Bayesian Investor Blog

Many people seem to be reacting to the recent stock market crash the way they wish they had to the 1987 crash, and a smaller number are comparing it to 1929.
The unusual resemblance to the crash of 1937 makes me expect something in between those two scenarios.

• The 1937 crash was caused in part by a sudden increase in caution by banks after the Fed significantly increased their reserve requirement. Banks played no interesting role in the 1929 or 1987 crashes.
• The 1929 and 1987 crashes followed stock market peaks in August, versus March and the prior October for the 1937 and 2008 crashes.
• The 1937 and 2008 crashes both came eight years after one of history’s largest stock market bubbles.
• The 1929 and 1987 crashes followed an increase in the discount rate to 6 percent. The 1937 and 2008 crashes followed decreases in the discount rate to 1 and 2.25 percent.

All four crashes happened mainly in October and their behavior in that month provides little reason for distinguishing them.
If the 1937 crash is a good model for what to expect in our near future, many investors who are currently following the lesson they learned from the 1987 crash will discover in early 2009 that the unexpectedly severe recession casts doubt on the belief that crashes create good buying opportunities. How many of them will stick to their buy and hold commitment then (when I expect it will be a good idea)?
When the extent of the recession becomes disturbing, remember Brad DeLong’s perspective:

Is 2008 Our 1929? No. It is not. The most important reason it is not is that Bernanke and Paulson are both focused like laser beams on not making the same mistakes as were made in 1929….
They want to make their own, original, mistakes..

(HT James Hamilton).

Book review: The Misbehavior of Markets: A Fractal View of Risk, Ruin & Reward by Benoit Mandelbrot.
Mandelbrot describes some problems with financial models that are designed to provide approximations of things that can’t be perfectly modeled. He pretends that pointing out the dangers of relying too much on imperfect approximations shows some brilliant insight. But mostly he’s just translating ideas that are understood by many experts into language that can be understood by laymen who are unlikely to get much value out of studying those ideas.
His list of “ten heresies” is arrogantly misnamed. Sure, there are some prestigious people whose overconfidence in financial models leads them to beliefs that are different from his “heresies”, but those “heresies” are closer to orthodoxies than they are to heresies.
His denial of the equity premium puzzle is fairly heretical, but his argument there is fairly cryptic, and relies on suspicious and poorly specified claims about risk.
He says market timing works, but the strategy he vaguely hints at requires faster reaction times than are likely to be achieved by the kind of investor this book seems aimed at.
His use of fractals doesn’t have any apparent value.
Mandelbrot is primarily a mathematician with limited interest in understanding how markets work. One clear example is his mention of a time when Magellan “was still a small fund, too small for any detractors to argue that its size alone gave it a competitive edge”. Any informed person should know that’s completely backward - larger funds have a clear disadvantage because they are limited to trading the most liquid investments.
Another example of a careless mistake is when he claims the evidence suggests basketball players have hot streaks, seemingly unaware that Tversky and others have largely debunked that idea.

The stock market reacted to today’s defeat of the bank bailout bill with an unusually big decline. Yet the news wasn’t much of a surprise to people watching Intrade, whose contract BAILOUT.APPROVE.SEP08 was trading around 20% all morning. Why did the stock market act as if it was a big surprise?
Did Intrade traders make a lucky guess not based on adequate evidence? Did they have evidence that the stock market ignored? Could the stock market have priced in an 80% chance of the bill being defeated (if so, that would seem to imply that passage would have caused the biggest one-day rise in history)? Could the stock market have been reacting to other news which just happened to coincide with the House vote? (It looks like the market had a short-lived jump coinciding with news that House leaders hoped to twist enough arms to reverse the vote, but I wasn’t able to watch the timing carefully because I was at the dentist).

It seems like one of these must be true, but each once seems improbable.

Arnold Kling, whose comments on the bailout have been better than most, was surprised that the bill failed.

I covered a few of my S&P 500 futures short positions at near the end of trading, but I’m still positioned quite cautiously (I made a small profit today).

Charlie Munger in the August 31, 2008 issue of Outstanding Investor Digest:

Let’s say you’re insuring against the outcome that people will lose money on a $100 million bond issue, and the credit default swaps, instead of amounting to $100 million, amount to $3 billion. Now you’ve got people with $3 billion worth of contracts that really have a big incentive in having somebody fail. And they may manipulate in some fraudulent or extreme way to cause a default in order to make the big collection.

There doesn’t seem to be enough transparency in financial systems to figure out whether this concern is relevant to this week’s panic.

News reports plus the pattern of crude oil fluctuations indicate that the large price increases around May and June were due mainly to Chinese desperation to guarantee a larger than normal margin of safety during the Olympics, not manipulation (although the results bear a good deal of resemblance to the results of manipulation).

For more than 2 months, Treasury Inflation-Indexed Notes maturing within 2 years have been selling at prices that apparently mean their yields are negative (e.g. see here and here). This isn’t the first time people have apparently paid a government to hold their money, but I can’t think of a previous case where yields reached -1 percent.
What can cause such a perverse situation? An expectation that the CPI would overstate inflation by as much as 1 percent would mean appearances are misleading and investors do expect to make money on those notes. I could make a case for that by focusing on the way that the CPI’s reliance on rents to measure housing costs hides the effects of dropping home prices. But most evidence about people’s inflation expectations (e.g. the University of Michigan Inflation Expectation report) say they expect more inflation than what can be inferred from the Treasury Inflation-Indexed Notes about expected CPI change.
So I’m inclined to conclude that we’re seeing investors paying abnormally large amounts in order to get liquidity, and probably plan to redeploy those assets somewhere else within a few months. If we see a big financial crisis soon, that strategy may pay off. But having people prepare for financial crises tends to reduce their magnitude, so I’m skeptical and am short t-bond futures.

Early this week, the Federal Reserve Board lowered interest rates at an unexpected time by a surprisingly large amount.
I see three possible explanations, which I think are about equally likely.

• The Fed has evidence that the economy is slowing more than markets have realized.
• The Fed has evidence that some big financial institutions have troubles that are endangering the careers of some influential people, and is bailing out those institutions in hopes that those people will use their influence to enhance the job security of the people in charge of the Fed.
• Bernanke isn’t interested in the kind of publicity he can get by maximizing the total number of rate cuts. He realizes that a steady, predictable series of small rate cuts doesn’t stimulate the economy as well as cutting rates far enough that it isn’t easy to predict that more rate cuts will be needed (for one thing, making further rate cuts predictable creates incentives to postpone borrowing to when rates are lower). If that’s what’s happening, it’s not going to work as well as he would like this time, because the markets think the Fed is following the predictable rate cut strategy that gives them publicity for doing something at the time that the average person is most concerned about recession.

In related news, Singapore has a system which is designed to stabilize the economy rather than to provide politicians with opportunities to claim credit for doing something about the economy.
China is imposing widespread price controls and suffering power shortages which hinder production. If China were like the U.S., I’d say it’s trying to recreate the experience the U.S. had in the early 1970s. But the way Chinese politics work, the central government probably will allow local authorities to use a lot of discretion in enforcing the price controls, so the price controls will probably only produce shortages in a few industries that are dominated by large state-owned firms.

Up to two months ago, I was not too excited by the claims of a bubble in the Chinese stock market. Maybe the stocks that trade only in China were at bubble levels, but the ones that trade in the U.S. or Hong Kong still looked like mostly good investments.
Much has changed since then. On October 17, PetroChina rose 14.5%, more than doubling in about two months. That was a one day gain in market capitalization of almost $60 billion, and a two month gain of $247 billion (doubling the market capitalization). I’ve seen similar but less dramatic rises in smaller Chinese stocks that trade in the U.S., but less on the Hong Kong stock exchange.
By comparison, the largest rises in market capitalization that I’ve been able to find in the technology stock bubble of 1999-2000 were a $50 billion one day rise in Microsoft on December 15, 1999, and a $250 billion rise (doubling) in Cisco which took four months.
I’m not saying that Chinese stocks are clearly overvalued yet, and I’m still holding some stocks in smaller Chinese companies that I don’t feel much urgency about selling. But the unusually strong and long lasting Chinese economic expansion, combined with the unusually frothy action in the stock market, are what I’d expect to be causes and symptoms of a bubble.
Bubbles in the U.S. have peaked when real interest rates rise to higher than normal levels. The Chinese government is keeping real interest rates near zero, and seems to think it can keep nominal interest rates stable and reduce inflation. That would be an unusual accomplishment under most circumstances. When combined with a stock market bubble, I suspect it could only be accomplished with drastic restrictions on economic activity, which would involve instabilities that the Chinese government has been trying to avoid by stabilizing things such as interest rates.
Without a rise in interest rates or drastic restrictions of some sort, it’s hard to see what will stop the rise in Chinese stocks. So I’m guessing we’ll see a bigger bubble than the U.S. has experienced. It’s effects will likely extend well beyond China.

Book review: Business Fairy Tales by Cecil W. Jackson.
This book provides a better analysis of financial accounting problems than you can find in the news media. But it’s not thoughtful enough for me to recommend it. The author sounds like an academic who has little experience as an investor.
The book provides little perspective on which mistakes did the most harm. I can’t tell whether the author sees any difference in seriousness of Enron’s inconsistent reports to the SEC about when it adopted mark-to-market accounting and the absence of market prices to guide its so-called mark-to-market accounting (it seems obvious to me that the former is trivial and the latter is outrageous, but I wouldn’t have learned that from reading this book).
I’m also disappointed that the book never takes the perspective of the villains to ask why they thought they could get away with bad accounting. Were they all confident that perpetually rising stock prices would ensure that investors would never complain? Could they have have thought they would make enough money before getting caught to profit even if they were punished? In some cases I can guess why the answer might have been yes to one of these, but in most cases I’m as puzzled as I was before reading the book.
The book suggests a number of signals that investors might look for to detect fraud. But none of them are valuable enough to change the way I read financial reports. A few, such as sales growth not meeting expectations or rising inventory / sales ratios, are valuable signs of an overrated company even though they rarely indicate accounting problems. Most of the signals the book recommends involve things like increases in receivables where there’s no obvious way to distinguish routine fluctuations from changes that indicate problems, so I suspect the number of false alarms would make these signals useless.
I suspect that avoiding the stock market during bubbles is a more practical and effective way of avoiding harm from accounting fraud than trying to follow this book’s advice. I’d guess that 10% of investors will learn to avoid bubbles if they try, but I doubt more than 1% will succeed at identifying fraud. If you do try to identify fraud, pay more attention to people such as Jim Chanos who have found ongoing frauds than to books such as this that only do post-mortem analysis.
The book claims that a benefit of Sarbanes-Oxley is that it restored investor confidence in corporate financial statements. This seems misguided. The stock market decline that prompted Sarbanes-Oxley was largely due to mistaken extrapolations of real trends in internet-related profits. Many investors prefer to exaggerate the role played by fraud because it distracts attention from the mistakes they made at the peak of the bubble. It’s unclear whether increased investor confidence is desirable. Accounting fraud is most common at peaks of bubbles because investor confidence makes it temporarily easier to avoid questions about suspicious accounting practices. Stock markets appear to function best with moderate amounts of suspicion among investors to help keep corporate reports honest.

This book does an excellent job of reporting important evidence showing that group decisions can be wiser than those of any one individual. He makes some good attempts to describe what conditions cause groups to be wiser than individuals, but when he goes beyond reporting academic research, the quality of the book declines. He exaggerates enough to give critics excuses to reject the valuable parts of the book.
He lists four conditions that he claims determine whether groups are wiser than their individual members. I’m uncertain whether the conditions he lists are sufficient. I would have added something explicit about the need to minimize biases. It’s unclear whether that condition follows from his independence condition, partly because he’s a bit vague about whether he uses independence in the strong sense that statisticians do or whether he’s speaking more colloquially.
Sometimes he ignores those conditions and makes unconvincing blanket statements that larger groups will produce wiser decisions.
He makes exaggerated claims for the idea that crowds are wise due to information possessed by lots of average people rather than the influence of a few wise people. For instance, he disputes a Forsythe et al. paper which argues that a small number of “marginal traders” in a market to predict the 1988 presidential vote were responsible for the price accuracy. Surowiecki’s rejection of this argument depends on a claim that “two investors with the same amount of capital have the same influence on market prices”. But that looks false. For example, if the nonmarginal traders make all their trades on the first day and then blindly hold for a year, and the marginal traders trade with each other over that year in response to new information, prices on most days will be determined by the marginal traders.
It’s not designed to be an investment advice book, but if judged solely as a book on investment, I’d say it ranks in the top ten. It does a very good job of explaining both what’s right and what’s wrong with the random walk theory of the stock market.
He does a good job of ridiculing the “cult of the CEO” whereby most of a company’s value is attributed to its CEO (at least in the U.S.). I was surprised by his report that 95% of investors said they would buy stocks based on their opinion of the CEO. They certainly didn’t get that attitude from successful investors (who seem to do that only in rare cases where they are able to talk at length with the CEO). But his claim that “Corporate profit margins did not increase over the course of the 1990s, even as executive compensation was soaring” looks false, as well as being of questionable relevance to his points about executives being overvalued. And I wish he had also applied his argument to beliefs of the form “if we could just elect a good person to lead the nation”.
Chapter 6 does a good job of combining the best ideas from Wright’s book Nonzero and Fukuyama’s Trust (oddly, he doesn’t cite Trust).
He exaggerates reports that the stock market responded accurately to the Challenger explosion before any public reports indicated the cause. He claims “within a half hour of the shuttle blowing up, the stock market knew what company was responsible.” I don’t know where he gets the “half hour” time period. The paper he cites as the source says the market “pinpointed” Thiokol as the culprit “within an hour”, but it exaggerates a bit. If the percent decline in stock price is the best criterion, then the market provided strong evidence within an hour. If the dollar value of the loss of market capitalization is the best criterion, then the evidence was weak after one hour but strong within four hours.
He also claims “Savvy insiders alone did not cause that first-day drop in Thiokol’s price.”, but shows no sign that he could know whether this is true. He seems to base on the absence of reported selling by executives whom the law requires to report such selling, but he appears to overestimate how reliably that law is obeyed, and to ignore a large number of non-executive insiders (e.g. engineers). He does pass on a nice quote which better illustrates our understanding of these issues: “While markets appear to work in practice, we are not sure how they work in theory.”