Pundits Practice Post Hoc

The mainstream media rounds up the usual suspects when trying to explain the latest stumble from the stock market. One expert had this to say:

Many factors have conspired to increase market volatility and push stocks lower over the last several weeks. Chief among them have been nervousness over the timing of Federal Reserve (Fed) interest rate increases, worries over the outlook for the Chinese and eurozone economies, the escalating Ebola epidemic in Africa, and rising geopolitical instability—particularly in the Middle East.

Others add the collapse in oil prices or commodities in general, global warming or just plain irrational fear. Technical analysts will cite the S&P 500 falling below the 200 day moving average or another favorite indicator, but that doesn’t explain why it fell through the glass barrier. Most of these are merely examples of the post hoc fallacy in which people notice that one event followed another and concluded that the earlier event must be the cause of the later one. An obvious example is attributing the rising of the sun to the crowing of a rooster.

Austrian Bull Riding

Earlier this year Doug French, a senior writer at Agora Financial wrote a nice review of my book, Financial Bull Riding. In case you haven't read the book, this might persuade you to take the ride:

How Austrians Ride the Financial Bull

By Doug French

The single most asked question I get at investment conferences is, “Do you have a list of money managers who invest guided by the Austrian School of economics?” The question is a good one. After all, the Austrian School stands alone in predicting the fall of the Soviet Union and the housing and financial crash.

Anyone with a retirement account has been whipsawed by the stock market over the past few decades. Fidelity’s Peter Lynch told everyone to buy stocks and hold. Everything would work out great. Diligent savers would even end up millionaires, courtesy of an ever-expanding stock market. The efficient-market hypothesis (EMH) provided intellectual support for the idea. The market reflects all information, so there’s no way to beat it, said the economists.

Forecasting Failure

The latest revision of GDP for the first quarter of this year caught most economists by surprise. A decline of 2.9% is the worst since the latest recession. Surprising most economists shouldn’t surprise anyone. The Laissez Faire newsletter alerted me to studies by the IMF economists Hites Ahir and Prakash Loungani on the abilities of private and public sector economists to forecast recessions. In short, their records are almost perfect, failure that is.

The photo of the Queen with the comment “Why did no one see this coming?” comes from a presentation at George Washington University on forecasting by the two economists. In a second photo, a London School of Economics representative responds, “Ma’am, to see this one coming would have ruined our perfect record of failure to see it coming.”

Markov Confirms ABCT

Greg Davies and Arnaud de Servigny offer a different take on diversification in their book Behavioral Investment Management: An Efficient Alternative to Modern Portfolio Theory. Chapter 6, “Representing Asset Return Dynamics in an Uncertain Environment was the most interesting chapter to me, and the one that adds confirmation to using the ABCT as a guide to timing the market. 

Modern portfolio theory tells investors to diversify their portfolios at least between two asset classes, stocks and bonds. A simplistic summary of the method is to use the statistical measure called standard deviation to assess the risks of asset classes and diversify according to risk. But in reality, advisers have found that a fixed ratio, say 70% stocks and 30% bonds, often works better without requiring as much work. 

Buffet's Investing Advice

Fortune magazine recently published an excerpt from Warren Buffet's annual letter to investors in which Buffet offers advice for the average investor. He starts by telling two investing stories:

This tale begins in Nebraska. From 1973 to 1981, the Midwest experienced an explosion in farm prices, caused by a widespread belief that runaway inflation was coming and fueled by the lending policies of small rural banks. Then the bubble burst, bringing price declines of 50% or more that devastated both leveraged farmers and their lenders. Five times as many Iowa and Nebraska banks failed in that bubble's aftermath as in our recent Great Recession.

What we have here is a failure to coordinate

                The great Austrian economist Ludwig Lachmann described the way the stock market works better than any economist I have read. He taught that expectations play a vital role in coordinating the decisions of entrepreneurs in the market process. Spot prices communicate important information, but only information about the past. For the economy to function well, that is, stay out of recessions, markets must coordinate the expectations of buyers and sellers, producers and consumers. Recessions are nothing but a failure to coordinate. Markets communicate expectations through the futures markets, including options and other derivatives, but primarily through the stock market.

                Following are excerpts from Lachmann’s books on the vital nature of the stock market to a well-functioning market economy. Lachmann shows that the market is neither mechanical, as the EMH suggests, nor irrational as behavioral finance insists. 

Great Expectations part II

The previous post introduced the concept of elasticity of expectations as developed by Ludwig M. Lachmann and applies it to the stock market. Lachmann added that the velocity of price change is important as well as the practical range and break outs from the range: 

“‘Explosive’ price change is seen to be the main cause of elastic expectations, both in the sense of violent change, and in that it destroys the existing basis of expectations, the sense of normality, which provided a criterion of distinction between the more probable, the less probable, and the highly improbable. It does so by demonstrating that the highly improbable, which had been excluded from our range, is possible after all. Now, as we saw, a price will pass the limits of the range with difficulty. As it approaches them it encounters increasing pressure from inelastic expectations resulting in sales at the upper and purchases at the lower limit. To overcome the pressure of these stabilizing market forces the price movement will most probably have to be carried by a strong ‘exogenous’ force, i.e. one originating outside the market, unknown to it and therefore not taken into account when expectations were formed.”[1]

Great Expectations – an Austrian economist lends support to technical analysis (part 1)

Does technical analysis of the stock and commodity markets have any validity, or is it the financial equivalent of reading tea leaves? Technical analysis encompasses a wide variety of methods, so a workable definition might be any method that uses historical prices and volume to predict future ones. Of course, the efficient market hypothesis denies that is possible. The alternative to technical analysis is fundamental analysis, which looks at earnings, dividends, management, sales growth, etc. to predict prices. 

 Technical analysts search charts for patterns such as head-and-shoulders, hammers, shooting stars, flags, pennants, double tops or bottoms, cups-and-handles, and many others. They employ multiple moving averages, relative strength indices, Bollinger Bands, Dow Theory and many other methods of analyzing price pattern and volume of trading. 

A few financial economists have tried to assess the validity of technical analysis methods with mixed results. Economists typically ridicule technical analysis, but a late great Austrian economist, Ludwig Lachmann, who championed the importance of the stock market more than any economist, provided support for technical analysis in his concept of the “elasticity of expectations.” He applied the concept to all kinds of prices, not just to the stock market, but it fits the stock market exceptionally well.

Five years after Lehman - Jobless Recovery Explained

Like a calf staring at a new gate, mainstream economists are mystified at the unemployment data that has given the US a jobless recovery for the past four years, five years after the collapse of Lehman Brothers.  Creative manipulation of the money supply by the Fed, massive bailouts of banks and other corporations, and historic federal spending have failed to lift aggregate demand. Why? Because all aggregate demand isn’t the problem.

Aggregate demand in mainstream economics has two sides, consumer spending and business spending, or investment. Mainstream economists forget that definition of demand. Also, they think that consumer spending drives aggregate demand because it makes up about 70% of GDP. However, GDP leads them astray because of the highly stylized and weird way it calculates business revenues. In reality, it is net domestic product, not gross, but that is a different post.
Austrian economics demonstrates that the investment side of aggregate demand does the driving, not the consumer side. Economist Robert Higgs uses net domestic investment to explain the jobless recovery in a recent article “The Sluggish Recovery of Real Net Domestic Private Business Investment"The Sluggish Recovery of Real Net Domestic Private Business Investment.”

“From these data, I have constructed the following index of real net domestic private business investment from 2005 to 2012, where the 2007 value equals 100:”

2005	81
2006	98
2007	100
2008	68
2009	26
2010	20
2011	36
2012	59

What is ABCT Investing?

Almost everyone has a blog today, so why would I bother to add my teaspoon to the deluge? I did so because I found a hole in conventional investing wisdom which I think needs plugging. I’m not the little Dutch boy who stuck his finger in the hole in the dam and saved the village below. But I think I have a perspective on investing that few others share and which could help people rescue their nest eggs from tragedy.

Stock Market Forecast

“"It is difficult to make predictions, especially about the future,” said Mark Twain.

But, investors have no choice but to attempt to forecast the stock market. Ludwig von Mises wrote,

"Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers. "[1]

The investor is the entrepreneur and must forecast future prices of stock, even if only to adjust his allocation of funds between stocks, bonds and cash.

Here is my lasted forecast of the S&P 500 for the next two quarters. The upper and lower lines are the upper and lower ranges of the prediction interval, that is, where the model predicts the S&P 500 will be. The middle, blue line is the historical value of the index.