaughtered’ are representative of market participants who see profits or returns as a secondary priority. Of course, everyone will likely say that they are in for profits but their subsequent actions will reveal of their unstated or subliminal priorities—or that actions should speak louder than words.

The great part in today’s marketplace is that the internet has allowed us vast access to information and on real time basis. This gives us the opportunity to screen information. And this also means that filtering information will tilt one into an information junkie to the risk of an information overload.

Again from Peter Bernstein[10], (bold emphasis mine)

We tend to believe that information is a necessary ingredient to rational decision making and that the more information we have, the better we can manage the risk we face. Yet psychologists report circumstances in which additional information gets in the way and distorts decisions, leading to failures of invariance and offering people in authority to manipulate the kinds of risk that people are willing to take.

In short information or facts can be tainted.

Agency Problem, Again

This brings us to the most sensitive part of information sourcing: the principal-agent or the agency problem

Economic agents or market participants have divergent incentives, and these different incentives may result to conflicting interests.

To show you a good example, let us examine the business relationship between the broker and the client-investor.

The broker derives their income from commissions while the investor’s earning depends on capital appreciation or from trading profits or from dividends. The economic interests of these two agents are distinct.

How do they conflict?

The broker who generates their income from commissions will likely publish literatures that would encourage the investor to churn their accounts or to trade frequently. In short, the literature will be designed to shorten the investor’s time orientation.

Yet unknown to the investor, the shortening of one’s time orientation translates to higher transaction costs (by churning or frequent trading). This essentially reduces the investor’s return prospects and on the other hand increases his risk premium.

How? By diverting the investor’s focus towards frequency (of small gains) rather than the magnitude. Thus, a short term horizon tilts the risk-reward scale towards greater risk.

Nassim Taleb has shown this in the analogy of the Turkey problem[11] as shown in the chart[12] above.

The Turkey is fed from day 1 and so forth, and as a consequence gains weight through the feeding process.

From the Turkey’s point of view such largesse will persist.

However, to the surprise of the Turkey on the 1,001th day or during Thanksgiving Day, the days of glory end: the Turkey ends up on the dinner table. The turkey met the black swan.

The turkey problem is a construct of the folly of reading past performance into the future, and likewise the problem of frequency versus the magnitude, both of which serves as the cornerstone for Black Swan events.

Going back, such conflict of interest may also apply to bankers too. Bankers are likely to publish literatures that goad their clients to use their facilities where the bankers earn from having more fees than focusing on the client’s interests of generating above average returns.

At the end of the day, for both cases the gullible investor ends up holding the proverbial empty bag.

So unless one is aware of such distinction, information embellished by statistics which may be construed as facts can instead represent promotional materials.

It is important to note that conflicts of interests emanating from the agency problem played a significant or crucial role during the bubble days that was also responsible for the last crisis[13].

In addition, the common practise of politicians and their apologists to present statistical facts to promote their interventionist agenda is another example of agency problems.

Most of these facts do not objectively represent the problems in a holistic sense, but instead are selectively chosen facts or data mined statistics that fits into their theories. These proposals are also usually wrapped in logical fallacies.

And most of their so-called solutions are usually framed with noble sounding intentions so that these will easily sell to the vulnerable voters. Little do the hapless voters know that such policies focuses on the short term are booby trapped with unintended consequences.

Conclusion: Ideas Have Consequences

Bottom line:

Ideas have consequences.

And so with ideas forged by false theories.

Prudent investors need to screen, test and falsify ideas and observe their validity rather than simply accepting them without due scrutiny. Failing to do so is to assume the risks of the proverbial Wall Street Pigs that have been the traditional fodder of Bears and Bulls.

Moreover, prudent investors should adapt on ideas that are likely to produce positive results over the long term at the same time reducing the prospects of being swallowed by black swan events.

In short, prudent investors need a critical and constructive mind to examine the usefulness of information as sources for ideas that underpins the subsequent action.

In addition, prudent investors must be vigilant with the source of information as this can reflect more of the interest of the information conveyor than that of the recipient.

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[1] Hayek, Friedrich von, The Use of Knowledge in Society

[2] McKinsey Global Institute Global Capital Markets Entering a New Era, September 2009

[3] Hayek, Friedrich von ibid

[4] Bernstein, Peter L. Against The Gods: The Remarkable Story of Risk, p 121

[5] Abs-cbnNews.com Listed firms' profits down 29% in 2008, May 31, 2010

[6] Tradingeconomics.com Philippines percent change in GDP at constant prices

[7] Bureau of Economic Analysis, National Economic Accounts

[8] InfiniteUnknown.net U.S. Stocks Post Steepest Yearly Decline Since Great Depression, Bloomberg.com December 31, 2008

[9] Taleb Nassim Nicolas Anti Fragility, How To Live In A World We Don’t Understand, Chapter 5, How (NOT) To Be A Prophet fooledbyrandomenss.com

[10] Bernstein, Peter Op. cit. P.278

[11] Wikipedia.org Black swan theory

[12] Kinsella Stephan, The Turkey Problem

[13] See Agency Problem: Examples, Risks and Lessons, December 25, 2009