Controlling Your Emotions
- I use a combination of macroeconomic analysis - with its basis in the Austrian School of economics - along with a proprietary asset pricing theory and model that understands the markets as a complex system. We use these two tools to understand global risk-seeking and risk-averting behavior as it exists on a macroscopic scale.
- Our 'Complexity Theory of Asset Pricing' and its model are important determinants of our portfolio's bias and operate at all degrees of scale (from very short term time frames to very long ones). I believe traditional asset pricing models like efficient market hypothesis, capital asset pricing model, modern portfolio theory, and microeconomic and macroeconomic fundamental analysis are entirely insufficient. I believe that negotiated financial markets are self-organized complex systems that exhibit both linearity and non-linearity in the price discovery mechanism thanks to the simultaneous presence of both rational and irrational investor behaviors. Novel statistical tools focused on modeling these systems are focused on measuring probability distributions rather than certainties and thus differ critically from traditional asset pricing models that ignore the essential role that irrationality and emotion play in negotiated markets. These behaviors interact in both positive and negative feedback regimes to produce global patterns of price that exhibit scale invariance (self-similarity). Our models attempt to recognize the signature of complexity in the marketplace and predict its important changes.
- Markets are not driven by fundamentals - all economic decisions are partly or wholly irrational, an insight developed by the behavioral economists - most notable among them Dan Kahneman, Amos Tversky, George Lowenstein and Ward Edwards (among many others). Equity risk premia are the result of a collective desire for greater or lesser risk-taking. This desire manifests itself in specific, scale-invariant ways: in the form of robust fractals, an insight developed by Benoit Mandelbrot, Edgar Peters and others.
- Markets are both non-linear and linear: both rational and irrational - The collective desire for risk-taking manifests itself in specific, scale-invariant ways in financial time series data: in the form of robust fractals, an insight developed by Benoit Mandelbrot, Edgar Peters and others. Both positive and negative feedback regimes are at work at all times in markets, leading markets to naturally oscillate back and forth at various amplitudes, phases, periods and cycles from bearish to bullish. Financial time series are leptokurtotic insofar as fat-tail events are far more frequent than a simple Gaussian distribution of returns would suggest. This reality yields interesting insights and potentially novel methods for managing assets.
- The Federal Reserve acts as a feedback force - both positive and negative - to changes in asset prices and as such it follows and does not lead changes in yields. As a government bureaucracy, it is beholden to political benefactors and rent-seeking industries. As a result of its 92-year history and constant inflationary policies, the value of the U.S. dollar has fallen more than 96%; this monetary inflation is actually a transfer of wealth from savers to spenders, from creditors to debtors and perverts both the capital structure and time preferences of all economic actors within the economy.
Outlook for the financial markets:
- The secular bear market is not complete - our long-term models continue to suggest the probability for a return of the secular bear market and the end of the cyclical bull market are near. The risk of equity exposure is significant within the current macroeconomic, psychological, and price regime. A deflationary credit contraction is beginning that we think will cause a significant dislocation in the global financial system within the next few years. Price deflation in goods, services, and assets has been a reality for the last five years and will likely gain force over the next three. Commodities have benefited primarily from the record excess credit creation by the world's central banks and far less by actual supply and demand dynamics. As such I believe they have one last bear leg in their secular bear market trend from the 1980s; after which hyperinflation will likely make them (particularly gold and silver) the single best source for capital gains, perhaps the best in generations. I believe that long term yields in U.S. treasuries will continue to fall for several more years and that the Fed will likely lower rates as early as January or February 2006. I continue to believe the U.S. dollar is in a multi-quarter (and perhaps longer) mean-reverting bounce that will; surprise markets with both its persistence and the gains it makes against other currencies despite the "known" macroeconomic problems with the U.S. dollar. Real estate markets are clearly and unambiguously in an unsustainable asset bubble that is likely to start deflating in early 2006 irrespective of what long-term mortgage rates are.
Thoughts on controlling risk and staying in the game:
- Start by controlling your own emotions; do not treat risk and reward differently. Read "Prospect Theory: Decision Making Under Risk" by Tversky and Kahneman. Understand that loss is simply risk manifest; risk is always present even if it doesn't result in losses. Develop risk/reward rules that are hard and fast: never risk more than a dollar to gain five (or three, or four...based on your risk tolerance and methodology). Never, ever become part of a crowded trade unless you have a system to understand when that trade is set to exhaust itself.
If I could give one piece of advice to attendees...
- Negotiated financial markets are highly irrational and operate under a macroscopic animus that determines what equity risk premia are. Fundamental data is not irrelevant per se but is a very weak data set from which to judge future likely changes in the behavioral state of equity investors. Not only is it a lagging indicator but it can also be legally and illegally manipulated in ways that interfere with its ability to provide insight into the probable future changes in equity premium. 85% of all active asset managers do not beat the S&P 500 because they accept that negotiated financial markets are efficient and that fundamental data is the best way to measure this efficiency. Understanding that both of those assumptions are wrong is the most important aspect of understanding the current and future behavior of markets.
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