Thursday, August 27, 2015

Big volumes don't mean the truth

On the mentality behind the mindless group think in physics and stocks

Florin Moldoveanu is a great example of the average member of the "interpretation of quantum mechanics" community. He says and writes lots of ludicrous things – about the (non-existent) problems with quantum mechanics and "clever" (demonstrably wrong and usually extremely stupid) ways to cure them – because he sees many people in his environment who do the same thing. Like almost all others in that community, he doesn't exhibit any truly independent scientific or creative thinking.

Now, he wrote an article about the markets
Is China's turmoil the next Lehman Brothers?
which makes it clear that he exploits the same "intellectual methods" in topics outside physics, too. As the title makes explicit, he believes that there's some "Great Depression" event going on in China and the world. There's none. Everyone who has some actual business in China – e.g. the food chains – says that they don't even observe any slowdown, let alone a dangerous one. And if there's a slowdown or drop in the market, it's being fought against by various policies of the Chinese authorities, anyway.

What you should do when the markets are wild according to Mr Moldoveanu?
One of the most imbecile advice typically found on CNN by their so-called experts like Richard Quest is that you should not panic and ride out the storm. Is there a topic he is not qualified in?
[Advisors are biased.] They usually give you the same cookie cutter nonsense of investing for the long term.
Sorry but none of these two wisdoms is "imbecile advice" or "cookie cutter nonsense".

The stocks' being a good investment in the long run is really the key to the understanding why rich people invest about 1/2 of their liquid capital into stocks. In the short run and sometimes medium run, the stocks may go down. They don't give one much certainty. But it's exactly this uncertainty that is rewarded by the higher average long-term returns which are close to 10% for stocks in almost any economy that will continue to exist for decades or centuries.

The stock prices may do wild things. But at the end, it is obvious that the risk is rewarded in the long run. You may look at the historical graphs and see that it has been the case. And you may also carefully think about the problem as a theorist. The equilibrium between the financial investments and stocks is unavoidably adjusting itself so that all previously hidden costs and benefits are incorporated.

Because neither money nor stocks will cease to exist – unless we allow some communists to conquer the world or something like that – people are deciding whether they go to the money or stocks. Each of them has a certain average growth and certain risks, especially in the short run. At the end, all advantages and disadvantages basically cancel: the stock-to-cash price ratio has a fair value. If one of the kinds of investment were objectively worse in the long run, it would die or it would have died away. It's clear that the stocks have the major disadvantage which is the risk and volatility; and this disadvantage must cancel with an advantage which are the higher long-term returns.

Alternatively, look at this logarithmic graph of the Dow Jones Industrial Average from 1897 to 2012 or so. There are lots of wiggles in the graph. The 1929-1933 bear market is visible: the maximum drop was nearly 90%. And you may see that between 1965 and 1983 or so, it seemed that the index wasn't growing at all. 18 years seems like a very long time of stagnation. But despite those features, the graph looks like a noisy upward function, doesn't it?

How does Dow Jones work relatively to the GDP? You may check e.g. this graph of Dow Jones over GDP between 1913 and 2006. The ratio was fluctuating – doublings and halvings weren't unheard of – but the "order of magnitude" was the same. In the first half of the period, the ratio was 30-150. In the second one, it was 15-60 or so. I don't quite understand the units but I trust the graph up to the overall scaling. Basically, when you hold Dow Jones stocks, you keep a fixed fraction of the (growing) GDP of the economy.

However, this graph makes the stocks look worse than they are. The reason is that the Dow Jones index (and most other indices) are left to drop when a company pays dividends – and its price therefore "technically drops". So the truth is that by owning Dow Jones stocks in the Dow-Jones-like mixture, you basically keep a fixed fraction of the American GDP even though you may spend all the dividends that you receive.

In other words, the total returns are much higher. You may reinvest the dividends (buy new stocks), too. How much does the story change if you own the Dow Jones mixture and reinvest all the dividends from the companies?

You see in the graph that the relevant average P/E has been about 25, so 1/25=4% of the value of your Dow Jones basket is paid in dividends. P/E was close to 20 up to 1985 but seemed higher (i.e. lower dividends than 5%) in recent decades, especially during "bubbles". OK, how is this counting changed? Since 1897, you may add the factor of 1.04 for every year – the growth of your portfolio from reinvested dividends. Over 118 years, you get the extra factor of 1.04118 = 100 or so from the reinvested dividends.

Combine it with the 2-fold drop of the Dow-to-GDP ratio discussed before and you see the following: since the late 19th century, the holders of the Dow Jones mixture of stocks who have reinvested all the dividends have increased the value of that basket as a percentage of the U.S. GDP by a factor of 50 or so. It's pretty good, isn't it? All the readers of The Reference Frame who have been patiently investing from the late 19th century must confirm that for such a straightforward strategy, it was a good one.

How is it possible that the stocks allow one to grow much faster than the GDP? Well, it's because most of the economy doesn't reinvest the dividends. Most of the time, people spend their income and enjoy their lives. That's why. (Well, one should also discuss the possibly changing percentage of the GDP that is created by the Dow Jones companies and so on but I don't want to describe all relevant effects that affect the dynamics of these variables.)

I said that the companies paid about 4% of their value in dividends every year – in average. If you spend the dividents, your Dow-Jones-to-GDP ratio drops two-fold; if you do reinvest them, it grows by a factor of 50 over the 118 years. There is a reinvestment ratio "in between" for which the partial-reinvesting-of-returns Dow Jones index stays fixed relatively to the GDP. If you get those 4% in dividends every year, you spend 3% (3/4 of the dividends) and reinvest 1% (1/4 of the dividends), you will keep your assets-to-GDP ratio approximately fixed. I think it may be a good estimate of the percentage of the income that is reinvested and not just "enjoyed". An important correlation is that it is primarily the rich people who invest and not just spend. They can afford it.

This is really one trivial reason why the rich people are needed for the long-term growth of the economy: they are those who actually invest and not just spend! If you want to create the growth (which ultimately improves the life of basically everyone), a straightforward recipe is to make the rich people richer. This important truth unavoidably follows from the reasoning. The leftists love to pollute your environment with all sorts of mumbo jumbo whose purpose is to claim the opposite – that you improve the future growth by redistributing money from the rich to the poorer ones – but it's easy to check that their logic is upside down.

But let me return to Florin. His main point is that you need "someone to tell you whether you should sell" and TV pundits or private financial advisers are no good. So who is the right adviser?
His claim is simply that your guide should be the changes of the stock indices whenever the trading volumes are high!
So if the volumes are low, it may be noise and you may "buy a dip" and "sell a bump". But if the volumes are large, they tell you an important truth about the future behavior of the stocks. Florin believes that it's because the institutional and really big traders must be involved in the trading and they know the truth!

Holy cow. His logic may be viewed as a rigorous proof "why you should be a mindless sheep that always moves with the herd". What's wrong with his reasoning? Well, there are four main problems:
  1. big volumes don't mean that the trading is dominated by rich or institutional traders
  2. big volumes don't mean that the trading reveals the truth
  3. someone's being a big institutional trader doesn't mean that he knows the truth
  4. even though the mythology underlying Florin's logic is completely flawed, many people follow this recipe, anyway
This collection of four claims of mine may be viewed as a circular reasoning but statements organized in circles may be true, too. They are actually more likely to be true.

Why are my statements basically true? The first statement basically follows from the fourth one. There are tons of people just like this Florin who are magnifying the trends they see. They contribute zero research to the calculation of fair values of the companies or the whole indices. They are just trying to copy what big herds are doing.

This unavoidably implies that there is a big positive amplifying feedback. When someone starts to visibly move the stock price or an index or the whole market in a certain direction, lots of mindless people and sheep indistinguishable from Florin will join him. So the actual big volumes always contain a big percentage of traders who just "copy". Because this positive feedback exists, it's obvious that you can't ever know whether the initial perturbation that started the big swings was caused by a well-informed, big, or institutional investor, or neither.

One way to see that big volumes can't imply the truth is that when volatility is high, big losses may be followed by big gains or vice versa – while the volumes are huge. We saw it in recent days. We have seen it at thousands of moments in the history, too. The volumes are large but the big gains and big losses can't be true (good predictors of the future direction of stocks) simultaneously because they contradict each other, don't they?

Even the claim that the big or institutional traders must "know the truth" may be seen to be wrong separately from others. They can't know it. No one can. Even if there were no small investors at all, the big or institutional ones would still try to fool and rob each other. Their being big just can't make them better than the rest.

What is actually the main reason that decides that certain (usually small) investors make losses (or smaller profits than the market) is that they can't survive the pressure. They invest some money to stocks – which means that they may lose a huge fraction of this value. They have been told so. It's common sense. But when the correction actually arrives, they realize that they actually weren't ready to lose 15%. They need most of the money. So they sell when the stocks are down 10%, for example, and are only "psychologically ready" to return to the market when it returns to the previous highs. Some of them – or other, new small investors – buy the stocks later and undo the drop. In this way, these scared small investors lose those 10%. The investors who can "really" afford to lose much of the money in stocks don't sell when the prices drop 10% which is why they ultimately reach the 10% returns.

The big, widespread fear is obviously a buying opportunity; and the excessive euphoria is a reason to sell. This recipe doesn't work and cannot work in every single case. But statistically, it's "mostly true". The correlation is unambiguous. If you sell and buy stocks at pretty much random moments and own them 1/2 of the time, you will only get about 1/2 of the returns (plus huge noise on top of that). If there's any recipe for "timing" that actually works, at least slightly, it's "buy the panic, sell the euphoria".

Florin Moldoveanu is the ultimate personification of the kind of disease that my proposed policies were and are meant to eliminate. People like that are the sources of huge positive feedbacks that amplify any noise, create huge instabilities in the markets (in both directions), reduce the efficiency and accuracy of the price setting which is the main "work" that the traders are actually supposed to do, and that ultimately hurts the whole economy and everyone who lives in it.

No, sorry. One may keep his calm and understand the stocks as an important long-term investment. Or one may do a more detailed work on individual stocks or the timing but one must do it right. Following the big-volume herds can't replace a correct analysis and ultimately can't beat the market, either.

Needless to say, the comments about the stocks were the topic I care about less. What is worse is that this guy and tons of others are following this mindless herd mentality in science – or what they pretend to be science – too. They say and write tons of nonsense because other people around them are doing the same. They never thoughtfully separate the truth from the untruth. Their (the quantum interpretation community's) writings are uncorrelated to the truth – they're noise and garbage. They just work hard to align their own garbage with the garbage around them to have the same color and shape. That's a sufficiently good strategy for them to survive in the garbage community.

You may see that such people become more reasonable and agree with important and demonstrably true insights when you talk to them individually. But because they mostly co-exist with low-quality pseudoscientists, they parrot rubbish most of the time. There is some percentage of non-rubbish they also parrot but they contribute nothing to the amount of valuable insights that science has, or the ratio of non-rubbish within the body of statements that are being made. This "copy the big herd" behavior that he recommends in the stock market is indeed a great description of what he does with quantum mechanics, too.

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