Sunday, February 16, 2014

How Market Analysis Fails

"How Markets Fail"
by John Cassidy

The first two-thirds of this book cover the history of economic thought.  It is interesting, and useful, but the author has some fundamental misunderstandings about market theory that undermine his argument.

The idea of the efficient market does not mean -- and would be stupid if it did mean -- that every stock is priced correctly.  Humans don't know the future, so they cannot be expected to anticipate the future of a corporation.  What the efficient market theory says is that the price of a stock reflects all information available at any given time.  This doesn't even mean that the price is the "correct" one for a given stock (if one could distill a correct cost based on a company's future profits).  It only means that, were any more information to come to light, people would adjust the price they would pay for a stock to account for it.  This is basically true by definition.  If someone thinks a stock is worth more than the current price, he will buy it, thereby bidding up the price.  If he thinks it is worth less, he will sell it, lowering the price.  And while any individual will only have limited knowledge, people in aggregate will have pretty good knowledge, so the price of a stock will tend to reflect a fairly comprehensive valuation based on a large amount of information.

One thing this theory does not say is that it is impossible to beat the market.  At any price, obviously some investors will win on a stock and some will lose.  If it goes up, the people who own a stock will win; if it goes down, they will lose.  As an individual, you may have a better understanding of a particular market or a particular firm than others, so you may do a better job of evaluating companies and their share prices than others.  Your understanding will be reflected in the price, but you are only one person, so it will not be reflected exactly in your interpretation; otherwise, every company would sell for exactly what you think it is worth, which wouldn't do you much good.  Warren Buffett has spent a lot of time criticizing the random walk theory of the stock market as though his success demonstrates that it must be wrong, but he is missing the point.  You can beat the market consistently, but it is extraordinarily difficult, which is why there are so few people like Warren Buffet who have made their fortunes entirely by buying and selling stocks with their own assets.  (Many people, of course, make money buying and selling stocks, as brokers or as fund managers, but they are paid primarily on fees or commissions, not on the success of the stocks.)  The number of people who think they can beat the market and fail outnumbers those who think they can beat it and succeed by a huge factor.  (Moreover, it is likely that, even if the market is completely random, someone would be as successful as Buffet, just as some will lose all their money.  I don't think his success is the result of luck, but you cannot point to the success of an individual as proof that skill is tantamount, any more than you could conclude that craps is a skill-based game because one person made millions of dollars from it.)

The power of the random walk theory comes in especially when dealing with aggregates.  While you might be successful is beating the market, you would only continue to succeed insofar as you kept your knowledge to yourself.  If everyone else knew what you knew, they would bid up the price of stocks to the level where they would no longer be a bargain for you, and you would be back at the starting point.  Any systematic approach to beating the market, therefore, is highly tenuous.  If you learn that a certain P/E ratio is the key to buying stocks, you might make money by investing based on your knowledge.  On the other hand, even if you're right, the prevalence of random factors may make it difficult for you to make much money.  If your theory is convincing, you could make more money by managing a fund, or even by selling your knowledge as an investment advisor.  Once this gets out, knowledge of your shortcut removes its advantage as people bid the P/E ratio up.  The only consistent way to beat the market is to understand an industry better than anyone else and to apply your knowledge to the purchase of individual stocks.  There is no way to sell this knowledge, because every decision you make is based on your general understanding, which is impossible to impart to someone else.  On the other hand, you have to continually renew your understand in order to retain an advantage over others, since conditions are always changing.

 "How Markets Fail" also devotes considerable time to the irrational behaviour of consumers:  the fact that we misconstrue probabilities, allow random factors to anchor the value we put on goods, and many other psychological quirks that have been uncovered in recent decades.  I have no dispute with the fact that consumers sometimes do a poor job of assessing the value of a product; the problem is that this is entirely irrelevant to efficient markets.

Businesses and consumers have fundamentally different goals.  Businesses want to sell goods and services for money.  The only reason they spend money is to acquire more money in the future.  Therefore, it is easy to assess how successful they are at any given point based on how much money they are making.  Ultimately, if they make less than they spend, they go bankrupt.

This logic does not apply to consumers, who are engaged in the opposite pursuit:  spending money to acquire goods and services.  There is no way to decide whether a consumer's purchase was "rational" because there is no way to compare different goods and services outside of individual preferences.  Let's say one person needs a mop and buys a cheap version that falls apart after a few months, while another person buys a more expensive version that lasts for years.  Who has made the more rational decision?  If the answer seems obvious, consider the person who disdains buying a mop at all and instead spends the money on a gift for his grandson, or a new gadget for himself, or on alcohol or drugs.  Which of these is better than buying a mop?  How can we tell?  There is no answer -- unless, of course, you want to set yourself up as the arbiter of human goals and tell each person what is best for him.  Since we do not believe in a bureaucratic elite making these kinds of decisions for individuals, there is no way to judge the rationality of an individual's purchases.

Cassidy calls this chapter of his book "Psychology Returns to Economics."  While there may be economists who have disdained psychology in the past, he misses the one school that places psychology at the center of its economic theory:  the Austrian school.  Ludwig von Mises, arguably the greatest proponent of Austrian economics (along with Friedrich Hayek), entitled his master treatise "Human Action" for a reason:  it is about why people act as they do, encompassing but not limiting itself to economic action.  The Austrian school is also the chief proponent of the subjective theory of value, which explains why there is no objective standard for assessing the value of goods outside of consumer preferences.

The rest of the book is a long preface to the final section, an account of the financial crisis of 2007-8 in which the author's theories are allegedly vindicated.  He begins his account with the Federal Reserve's "drastic reduction in interest rates." "In real estate bubbles, particularly, monetary policy is key. Low interest rates provide the helium that inflates the bubble" (p.239). The Fed's low-interest rate policy effectively created the real estate bubble.

You might be surprised, therefore, to read in the conclusion that "the unfettered free market has disgraced itself in full public view." The unfettered free market? Did the author read his own explanation that the Fed was the prime mover behind the bubble? Actually, though, the conclusion comes as no surprise. The author's thesis is that the "utopian economics" of free-market thinkers has to give way to the "reality-based economics" of those who believe that markets are inherently unstable and require careful government regulation. Whatever his actual account might be -- and the chapters in between the introduction and conclusion are surprisingly moderate in tone and sometimes even fair to market economics -- no reader could doubt that his conclusion would place the blame entirely on the free market, with the government to blame only insofar as it failed to fix the broken market.

Alan Greenspan is a central antagonist of the book, a free marketeer who fiddled while the financial markets collapsed. Never mind that he sat as the chair of a government institution that actively promoted the bubble for which his supposed hands-off policy was to blame. The author fleetingly recognizes this contradiction on p.234 when he acknowledges that, "if he had seriously believed what he wrote," he would have lobbied for the Fed's abolition. But that doesn't matter; in the author's view, since Greenspan believed in free markets, free markets must have been responsible for the bubble.

Cassidy mentions the Community Reinvestment Act only once. This act, passed in 1977 and amended several times in the 1990's, required banks to expand their lending criteria to people who would not traditionally have qualified. It led directly to the creation of a number of new types of mortgages designed to extend credit to people lacking traditional qualifications, such as a good credit rating, a proven work history, or sufficient money for a down payment. Although Cassidy spends considerable time explaining why the expansion of subprime lending was a mistake, he considers any attempt to connect it with the CRA or Clinton and Bush era attempts to expand home ownership as "antigovernment posturing." Among his proposals to prevent another crisis, however, is an expanded federal role in preventing "predatory lending." This is a classic case of the government stepping in to solve a problem that it created in the first place. Cassidy cites one economist who assesses the problem this way: "Why are the most risky products sold to the least sophisticated borrowers? The question answers itself. The least sophisticated borrowers are probably duped into taking these products" (p.348). The question does seem to answer itself, but in a completely different fashion: the only mortgages that "the least sophisticated borrowers" qualify for, or are able to take on, are the ones that are also risky.

You won't find much about the role of Fannie Mae or Freddie Mac in this account. He hardly mentions them in the narrative, even though he acknowledges that "the primary driver of [the] deterioration in credit standards was the buoyant mortgage securitization market" (p.245) -- a market that these enterprises were specifically set up to create. You won't read how they began buying subprime mortgages during the Clinton administration, then drastically expanded their role in the subprime market in the years leading up to the financial crash. You won't hear how Fannie Mae and Freddie Mac are exempt from regulations that apply to other financial institutions, or how they kept much lower reserves than the banks that Cassidy criticizes for being reckless. And, of course, you won't hear about how various members of Congress and the Bush administration tried to audit Fannie and Freddie, and how they were brusquely rejected by the heroes of "reality-based economics" such as Barney Frank, who asserted in 2003, "These two entities … are not facing any kind of financial crisis," and, "I want to roll the dice a little bit more in this situation towards subsidized housing." In an amazing passage, he actually blames the government's failure to rescue Fannie and Freddie earlier to "senior congressmen [who] remained wedded to the nostrums of Milton Friedman" (p.322). I can't tell if he thinks Frank is a believer in Friedman, or if he thinks Republicans were responsible for Fannie and Freddie's risky loan portfolios, but either is equally absurd.

The facts about Fannie and Freddie would interfere with the author's thesis that the crisis was all about an unregulated free market, but their status also demonstrate the problem with expecting regulation to prevent crises: who will watch the regulators? After all, Congress was in a unique position to reign in Fannie and Freddie during the years leading up to the crisis, but pointedly refused to do so because Frank and his ilk though they were doing a fine job of expanding home ownership. So eminent a financial figure as former Democratic Treasury Secretary Robert Rubin, who was on Citigroup's executive board, advised the corporation to raise its "tolerance for risk" in 2005 (p.296). Most economists, even those in the "reality-based" camp, saw nothing wrong with the expansion of the subprime market. Even if the government had pursued the most actively interventionist path in regulating the mortgage market, therefore, it would have done nothing to prevent the crisis because most people in a position to make a difference -- Democrats as well as Republicans -- didn't see a problem.

Government can and should enforce contracts, but it is illogical to expect bureaucrats to have a better understanding of economic trends than people actually in the market. Of course, CEO's are just as often wrong, but the market has a way of dealing with them: they get fired, and sometimes their companies go bankrupt. When bureaucrats make poor decisions, such as Barney Frank's ill-timed defense of Fannie and Freddie, they just sweep it under the rug. Five years later, Frank made the incredible assertion that "the private sector got us into this mess. The government has to get us out of it." Not only is Frank still in Congress, but there are people like Cassidy around to write books to argue his case.

I don't disagree with everything that Cassidy writes. Almost all of it, but not quite. I think he is correct that the structure of corporate CEO pay is skewed excessively toward short-term results, something that I have had occasion to comment on (privately) in the past. Unlike him, I have no confidence in the government's ability to design a more effective way of paying CEO's, but I think the private sector will come up with something.

Sunday, February 9, 2014

Syria and Westphalia

Those who spend a lot of time around me might suspect that this post is another attempt to drag the Peace of Westphalia into anything and everything, but in this case I am entirely innocent.  The idea of linking Syria and Westphalia had never occurred to me until I stumbled across it on an unrelated search last week.  I found that it was not a new or isolated connection, but one that has been going since the beginning of the Arab Spring and has been raised by several people from different angles.

The earliest reference that I have seen (without spending much time trying to ferret out exactly how far back this goes) is this article by Henry Kissinger in the Washington Post nearly two years ago.  He approaches Westphalia from the traditional standpoint of sovereignty, which is kind of depressing because I would hope that people would start getting over that mistake by now, but hardly surprising.  Most other references I have seen link Syria and Westphalia in a similar fashion:  intervention in Syria challenges the international order of sovereign states established in 1648 at Westphalia.

I have found one article that takes a completely different tack.  It appeared in the "Los Angeles Review of Books" and was written by Robert Zaretsky under the title Syria and the Peace of Westphalia.  Zaretsky makes passing reference to sovereignty as a key feature of Westphalia, but his argument is not about sovereignty or intervention at all.  Instead, he approaches Syria as a region struggling to hold together a central government in spite of deep-seated religious differences among its people, much as the Holy Roman Empire was in the first half of the 17th century.  He proposes a federalist solution along the lines of the Peace of Augsburg (1555), as modified by the Peace of Westphalia:  different regions could have different established religions, and people who wanted to live in an area where their faith was predominant would be encouraged to move to one.  If they chose to stay behind as a minority, "they would be granted limited rights and protection to practice their faith."

Merely by recognizing that Westphalia was based on international intervention in the religious and political affairs of one state, Zaretsky has shown himself to understand it better than almost any other commentator.  And, since I am a strong believer in federalism, I think his solution is promising.  However, I would like to point out two differences with the situation in 1648 that make it problematic.  The first is that the Holy Roman Empire was already politically decentralized to an extreme degree.  It needed no new structures to allow its constituent parts -- duchies, counties, cities, and so forth -- to exercise a large degree of self-government; they had already been doing so for centuries.  In Syria, there is no tradition of regional government, so creating new territories along religious lines and setting up administrative organs would be a major challenge.

The other difference concerns the geopolitical situation around the Holy Roman Empire compared to that around Syria.  The Empire was surrounded by states that had basically resolved their religious problems (mostly by eliminating the minorities in one way or another, but sometimes by compromise).  The Reformation was over a century old by 1648; unlike in the 16th century, when restive minorities proselytized across the Continent and fomented rebellion, most of the missionary zeal had spent its force and political institutions had had a chance to adapt to new realities.  There was, therefore, not much chance that the Empire's religious peace would be upset by subversive outsiders.  This was especially the case because of France's role as a Catholic power which supported Protestant estates in the Empire.  France did not want Catholics to unify the Empire, which would probably benefit their Habsburg opponents, but neither did they want to see Protestants make gains at the expense of Catholics.  It was a difficult position to maintain, but as long as France was the most powerful nation in Europe, it was unlikely to allow either side to make drastic changes -- as it had demonstrated in the 1630's, when it intervened to limit the expansion of its own ally, Sweden.

Syria has none of these benefits.  The Shi'a-Sunni conflict, although many centuries old, has not settled into anything like mutual toleration.  Both sides have shown themselves willing to use terrorism to destabilize their opponents, which makes it difficult for any state to hold together, especially one that would be based on a loose, federal structure.  Chronic instability in its neighbours, Lebanon and Iraq, creates an even greater challenge for Syria.  There is also always a possibility that the government might become involved in a foreign war, and the Holy Roman Empire offers little encouragement in this regard, since different estates took different sides in several foreign conflicts after 1648.  The Empire was able to remain together in spite of this because it had centuries of history, a common language, and common institutions in its favour; it is doubtful if a federated Syria would be able to come together again after its parts fought each other.

The conflict between Austria and Prussia -- nominally both part of the Empire -- was itself a driving force behind the international conflicts in the middle of the 18th century. Would a federated Syria also tempt foreign powers to seek relations with individual Syrian regions, perhaps with the overt aim of defending that region's religious position, but with a covert intention to weaken the central government and perhaps ultimately to take over?  It is precisely the fact that the Peace of Westphalia was not based on state sovereignty that creates a difficulty with this solution, because the introduction of semi-sovereign units below the state level expands the opportunities for conflict enormously.  Sovereignty creates issues of its own, but in a volatile region where governments have little respect for each other's legitimacy, the existence of a powerful central government limits opportunities for meddling.