The
Stock Market, Science, and History
This article
discusses the nature of the stock market and of market societies.
Isaiah Berlin (1909-1997) was,
perhaps, the most articulate spokesman for liberalism since John Stuart Mill. A
political philosopher and the founder of Wolfson College at Oxford, he is less
known in the United States. To read Mill is to traverse the sunlit meadows of
what was to become Victorian optimism. To read Berlin is to traverse these
meadows dappled by the wars of the early 20th century. Denying the
absolutist claims of political ideologies, Berlin advocates “value pluralism,”
the view that practical life at the level of society cannot be reduced to a
single vision.
Berlin’s writings are a
sometimes turbulent stream of sentences, some more than 120 words in length,
replete with qualifiers, quantifiers, comparisons, and contrasts. It is
definitely not Internet writing. Why are we discussing Berlin? It is because he
makes outstanding common sense, stating two practical ideas useful to investors
when dealing with real markets:
1)
The necessity of preserving, in human affairs, an “imperfect
equilibrium.”
(by means of error correction, if you
will)
2) Having a personal set of
principles to act in a complex environment.
In the following, we discuss the
cyclical fed model in terms of these ideas, which ultimately relate the stock
market to the modern social order.
Society at an Imperfect Equilibrium
The concept of equilibrium, that state to which all
things tend, is crucial in economics, for it provides the order that makes
classification and mathematics possible. However, we find that the real, error-correcting U.S. stock market can
be estimated by an econometric equation only over the long-term, and that the
market crosses the regression line at times rather than mean reverts.
A great deal can be learned from economics, but our
contention is this: science simplifies and validly generalizes on an immutable
(or long-term) basis. History, on the other hand as Berlin relates, is a
chronicle in time of, “that which differentiates one thing, person, situation,
age, pattern of experience, individual or collective, from another.”1
Put another way, there is a marked difference between the physics and history.
Both fields have a respect for the facts, but whereas physicists seek from the empirical
facts immutable and valid generalizations; historians seek from the empirical
facts convincing explanations of people and situations in actual time.
Our study reveals that the
error-correcting market has both aspects. The market has a long-term aspect
that is measured by the OLS regression model that describes order. The market
also has a short-term aspect which departs from this regression and which,
moreover, correlates well with actual and timely events. From the data, it is
quite possible to identify the real events that mark large departures from
equilibrium - the stygian depths of OPEC despair, the market’s overreaction to
the economic recovery of 1987, the New Era exuberance of the Internet, and the war in Iraq. (We wrote that
article in 1999 before discovering dynamic error correction in the econometric
literature.)
At this point, we can quite validly say that to
understand the market is to deal with more than the long-term, but also to
understand the market’s short-term reactions to history and politics. The
skills for doing so are, as Berlin writes “synthetic,” “…it is an awareness of the interplay of the
imponderable and the ponderable, of the ‘shape’ of things in general, or of a specific
situation, of a particular character, which is precisely what cannot be deduced
from, or even formulated in terms of, the laws of nature demanded by scientific
determinism.”2 This kind of intuitive skill is found more often on
the trading desks of Wall Street, where traders constantly deal with markets as
a medium.
Although Berlin writes a lot more about disequilibrium
than equilibrium, he points out that the latter, albeit imperfect, is necessary
for society to remain in an “estimative state.” His view on how this is
achieved is correct, “…the end of political action is not some static
perfection, but the adjustment of interests and activities (our
emphasis) as they arise; when they arise; since…it is natural to men to pursue
different and, at times, incompatible ends; nor is this an evil, for diversity
is the price – and perhaps the essence – of free activity.”3
Political consensus is also the source of institutions.
Principles
We’ve been asked why we discuss
philosophy. The answer is twofold:
1) Philosophy
provides a consistent set of principles with which to act in the complex market
environment. In this traditional sense, philosophy is very practical: it helps
people reflect upon their lives and the world. Consider this major investment
inconsistency: You trade (the winners) when you think you are investing; then
you invest (in the losers) when you think you are trading. By temperament,
people are either value investors or momentum traders. It is a good idea to
have an investment philosophy.
We are value
investors, meaning that in the ordinary course of events, a drop in the price
of a stock is a possible buying opportunity, provided the drop is not caused by
a deterioration in business fundamentals, causing an intrinsic loss of capital.
2)
The second reason is that philosophy can explain why there are value and
momentum investors.
Markets, as our readers have ascertained, are complex - a major coordinating element in liberal societies, how could they be otherwise? The price of a stock is set by the constantly changing intersection of supply (sellers) and demand (buyers). A study of how this intersection behaves is our major concern. The complete answer to how markets behave is not to be found solely in equilibrium economics.
Berlin
suggests that the history of human knowledge is, to a large degree, an attempt
to shuffle all information into two major categories: the empirical (to which
the physical sciences and econometrics correspond) and the theoretical (to
which mathematics corresponds). The crucial test of whether knowledge falls
into these two major categories is whether you know where to look for the
answer.4 To find the answer to a question of fact, what is TCP/IP,
you can do an Internet search or ask an expert. To find the answer to a math
question, you can look in a math textbook. What happens, Berlin asks, when you
are confronted with the questions: What is the relationship between free will
and determinism? What is the meaning of the future? We might add, is the price
of a stock likely to be higher tomorrow, in five years? To answer these kinds
of questions, there is no single textbook or expert to turn to; philosophy
studies the categorical frameworks, or organizing principles, that people use to
answer these kinds of questions.
Consider two
very different organizing principles. Sir Issac Newton (1642-1727) discovered
the set of laws governing celestial and terrestrial mechanics, thus setting the
standard for superior knowledge in other disciplines which began a like search
for universally rational principles. The ensuing debate, as to what is the most
valuable kind of knowledge, was brought to an end by the growth of studies in
the nineteenth century that valued the particular and the past, such as
history.
The
integrating concept of our econometric market analysis, spanning these two
opposite viewpoints, is time. Over a long period of time, due to the Fed’s
countercyclical monetary policy, the equilibrium level of the U.S. stock market
can be described by quantitative analysis (the fundamental kind), with
scientific methods developed since the Enlightenment. The purpose of
institutions is Newtonian, to increase societal predictability. Over a short
period of time, the stock market’s excursions from equilibrium are affected by
the momentum of business and historical trends, because these excursions are
primarily traders’ reactions to actual events.
This article
has shown that through error correction, the intersection of market supply and
demand has both long-term and short-term components. We focus mainly upon the
long-term value component, as it is in accord with our temperament. Value
investors also look to short-term event catalysts, but as ancillary concerns.
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These
references are noted because we
quote Berlin extensively. If any of our readers would like to peruse Berlin, we
suggest his essays in The Sense of Reality ( 1997 ed. ). These
essays are relevant to stock market investing because they are about the nature
of judgment.
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This article
seems to have inspired some controversy. The main criticism is that we
unrealistically condemn the use of military force in a violent world. This is
not our opinion; our major point is that military force, whether justified or
not, has real costs. Wars have both a direct cost in terms of blood and
treasure and also an indirect cost of decreased public confidence in the
future. More than 2700 years ago, the poet Homer made this explicit in the Illiad,
describing the chaos of war as opposed to the benefits of peace5. Lest there be any doubt of
this, in the New York Times 7/6/05 edition Thomas Friedman reports, “I was
having coffee at a Gaza hotel on Saturday with a group of Palestinian and
Egyptian businessmen when one of the Palestinans, half-serious, half-joking,
gave me a stock tip. ‘Nablus.’ The Palestine Securities Exchange, located in
the West Bank town of Nablus, has skyrocketed since the Israeli-Palestinian
cease-fire went into effect in February.”
The command
and control method of spreading the structures of democracy by war doesn’t work
simply because the method contradicts its goal. Democracy is a peaceful way to
resolve conflicts. It requires sound institutions, people with a democratic temperament,
and at crucial times good leadership.
In the real
world, the U.S. can best lead by positive example and encouragement. Above all,
the development of democracy requires making perspicacious distinctions - not
all countries are the same - and patience, when dealing with real people who
are being asked to change how they deal with each other and with the world. This
excellent documentary by the Washington Post (requiring patience to
download 6) makes
these points about the development of democracy in the Mideast. We would say
the same about the development of democracy in the rest of the world.
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Solon was
elected chief executive officer of the Athenian state in 594 B.C. in order to
end the civil strife between classes and restore cohesion to the polity. He was
asked whether he had given the Athenians the best laws possible; he replied,
“The best they would receive.”