A Canadian on Wall Street

I’ve been reading the second edition of Robert J. Shiller’s Irrational Exuberance, with its 2005 additions and a part-focus on the numerous real estate bubbles that seemed counterpart to the stock bubble that initiated the book. He makes the excellent point that real estate has actually been a pretty mediocre investment except for in a few rare, short timeframe situations — one of which we happen to be in now, but for how much longer? Much of the long-term gains disappear in the light of inflation. He also makes a good point in one of his syndicated columns that real estate as an investment was not a very common thing for much of the past century, that talking about real estate the way we do now even a few decades ago would have been analogous to collecting cars — it was done, but not commonly and the house was not viewed as an investment vehicle, but as it is: the place you live.

Before the real estate boom of the late 1970’s, hardly anyone was worried about rising home prices. A search of old newspapers finds surprisingly few articles about the outlook for home prices. Those that did appear generally seem to be based on the assumption that minor fluctuations in construction costs, not massive market swings, drove the modest home price movements that they noted.

Indeed, hardly anything interesting about home prices was ever reported at all, aside from an occasional comment in an article about something else. For example, an article in The Times of London in 1970 argued that rising home prices reflected the switch to a new British Standard Time (imposed as a three-year experiment in 1968 to facilitate commerce with Western Europe by putting Britain in the same time zone). The article claimed that the change raised costs by forcing British construction workers to perform more of their jobs in relative darkness. Speculative investment behavior was hardly an issue in those rare instances in which home prices were discussed.

To understand the nature of the subsequent shift, consider that it is hard to find anyone today who worries that automobile prices will soar because rising demand in China and India for steel and other materials will push automobile prices out of reach in the future. Though a small group of collectors invests speculatively in antique or specialty cars, the idea of speculating in automobiles just is not in the public consciousness. That is how it was with housing until the late 1970’s.

Anyhow, very appropriate reading these days. It’s been an interesting past week, with various pundits arguing back and forth about whether this is a temporary blip versus a longer duration thing. I’ve sold out of most of my positions, with some moderate gains and some moderate losses, because I’m a little bit wary — I really have thought the market was overpriced and slim pickings, but I was still putting money in speculative stocks when I probably should have remained in cash or moved strictly to dividend-based investing. Why was I doing this? Because it’s hard to sit on one’s hands when you’re babysitting a cash hoard; the tendency is to want to be active, to make “moves”. Anyhow, I don’t know what the market will do in the next while, but I felt uncomfortable where I was — I had some exposure to emerging markets, too — and so I just had to follow my instinct and sell. I may be wrong, but don’t kid yourself that there’s some empirical basis for buying or selling. It still always comes down to hunch.

It’s very difficult to write a site focusing on financial and investing related topics without veering too close to the realm of the “analyst”. I’ll be honest, it does seem utterly amazing that we have such a plethora of people who are dedicated to coming up with reasons, some rational, some not so much, to invest our money in a particular stock or sector. Although sales and analysis are often considered separate arms of the finance industry, it strikes me that analysis is essentially a form of marketing. Whether it’s the analysts of the big banks’ investment arms or the analysis of blogs and newsletters and various independent investors, there’s never anything completely impartial in the views and opinions that are put forth. We listen, because there’s a veneer of empiricism to it, but compared to science (which, too, can be co-opted by marketing — see the pharmaceutical industry for a good example of this), financial analysis, such as it is, can often be a pretty depressing landscape to survey. As anyone schooled in doubt and skepticism might ask, what has been truly verified? Except for behavioural finance and economics, there’s very little that’s made sense to me of current financial thinking. People are still smitten with pseudo-scientific methodologies based on arbitrarily chosen statistics, developing applications and algorithms that act without awareness of psychological events, when it seems to me the only thing in investing that really matters is to be conscious of the mass psychology and to take advantage of it, whether that’s done through “value” (usually implying that a stock is not well liked and hence has not been pushed up in price) or “momentum” (taking advantage of the herd mentality).

Here’s a question: what’s a value stock that never goes up in price? Was it still valuable if it remained unloved? The value investors have convinced themselves that, yes, there is some intrinsic value that was always there. But the fact is, price (and value — even though some people like to imply these are separate) is a psychological construct (gold is a case in point) that can’t be tied to specific attributes of a company in the abstraction of the market. If people were able to sustain a mania indefinitely, then prices would never fall, even if a company was actually doing poorly. But when a company does poorly, or for a variety of other reasons, that mania becomes harder and harder to maintain. Reality intrudes. But is reality really a “return to value” or just the pendulum swing, a reflection of cyclicality that is present in so many natural forms? And is the market chaotic in a way that is predictable or not? How can individuals really understand the interaction of so many competing forces?

I think we stick to our seemingly rational analysis of stocks, P/E ratios and earnings reports because otherwise it would be a fool’s errand to try to synthesize all that information. It’s easier to focus on a few numbers and try to make it represent the whole. When an analyst is right, we ascribe skill to them, as if they were a scientist who had hypothesized something and had their hypothesis confirmed, because if we were to think otherwise, it would really undermine a whole industry. What? I think people look at finance and investing, and see numbers, and think that because there are numbers that it’s completely quantifiable — ultimately though, I think we’re in a casino where there is no house and no odds, because by its very nature the market’s rules are constantly changing.

—

I wrote the above last night as I was going to bed, and didn’t post it, thinking it sounded a little kooky and speculative and not particularly cogent, but in light of today’s bloodbath (all red) in the markets, I figured it was strangely appropriate and dare I say… prescient? Let’s see how the “analysts” attempt to rationalize what was probably only moderately rational and mostly a lot of stampeding for the exits — the psychology of herds.

Terrific article about economics as it works in the animal kingdom, sent to me by a coworker. The following example has felt somewhat appropriate lately, heh:

Sarah F. Brosnan, one of my colleagues at Yerkes, went further in exploring reactions to the way rewards are divided. She would offer a capuchin monkey a small pebble, then hold up a slice of cucumber as enticement for returning the pebble. The monkeys quickly grasped the principle of exchange. Placed side by side, two monkeys would gladly exchange pebbles for cucumber with the researcher. If one of them got grapes, however, whereas the other stayed on cucumber, things took an unexpected turn. Grapes are much preferred. Monkeys who had been perfectly willing to work for cucumber suddenly went on strike. Not only did they perform reluctantly seeing that the other was getting a better deal, but they became agitated, hurling the pebbles out of the test chamber and sometimes even the cucumber slices. A food normally never refused had become less than desirable.

On a vaguely related note, a good piece on the shift from efficient markets theory to behavioural finance, by Robert Shiller.