Thursday, April 22, 2010

The Bernanke Put: Creating Tetrodoxin Investors - By Cliff W. Draughn

In the realm of academic sciences there sits at the top of the food chain the world of physics. The world according to Galileo, Pascal, and Newton can be quantified and the laws governing cause and effect put forth in intricate formulas and mathematical equations that hold true. Physics, according to Wikipedia, “is the natural science that involves the study of matter and its motion through space and time, as well as all applicable concepts, such as energy and force. More broadly, it is the general analysis of nature, conducted in order to understand how the world and universe behave.” In the world of mathematical physics, atomic physics, molecular physics, and quantum chemistry, one can define the universe in mathematical fashion. For example, as we all know from Newton’s laws of motion, to every action there is always an equal and opposite reaction. If I drop a ball of a specific size and density from a specified height, then based upon the physical aspects of the ball, the length traveled to the floor and the hardness of the surface it hits, a physicist can tell me mathematically how high the ball will bounce once it hits the floor. And not only once, but the height of all the subsequent bounces until it comes to rest on the floor.

In academia, somewhere below the world of physics lives the world of economics. Economists and investment professionals aspire to be physicists. The desire to quantify economic movement or behavior with formulas has become an obsession for the modern-day investor. The attempt to predict future outcomes based upon a given set of historical economic variables is the Holy Grail that we seek. However, there is one huge problem in quantifying the economic and investment world: you are dealing with human behavior that is often rational but at times can be completely irrational. For the purpose of argument, let’s use our above bouncing ball as a metaphor for today’s investor. If you take an investor and drop him from, say, a level of 1500 on the S&P to 700, then from a physics perspective one could project a rebound of returns. Given that humans are perfectly rational individuals who will always invest money to its highest and best utility with the least amount of risk, then one could employ mathematical formulas to draw conclusions as to how high the markets would recover. However, humans do not react to events as does mute physical matter: …we have the ability to be emotional, to rationalize, to anchor, and in many other ways make irrational decisions. For example, economists could apply the number-sequencing theory of Italian mathematician Fibonacci to the above example, and arrive at the conclusion that the investor should bounce to an S&P level of 1206. However, what if the investor behaves irrationally and, upon hitting the floor the first time, grabs an anchor for fear of bouncing again and again? Or what if he hits feet first and has the vertical jump of a Michael Jordan? Although there has developed a series of econometric laws using mathematical trend lines and what is commonly known as technical analysis, I question if we can actually measure human behavior. Are markets indeed efficient? Ben Graham once wrote:

Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw there from….Whenever calculus is brought in, or higher algebra, you could take as a warning that the operator was trying to substitute theory for experience, and usually also to give to speculation the guise of investment.”

In my opinion, what Mr. Graham is trying to make you and me aware of is that critical thinking regarding financial markets is an underappreciated asset in this investment world. The trend is your friend, don’t fight the tape, let your herding instincts go with the flow – are all statements that reflect investors’ greed and fear of missing the next upward move in the market, regardless of valuations. Investment professionals have become consumed with sophisticated trade formulas, algorithms, and program trading and have forgotten how to apply common sense to the models. When events like 2008 occur (what the investment world terms as “fat tail” events and what Nassim Taleb referred to as “Black Swans”), the investment world dismisses the bursting of the bubble as a one-in-a-thousand occurrence. But why do investors get caught by these 3-sigma events, such as in 2008? In my opinion, it is a simple lack of critical thinking, where statistics, benchmarking, and status relative to your peers replace common sense. And that brings me back to the title of this newsletter. I am sure many of you are still wondering what the heck is a Tetrodotoxin Investor, and how does Fed policy create such?