 Ain't Misbehaving
Bill Bonner
The
Daily Reckoning
Oct 25, 2004
The Daily Reckoning
PRESENTS: No matter how hard we try to produce theories and
hypotheses to explain the market, it will always prove to be
unpredictable. It turns out we live in a riskier world that we
thought, and sometimes all we have to go on is intuition and
experience...
The financial
world was undressed recently. A new
book
by Benoit Mandelbrot and Richard Hudson, The (Mis)behavior of
Markets: A Fractal View of Risk, Ruin and Reward, revealed the
naked and revolting truth: Modern investment theories are "nonsense."
Mandelbrot
is a mathematician at Yale who has popularized the idea of fractals
- elaborate and unpredictable natural patterns, such as frost
on a windowpane.
Fractal patterns
have been thought to describe patterns of market prices. As far
as we know, no one has succeeded in developing a successful trading
model based on fractal mathematics (of course, if we had, we
might not tell anyone, either.)
Several Nobel
laureates owe their prizes, their prestige and their incomes
to what is known as the Efficient Market Hypothesis (EMH), or
simply the Random Walk. No idea about finance that was ever flushed
out of the frontal lobe ever enjoyed greater acceptance. None
ever received more recognition. And none ever sucked so much
money out of the lumpen. But the Efficient Market Hypothesis
is really nothing more than an elegant subterfuge, based on propositions
everyone knows are false.
The basic idea
is that the market is smarter than any investor. No matter how
hard you try, you can't beat the market... because at any given
moment all that is known about a share price is reflected in
the share price itself. The price - no matter how absurd - is
thought to be "perfect." No better price can be imagined.
Yet a different price tomorrow is almost a certainty. Each day,
prices move. One day gives you a price that is perfect. The next
day may give you a price only half as much, but that too is perfect.
Mr. Market is always right; he just changes his mind.
Since an investor
cannot have a better idea of what a share is worth than the market
itself, he cannot do better than buy at the market price, whatever
it is. The actual performance will be random. He might as well
throw a dart at pages of The Wall Street Journal. Or buy the
index. He will get the same return. Anything else would call
into question the whole idea - unless it were purely luck, purely
random... in no way connected to conscious effort on the part
of the analyst or stock-picker.
A corollary
of the EMH was the idea that prices and rates of return were
distributed evenly, according to what is known as the bell curve.
Another way of saying this is that prices will usually be normal...
or average... and that they will only be abnormal in a normal
way... that is, abnormally high or low such as might be predicted
by a standard bell curve distribution.
This was the
idea that led Long-Term Capital Management, for instance, to
invest billions of dollars on the proposition that if prices
fell in a range outside of the norm, you could calculate the
odds of how likely prices were to come back. LTCM had 25 Ph.D.s
on the payroll. John Meriwether put them to work calculating
standard deviations on various debt instruments - among them,
Russian bonds. In 1995, the fund made 42% on its money. In 1996,
the rate of return was 40%. But in 1998, Russia defaulted on
its bonds.
But the bell
curve, or the standard distribution, applied to finance is "nonsense,"
says Mandelbrot. It may be nonsense applied to many other naturally
occurring phenomena, too. The seas in Holland, for example, were
thought to rise 3.83 meters above "normal" only once
every 10,000 years. Yet they rose that high in 1953. Records
showed that they hit that level back in 1570 too. There was something
wrong with the calculation. Standard deviation measures didn't
seem to work. The world was a riskier place than people thought.
It came as
a shock to Myron Scholes and Robert Merton. The two Nobel Prize
winners at LTCM had staked their careers, reputations and money
on the perfectly logical idea that bond prices followed a bell
curve pattern... and that if they reached the kind of extremes
LTCM was seeing in 1998, it was a not a defect in their logic,
but a huge buying opportunity. The odds were vanishingly small
that prices would go further out of whack, they thought. Finance
was a science, after all, and science gives predictable results.
Every time.
And yet bond
prices went further out of whack. Traders at other companies
knew what was happening. They had studied the same theories.
They guessed that LTCM had loaded up with risky bonds... they
also guessed that the company tottered on a high wall of debt.
They did just what you'd expect: They gave it a push. Prices
fell even further.
The old-timers
knew the Random Walk theory was nonsense. There is always a lot
of random noise in markets - as in life itself. But there are
patterns, too. The trouble is, the patterns - like fractals -
are variable and largely unpredictable. Markets go up and down.
The movements are not only mostly unforeseeable, but perverse;
they move in tandem with the broad strokes of human sentiment.
As people become more comfortable, more sure of themselves and
the future... more confident and expansive... they tend to bid
up prices. A house that was worth only $100,000 when they expected
nothing but shelter from it rises to twice as much when they
expect it to finance their retirement.
But investors
only expect such a result after a long experience of pleasure
returns. That is, they expect asset prices to rise after they
have already risen, not before. The mood of the crowd reflects
what has just happened, not what will happen next.
House prices,
like everything else, cannot go up forever. Who would be able
to afford them? Instead, they go up and down... and perversely,
go down when they are most expected to go up... and up when a
bull market is least expected. This is, of course, not an insight
based on Efficient Market Hypothesis, but one that springs from
experience... and intuition. No one ever won a Nobel Prize for
saying so, but it never made anyone go broke.
Mandelbrot
points out that when you actually look at market prices, you
find patterns that differ greatly from those predicted by mainstream
financial theories. "Outlier events" - those that are
supposed to happen only once in a blue moon - actually happen
all the time.
Citigroup looked
at daily changes in the yen/dollar exchange rate, for example.
It found that moves of five standard deviations were not uncommon,
even though they should only happen, according to the theory,
about once every 100 years. They even found one "heart-stopping"
move, 10.7 standard deviations from the norm. What were the odds
of that? Even if Citigroup had been trading dollars and yen every
day for the last 15 billion years - from the Big Bang to the
day after yesterday - such an event shouldn't have happened a
single time. But it did.
And look at
what happened to the Dow Jones on Oct. 19, 1987. It fell 29.2%
- an event that registered 22 on the standard deviation scale.
Not only do
the markets produce events that should never happen, they also
act in other ways that intuition might predict, but existing
theories cannot fathom. According to EMH, prices - like dice
- have no memory. One day's perfect price is thought to be completely
independent of yesterday's perfect price. This is what mathematicians
call "independence" and contrarian investors call "more
nonsense."
It is nonsense
because human beings use prices as points of reference. A man
who owns a stock worth $50 one day is reluctant to believe it
is worth only $5 the next. He has no idea of what it is worth
except what the market tells him; yesterday, it told him it was
worth $50... and it's a shock to discover that it is worth only
a tenth as much.
This, or something
we can't explain, causes the phenomenon described by the old
saying, When it rains, it pours. Periods of intense volatility
cluster together; bad news piles up in what is known as "positive
short-term serial correlation." Markets don't really just
bounce around randomly, in other words, but there are periods
when things go well and periods when they don't. There are bull
markets and bear markets, as any old-timer's intuition could
have told you.
Investing isn't
rocket science. In fact, it isn't any kind of science. Instead,
it is a human study, like poetry or prize fighting. And as in
all the human studies, the problems one confronts are not bounded
engineering problems but unbounded, infinitely complex ironies.
If you do the calculations correctly, you can fire off an artillery
shell and it goes where you expect. But market prices often go
in the exact opposite direction, no matter how well you do the
numbers. It is easier to send a spaceship to the moon, in other
words, than it is to win an argument with your spouse or figure
out which way stocks are headed. And if you are going to follow
advice, an old-timer's intuition is probably a better guide than
modern portfolio theory.
The markets
ain't misbehaving, in other words: They're just doing what they
always do.
Regards,
Oct 25, 2004
 Bill Bonner
The
Daily Reckoning
Editor's Note:
Bill Bonner is the founder and editor of The Daily Reckoning.
He is also the author, with Addison Wiggin, of the NY Times,
Wall Street Journal and international bestseller: "Financial
Reckoning Day:
Surviving The Soft Depression of The 21st Century" (John
Wiley & Sons).
321gold
Inc Miami USA
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