I’m thinking about adding a category called "The Philosophy of Markets." Why? Because I frequently read statements that are just philosophically incorrect, and can lead investors down a wrong line of thought.
Case in point: An article by the otherwise sharp Mark Hulbert on uncertainty (Profiting from the uncertainty discount).
Ask your self these questions: What is "Certainty?" How about "Uncertainty?" Where does "Probability" fit into the investing schema? Just a little deep thought about these questions goes a long way in understanding the nature of risk and probability.
I long ago concluded thay the Wall Street aphorism "The Market Hates Uncertainty" is a canard.
Hulbert makers a different point about uncertainty in this discussion:
Dan Seiver is [emeritus professor of economics at Miami University of Ohio and currently a visiting professor of economics and finance at San Diego State University and the University of San Diego].
Seiver points out that, in focusing on whether Bernanke will or will not do this or that thing, it has become too easy for us to overlook the impact that the sheer uncertainty is having on the markets. After all, as any market theoretician will tell you, markets crave certainty. It therefore is a safe bet that the stock market currently is lower than it would have been if Alan Greenspan had somehow been able to continue as Fed chairman. (emphasis added)
I find this statement inaccurate, and for many reasons, and on multiple levels.
Markets are all about uncertainty, and how to apply a future discounting method to it. Without uncertainty, there wouldn’t be a buyer for your sale and a seller for your buy. Any certainty implies that the future is definitetively understood and known — therefore, we can figure out precisely what its worth.
The closest I can come to a statement of certainty is that the Federal Government will not default on their credit obligations to repay U.S. Treasuries. That certainty is worth about 4.5% a year, in the form of a 10 year bond. Thanks to the flat yield curve, the two year duration yields about the same return, witht he one year a smidgen behind that.
Any attempt to generate returns over that amount — 4.5% — is defined as the reward for taking on uncertainty.
Indeed, the only times Markets are "certain" seems to be at tops and bottoms. In Q1 2000, the markets were certain that valuations no longer mattered, that new metrics applied, and that stocks would continue to grow forever. Indeed, tops can be defined as a period when uncertainty is replaced with a false certitude, when everyone is bullish and long, and there are no uninvested buyers left to come in and take markets higher. We have both certainty, and uniformity of belief.
At bottoms, a dollar is only worth 75 cents, the baby gets tossed out with the bathwater, and everything goes to hell because investors are certain we are going to go much much lower.
Since the future is unknown, it is by definition uncertain. And as we have seen, forecastors (present company included) have proven to be notoriously poor at prognosticating the unknown.
But given Professor Seiver’s view, how might this so-called uncertainty manifest itself? Why, by making stocks underowned, and therefore potentially be a bullish play! (Of course! Why didn’t I think of that!)
Hulbert notes:
One implication of Seiver’s analysis is that our exposure to stocks right now could be somewhat higher than it would be otherwise. That’s because, as Wall Street gets to know Bernanke and his actions become more predictable, the market’s uncertainty discount gradually will evaporate.
Huh? How uncertain will Bernanke’s actions be? Its not like Vladimir Putin took over the Fed. The Federal Reserve will raise rates either nonce, once or a few more times. Historically, the odds favor they will tighten a bit too much in their quest to stop inflation.
Further, probabilities are that when they are done tightening, the markets will be lower 6 months later (71% of the time) and 12 months later (64% of the time).
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With this post, I am adding the category "Apprenticed Investor." In the future, whenever I come across a concept I want to address in that series at the Street.com, I will also use this tag . . .
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Source:
Profiting from the uncertainty discount
By Mark Hulbert, MarketWatch
Marektwatch, 12:01 AM ET Feb. 1, 2006
http://tinyurl.com/afw95
I have always wondered about that certainty thing. It never really made sense to me.
Hmm…Where is the proof of Seiver’s statement? Is this an axiom? ie, Self-evident? As I recall Heisenberg’s Uncertainty Principal was actually derived from mathematical analysis. Oh, I forgot. We are talking about journalism………..never to be confused with truth.
I guess this is what happens when you need to fill a page full of print every day. You become like CNBC. ie, Filling the airways and our brains with mindless gibberish that pushes out a more important memory of that great bacon cheeseburger I had last night given my brain’s limited capacity for drivel.
The Geoffey Colvin Fortune article at:
http://money.cnn.com/magazines/fortune/fortune_archive/2006/02/06/8367977/index.htm
makes the point. Emeritus smeritus, in the words of the Wizard of Oz:
Wizard of Oz: They have one thing you haven’t got: a diploma. Therefore, by virtue of the authority vested in me by the Universitartus Committiartum E Pluribus Unum, I hereby confer upon you the honorary degree of ThD.
Scarecrow: ThD?
Wizard of Oz: That’s… Doctor of Thinkology.
I like the idea of a philosophy of the markets tag. It’s been on mind as I read two articles in the last few days which implicitly reject any efficient markets theory, which I think highlights flaws in the arguments about Sarbanes-Oxley and Enron’s implosion.
The NYT ran another piece on SOX quoting an expert saying the market unfairly punished companies for disclosing small flaws in finacial controls. But if it is really a small problem, the market should see that and price it in. Any over-reaction in price should be temporary and a buying opportunity. Either SOX has created a major exception to efficient markets or Wall St hates to be transparent and accountable.
Also the defendants at Enron seem to be blaming short sellers and the Wall St Journal for the ‘death spiral’ in stock prices. Seems to me that short sellers only have an impact if they have reason to be short.
Sorry not to have URLs at the moment. But I like the idea of the philosophy of the market and some of the analysis that might flow from it.
What does the Fed Chairman have to do with the confidence in the stock market? The only reason Greenspan had this confidence was what many people refer to as the Greenspan put. His willingness to provide liquidity to the system during financial crises. That’s not rocket science. I would posit that a vast majority of equity portfolio managers have no idea what drives interest rates and the bond market. They only have a variable for discount rates in their models but i doubt many (especially young hedge fund mgrs) have sat on the trading floor at Salomon Bros or in the Eurodollar pits in Chicago where billions are transacted per ticks on the wire. Greenspan and Fed policy has little to do with the day to day price action in bonds. They may drive swaps traders anticipating policy direction, but the Fed is often wrong and “behind the curve” on interest rate policy. If you notice the yield curve tends to tighten credit when the Fed is easy and eases credit when the Fed is tight. I would suggest that going back say, 12 years and remove the Fed actions from the economy, the bond market would have done all the tightening and easing for us. Why is it necessary for the Fed to be constantly tweaking the overnight rate? Are we to suggest that one man has the omnipotence to always know what ails the economy? that’s ridiculous. i thought we were for free markets. let the bond market determine borrowing and lending costs. not a bureaucratic economist. At 4.50%, it seems we are right back where we started, in 1994. had Greenspan not been jacking with the target rate throughout all those years would things be any different? i doubt it. i think he added to the uncertainty not removed it. interest rates should be driven by borrowers and investors, not by economists.
Geez Barry before we tackle “philosophically incorrect” statements we should first tackle the much simpler and more extensive “statisticallly incorrect” statements.
I like the idea of a philosophy of the markets tag. It’s been on mind as I read two articles in the last few days which implicitly reject any efficient markets theory, which I think highlights flaws in the arguments about Sarbanes-Oxley and Enron’s implosion.
The NYT ran another piece on SOX quoting an expert saying the market unfairly punished companies for disclosing small flaws in finacial controls. But if it is really a small problem, the market should see that and price it in. Any over-reaction in price should be temporary and a buying opportunity. Either SOX has created a major exception to efficient markets or Wall St hates to be transparent and accountable.
Also the defendants at Enron seem to be blaming short sellers and the Wall St Journal for the ‘death spiral’ in stock prices. Seems to me that short sellers only have an impact if they have reason to be short.
Sorry not to have URLs at the moment. But I like the idea of the philosophy of the market and some of the analysis that might flow from it.
I guess being a financial journalist or professor emeritus of economics means one can spit out ignorant gibberish while appearing smart. What on Earth does “…our exposure to stocks right now could be somewhat higher than it would be otherwise” mean? What does it have to do with the stocks’ prices? How can it be “safe bet” that the market IS lower than it WOULD HAVE BEEN? How can one bet (safely!) on something that “would have been”? What the heck is a “market theoretician”? Would it be the same as, for instance, “driving theoretician”, that is, the guy who does not drive himself but tells everybody else how to? This junk should be simply ignored.
Small Investor Chronicles
vfoster:
That’s the irony. If you let the market do it by itself you could end up with excesses and/or rigidities. Basically, you could argue that the Fed is there to massage the markets in order to avoid bubbles.
But they’re the first one to tell you that they can’t spot a bubble until it pops.
Go figure.
“I long ago concluded that the Wall Street aphorism “The Market Hates Uncertainty” is a canard. ”
I don’t know about the markets, but humans certainly hate uncertainty. The quest for certainty is one of the primary drivers of human behavior. Our affinity for education, religion, and science all reflect the desire for certainty. Our ever-increasing love of all forms of insurance are another symptom of the need for certainty. I would imagine that while the mechanics of the market require uncertainty, much of the market’s behavior is driven by the desire for more certainty concerning the obviously uncertain future.
One might say that the market IS the interaction and interplay between the human principles of certainty and uncertainty.
Google’s quote of the day:
“Most people would rather be certain they’re miserable than risk being happy.”
– Robert Anthony
Anon,
The markets are a collection of humans . . .
“The markets are a collection of humans . . . ”
Yes, of course, but why then conclude that “The Market Hates Uncertainty” is a canard?
The market is a collection of humans who came there for its uncertainty. “Uncertainty haters” stay in cash. If they show up in the market they are either ignorant or delusional, or both.
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Small Investor Chronicles
Hyman Minsky observed that “Stability is unstable.” This could also be translated to “Certainty is uncertain.”
Stability breeds overconfidence which in turn breeds distortion. Barring that, prolonged assumptions of a steady state grow shaky over time; gradual changes at the margin always erode that state. Sometimes this leads to a punctuated equilibrium type event, in which the missing volatility shows up at all once (and the prevailing belief structure is violently altered). Holding on to yesterday’s belief in the face of mounting pressure is like ignoring the cracks in the dam (until it bursts).
All this stuff is a modern day riff on Heraclitus’ ancient observation that it’s impossible to step in the same river twice. A good thing, too, because the only lasting antidote for change is death.
As for what the market ‘wants,’ perhaps it’s short sighted to assume the market ‘wants’ just one thing. In reality you have a whole host of incentives and at least three distinct groups–Wall Street professionals, the investing public, and the companies themselves–with conflicting motivations and risk profiles that are constantly at odds. Broad market behavior is an emergent property born of this whirling gestalt. Confusion often comes from making a thing more complex than necessary, but it’s also possible to oversimplify. Just my .02
“The market is a collection of humans who came there for its uncertainty. “Uncertainty haters” stay in cash. If they show up in the market they are either ignorant or delusional, or both.”
Disagree. If this were true the sunshine gang would not spend so much time trying to dismiss uncertainty and vanquish doubt.
Perhaps it is more accurate to say the public wants ‘constant upward trend’ as a steady state. It is not a fixed price that they wish to remain unchanged, but a relationship of price to movement over time. The notion that “I can rely on X% return for the next X years” implies a desire for change on a superficial level, but on a functional level is represented in the (wishful) mind as a rock-solid, i.e. certain, thing.
“‘constant upward trend’ as a steady state” is a “certainty”. Bank deposits do that. Markets don’t do that as a general rule. Some markets HAVE DONE that in the past, but there’s no guarantee they will do that in the future. That’s the nature of the beast.
The sunshine gang are is attempting to reduce uncertainty because of a combination of elementary ignorance, political gamesmanship, and various vested interests and conflicts thereof.
“The sunshine gang are is attempting to reduce uncertainty because of a combination of elementary ignorance, political gamesmanship, and various vested interests and conflicts thereof.”
Well certainly. No pun intended. (Okay, maybe a little intended.)
There is a divergence between what the market actually is and what its participants wish it to be. When we talk about what the markets ‘want,’ we are talking about the wishing part. Desire is a function of perspective, regardless of how wrong-headed or distorted that perspective might be.
You said the market is a group of folks who “came there for its uncertainty”; this may be the unintended reality of the situation, but I can assure you it is not the majority’s desire or intent. The average Joe wants Ibbotson studies and lead pipe cinches and safe as milk long term trends. In otherwords, they want certainty in an uncertain world. In some ways the entire business of Wall Street is founded on playing to this wistful desire, cultivating notions of certainty under false pretenses. You conflate the reality of uncertainty with the prevalence of wishful thinking. It is the wishful thinking–the desire for certainty on the part of all parties, manifested as steady state upward trend–of which we speak. Whether such conditions actually exist is moot. Political promises and mutual fund avertisements underline this dynamic nicely.
Not entirely off the subject, I hope. The observation about Greenspan and Bernanke being likely to churn out very similar monetary policy results is exactly right. In other ways, the two men may be quite different (after all these years of chatty Greenspan, we may end up calling Bernanke “Silent Ben”), but the obsession with figuring out whether Bernanke is hawkish or dovish relative to Greenspan has generated far more ink than is justified.
Trader75, I see your point… In fact, the lack of appreciation of the inherent uncertainty of the market by its participants may in and of itself make that market more “risky” and reduce returns.
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Small Investor Chronicles
This is obviously a gold mine: the Philosophy of Markets. Philosophy is all about denying certainty and promoting risk. [Deny this at your peril.]
Marketing philosophy on the other hand is like David Byrne (next to Mozart, Barry’s fave) says, “risky business”. [You want to know or you want to make money?]
BR–
Elegant piece. Loved it.
The market is a place for money to meet those who can do something with it. That’s all it is for.
A New Era:Nervous about Helicopter Ben
Bernanke is now the new Fed ChairmanSince his nomination => dollar up , gold up more than 20%,shaky markets,the removal of uncertainty [the nomination] hasnt been helpful.I suspect that the believers in continuity are missing…
The market is not an animated conscious entity and thus isn’t capable of liking, disliking, or snoozing. Slimy speculators and gullible gamblers probably enjoy uncertainty but that’s about as insightful as saying 16 year old boys love to masturbate. And speculators are about as productive as those 16 year olds.
Businesses do not like uncertainty. The existence of the corporation and its bureaucratic structure and specialization testify to that. And the way competitors seeks to eat their enemies.