Archive for the ‘Trashing Rationality’ category

Did behavioral finance get it wrong?

Human beings may not be nice and dumb

Herbert A Simon got the Nobel Prize for economics in 1978 for his research on decision making process within economic organizations. Herbert is considered one of the most influential social scientist of 20th century. A study of history of behavioral finance also cites his 1955 paper “A behavioral model of rational choice” (1955) as the first thought which started it all.

Though the paper starts with the need for a revision of the economic model which assumes that the economic man is rational, has knowledge, computational skills, is well organized with stable system of preferences, can plan alternative courses of action, reach highest attainable point on preference scale but clearly states that the aim of the paper is not to discuss these doubts, or to determine whether they are justified but to think about a revision, a direction towards a better economic model. The author did not mention irrational or ‘not rational’ anywhere in the paper. The author mentions that entities may possess a hierarchy of rational mechanisms and comparing computation (computer) with humans is very difficult, as both may get labeled as a moron in a different situation. This should shock some of the behavioral finance believers who have accepted clichés like “Human beings are nice and dumb” by Terry Burnham (Harvard) and have started to believe that it is more about irrationality than rationality.

Herbert’s bounded rationality is a concept at the soul of behavioral economics. Daniel Kahneman (Nobel Prize winner 2002) proposes bounded rationality as a model to overcome some of the limitations of the rational-agent models in economics. Putting simply bounded rationality suggests that there is never enough knowledge to take decisions and hence the limitations in decision making. Unlike Daniel, Gerd Gigerenzer, a German psychologist argues that heuristics (thumb rules) should not lead us to conceive of human thinking as riddled with irrational cognitive biases, but rather to conceive rationality as an adaptive tool that is not identical to the rules of formal logic or the probability calculus. Gerd suggested that bounded rationality was misinterpreted by behavioral finance.

Did behavioral finance gurus got it all wrong? Did they just over emphasized the limitations of human decision making instead of working on a model as Herbert intended? Was it easier to deal with limitations than work on a rational thought model? Does this prove that fundamentalists are indeed correct in suggesting that behavioral finance is the great story of human errors?

It was not just the fundamentalists but even Gerd who mentioned about the behavioral finance over elaboration of human decision making limitations and the human inability to cope with optimized thinking. Gerd talks about simple alternatives to a full rationalizing analysis and how simple heuristics frequently lead to better decisions than the theoretically optimal procedure. After you read Gerd, heuristics suddenly start to sound better than what behavioral finance made it out to be - just an error.

This is not the first time great ideas have been ignored. Herbert’s initial thoughts on Artificial intelligence were ignored for 7 years. But the paper which I feel has not got its due attention in economics and psychology is the one he wrote in 1962 on the ‘Architecture of complexity’.

In that paper, he said that complexity frequently takes the form of hierarchy. Systems are hierarchic systems independent of specific content. Systems are interrelated at higher and lower levels. There are elementary subsystems. He detailed hierarchical social systems, biological, symbolic, self reproducing systems and even hierarchic structures in social interactions. Complexity had to evolve from simplicity. This was Herbert’s attempt to explain power law distributions (exponentiality in nature). Path of construction of a complex system is through the theory of hierarchy. If time is indeed a triad and hierarchical, we can easily comprehend Herbert’s architecture of complexity.

Can behavioral finance also suffer from bounded rationality? Claiming humans to be irrational when they were the ones who created such great things in the first place (including markets), the irrationality does not seem to add up somewhere. So the few questions for behavioral finance could be linked with the order. Can behavioral finance define and quantify long reversals in markets? Are these long reversals recurring? How different are these long reversals from the subject of time cycles (order) written over the last few hundred years? If investor autonomy is worthless (Benartzi, Thaler), finding Peter Lynch is tough (Hersh Shefrin) how can investors chose between passive index alternatives? Is there an order between passive index performances? Is this performance cyclical? If market success connected to addition and subtraction (Thaler, Lamont) what is the mathematics in long reversals and behavioral finance? We got the idea of irrationality but where is the model of rationality which Herbert proposed? How does behavioral finance change if time is the order Herbert was mentioning?

The Architecture of Complexity
A behavioral model of rational choice

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Trashing the AXIOMS (Archive)

First published on 19 Mar 2007

We humans are strange beings, we love to trash what we create, wealth or peace. It’s a harsh reality. Euphemistically we might call it a new age theory, or evolution. But the reality is that psychology is calling 200 year old economic thought as junk. And guess what, Douglas McGregor (1906-1964) and Abraham Maslow (1908-1970) might just be laughing about how they might finally turn out to be the real contributors to modern economics. Mc Gregor whose work was based on Maslow’s hierarchy of human needs coined the Theory ‘X and Y’ of management. The first psychologist ever to work at MIT, talked about management styles that assumed employees to be lazy, irresponsible and with little ambition on one side and with all the good traits on the other. The good ‘Theory Y’ assumes that we humans as employees want to do a good work and create. Latest research on behavioral finance concurs with ‘Theory Y’ and call humans as nice and not selfish. The studies have even proved that the economic belief that more money is better, is not true. We humans are not motivated by more money. After a point happiness disassociates from money.

But behavioral finance does not end its recourse here. It adds that apart from being nice, we are also dumb. Putting it simply a majority of us are “penny wise and pound foolish”. If majority of us are like this that means either we love to lose the valuable pounds or the economics we have been taught is all wrong. The latter seems more reasonable as behaviorologists have also pointed out that we humans are also loss averse. We can not be loss averse and still lose, so there is definitely something wrong in the way we have been taught.

Economic axioms are not universal truths, some of them are far away from truth, it’s just that nobody questions them. The big one is the interest rate axiom. The lower the interest, the better it is. This seems logical, but it does not work. Higher the better, is what stock markets around the world suggested starting 2004. A two year yield curve for Japan, US and India exhibited similar results. India witnessed a falling interest rate scenario from 2001 till 2004, as the yields dipped from near 8 down to 4.5. This was accompanied by a sideways Sensex till 2003 hovering near 3000. Then starting 2004 when the yields took off from 2004 back to 8, the benchmark quintupled. The Nikkei doubled and Dow moved up 63%. One might say, “This was an exceptional time for global prosperity, we all know that falling interest rates are positive for stocks”. Wrong. 1929 Depression happened in a falling interest rate scenario. The theory that rising interest kill stocks, or interest rate tool has predictive value, and central bankers are economic wizards is incorrect. Ex Federal Reserve, Chairman, Alan Greenspan admitted that the ability of people to think that central bankers can avert recessions is “Puzzling” for him. Inflation and Interest rates can be controlled be a central banker, but whether they will have the desired effect on the economy is doubtful. Globally, interest rates are seen to rise and fall together and there is an inflation cyclicality much beyond local tinkering.

Economic reasoning is not always unequivocal. Is rising currency good or bad for the market? Dollar-Dow correlation oscillates from positive to negative. Correlations are never permanent. Hence giving currency strength an axiom shape is inappropriate. We can extend the same argument to Oil. “Oil price rise is not good for the economy, but this time it’s different”. Good news and bad economic news is make believe and convenient. “The same news was good yesterday, but today it has got diluted by the x factor”

Another axiom is making the ‘Buy and Hold’ strategy almost synonymous with investing. Well, if it worked for Warren Buffet, it may not necessarily work for us. Buffet started working at his Father’s brokerage in early 1940′s. This was after the depression. Buffet bought when no body was looking at stocks, so he was more of a contrarian and timer than a buy-hold investor. Ofcourse he held on to what he bought for more than a few futures trading days. These days they say, “if you don’t sell fast enough, you might hold for a long time”. Diversification is thought to be another way to mitigate risk. It is good if one understands that assets are not just stocks. And that there is a difference between real estate and cash. Understanding the subprime mortgage mess might shed some light on this. And also the fact that if you really want to emulate Buffet, we need to have cash at the bottom, not eroded stocks, waking up to the harsh reality of earnings.

Markets can fall with or without earnings. As stock prices do not track earnings. 1920-29 was a period of rapid earning growth. Real S&P composite earnings tripled over that time and real stock prices increased almost sevenfold. 1950-59, S&P composite tripled again, but this time earnings grew only 16%, over the entire decade. There are many other bull market examples where one can not illustrate the earnings logic to justify multifold increase in stock prices. The argument can be extended to explain dividends and price changes. We ask for dividend at market bottoms and not at a market top. The relationship is inverted and the reasons are half baked. They only explain us why stocks go up, not why they come down. “The come down because of global risk and they go up because of real earnings”. Yeah right!

After all the hard work, what are we left with, a portfolio in a local currency. How competitive is the local currency anyway? How convertible? Are we in a country, which only sees currency strengthening. Or does our central banker appease us with a managed float or a target zone currency management jargon. If we become richer every year, as the local paper strengthens, then the local exports may flounder. The companies we buy on the stock market might be thrown out of business, just because we can afford a longer vacation in Europe. Richer in a quarter and poorer the next is all what currency plays are all about. Cross border mergers are a reality, we pay and convert from our pocket when we bid for companies around the world. Individually we may not have a currency risk, but the stock we buy is in the heat of things. We wish currency crisis stays next door, but it is happening, every day. Ask a currency trader, it was never trickier.

Hence, the real currency is not the local paper, but Gold, at least it’s traded internationally, is an alternate for money and plus it’s rising. And if we hit a crisis, euro becoming the same as dollar or dollar becoming half as much as euro, or yen strengthening back to 80, we are left with only a few risk management strategies. One of them is Gold. So how rich is our Sensex portfolio in terms of Gold? If the real money was Gold, then the Sensex portfolio is the same as it was in 2000. Real money has moved on and Sensex is still back at the seven year historical high. We are not as rich as we think we are.

Economics that we know can not help us survive, leave aside making money. Market is not a conventionl model. Bull markets have their own geniuses, sucessful corporations and stories, which disappear as the trend changes. We are a historical juncture once again, this time it is bigger. How far will new information and extraneous reasons help us remains to be seen. But what definitely cannot help us is the X in the axiom.


Deficient Market Hypothesis (Archive)

First published on 17 Feb 2007

If there is something bigger than stock market crash or a meteor crashing down on earth, it’s the death of an economic theory. After all, if the economics is right, we can still detect and divert a catastrophe. Economics is why we think we live today and is what we think will be the reason generations will live tomorrow.


We at Orpheus believe good theories are for a generation after which they are thrashed or rehashed. Scientifically the unifying theory remains elusive and somewhere the construction and reconstruction attempts have pushed scientists to recreate the laboratory Big Bang. The new emerging theories we believe will unify science and emerging economic theories, which are much broader in their scope. By the way, did you know we have Econophysics? The subject ties up Economics and Physics.

So here we are with the young, ready to bury the old. Efficient Market Hypothesis is one such theory that has reached burial ground after nearly half a century of existence. And like always markets are ahead of the event. US markets have given many cues starting 2000 that Eugene Fama’s market hypothesis might be deficient.

But what is so important about this theory that even it’s marginalizing deserves such attention globally, in India and in other emerging markets. EMH makes many assumptions. First it says that supernormal returns are not possible. DOW Jones moving up by 1000% over the theories life trashes the first assumption. You can make supernormal returns in markets. Second it says, every news that matters is in the price. This also means that any thing which can affect the price is new information. This extrapolated assumption has justified the “Impact Analysis” industry i.e. how new news will effect prices. So first there is a multi billion dollar information industry and then another multi billion dollar industry that studies the impact of the news on the asset prices (popularly known now as stock market).

The latter industry, what we also call popularly as ‘Equity Research’ is under tremendous stress in America. There are studies written to revive the industry. The crash of 2000 has questioned the accountability of research and how to make Wall Street pay for research. The best Wall Street research firm gives an accuracy of 34% with two open recommendations a week. The stresses are building up especially with Sarbanes-Oxley 2002 corporate governance act tightening around the financial intermediaries.

Overall, the industry is figuring out a revenue model for the inaccurate, unaccountable work, which takes away a sizeable part of the already shrinking market commission. Order flows are moving to electronic systems, as clients don’t want research that does not work. There is also a joke about selling ‘Equity Research’ by passing it on with a 50 dollar note inside. “Some motivation”, they call it to open the glossy in consequential pages.

And if this internal struggle was not enough, we have questions being raised about huge bonuses, and bestsellers written, rightfully asking, “where are the customer yachts?” We also have the famous Jamie Oli case. An ex tax accountant with the Dynegy, an energy trading firm. The judge presiding over the case had to rework on his Economic after Oli’s lawyers proved that it was tough to quantify the impact of news released by Oli on the price fall. In crux, American law firms have proved in their recent published research that market prices are far from efficient and sentencing someone to 24 years of prison on a flawed economic hypothesis is harsh. Recent research papers have also gone ahead and proved that New York Stock Exchange prices are inefficient. Oli finally got a reduced sentence of 6 years on Sep 2006.

Speaking from a market psychology perspective, what market fancies is what outperforms. And outperformance is not a straight line, like the Sensex outperformance of Dow since 2003 reaching a two decade low. Straight line approach is also non acceptable to changes. Big changes are not introduced at a top, big changes find their footing at a bottom. Historically it has been seen that regulators just like market participants are complacent at a market top and get into activity at a low. The other graph is the DOW marking the signing of the Sarbanes-Oxley act, at a low. And this was also the time Daniel Kahneman, the only psychologist ever got the Nobel prize for economics. And global market meltdown does not only destruct wealth, it also creates and nurtures new. And meltdowns happen when people are the most complacent. And failing theories do sink multi billion dollar industries, overnight.


The momentum psychology

Momentum investing done by the majority of investors and fund managers today is a feel good factor that does more damage than benefit to a portfolio.

According to behavioral finance Momentum investing is at the heart of investor mistakes. But do you know whether you are a momentum investor? Putting simply, if your stock picking is news based, volume based and price based you are a momentum investor. Your belief in market movers and stories ties you to momentum. What’s good about momentum investing? The majority is with you. So there is comfort in numbers. Momentum periods can be extended and large. Not being a momentum investor could be painful as you could miss substantial price movements. Momentum investing is also more about investing in growth, winners, successful companies, stocks that are already identified as performers. The technique is about doing what the majority is doing. Be it technical oscillators which continue to suggest that the trend is running or fundamental indicators which tell that earnings continue to be good, momentum is about our need to speculate with safety that we are not alone. The technique is also about good stocks and bad stocks. Behavioral finance has written about investor’s ability to ascribe more value to the company that the market considers good and reject the ones the market thinks are bad.

Majority of the investors today are momentum investors irrespective of the technical, fundamental or quantitative approach they use in stock or sector selection. Investors don’t change their investment style because they believe in market efficiency or inefficiency. Actually the majority of investors doesn’t care or even know about the debate. The momentum psychology rules them. Even analysts and experts suffer from the momentum psychology. After the hard lessons from 2000, the street has started paying more attention to analyst’s calls against market momentum. The calls are still few. Being against market momentum is a hard skill owing to the fact that market timing tools are at a nascent stage and few attempt to do it. Being few in numbers, market timers are generally judged harshly. A prey standing alone is more prone to attack from the hunter, in numbers, probability of being killed seems low.

Life would have been easy if an investor get’s on the bus to the zoo with a group of friends and come back on his own or goes somewhere else from the zoo leaving his friends behind. Such individual behavior may leave us with few friends in real life, but unfortunately how we are in real life is how we are in markets. Very few can dissociate their economic life from their social life. We will invest together in real estates and lose together in real estate. Momentum investing is genetic, you were born with it and to comprehend, question and change it is a monumental obstacle. Once in a while you might say “Wow!! I was smarter as I exited earlier”, but till the time you break the momentum psychology and social thinking you are and will be a momentum investor whose luck may not protect him every time.

Some investors may now say, we relate to this and this is why we look for smart money managers. Looking for performance in money management is an extension of momentum investing. History of market literature has proved that your fund manager did not beat the benchmark over the long term. So what are you left with? In the end market is the best performing benchmark and all your effort is a waste of time, if all that internet and news and research gets your portfolio returns marginally higher or lower than the market why not just buy the benchmark.

I am trying to convince you that if the investment approach where you are the fund manager (or you chose one) does not beat the benchmark, you need to restrategise and rethink the value of your time. It’s not easy for a money manager to tell this to his clients (that he screwed up), but this is the hard truth. Not very many managers will tell you this, what they will show you is how the comparable benchmark has done or how risky was the portfolio. We don’t judge our money managers harshly because we are in love with them and this is why there is no real alpha just beta. If you think the idea is going too fast in challenging your mindset, you should read Robert Arnott’s, Fundamental Indexing. Arnott runs Research Affiliates and has challenged the benchmark creation itself. According to him the way we construct our benchmarks is itself flawed and even the case for indexing is weak. Benjamin Graham (father of security analysis) proposed the case of indexing as superior stock selections get tougher. If the gods of fundamental investing dissuade you from stock selection and push you to passive index investing, you as a reader have to judge where you and your fund manager are on the learning curve.

Actually my aim is not to convert or dissuade you against riding the trend, be a momentum investor because without what the majority does with momentum psychology there would be no market. Very few market literatures really acknowledge this economic role. Momentum investing creates the economic cycle. Who is not a momentum investor? A person who does not bet on trends, news, and price movement but on sentiment extremes, low risk entry points and value. This is how growth and value cycles are created. Momentum investor pursues growth takes it to unsustainable extremes when the cycle turns and brings on value purchasers who give prices support.

According to a paper on growth and cycle written by Arnott, the market did a good job in differentiating between growth and value, but that the market discounted the value companies too deeply and paid about 50% more premium for growth companies, relative to the value companies. Although growth stocks (those trading at high multiples) do historically exhibit superior future growth, the premium carried in their market price is too high to be justified by reality. Arnott talks of distinct pattern in time i.e. periods that begin with low valuation (growth stocks prices at a small premium to value) followed by fast rising valuation (major rally for growth stocks). For spans of 20 years or more years, the market never failed to overpay for the long term realized successes of the growth companies. Value has outperformed growth in most years, in most markets around the world for decades. Have we learned from this experience? Investors have always paid more for premium stocks than value stocks? Arnott’s fundamental indexing has an overlap with Behavioral finance, which also talks about buying the winners and selling the losers. Are both of them not talking about performance cycles? And how without understanding the Cycle (Time) investing is incomplete and just momentum driven?

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The Taleb conundrum

I first read Nassim Taleb’s story on virtue of buying cheap options in 2000. It was a tough time for an option believer in those days in India. Out of my basement stint for an e broker, which was struggling under startup pressures with “nobody seems to be interested in futures” statement mailed to me, Taleb inspired me at a critical time. Eight years, I still believe his cheap option strategy is virtuous, but there is lot about Taleb’s random strategy that troubles me to the extent of challenging it. I have mentioned some of my disagreements prior, but the guru’s work deserves a serious debate.

First and foremost, Taleb makes no claims of being able to beat markets. What this means is that Taleb is not in the predictive business. His hedge fund Empirica was into hedging solutions and not into predictive forecasts. We at Orpheus are into the predictive business, but we also make no claims of beating the market. But there is a difference. There are many ways you can beat a market. You can either give more returns than DOW Jones or Sensex over a year. Or you catch every multi week move that the DOW or Sensex might make over the year.

For example 2007 Sensex saw 6 major turns starting 07 Jan 2007 at 13,860, followed by a upmove to 14,538 on 11 Feb 2007, after which we saw a dip till 18 Mar 2007 till 12,430, from the week ending 18 Mar 2007 till 22 Jul 2007 Sensex pushed up till 15,565, a small dip followed till 19 Aug 2007 at 14,141 and then one way upmove above 20,000 till 13 Jan 2008. On a net basis though the Sensex moved up 50%, but on a gross basis markets move up 77% and down 23% in total six moves averaging 20% each.

A derivatives trader is not concerned about net yearly moves, but all tradable moves whether up or down. So beating the market would mean capturing the entire 101% gross move in Sensex for the year, a tall benchmark and a near impossible task to achieve. But capturing 50% of the net return of 2007 was easy for a buy and hold investor invested from 07 Jan 2007 till 13 Jan 2008. But this passive investor may have beaten the market in 2007, but the market is beating him in 2008 now that it’s down 28% for the year.

Beating the market hence is a misnomer, a jargon which does not mean anything. Any hedge fund that operated from 1975 till 2000 and caught the 1987 meltdown can claim to have beaten the market. It’s more about double digit or tripple digit returns that suggest predictive knowledge and trading expertise. Like what Robert Prechter did when he made 444% in a three month monitored options trading account. Just like many traders do, day in and day out, some survive and some shine. But then trading itself is a hard task, you can actively trade from the age of 26 to 45, like what Taleb did, but then market cycle overtakes the human cycle, the very reason we continue to live the illusion of beating the yearly return of a market and not some supernormal or triple digit returns. Taleb’s philosophy is not for the traders who want to beat the markets and want to make triple digit returns. Taleb’s 1987 jackpot was the one off event that he admits hit him from out of the blue and it had nothing to do with predictive value.

Second. His idea of Randomness is flawed. There is not one man who saw the 1987 crash (I know three of them), or one trader who saw the 2000 tech bubble bust, or one Goldman Sachs, which saw the subprime mess shorting opportunity, there were many who saw the real estate crash in US. Randomness is for the masses. As they don’t understand how markets work. Markets are clock work and not random as Taleb claims. Forecasters have proved it again and again giving not only great calls but also timing them. There are technicians who timed a short call two days before Sep 11, and there are technicians who said after Sep 11 that markets should bottom anytime soon. In 21 trading days DOW hit base and in 40 trading days markets were back above SEP 11 levels. Bill Sarubbi timed Gold for 2007. How can you time markets, if they are random.

Taleb’s hypothesis is weak and does not comprehend random events like earthquake and disasters that don’t affect the markets. Recent Chinese earthquake was all over the news, and the SSEC (Shanghai Index) went up for three days after the earthquake. Even the deadliest Tsunami, which killed more than 225,000 people in eleven countries, was followed by rise in stock market valuations around the globe. Assassination of presidents and prime ministers are random events with poor correlation with market crashes. Market randomness is predictable and has nothing to do with event randomness, which may or may not affect the market. All that does influence the market is non random in nature and is non linear mathematics, pure in its structure. Power law, Fractals, Cycles and sentiment measuring tools have high predictive power. And Black Swans have nothing to do why DOW goes up or down.

Third. Though recent broker inventiveness and rush for trading volumes have lead to the mushrooming of a zillion leveraged products (example 1 to 100 leverage), classically options offered a protected leverage compared to Futures. No wonder the upside was unlimited compared to the downside. The only catch was that 85% of the Options generally expired worthless. And if you are just buying cheap options, volatility or chance will definitely make you rich on that black day like 1987. Volatility is cyclical and starting 2007 is moving up in a 25 year cycle which should top somewhere in mid 2015. This means that chances for buying cheap options are going to be few, but profitable.

Good forecasts cannot be subdued with randomness talk. And there are living legends like Richard Russell forecasting markets day after day starting 1958. Options are versatile instruments that can do better than wait for that 1987 crash again. Being on the long side helps as option writing has unlimited risk that can implode and cause more than a Barings’ failure.
What we have been doing is for you reader’s to judge. But early 02 Jun we gave you a JUN strangle strategy. Markets were at inflexion points, with no clear supports and downward momentum pushed us to run with our negative broad market view. Barring CNXIT (Tech Index)

WAVES.IND.020608 was negative for every other market sector. The Strangle resulted in an 81 percent return without transaction costs. The illustrated chart highlights the decay in OTM call options, the fall of NIFTY over the last two trading weeks, the rise in OTM PUT option premiums and the resulting STRANGLE payoff premiums.

We still remain negative on the market. But considering prices have hit the previous iv wave supports for many of our covered indices, the early next week prices could attempt a sub minor bounce. Markets might get choppy for a few days before turning down again, pushing lower. We will review any new strategies on Wednesday in our mid week WAVES.IND issue. Till then we hope we clarified a part of The Taleb conundrum.


Blind men and the elephant

Demand-supply dynamics are not only differentiating economics from finance but reshaping capital market research

At a farewell party last night, we found that five of us had the same birthday, which was quite a coincidence as the gathering was small. There, a friend from Lebanon who is a senior techie at a Fortune 500 infrastructure company asked me to explain how such recurring coincidences take place often. There was no traditional answer for his question. I told him that just like clustering of market prices was a cyclical reality, and such coincidences happen again and again with cyclical precision.

The age of confluence is full of many such coincidences and witnesses a mixture of cultures, thoughts, sciences, information and above all the human emotion, which continues to oscillate from one extreme to the other, changing the way we comprehend and see things. This is why time and again traditional or conventional research has come under fire. How accurate is it? How accountable and how relevant?

The Indian legend of the six blind men and the elephant fits the predicament well. The blind men are the traditionalists trying to understand what they can’t see. It’s not because they are blindfolded, but because the tools they use are archaic and only explains a part of the picture. Times have changed, as a neuroscientist, physicist, biologist, psychologist and historian are challenging the economist on his home turf.

The new age brings with it an overload of information and a host of parameters, which are humanly impossible to interpret and analyse. This is why what we have been doing for a long time, analysing and valuing markets based on available information and demand and supply gaps is futile. A recent paper suggests that we got it all wrong and there were certain subjects like economics and finance we should never have mixed in the first place. The new model of finance suggested by Robert Prechter and Wayne D Parker in the Journal of Behavioral Finance explains why our tools are ineffective and why fundamental analysis does not work in markets.

The fundamental analyst calculates an intrinsic fundamental value using a number of objective features, such as the company’s industry position, sales trends, profit margins and earnings, asset composition and liquidity, and its mix of financing. However, the market may not always reflect this value and may deviate owing to investors’ non-rational emotions. The analyst makes two assumptions here. One that the emotion is temporary and second, that the markets will revert to the mean after rationality returns. According to Stephen F LeRoy, economics professor at the University of California, Santa Barbara, “The only problem with fundamental analysis was that it appeared not to work.” And economist Alfred Cowles’s study showed that fundamental analysts’ forecasts actually yielded worse results than random choice. No wonder the world’s best research company had an accuracy of 34 per cent. The report was published by Bloomberg last year.

Stock price action over the past ten years has especially confounded fundamental analysts, who have watched share prices fluctuate wildly despite little change in traditional “fundamental value” (or in some cases despite no fundamental value at all). The data also suggests that the stock market is blissfully unaware of the dividend discount model and the earnings discount model. Financial market prices are not stable but dynamic, and they are not dependent upon but rather substantially independent of supposedly related “fundamental” values. And from the point of view of fundamental analysis, prices spend far more time deviating from the mean and the “fair value” than reflecting them.

Prechter and Parker also define economic and financial markets. The former catering to utilitarian goods and services, while the latter for investments and speculations. Demand and supply relationships differentiate economic from financial markets. In economic markets, demand generally rises as prices fall and vice versa. In financial markets, demand generally rises as prices rise and vice versa. This difference is essential because the behaviour of economic markets is compatible with the law of supply and demand, while the behaviour of financial markets is not.

Sensitivity to oil prices explains the economic behavior well, as people change transport habits to cut back on consumption. Higher the price, more sensitive and subdued the demand. On the other hand, in finance, prices do not influence behaviour in this manner. The volume of trading in the stock market goes up with price. Higher the price, higher the demand.

Prechter and Parker explains the new socionomic theory of finance that should replace the dysfunctional old Efficient Market model. Prices are driven by mood of the majority as they herd. Valuations are a direct measure of investor optimism or pessimism about the valuations they believe others will place on stock prices. What is new in socionomics is that social mood trends are unconsciously determined by endogenous dynamics, not consciously determined by the rational evaluation of external factors, and investors’ unconsciously regulated moods are the primary determinant of the direction of stock prices.

The paper rekindles the old debate of how we are using a wrong economic model for the financial markets. The traditional way to value markets and assets with demand-supply gaps is flawed. Global equity research model is dead. “From the Ashes of the Equity Research Model” was a report issued by the Tabb group in April 2006. The report claimed that the business model for research was broken and the death of the equity research model had really unfolded over the past 10 years as investors migrated toward passive investment strategies, lower transaction costs and self-directed electronic trading. And if economic models like Efficient Market Hypothesis were believed, it was impossible to outperform the market and that meant that investment research ultimately had no value. The big bucks were in large-cap research. And even this left a huge section of mid-cap and small-cap under researched and under serviced.

An alternative model of research is already thriving in the US, and it’s only a matter of time that it is accepted globally. The new capital market research model should be different from the old one and clarify some broad misconceptions of traditional research such as capital market research is free; it is linked with money management revenue; it is incapable of earning big bucks on its own; it needs domain knowledge ie to know about coffee plantations all over the world to forecast coffee prices; it means access to privileged information; it is extrapolation; it is resource intensive; it is not accurate and accountable; it cannot be global and local at the same time and it can never be a standalone business. Non-traditional research addresses all these misconceptions and a research revolution is already under way. What we need is a few more coincidences, a few more questions and an elephant to blow the blinds away.


Breaking NEWS

The markets have consistently proved that profiting from news breaks is not an easy task.

Even in 1850 people needed faster stock news. And Reuters used carrier pigeons to do that. The birds were faster than the post train. This was the missing link to connect Berlin and Paris.

The stock news from the Paris stock exchange could reach market players in time to profit from it. That was then, now things are different. Now we have 24 hours markets, so even if London bombing news reaches you early, by the time the spot starts trading, you have futures that are moving up from extreme discount as spot moves down. The discounting mechanism works in a totally different way.

Now, not only market players know how to use leverage but also markets discount news differently each time. The relevance of the news is seen post facto. If the prices went up, the news might be good and vice versa.

Reuters did create a successful model by delivering the news on time. But he never really wanted to teach us how to interpret news. The market was left to do its interpretation.

How people saw news in 1850s is not very different from the way we see news today. We care about the news till the time we anticipate a reaction. We give the markets reaction time and then we have another news item to digest.

Cause and effect is a multi-billion dollar industry. We have the cause and we study the effect, writing tomes of news or research around it. For example we have the Budget effect in India or the US Federal Reserve meeting effect.

The events are watched and written about carefully to gauge an effect on the market. Why does a good budget take markets by surprise? We are too busy in the inertia of changing market prices that we really never bother about challenging the news effect. It does not work.

Markets lead economies. The S&P 500 is the best known forecasting indicator for the US recession. And in the same way, the Sensex or the Nikkei can tell more about local economies then macroeconomic indicators.

Markets digest and discount news much before they appear in the newspaper. And this is why the stock market news is always late. It is never in time to profit. Rather good news is used by smart investors to sell and bad news is used to buy in. One always gets a better entry or exit price.

And what about the bad news which pushes markets up? JFK’s assassination pushed the market up the next day. September 11 was not the end of the world, but a good time to buy. Wars happen at market bottoms not at tops. The Kargil war was a good time to dig in to be a contrarian. Why is it a known fact for an investment psychologist that one should sell on news or buy on rumour? Why is contrarianism so logical, so rational and still so tough to practice? How do market technicians give price targets without knowing the future or news? How do technicians have a better chance to tell you what is going to happen in the next minute than an impact analyst?

Investigative research cannot beat the accuracy of market timing. The truth is that price forecasting has nothing to do with news. Though the link works upside down, if you are using good news to exit and bad news to buy in. If timing the markets had something to do with news, why has the dollar not been dumped yet, despite all the calls from reputed media and academicians that the dollar story is over? Dear Professor, the point is that you cannot forecast the dollar’s strength and price targets from macroeconomic news.

Although the news media looks detached, it’s a part of the market events. Stock markets are news churners. We have an interest, an appeal and an audience, the right mix for a business model. The stock market also has star quality after all, the markets are the real fortune tellers, rich today, richer tomorrow.

Robert Shiller mentions in his book ‘Irrational Exuberance’ about this aspect. And he even goes ahead and mentions that it’s no accident that financial news and sports news together account for roughly half of the editorial content of many newspapers today.

He even mentions about our fancy with new highs. We made a new historical high today, on volumes or on price or the constant records that are being consistently bombarded by exchanges around the world. This only adds to the confusion people have about the economy. It makes it hard for people to recognise when something truly and importantly new really is happening.

Then we have Victor Niederhoffer, the legendary hedge fund manager who published an article that sought to establish whether days with news of significant world events corresponded to days that saw big price movements. He tabulated all very large headlines in The New York Times from 1950-1966. Out of the 432 significant world event days, 78 (18 per cent) showed big price increases and 56 (13 per cent) showed big decreases.

He concluded that many of the world events reported did not seem likely to have much impact on the fundamental value represented by the stock market. Perhaps what the media thought was big national news was not what was really important to the stock markets. And there are also statistics about absence of news on big price change days. The ‘breaking’ news is just not there.