Monkeys, Physics Books, The Keys To The Universe And The Gambler's Fallacy
"Even in such a time of madness as the late twenties, a great many man in Wall Street remained quite sane. But they also remained very quiet. The sense of responsibility in the financial community for the community as a whole is not small. It is nearly nil. Perhaps this is inherent. In a community where the primary concern is making money, one of the necessary rules is to live and let live. To speak out against madness may be to ruin those who have succumbed to it. So the wise in Wall Street are nearly always silent. The foolish thus have the field to themselves. None rebukes them." -- John Kenneth Galbraith
Galbraith so appropriately describes the environment of today. How much happy talk have we had to endure? Both from Wall Street and politicians of both parties? While many knew what was going on yet said nothing. Mostly for personal gain at the expense of society.
Before the world blew up I was meeting with a top quant and hedge fund executive - a PhD in economics. He had twenty years of financial model building experience. A relative grand old man in the field of quantitative analysis. Our discussions weren't focused on the particular topic of model creation or investment strategies but we talked about much of his analytical work. Within the first five minutes of our discussion I knew the underlying premise of his models, and therefore, his investment methodologies were based on scientific lies. The fact that he had twenty years of experience was irrelevant. Underlying fundamentals gave the appearance of temporary brilliance. Now the market is proving otherwise.
At one point I asked him if he had ever considered his work was inaccurate or would fail. I received a puzzling look that was clearly meant to convey that my question was silly. While my friend was contemplating his response, I offered up a question as to what he thought would cause his work to fail. He actually gave an accurate answer. As our conversation on the topic ended, he told me some of the most brilliant minds in the world were running trillions of dollars through this strategy and the environment I was presenting was "nearly" impossible. "Nearly" is akin to making a trip to the grocery store when it comes to the distribution of economic outcomes. "Nearly" is what created this crisis. "Nearly" cost Napoleon an empire. "Nearly" kept me out of the NBA. We are in the middle of "nearly" as I type this.
A month or so after our meeting the financial economy changed forever as did the success of much of his work. What does this prove? Scientific mountains can be, and often are, built on completely unsound foundations. They are chalked up as mistakes. We've all made our fair share of mistakes but when it comes to our banking system, we should never be allowed to play games with scientific mountains.
"Bear markets in this type of environment can start very swiftly with little time to react." - a remark I posted on here back in early July of 2007. A time when the seeds of deception were still growing. Most have been caught off guard at the speed of this market and therefore have been and continue to be on the wrong side of this market. The vast majority of professionals have spent the last two years trying to call bottoms and enter the market on the long side only to get blown out of their positions time and again. Or to mount larger and larger losses.
I post these remarks to make an important point. Much of the hedge fund and quantitative investment work we see before us is based on faulty or even completely invalid analytics. The problem with much of this investment "science" we see today is dramatically "curve-fitted". In other words, models that were over-optimized so that they produced dramatically powerful historical results. Results that appear brilliant in the rear view mirror. But, this approach invariably causes models with little relevance as to how the world really works or any validity in the future. And, therefore, no lasting relevance or with little future viability. Backtesting in itself is most often erroneous science. Unless one is able to replicate the exact fundamentals of today, and that is impossible, using backtested metrics should be understood to have severe limitations and high failure rates.
A perfect example of curve-fitted results are the constant bottom callers we have seen over the past eighteen months. And, calls for significant bear market rallies as we saw in the 2000 to 2003 decline. I have said repeatedly that those expecting similar characteristics to the last market are going to be sadly mistaken. We've had call after call anticipating rallies similar to ones we saw in that bear market. And, indeed they have been completely wrong. This is most definitely an environment where overly optimized results are failing on every level. And, that includes much more than the stock market. Even economics in general. A pseudo-science that suffers drastically from over-optimization. It's a statement of fact that Wall Street has spent hundreds of billions of dollars, millions of man hours and decades developing quantitative work that is a fallacy. All of that money was spent building nothing more than expensive lies. And they did it with society's money.
Many of these constant calls for rallies are based on the faulty logic of the Gambler's Fallacy. That at some point the market must rally. Why? Because it has gone down so much? Because we had rallies in other bear markets? Because your curve-fitted data says so? There are many bases for this fallacy. One is a basic lack of understanding of statistical probabilities. Another is a lack of understanding of the limits of science - which in itself is bad science. Another is a lack of understanding of the fundamentals that drive investment factors. Another is curve-fitted or voodoo science. Another is simply based on belief, more appropriately termed as lies, that the market reinforces time and again - in other words buying dips is rewarded. Not just over a market decline but over a generation of bear markets. We see this in more than calls for market rallies. We see this in the constant babble telling us it is finally this time that banks are now attractive again and again and again. Or, that wide spreads in bonds tell us now is a great time to buy. Or that municipal bonds represent safety. Or that commodities are a buy after imploding. Or that emerging markets now represent great value as they teeter on the precipice. The list goes on and on. And, instead of taking the great gift the market is giving them, we see nearly everyone trying to trade or invest against the trend. In this environment, that's no different than trying to drink from a fire hose.
We can conclude the foolish have the field to themselves as Galbraith told us. That most of the people using these models don't have a clue what they are doing. Which, quite frankly is why some of the top hedge funds in the world have collapsed. Many of these firms are held in such high esteem their leadership has achieved cult-like status for their abilities. This misguided faith is no different than that in CEOs we debunked in the PwC CEO Survey we looked at some time ago. Some top funds lost 50-70% in a single month. They will never recover. A 70% loss requires a greater than 200% gain simply to get back to neutral. That's a 200% gain on all of their investments. Not a 200% return on a trade. And, with substantial hedge fund fee levels, it would require substantially greater returns. Most hedge funds won't survive. Even funds that have done relatively well to date will not survive. The reality is that we assigned erroneous values to hedge funds. Their brilliance was really a factor of being lucky. Being in the right place at the right time. Never confuse an excess of credit with brilliance. Macro factors beyond their control or knowledge led to their perceived abilities. And, now we see the truth is exposed - that most were contributing to the destruction of our financial system. And, that we listened to many of these people for decades. Their fallacious economic ideals were building deeper and deeper lies into the core of our economy until they became systemic.
One more time, you might want to remember something. In the last eighteen months we have seen some emerging markets down 75-90% without any rally to speak of. The rallies expected in the U.S. haven't materialized either. Yes, we've seen stabilization points and two or three day moves of twenty percent but that's not a rally. It's a reprieve.
What might we take away from this? A lot of people did a lot of really stupid things in the name of science over the last twenty plus years. Maybe more appropriately put, if you give a monkey a physics book, don't expect him to discover the keys to the universe. And as we are finding out, not only did the monkeys not discover the keys to the universe, but they actually destroyed the universe.
Galbraith so appropriately describes the environment of today. How much happy talk have we had to endure? Both from Wall Street and politicians of both parties? While many knew what was going on yet said nothing. Mostly for personal gain at the expense of society.
Before the world blew up I was meeting with a top quant and hedge fund executive - a PhD in economics. He had twenty years of financial model building experience. A relative grand old man in the field of quantitative analysis. Our discussions weren't focused on the particular topic of model creation or investment strategies but we talked about much of his analytical work. Within the first five minutes of our discussion I knew the underlying premise of his models, and therefore, his investment methodologies were based on scientific lies. The fact that he had twenty years of experience was irrelevant. Underlying fundamentals gave the appearance of temporary brilliance. Now the market is proving otherwise.
At one point I asked him if he had ever considered his work was inaccurate or would fail. I received a puzzling look that was clearly meant to convey that my question was silly. While my friend was contemplating his response, I offered up a question as to what he thought would cause his work to fail. He actually gave an accurate answer. As our conversation on the topic ended, he told me some of the most brilliant minds in the world were running trillions of dollars through this strategy and the environment I was presenting was "nearly" impossible. "Nearly" is akin to making a trip to the grocery store when it comes to the distribution of economic outcomes. "Nearly" is what created this crisis. "Nearly" cost Napoleon an empire. "Nearly" kept me out of the NBA. We are in the middle of "nearly" as I type this.
A month or so after our meeting the financial economy changed forever as did the success of much of his work. What does this prove? Scientific mountains can be, and often are, built on completely unsound foundations. They are chalked up as mistakes. We've all made our fair share of mistakes but when it comes to our banking system, we should never be allowed to play games with scientific mountains.
"Bear markets in this type of environment can start very swiftly with little time to react." - a remark I posted on here back in early July of 2007. A time when the seeds of deception were still growing. Most have been caught off guard at the speed of this market and therefore have been and continue to be on the wrong side of this market. The vast majority of professionals have spent the last two years trying to call bottoms and enter the market on the long side only to get blown out of their positions time and again. Or to mount larger and larger losses.
I post these remarks to make an important point. Much of the hedge fund and quantitative investment work we see before us is based on faulty or even completely invalid analytics. The problem with much of this investment "science" we see today is dramatically "curve-fitted". In other words, models that were over-optimized so that they produced dramatically powerful historical results. Results that appear brilliant in the rear view mirror. But, this approach invariably causes models with little relevance as to how the world really works or any validity in the future. And, therefore, no lasting relevance or with little future viability. Backtesting in itself is most often erroneous science. Unless one is able to replicate the exact fundamentals of today, and that is impossible, using backtested metrics should be understood to have severe limitations and high failure rates.
A perfect example of curve-fitted results are the constant bottom callers we have seen over the past eighteen months. And, calls for significant bear market rallies as we saw in the 2000 to 2003 decline. I have said repeatedly that those expecting similar characteristics to the last market are going to be sadly mistaken. We've had call after call anticipating rallies similar to ones we saw in that bear market. And, indeed they have been completely wrong. This is most definitely an environment where overly optimized results are failing on every level. And, that includes much more than the stock market. Even economics in general. A pseudo-science that suffers drastically from over-optimization. It's a statement of fact that Wall Street has spent hundreds of billions of dollars, millions of man hours and decades developing quantitative work that is a fallacy. All of that money was spent building nothing more than expensive lies. And they did it with society's money.
Many of these constant calls for rallies are based on the faulty logic of the Gambler's Fallacy. That at some point the market must rally. Why? Because it has gone down so much? Because we had rallies in other bear markets? Because your curve-fitted data says so? There are many bases for this fallacy. One is a basic lack of understanding of statistical probabilities. Another is a lack of understanding of the limits of science - which in itself is bad science. Another is a lack of understanding of the fundamentals that drive investment factors. Another is curve-fitted or voodoo science. Another is simply based on belief, more appropriately termed as lies, that the market reinforces time and again - in other words buying dips is rewarded. Not just over a market decline but over a generation of bear markets. We see this in more than calls for market rallies. We see this in the constant babble telling us it is finally this time that banks are now attractive again and again and again. Or, that wide spreads in bonds tell us now is a great time to buy. Or that municipal bonds represent safety. Or that commodities are a buy after imploding. Or that emerging markets now represent great value as they teeter on the precipice. The list goes on and on. And, instead of taking the great gift the market is giving them, we see nearly everyone trying to trade or invest against the trend. In this environment, that's no different than trying to drink from a fire hose.
We can conclude the foolish have the field to themselves as Galbraith told us. That most of the people using these models don't have a clue what they are doing. Which, quite frankly is why some of the top hedge funds in the world have collapsed. Many of these firms are held in such high esteem their leadership has achieved cult-like status for their abilities. This misguided faith is no different than that in CEOs we debunked in the PwC CEO Survey we looked at some time ago. Some top funds lost 50-70% in a single month. They will never recover. A 70% loss requires a greater than 200% gain simply to get back to neutral. That's a 200% gain on all of their investments. Not a 200% return on a trade. And, with substantial hedge fund fee levels, it would require substantially greater returns. Most hedge funds won't survive. Even funds that have done relatively well to date will not survive. The reality is that we assigned erroneous values to hedge funds. Their brilliance was really a factor of being lucky. Being in the right place at the right time. Never confuse an excess of credit with brilliance. Macro factors beyond their control or knowledge led to their perceived abilities. And, now we see the truth is exposed - that most were contributing to the destruction of our financial system. And, that we listened to many of these people for decades. Their fallacious economic ideals were building deeper and deeper lies into the core of our economy until they became systemic.
One more time, you might want to remember something. In the last eighteen months we have seen some emerging markets down 75-90% without any rally to speak of. The rallies expected in the U.S. haven't materialized either. Yes, we've seen stabilization points and two or three day moves of twenty percent but that's not a rally. It's a reprieve.
What might we take away from this? A lot of people did a lot of really stupid things in the name of science over the last twenty plus years. Maybe more appropriately put, if you give a monkey a physics book, don't expect him to discover the keys to the universe. And as we are finding out, not only did the monkeys not discover the keys to the universe, but they actually destroyed the universe.
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