Apr 24th 2014

Institutionalized Fraud: How Wall Street Survives on Predicting the Past

by Jeff Schweitzer

Jeff Schweitzer is a scientist and former White House Senior Policy Analyst; Ph.D. in marine biology/neurophysiology

"Bull Market - A random market movement causing an investor to mistake himself for a financial genius." Anon.

Entertainers and charlatans who claim to read minds use a common trick of stating the obvious. "I feel there is someone in the audience thinking about a man named Peter." Given that Peter is a common name, most likely a few vulnerable souls in the crowd will yell "yes, yes" in rapt amazement. If the seer is unlucky that night with an unusual absence of Peters and nobody answers, he would quickly move on to find the right name in a skilled way that obscures the fishing expedition. "I sense that you're concerned about money" and there is a yelp of recognition among those who know a Peter (or Paul or whoever was selected). Because money is a common concern, he has a good chance of scoring a hit. If not he can glide to another high-probability stab with talk about a sick loved one. And so on goes the evening until the man with magic powers of mindreading saw that Betty just lost Peter to cancer and is now concerned with saving her house. Amazing!

Predicting the Past

But this is pure amateur hour compared to Wall Street. The gurus of the street go one better by making predictions of past events, cutting out the middleman fishing for clues. Well, to be fair, not predictions exactly, but ex post facto explanations that are presented as having been known prior to the actual event; a pseudo-prediction. The genius in this is that any explanation of cause can be modified to fit actual circumstances. There is no way to lose; no way to be wrong. Let's say unemployment figures came out better than expected, and the market responds with an upswing. The headline: "Market expands in the face of positive job growth." But if those exact same figures came out and the market declined instead, the headline would be: "Market shrugs off employment numbers already anticipating positive growth." Do you see the game? Take any result from yesterday, and manufacture a cause that would lead to that result. You sound like you know what you're talking about when in reality all you've done is predict the past, a game of low skill. Yet this fraud of explaining market behavior is the very heart of Wall Street, as we will see later.

I have been collecting Dow Jones headlines daily for the past 10 years, all from the same popular source (Associated Press as quoted on MSN Money), and the reading is entertaining. The funniest are those read in sequence one day to the next. This is true no matter the source, including major newspapers like the WSJ or NYT. Here is a taste:

Friday, February 1, 2013: Dow Jones crosses 14,000 as job report sparks rally.The index reaches a milestone not seen since October 2007 as investors cheer a decent January employment report and improvements in manufacturing and consumer moods.

Monday, February 4, 2013: Look out below: long slide in market is just beginning. Last week's optimism fades as structural problems and trouble in Europe re-emerge, threatening a months-long downtrend.

Tuesday, February 5, 2013: Wall Street bounces back, Dow briefly passes 14,000. U.S. stocks rose on Tuesday, with the Dow rising above 14,000, as earnings came in stronger than expected and investors sought bargains a day after the market's biggest drop since November.

We can just make stuff up with aplomb. One day we say the market rises as "investors cheer" good employment numbers; the very next day we attribute the decline to "structural problems" and look forward to a long decline! Were those structural problems not present yesterday when investors were cheering? Then the following day all that is forgotten (what structural problems?) and we see a bounce back because of strong earnings and bargain hunters. So the decline on Monday was not the beginning of a long slide, as predicted on Monday, but a dip from which the market recovered the following day. No mention on Tuesday of Monday's failed prediction of a long decline. Of course if the market had continued to decline on Tuesday, it would be offered as evidence of a long decline. That is, until the next bump up, when all that would be forgotten. Also, note that when the headline was touting a rally there was no mention of the "month-long downtrend" that was trotted out the next day when the headline was about a decline. Comical.

Weaseling the Future

When the talking heads are forced to venture beyond the comfort zone of predicting past events and are compelled to discuss the real future, they have refined the art of inanity, making nonsensical statements that can be true no matter what happens next. In the USA Today of Monday, April 22, 2014, the editors posed the following question to several experts: "Is the pullback over?" Here is what Rod Smyth, chief investment strategist at Riverfront Investment Group, said: "Given the decent shape of the economy, the broad market doesn't look as if it'll get dragged down by the loss of momentum in growth stocks." Could that statement be any less informative? He goes on to say that he "would be more inclined to look at this as a correction to an on-going bull market." There is enough wiggle room in that to accommodate any future: if the bull market continues, he can claim he predicted that; if the market declines, he can say the correction is just continuing. If the market crashes, and there is no hint of a bull market, he can find refuge in the statement's deliberate ambiguity using terms like "more inclined" and "doesn't look as if." But Rod is in good company, with other experts looking at the same market predicting the opposite outcome. Ann Miletti, senior portfolio manager at Wells Fargo Advantage Fund, says the following mouthful: "Those momentum stocks that took a beating still aren't cheap, which means they'll likely be subject to further bouts of selling as Wall Street looks to bring those pricey names down to more normal valuation levels." A powerful statement except for the "likely to be subject to" that just means that anything could happen. Let us not leave out Bill Hornbarger, chief investment strategist at Moneta Group, who says with amazing clarity of the obvious, "The market has lost its momentum and investors should expect more ups and downs ahead." Really, the market will fluctuate? Incredible insight. This is why we will see below that "chief investment strategist" is no more meaningful than "blind monkey throwing darts." At least the monkeys recognize the inherent reality of randomness and the unpredictability of the future -- which brings us to the next phase of this discussion.

The Future is Predictable Only in Greek Myth

There is no Oracle of Delphi in the real world; yet Wall Street exists solely on the idea that such a creature exists. Testifying before the Senate in 1967, Nobel Prize-winning economist Paul Samuelson declared: "A typical mutual fund is providing nothing for the mutual fund owner that they could not get by throwing a dart at a dartboard." He was rekindling an idea initiated 40 years earlier by Edgar Lawrence Smith, who presented in 1926 the first credible attempt to estimate the long-term return on stocks through empirical analysis. In his book Common Stocks as Long Term Investments, Smith looked at stock investments assuming no market timing or stock selection ability whatsoever; instead he used a hypothetical investor who simply held onto stocks, and found that such an investor outperformed professional bond investors.

Building further on Smith's idea, and Samuelson's elaboration, Burton Malkiel published in 1973 his now-famous attack on the financial establishment in a book entitled, A Random Walk Down Wall Street (W.W. Norton & Co Inc.). Malkiel's work is perhaps the most important and most unread book of the century. His was no ordinary academic think piece. With this book, Malkiel launched a direct and aggressive challenge to the authority of Wall Street, drawing conclusions from his logic and data that cannot be refuted. His work was and is still today reviled by brokers and others with a vested interest in the status quo. In his publication, Malkiel postulated that a blindfolded monkey throwing darts at a newspaper's stock tables could outperform any stock picker over time. This fundamental concept is true for a simple reason: the future cannot be predicted. And its truth reveals the fraud of every single person on Wall Street who claims to have a system to beat the market. Why? Because monkey's throwing darts do better than professional money managers over decades. Don't believe me? Check out the statistics and returns from impartial studiesof money manager performance. Here though is the bottom-line conclusion: Barras, Scaillet, and Wermers tracked 2,076 actively managed US domestic equity mutual funds between 1976 and 2006. They found that after fees, three-quarters of the funds exhibited zero alpha, a fund's excess return over a benchmark index, with virtually all the remaining having a negative alpha. Only 0.6% showed positive alpha, which is statistically insignificant, a consequence of inherent randomness. Better yet, do the research yourself; it is easy enough. Get the prospectus from any mutual fund and compare its performance to the market over any given 10 or 20 year period. You'll arrive at the same conclusion: monkeys do better than professional money managers.

We tend to resist the message about blindfolded monkeys so elegantly put forth by Malkiel because all of us so desperately want to believe that something about the future can be predicted. We crave that illusion of control over our destiny. After all, you can "predict" that the sun will rise in the east tomorrow morning. But in fact that is not a prediction of the outcome of a statistical probability at all; it is the known result of orbital mechanics. Predicting movement in the stock market is entirely different: once you enter the market, at that precise moment you have exactly a 50.000 percent chance that the stock if it moves will move up or down in price. Nothing you do beforehand, no amount of research, no amount of technical analysis, no amount of wishing upon a star will change that simple fact. But there remains one more important element: when you exit the stock market, you have exactly and precisely a 50.000% chance that the stock if it moves will move up or down from that moment forward. Any effort to change that rule of nature, to nudge that 50 percent mark off center, is completely and hopelessly futile. Try and you will fail, as everybody has before you. Ask those 2,000 professional fund managers. Once you enter the market, you can only know one thing: with time the stock will go up or go down over time. Any statement or claim beyond that is witchcraft, and you can never predict which of the two will prevail for any one stock. It is impossible. You may think you're a genius with a no-lose strategy that works great during an expansion. You are not a genius. Things look less promising during a contraction. See how you do over the next 10 to 20 years, and compare your performance to a blind dart-throwing monkey who chose stock randomly with no knowledge of past performance or predictions of future gains. Monkey wins or draws every time.

The only legitimate idea supporting Wall Street is that the global economy will expand over time. This is a reasonable assumption, and one supporting the idea of buying stocks randomly and holding them over long periods. But even that basic assumption could prove illusory. An "outlier" like nuclear war, asteroid hit, deadly pandemic, or some other global catastrophe could render the assumption meaningless. Such possibilities do not preclude investing in the future - we have no choice but to hope that such calamities are far down the road. But they do emphasize how little we know about the future, and how inherently the future is unpredictable. Until Wall Street stops pretending otherwise with "investment strategists" and mumbo-jumbo about "structural problems" that disappear overnight, the entire enterprise is based on the fraudulent idea that the future is predictable at a fine scale. It is not - and never will be - as a fundamental reality of nature. Investors, both institutional and individual, need to wake up, ignore the experts and pundits, and start throwing darts. Ignore the inanity of "experts" and "investment strategists" and "market analysts." They are a terrible sick joke. The data are unambiguous and the conclusions robust - the experts know no more about the future than you do. We want to believe otherwise, we strongly resist this reality, we think that experts are smart enough to create an edge, beat the system, overcome the odds. They are not - and that is the only truth about Wall Street that has any meaning. The rest is a form of institutionalized fraud, a huge fraudulent scheme in which all the players agree to accept a Big Lie that allows them to pretend they know what they are doing. But they don't.

As an aside, I exclude from this discussion the extremely, extraordinarily rare opportunity for true arbitrage, where the trader knows - usually as a technical flaw in a trading mechanism or a glitch from tiny time differences that can arise in global trading -- at the moment of trading that his purchase price is lower than his subsequent sales price. If you have in hand simultaneously your purchase and sale price at the moment of your trade, you are not predicting the future.

You might feel better if you do "research" before buying a particular stock by looking for trends, trend line patterns, or breaks in trends, but you are just whistling in the dark. Finding sideways channels and trading the breakout sounds impressive, but is completely bogus. Identifying 1-2-3 formations, or rounded bottoms or triangle formations or using simple and weighted moving averages buys you nothing but wasted time. Bar charts are fancy and impressive but are not predictive any more than is a painting by Jackson Pollock. And don't be smug if you eschew technical trading for fundamentals; sifting through fundamentals and macroeconomic data to identify discrepancies between the inherent value of a company (or commodity) and the current market price of that asset is equally a fool's game as a trading strategy. The results of any of these research techniques or trading methods yield nothing more accurate than predictions made by flipping a coin. Quite literally. You are no better off than if you selected a stock completely at random. That this perfect truth is so difficult to accept is testimony to how effective the Big Lie has become. But you need not succumb. Choose your own path based on reality rather than false hope and deny the Big Lie. Those blindfolded dart-throwing monkeys tell the entire story; those monkeys give us the picture more accurately than any so-called expert or investment strategist or fund manager ever could.

Follow Jeff Schweitzer on Twitter: www.twitter.com/JeffSchweitzer




  

 


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