Notebook, 8 June 2012: On Markets and Electorates

“When you all grow up, most of you will be average adults.”

     —High school teacher to my class. By definition, most of us would be “average.” However,this assertion was taken as an insult by all of my classmates.

You’ve paid good money to take your family to the museum. A red line on the floor takes you through the museum, but the exhibits are no closer than forty feet away. A sign politely asks you to stay on the red line. The line aimlessly circles a post. Do you:

  1. Ask what’s going on?
  2. Ask for your money back?
  3. Shut up and just walk the line

Something I saw on television. The answer is that many people will do as asked and walk the line. Add an official looking seal to the sign and you get greater compliance. Station a mean looking but elderly enforcer (even though he says nothing) along the line and even more people will walk the line, forgetting why they came to the museum in the first place.

Here’s another. You’re among a group of people asked to choose which, among three different length lines, matches a fourth. You are the last to answer. The answer is C, the third line. It’s right there, plain for all to see. Should be easy, right? Except everyone else chooses line two (as they were previously instructed to by the researcher). What do you do? About a third of all respondents will knowingly ignore what they see to be a hard fact in order to conform to the group.

One more from that show. You stare up into a tree, you get ignored by passersby. Add two or even better, three people staring up, and you’ll attract a crowd. All with craned necks. Tell them you’re looking at a snake up there and you can get a bunch of people to admit they see it as well. But there’s no snake, there’s nothing at all up in that tree. Not only will they spend considerable time looking for it, but some will invent stories about the snake’s position, color and movements. It takes three or four people to get this going, but if you have fifteen people doing it, about 90% of everyone else will gaze at that nonexistent snake.

It gets worse. After only six days, the infamous Stanford Prison Experiment had to be cancelled. A psychologist coming late to the study was so sickened by what she saw that she demanded the two week experiment be halted immediately. All the participants were subjects, divided into “guards” and “prisoners.” After only a few days, the prisoners showed signed of deep distress while the guards became sadistic, even more so off camera than on. Can you say Abu Ghraib?

It gets even worse than this. The next time you are in a group of at least five, look around you and try to pick out the 60% of those around you who will willingly put your life in danger when goaded on by an authoritarian figure. These people will ignore their own personal misgivings and endure considerable discomfort in order to comply.

None of these examples is an isolated finding. Each has been confirmed repeatedly by independent researchers. These findings meet the strictest measures of scientific rigor.

And, of course, our financial markets as well as our political system couldn’t exist without all of these.

“The Markets Hate Uncertainty”

Using your sexy internet trading platform, you notice the five day moving average of a stock has just risen above the twenty day moving average. Question: Is this a buy or a sell signal?

Answer below.

Try predicting the future. You may, if you wish, participate in an IARPA (Intelligence Advanced Research Projects Activity) study of prediction. I did for awhile. The questions involve all sorts of topics, from the probability that bird flu will pop up in Italy by a given date, to the closing of the S&P 500 in a few weeks, to the likelihood that Gadhafi would remain in power for a month (real questions, since closed). My predictions were correct about 65% of the time, though I tried to stick to questions with binary choices (while the pundits were saying Gadhafi would last a week, I was right and they were wrong. He was still fighting when that month ended). I have no idea where the S&P will be in a fortnight, and nobody else does either. Yet people put their money down on exactly this most difficult kind of prediction, and they are quite happy and excited to do so. Speaking from experience, the prospect of a big hit is enticing, but that’s not all.

Right now, the CEO of Knight Capital Thomas Joyce is on CNBC saying, “. . . think long term. The stock market is on a thirty year run. You will be rewarded.” That’s the mantra. Your payoff is, in time, inevitable. But is it? On the other hand, the most ignored words in the investing world are, “past performance is no guarantee of future results” and I subscribe to this view. Yet still on CNBC, I hear superficial analysis, little new information, and analysts who hedge every comment and position they make. Yet people still feel enthusiastic about the theory of stocks. Pure greed plays its part. I am convinced this is half the coin and the other half is a willful blindness, and it turns out, people are willing and capable of ignoring a lot.

A paper titled Judgement under Uncertainty: Heuristics and Biases lists quite a few things investors would do well to think more thoroughly about:

“. . . people rely on a limited number of heuristic principles which reduce the complex tasks of assessing probabilities and predicting values to simpler judgement operations. In general, these heuristics are quite useful, but sometimes they lead to severe and systematic errors.”

  1. People are insensitive to prior knowledge of probabilities. Even knowing that a population of 100 professionals consists of 70 lawyers an 30 engineers, people will predict that any given individual in that population belongs to either profession based on a description, a representation, rather than their knowledge of the actual ratio.
  2. People are insensitive to sample size. Regardless of the size of a population sampled, people will assign the same distribution of a characteristic, say for height, whether they’re thinking about 5 individuals or 100.
  3. People harbor misconceptions of chance. Each toss of a coin has an exactly equal chance of landing heads or tails, yet people answer that H-T-H-T-T-H is a more likely sequence than H-H-H-T-T-T, because it looks more random.
  4. People are insensitive to predictability. Again, people tend to assign the likelihood of a particular outcome based on its description, rather than assess real world factors. Spoken of highly, like AAPL, people feel it will be very profitable. Spoken of in a mediocre or disparaging way, they will predict likewise.
  5. People tend to feel predictions based on representations are valid, even when the actual conditions determining outcomes are ignored or unknown.
  6. People misjudge through regression. A large group of people are given a pair of aptitude tests. Selecting the ten best performers on one test, people find their results are disappointing on the second. Conversely, selecting the ten worst performers on the first test, people will judge their performance on the second more favorably.

So let’s talk about financial reporting. Today, Thomas Joyce notes that the stock market has had a 30 year run, so you can trust it. Will this run continue? Will the indexes regress to the mean? What has gone into that 30 year run and does this have any bearing on the stock markets’ future performance?

System I thinking would accept Joyce’s statement. Many of us are old enough to have lived through the stock markets’ climb, so why not? System II thinking would ignore the hasty judgement. So let’s look at the performance of the S&P 500 over the last 30 years.

The index has indeed risen. In 1980, it ran about 150 or so, and by 2009, was tickling 1000. Now, it is over 1300. While the S&P 500’s PE ratio is today back near historic levels, it has in the last 30 years been trending steadily upward. Stocks have gotten more expensive as share prices have risen faster than company earnings. How did this happen? Inflation. There is more money in the market today than there was in 1980.

I don’t think it can all be explained by traders reinvesting their gains, at least not wholly, because there’s huge source of liquidity entering the markets every week: your IRA and 401k contributions, from which 64 million working Americans have injected, in one year, $134.7 billion into financial markets, and we’ve been steadily driving about $1.5 trillion in this direction since 1976, when the first tax-deferred retirement plans were created. Any economist seeing this would agree that putting this much money into a closed system for this long presents a classic inflation scenario, and that when distributions outweigh contributions, a classic deflation scenario results. I believe that this is more than likely a huge macro influence on financial markets. There’s more. When unemployment is high, people are not contributing as much, and some may even be withdrawing their savings to keep out of foreclosure or to send a child to school. Pressures on financial markets are even greater.

Nobody but me seems to think this bears mention. Nobody but me seems to recognize that since you get the tax break only if you give your money to Wall Street, this is, in fact, a federal subsidy. so this 30 year run may be about to slow, or even reverse itself. If the law changed eliminating or reducing the penalties for early withdrawl are enacted, what might happen? If the tax deferral policy was, say, halved in order to raise revenues to pay down the deficit, what might happen? What if even one plan became insolvent?

The point is, nobody talks about it, but do they even think it? Or are they ignoring an important source of risk in favor of some kind of intuitive “reasoning?” Are people simply going along with the crowd? What have we talked ourselves into?

Answer to the question above: It should be a sell signal, as neither a five nor twenty day moving average should present enough of a statistical universe to risk an investment. At any rate, you should be very wary of buying on the high here. Of course, the stock might be on the move, however it might be somewhat more likely to regress toward the mean, the random walk might kick in, another company, another sector may be about to boom and suck all the oxygen in the room, or the active traders may simply decide to take their profits and move on. Maybe the company itself will be be forced to restate earnings. Take a look, by all means. Looking costs you nothing but time & effort, and you may learn enough to come to a well-informed decision. If, however, this is all you know about the company and on this basis you decide to invest anyways, you’re a lousy trader. Stop being a lemming and take control yourself. Try buying on the dip.

This was a scenario taken from an actual stock-trading TV ad. The actor and the music seemed to indicate that this was a stock about to break out when this is completely unknown. At the end of the commercial, the guy buys on a head-and-shoulders pattern, which can go either way. Helped out by his sexy online trading platform (and some erroneous thinking which this ad reinforces), the man has made himself into little more than a noise trader.

Here’s a question. Does a free market increase prosperity? A heuristic (experienced based) conception is that it indeed does, but does it really? In fact, the income profile of the United States has remained unchanged for the last thirty years, and the data suggests that it has remained constant for the last fifty to sixty years. The percentage of the population who are rich, middle class and poor has seemingly remained unchanged. What has changed is that the rich have gotten even richer. Not so the rest of us.

But who am I kidding? Do I really expect the average reader to read through a boring report and consider the ways data might be distorted by logarithmic scales? Well, I don’t have to. The Organisation for Economic Co-operation and Development puts it concisely:

“The United States is the country with the highest inequality level and poverty rate across the OECD, Mexico and Turkey excepted. Since 2000, income inequality has increased rapidly, continuing a long-term trend that goes back to the 1970s.”

Or, I can show them a picture:


Source: Congressional Budget Office (pdf)

The evidence shows that in the US, free markets aren’t what they’re cracked up to be.

The Ten Cent Samaritan

The title above refers to an experiment first conducted years ago, when you could make a call from a phone booth for ten cents, which showed that we are profoundly affected by external stimuli. In New York City, the subject enters a phone booth. Some find a dime which had been placed there, others have to pony up the ten cents themselves. After the call is made, a staged accident takes place just outside the booth—a woman loses her grip on some papers she carries and drops them on the sidewalk. Only 4% of those who paid the ten cents themselves bothered to help the woman gather her papers, but almost all, 88% of those who found a dime in the phone booth, helped pick them up. Maybe we instinctively believe in karma or something, nonetheless, that’s an astonishing difference. For almost a century now, experiments like this and the ones I cited above, have demonstrated that human behavior ls more often than not, entirely irrational.

How does this express itself in our politics? Governor Scott Walker survived a recall election in Wisconsin this week. Mostly known as a union breaker, he found solid support among working class men, whom one would think would support organizations and measures which tended to strengthen their position. To be sure, tons of money poured into the state to keep him in office. One estimate I read said that Walker supporters outspent Barrett 8:1, but I don’t think that entirely explains it. I’ll bet those working class males were partly angry over seeing all those political ads while they were just trying to relax and watch the game. I’ll bet that among themselves, and I’ve seen this firsthand, they hate the social agenda of the left. In short, they work hard enough and when it comes time to relax they demand it. Having just finished a temporary job involving hard physical labor, I understand this completely. I spent all my free time recovering from work—so I could go to work again. Weighing the pros and cons of an issue isn’t easy, it’s not supposed to be easy, and angry at being asked to make an uncomfortable decision, they evidently voted against their own interests. They voted against their own rights to bargain collectively. They voted for the candidate who wants to raise their taxes and lower the taxes of the people they work for. They voted for the party which will ask them to work harder and longer while getting paid less. They voted for the candidate of the party which wants to dismantle the social safety net they are already depending on if they have elderly family members. They voted for the candidate who will callously make it more expensive to send their children to college.

Irrational.

This also demolishes, in my mind, the entire body of economics which rests upon the notion that economic decisions are made rational individuals maximizing their individual economic utility, because we are anything but rational.

Of course, making the hard decisions is not what the political process is all about. Most voters stay home. They can’t be bothered. Voters need to know a lot and it is only rational to recognize that voters are looking for the easy way out. Getting up to speed is difficult. I’ve been working hard at it myself for five years now, and I’m still nowhere near there. For much of that time, I was either unemployed, or working only 30 hours a week. I could never hope to conduct this kind of study were I working full time, particularly as I mentioned before, if I were mostly concerned with recovering from the pains resulting from the job. Compounding the problem is that among democracies, the US has the most complex system of federal, state and local level offices, many of whose concerns overlap, to fill. Voters are supposed to know exactly the powers and responsibilities of each?

So we take our cues elsewhere, not least of which is the messenger (and here). Call it “cultural cognition” or “motivated reasoning” when speaking to scientists, “tribalism” when speaking of perceived enemies, or “following the crowd” to yourself,

Political science 101. One of the first things they teach you is that the individual sees the world through a perceptual screen, severely distorting what messages get through. This applies to everyone. In fact, it is unavoidable. I do it myself and I can feel when it is happening: I feel better. My confirmation bias is triggered and I feel confident in my assumptions. This is classic System I thinking at work. Fortunately, I have made enough mistakes in my life not to trust many of my own assertions and often enough I stop myself before opening my mouth.

Still though, these days I generally like what I see. What I tell the most rabid free market supporters is that when their theology was formulated, there was no data. This is perhaps the biggest change in the last thirty years: we now have enough hard data like a century’s worth of income tax records and price histories of everything from cars to crackers, as well as the computing power readily available to look at the data which didn’t exist when Hayek, von Mises and Friedman formulated their theories of political economy. This kind of good, hard look at real data was unavailable to Adam Smith, as it was to James Dorn and Bernard Siegen in the seventies. So far, the data seems to show that at best, the income profile of the United States appears to be unchanged, though America’s wealth is more concentrated now than at any time since the age of the Robber Barons. Maybe more so now.

So why do people vote against their own interests? The messenger? If you don’t like a candidate’s position on tax relief, on gay rights or on Israel, are you really going to listen to his/her economic policy? Even in the most nonpartisan of times, the answer is that you are lots, lots less likely. In the current hyper-partisan atmosphere we suffer under, you are even threatened with being thrown out of the group entirely. So we have politics based on the merits of an argument losing out the voters’ perception of the messenger. Experience trumps aggregated data. Even a bad employment report, like the one a week ago which sent the Dow down over 400 points over two days, have been more than recouped on basically no news: the European Central Bank’s Mario Draghi and Fed chief Ben Bernanke basically said they’ve done all they could, and that politicians had to do more themselves, but the situation remains unchanged. This week’s report on initial unemployment claims showed no change. The situation in Greece remains the same, with an important election scheduled for 17 June. Spain had already asked for greater inter-eurozone cooperation in banking and governance and that didn’t move the markets. The only news I can think of which might have moved the markets was Scott Walker’s survival of the Wisconsin recall. Is this week’s market rebound actually the Scott Walker bounce?

Probably. Which tells you who is invested, what their politics are, what they care about, and what they don’t care about.


Sources and Further Reading::

“Asch conformity experiments”, Wikipedia: The Free Encyclopedia. Wikimedia Foundation, Web. 5 June 2012.

“The Man Who Shocked The World”, Psychology Today, Success Publishers, Web. 5 June 2012.

Poundstone, William. Priceless: The Myth of Fair Value (and How to Take Advantage of It). New York: Hill and Wang, 2009. Print.

“Information Distortion and Voting Choices: The Origins and Effects of Factual Beliefs in Initiative Elections” Policical Psychology. Department of Communications, University of Washington. Web 8 June 2012.

“Judgement under Uncertainty: Heuristics and Biases” Science. American Association for the Advancement of Science. Web. 7 June 2012.

“Thinking, Fast and Slow by Daniel Kahneman – review” The Guardian. Guardian News and Media Limited. Web. 8 June 2012.

Krugman “Economic Tribalism.” The Conscience of a Liberal, New York Times. The New York Times Company. Web. 8 June 2012.

Schudson, Michael, “America’s Ignorant Voters.” unknown, Web. 8 June 2012.

Piketty, Thomas and Emmanuel Saez. “The Evolution of Top Incomes: A Historical and International Perspective.” American Economic Review: Papers and Proceedings, 96, 2 (May 2006): 200-205

Anthony B. Atkinson & Thomas Piketty & Emmanuel Saez, 2011. “Top Incomes in the Long Run of History,” Journal of Economic Literature, American Economic Association, vol. 49(1), pages 3-71, March.

Warren “The Coming Collapse of the Middle Class” Barry Ritholz, The Big Picture. Web. 7 December 2009.

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