Archive for April, 2009

Irrational Exuberance

irrationalexuberance

Irrational exuberance - At the recent meeting, a client said that it is time for new valuation theories as old theories are dead. This coming from someone who made it to the Top 300 rich list of Romanians indicated what smart money was thinking. It also illustrated how much time it took for a mainstream thought to be challenged.

Shiller’s theory

It was about 30 years ago, Robert Shiller - the award winning economist, author of Irrational Exuberance, a bestseller that challenged the Efficient Market Hypothesis (EMH) in an article published in the American Economic Review in 1981. 30 years, yes that is what it took. This is how outdated we are in our thought.

This was my second reading of the book. I read the first edition in 2000. Unlike Beyond Greed and Fear by Hersh Shefrin, Irrational Exuberance was more focused and had more objective criticism of conventional research thought. Despite the incredible timing of the book which shuts up comments like “who knew it?” The author calls himself plain “lucky” and makes no claim of having a forecasting ability. He also talks about the role of opinion leaders to stabilize markets even if in a minor way.

In a follow-up discussion paper titled From Efficient Market Theory to Behavioral Finance, Shiller explains how in the 1970’s it would have been wishful thinking that models which describe the world around us could be true.

Anomalies in the EMH were discovered in 1970’s and it was the excess volatility of the stock markets which was too large an aberration to remain unexplained. In simple terms, changes in prices occur for no fundamental reason and are primarily driven by mass psychology. He does mention other drivers like “sun spots”, albeit casually.

On to behavioral finance

To validate his case he takes present value (PV) of dividends paid on S&P composite stock price index discounted by a constant real discount rate for the period (1871-2002). He demonstrates that PV behaves remarkably like a stable trend. In contrast, stock price index gyrates, wildly up and down around this trend. This proved that there is excess volatility in the aggregate stock market relative to the PV implied by the EMH.

You cannot defend the EMH. Markets are crazy, even if not totally. There has been no effective study linking fluctuations with fundamentals till date. This is where Shiller moves to another explanation, behavioral finance feedback model which is the academic form of a feedback theory first written by Charles Mackay in 1841 in his book Memoirs of Extraordinary Popular Delusions. The book described the famous tulip mania of 1630’s, a speculative bubble in tulip flower bulbs, with words that suggest feedback and the ultimate results of the feedback.

A price to price feedback theory causes word-of-mouth enthusiasm giving birth to new era theories and popular models that justify price increases. The feedback that propelled the bubble carries the seeds of its own destruction. Smith, Suchanek and Williams (1988) were able to create experimental feedback trading.

All in feedback loops?

Shiller is unequivocal regarding the feedback loops as the explanation for excessive volatility or bubbles. He supports his case by research in cognitive psychology, which shows that people try to predict by seeking the closest match to past patterns leading to feedback dynamics. Such human interactions, he says, are the essential cause of speculative bubbles (positive and negative), which appear to recur across centuries and across countries. Recurring ponzi schemes is an example.

We have some questions and observations on Shiller’s case. Is the model Shiller working on for 30 years an all-encompassing one? What he mentions as appearing to recur not cyclicality in time? Is he not just replacing cognitive psychology patterns with another pattern which seems consistent with some combination of feedback effects driving the stock markets? Why even after 30 years of challenging and a Nobel Prize for behavioral finance are fundamental stories so engraved in human psyche? Is behavioral finance a capable alternative to conventional research? Is psychology really driving the markets? Or are something like “sun spots” more significant than what Shiller thinks.

Role of proportion

What about proportion? Everything is ruled by proportion, why is psychology so special? Why there is repetitive mention of 30 years, 10 years in Shiller’s work? Why does he not mention about all the work done on time cyclicality which is as old as the dividend data he charts? Is it too much for him to admit that the basic tenet of behavioral finance “what goes up comes down and what goes down comes up”, is nothing but a cycle? Why does he never mention Edward R Dewey, chief economist of President Hoover who said depression was a cyclical reality? Why in his now famous comparison of dividend PV and stock prices he does not observe the 30 year cycle? From a time perspective, all the talk about excessive volatility may have disproved the EMH, but it does not prove that feedback loop is the final explanation. Bubbles are a cyclical phenomenon caused in time and both amplification and time are mathematical aspects.

The question of “when” which 83 per cent of Shiller survey respondents including Shiller himself admit being an illusion and an opportunity too good to be true might be a thought 30 years behind its time.

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Oil vs. Dow

The OIL vs. DOW ratio line depicts OIL performance compared to DOW. The ratio line in Fig.1 suggests that OIL underperformed DOW from July 2008 till Dec 2008 after which there was an OIL reprieve as OIL moved up from a low of 34.8 to the current near 50 levels.


The ratio line is at 1 now. This means that OIL matches its performance with DOW. The forecast on either DOW or OIL is linked to what this ratio line would do? Will it move up back above 1 or is it going to turn back down? Performance cycles suggest that OIL could underperform DOW for more than the next few months. Only after which we should see a secular BULL on OIL compared to DOW.

Even individually, time oscillators suggest that the best of OIL for Q2 is over (Fig.2) and OIL could be headed down till MAY. Any leg up till 55 should be final before the turn down. This means that we continue to look at a large intermediate bottoming on OIL and not otherwise. We captured MINOR traded moves on RELIANCE, ONGC, VERBUND, CVX and NATGAS. Even on BRT we captured the MINOR C wave up. But we remain unconvinced of a secular up trend on OIL now.

We have carried the various ANTICIPATED AND HAPPENED cases and the latest tracker.

Enjoy the latest WAVES.OIL

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WAVES.OIL is a perspective product published once a week. The report covers BRENT, WTM, XLE (Energy SPDR), top energy stocks, Natural Gas and related FUTURES. The product highlights Primary (Multi Month) and Intermediate (Multi Week) price trends. The report illustrates key price levels, price targets, price projections and time turn windows. The product uses Elliott waves, traditional technical analysis tools and sentiment indicators.

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The Euclidean Proportion

euclid2

Euclid’s geometry is a model for everything, including stock markets

The Romans developed the Roman hand abacus. It was the first portable calculating device. It greatly reduced the time needed to perform the basic operations of Roman arithmetic using Roman numerals. However, there was a problem regarding complex multiplications and storing previous calculations. The Hindu (later called as Arabic numerals) number place value system resolved this problem.

How Aryabhata did it with a symbol like zero in the 3rd century BC could be linked to his sense of proportion. Euclid a century later created a subject built on proportion. Geometry is about proportion, a pure science studying symmetry. Euclid’s Elements is the most successful textbook in the history of mathematics. His system of rigorous mathematical proofs remains the basis of mathematics after 23 centuries, classifications and super classifications later. His mathematical proportion rules nature, science, life, economics and markets like nothing else.

The first example of proportion can be seen in the animal kingdom, the larger the size, the smaller the number. Whales, Tigers and insects, the number of animals in one class falls as the size of the animal decreases. There are much more insects compared to tigers, and more tigers compared to whales in the world. The language we use to communicate is also proportional. The most common word in the human language is spoken twice as much as the next most popular word. The frequency keeps decreasing mathematically as the popularity of a certain word decreases. Information that we use as news is also proportional. The number of the most popular news stories, films, or soap operas we watch are proportionally linked to the other news, films and soaps. Population distribution, intra city or inter city is mathematically spread. Wealth allocation is also proportional. The larger portion of the wealth of any society is owned by a smaller percentage of the people in that society.

The World Wide Web is proportional. A study of the web’s structure, reveals that it isn’t the fully interconnected network that we’ve been led to believe. The study suggests that the chance of being able to surf between two randomly chosen pages is less than one in four. Researchers have analyzed 200 million web pages and 1.5 billion hyperlinks. Their results indicate that the web is made up of four distinct components. And however, you may divide or slice the web, based on stock market based websites, based on entertainment links, based on region or religion; you will get the same structure of four components. The number of births or deaths highlights proportion again. The universe till the sub atomic level is connected with the same proportion.

What we thought was mystical; the divine proportion is a part of this large proportion we are talking about here. Seen in pyramids, in prices, in religion, in science, the divine proportion has been espoused by scientists, mathematicians, historians etc. The Fibonacci series is no magic; it’s a statistical series, proportional.

Our misconceptions as human beings are also proportional. What behavioral finance calls as overestimation of skills is nothing but the same proportion at work. 90% of the people rate themselves in the top 10% of their class. Proportion is also the reason we as human beings herd. If we have proportion in behavioral errors then it’s not surprising that we proportionally herd to buy and sell, invariably at the wrong time.

Demand and supply is proportional, reported macro economic data is proportional, market and prices are proportional. Even our favorite and popular tools of market analysis are proportional. Fundamental analysis has a sizeable content on ratios. Don’t be shocked, but it’s true that price/book, prices/sales, prices/earnings are ruled by the same proportion. Technical analysis is also about proportional patterns. Any statistical time series lifeless or with life has a proportion. A random toss of a coin will lead us to the same proportion. Mandelbrot’s clustering and Taleb’s randomness is also proportional.

The proportion in mathematics, gives rise to patterns, symmetrical patterns and natural patterns. The Ulam spiral is a simple method of graphing the prime numbers that reveals a pattern. It was discovered by the mathematician Stanisław Ulam in 1963, while he was doodling on scratch paper at a scientific meeting.

Now that we understand that proportion is nature’s law, we should spend some time comprehending the challenges of proportion. Because it’s ubiquitous, humans don’t give it that importance. A majority of us will also find it tough to believe that everything is mathematically linked. Our day to day life suddenly loses all its complexity. There is so much redundancy in the system, which can never be taken out even if with the greatest depression. We can never come to accept how simple it all is. Humans are unable to see the degree of proportionality i.e. the range of proportions, top down proportionality of everything. Only a few can quantify proportion in a workable model that gives trading or investing signals. It’s strange but we use them every minute of our working day, even when we are sleeping, but still don’t see them.

Proportion was always relative, a ratio. The top market, top decade, top week, top sector or worst stock is all about comparisons, a ratio. There is nothing like absolute proportion. Analyzing anything needs a sense of proportion. We break aspects or parameters to analyze them. Constructing or reconstructing is about proportion, whether it’s architecture, philosophy, culture, markets anything.

Life would be random, if God would throw a dice. He does not have time for doing this. He gave us proportion and ability to think and question. Are all these proportions linked? Whether what Euclid did was a complete model for and of everything? Is it so simple?

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The Gold collapse

We have no intention of playing the FOOL’s game. As we know the fool’s game is fractalled. While we are talking, it’s happening at various degrees, somewhere on this planet, somebody is fooling somebody to make a gain.

How do we know? Gold is the classic example. The excitement to movement ratio for Gold is at a peak for the last two years. Rather it has moved higher. What the ratio means is that there is more excitement but less net movement on Gold prices and vice versa. We wrote about FOOL’s GOLD the first time in APR 2008. The fool’s gold has not been found as prices are still at 2008 level for the last 12 months.

What we are seeing is an extended test of patience. It will go up now is how the spin makes you believe it. “Now”. Gold is still all over the news.

“hedge your life against the crisis” ,“Buy Gold on Weakness”, “Buy Gold in 2009”, “Gold-2009.com”, “Why Buy Gold in 2009?”, “Gold conferences at London”, “Central Banks buy Gold”, “2/3 of the traders advise to buy Gold – Telegraph”.

The quarter also ended yesterday. This was the sixth quarter with no net movement. Not that we love to be contrarians, but excitement, intermarket trends, cycles suggest more of an impending collapse on Gold rather than otherwise. All move up remains ‘UP BUT TOPPING” for us. We don’t see many talking about the ‘GOLD COLLAPSE’. A Google search might take you to a 2005 story.

We review any positive expectation only above 1,000. Till then we wait for 900 to break. The latest WAVES.GOLD has carried ANTICIPATED and HAPPENED cases on TISCO, ZINC, ALCOA.

Enjoy the latest WAVES.GOLD

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