The Famous Fama - Investing is Gambling

Eugene Fama, the 2013 Nobel prize winner in economics, a professor at University of Chicago and a director and consultant for Dimensional Fund Advisors, recently said at a conference,

 I have one word for you and you're not going to like it - chance.

Of course, Fama is famous for his support of the Efficient Market Hypothesis (EMH) which states that the stock market is so efficient at pricing new information that investors can never beat broad market indexes such as the S&P 500. Fama's advice to investors is, 

You decide how much you want to tilt to these [types of risks and] returns and then you diversify the hell out of it," Fama said. Choose your asset allocation and then make sure you get fully diversified portfolios that get you there.

Investors who followed Fama’s advice lost enormous sums in the market crashes of 2000 and 2008. So many “anomalies” in the EMH have popped up that they gave birth to a new industry called behavioral investing that insists investors are not rational and make many mistakes.

In the short run, say under three months, movements in the stock market are essentially random. In the very long run the market tends to converge to the net present value of future earnings (NPV). So in both periods the EMH is correct. But in the medium run, the market deviates a great deal from NPV, and thus supports behavioral investing theories.

Austrian economics untangles the confusions of both the EMH and behavioral investing for serious investors. A chapter in my book, Financial Bull Riding, goes into more detail about what is wrong with both the EMH and behavioral investing schools of thought. Short run deviations in the market, such as what day traders attempt to profit from, are impossible to predict, while the long run trajectory offered by NPV is highly subjective because the analyst must forecast earnings (very difficult) and choose a discount rate (constantly changing). 

However, the medium term market is fairly predictable because it follows profits closely and responds to the risk tolerance of investors. The value may diverge from the long term NPV, but that doesn’t mean investors are irrational as behavioral investing insists. Investor risk tolerance and knowledge changes over time depending on circumstances, mostly profit reports. I use quarterly corporate profits and price/earnings ratios in the forecasts I publish on this blog and the model explains about 70% of the change in the quarterly averages. For economic and financial models that is a good fit. 

In addition, Fama and most analysts look to the percent returns of indexes as the standard measure for investment performance. For example, if the S&P 500 is up one year by 10% then your investments had better return more than 10% or you have failed. But as I show in my book, hedge funds consistently fail at matching the S&P 500’s percentage returns, yet make their clients far more money than those clients would have made passively investing in an index. They can do that by avoiding large declines in the market, such as happened in 2000 and 2008.

Professors like Fama forget that compounded interest works against the investor in bear markets just as it works for him in bull markets. To recover from disasters like 2000 and 2008, investors need extraordinarily good returns in bull markets. For a simplistic example, assume the stock market fell 30% at the beginning of the year and stayed down the entire year. Not only has the investor lost 30%, but he has forgone interest he might have earned in bonds. Then the market going up 30% the next year will not recover his losses because his base is lower. He will need about a 60% increase in order to recover his lost investment plus opportunity costs.

The Wall Street Journal printed a critique of hedge funds in the May 27, 2014 southwest edition page C6, with the headline “Hedge Funds Don’t Live Up to Their Billing.” The article said that HFR’s composite index of hedge funds returned 72% over the decade ending last month compared to a return of 100% for the Vanguard Balanced Index Fund, which has an allocation of 60% stocks and 40% bonds. Hedge funds got their names because the managers hedged against market downturns using short selling and derivatives. Hedging is the same as buying insurance against a market decline. Obviously, the costs of the insurance will weigh down returns in percentage terms, but will pay off handsomely after a disaster.

Studies have shown that hedge funds have significantly under performed the broad indexes in percentage terms while returning more to the investor in dollars than a broad index would. It sounds counter intuitive, but it’s worth checking out. As Fama said, “This is arithmetic, not a hypothesis.”

Of course, a better way is to learn how Austrian economics ties the stock market to the business cycle to fine tune your hedging as I show in Financial Bull Riding.

Microwaved Marx - Piketty and his Capital

Thomas Picketty’s book Capital in the Twenty-First Century is on the best seller lists, so although it’s not about investing, it’s about economics, I felt I should add my comment to those of many others. 

1.       Piketty makes a grave statistical error: when comparing groups, those groups should be as homogeneous as possible in all areas except the one being investigated. In other words, don't compare apples and oranges. Piketty assumes that the economic regimes in place over the past three hundred years were all the same. They weren’t. The West veered sharply from laissez-faire policies in the late 18^th and early 19^th centuries to various flavors of socialism in the late 19^th century. Germany implemented socialist policies in the 1870’s. The UK and US followed later, with the US having become almost pure democratic socialist under FDR with tax rates on the rich higher than Piketty recommends in his book as a cure for inequality. Piketty ignores those changes in regimes and classifies the entire period under his investigation as capitalist. In fact, the growing inequality since 1970 that he complains about has happened because of increased socialism.

2.       Piketty assumes that increasing inequality is a feature of capitalism, ignoring the fact that inequality was never higher than that which existed in the old USSR and communist Eastern Europe. His assumption is pure Marx with no supporting evidence. In fact, the Nobel-prize winning economist Robert Fogel in his Escape from Hunger and Premature Death demonstrated that laissez-faire regimes cut inequality in half in the UK and US by 1900. But Piketty doesn't like the Gini coefficient that Fogel and most economists use; it contradicts Piketty's thesis. So he invented his own metrics. 

3.       Piketty pimps for a tax of 80% on the wealthy. But as most bad economists and Marxists, he assumes that the wealth of the rich is idle, consisting of dusty old gold coins sitting in a warehouse. In reality, which completely escapes Piketty, all wealth held by the rich today is working hard at businesses to create jobs. The economist Thomas Stanley, famous for his The Millionaire Next Door demonstrated that 85% of the wealthy in the US earned their wealth by growing businesses. Only 3% inherited it.

So what happens when governments take 85% as Piketty demands? The money dedicated to investment gets turned into greater consumption when the government distributes it to the rest of the nation. Investment declines and consumption increases. Any freshman taking intro to economics knows that will cause the production possibility frontier to collapse, which means in laymen’s terms that we all get poorer together.

4. Piketty ignores the fact brought out by McCloskey in her Bourgeois Dignity that the wealth of even the poorest in the West is roughly 30 times, not 30%, but a factor of 30, greater today than in 1900. Inequality is rising, but from a point at which even the poor today are amazingly wealthier than a century ago. 

Piketty’s book appears to be microwaved Marx with a dump truck load of data designed to smother the reader and prevent him from thinking. Like a magician, Piketty uses data to distract the reader from what he is really doing. 

It doesn't help that many conservative economists defend the status quo. It's hard to deny that in at least some ways a lot of Americans are worse off. For example, Vern Gowdie, an Australian financial planner, wrote recently in "How the Fed Creatively Tortures the Data:" 

"Michael Greenstone and Adam Looney of the Hamilton Project went deeper into the median income numbers and discovered this rather depressing finding:

"[M]edian earnings for men in 2009 were lower than they were in the early 1970s. And it gets worse… Between 1960 and 2009, the share of men working full-time fell from 83% to 66%, and the share not making formal wages tripled from 6% to 18%. When you take all men, not just those working full-time, [you see] a plummet of 28% in median real wages from 1969 to 2009." 

Conservative economists need to quit defending the US as a capitalist economy. It hasn't been even close to capitalist since 1929.  We need to place the blame for rising inequality where it belongs - on socialist policies. These include the Fed's inflationary policies that benefit the rich at the expense of the poor and regulations that reduce competition and enrich established corporations.  

Some of the best reviews of the book I have read can be found at these links:

"The return of patrimonial capitalism":

"Capital Punishment"

"Piketty's Capital I"

"Piketty's Capital II"

"Piketty's Capital III"

"Piketty's Capital IV"

Fed Inflates Capital Markets!

In an email newsletter sent out by the Wall Street Journal called Macro Horizons, Michael J. Casey appears to grasp a point about monetary policy that few other mainstream economists can get a grip on, while Austrian economists have taught it for decades: inflationary monetary policy benefits the rich. He wrote,

Easy money translates into gains for those who are rich in assets, especially financial assets, and that excludes a large swath of the population [italics in the original].

I assume Casey is a mainstream economist because the main point of his post was the need for central banks to maintain monetary “stimulus.” The quote above follows this:

The subject of disinflation is the focal point of Wednesday’s data, where we are being reminded of its nonexistence in the industrialized world and of the risk that it could morph into outright deflation. This is most evident in Wednesday’s CPI data out of Europe, which is why the notoriously stimulus-shy Deutsche Bundesbank insiders even came around to telling the Journal Tuesday that they were considering backing actions at the European Central Bank’s June meeting to attack the disinflationary trend. But we’re likely to see the same later in the U.S. producer price data and in the U.K., whose economy is otherwise growing strongly, the Bank of England indicated that it still sees no great impetus for inflation to breakout. There was a time when this scenario of growth, coupled with low inflation, was seen as a “Goldilocks” scenario, a perfect not-to-hot, not-too-cold combination where policy would stay accommodative but gains could be had in the economy and markets. But the longer we flirt with deflation – which translates most directly into near-zero wage growth – the more that the adoption of hyper-accommodative policies tends to exacerbate the other great scourge of our age: inequality. 

Recession without rising rates?

Can a recession, and the simultaneous meltdown of the stock market, happen without the Fed raising rates? Hayek wrote Prices, Interest and Investment to show that it could and he used Ricardo Effect as the principle to demonstrate it. 

When I decided to teach an intro class in economics at a small private college, I worried about delivering mainstream economics when I had become convinced of the Austrian approach after earning an MA in managerial economics at the University of Oklahoma. But as I taught I realized that mainstream economics textbooks teach a lot of Austrian economics; mainstream economists just don’t know it.

Mainstream economics textbooks present economics as a series of unrelated topics. Even mainstream macro economists have recognized the animosity between micro and macro. I found that the Austrian aspects come out when I stitch together those disjointed topics. Here is an example of how I teach the Austrian business-cycle theory and Hayek’s Ricardo Effect using nothing but the tools presented in standard intro textbooks.

Resurrecting Hayek’s Ricardo Effect will disappoint a few Austrian followers who, having done a quick search of the internet on the topic, have decided that critics demolished Hayek’s theory decades ago. Hayek introduced the effect in his Prices, Interest and Investment and amplified it in The Pure Theory of Capital. The only contemporary author that I’m aware of who takes it seriously is Jesus Huerta de Soto in his book, Money, Bank Credit and Economic Cycles. I include it in my book, Financial Bull Riding.

Hayek didn’t respond to many of his critics so some assume that Hayek had given up on the Ricardo Effect, but he hadn’t. Hayek recognized that his critics didn’t understand the effect because they had a poor grasp of capital theory. In fact, anyone who has read the three descriptions of the effect mentioned above will immediately grasp that Hayek’s critics attacked straw men, but never Hayek’s Ricardo Effect. Hayek answered his critics with Pure Theory of Capital.