Towards Ecological Rationality

Economics as a discipline has detached itself from both psychology and political philosophy in an unfortunate turn of events that has led what used to be known as political economy to become an exercise in obfuscation through mathematics. By assuming what was supposed to be proven, and by blurring the lines between descriptive and normative theory, economics as it is currently practiced has become increasingly irrelevant to the description of the interaction of people going about their business. By forgetting that the economy is in the end comprised of people and instead hypothesizing a rational representative agent economics has assumed away that which it is supposed to describe and explain.

The problem is that economics divorced from political philosophy and psychology has been the cause of much mischief and suffering. It was thought that self-regulating efficient markets populated by rational economic agents pursuing their own interest would ensure the best possible outcome for everyone. But this Panglossian “invisible hand” was invisible precisely because it was not there. Ask Alan Greenspan, who, when asked by US congressmen why the crisis was not foreseen, admitted to finding a flaw in his worldview, his ideology (Andrews 2008). Four years on and the Global Financial Crisis is arguably still ongoing. Part of the blame can be laid squarely in the lap of neo-classical economics, which became obsessed with physics envy in its use of mathematics yet all the while almost obsessively ignoring psychology and real people. This unfortunate state of affairs needs to be rectified and getting rid of the rational representative agent with his well-ordered, transitive preferences is a first step. .

When the student of psychology is first confronted with the idea espoused in standard economic theory that people (or economic agents as they are called) are rational, have well defined preferences, take into account all relevant information in forming their preferences and making decisions, make decisions that maximize their utility (with utility being a catch-all phrase for anything someone perceives as good), and take into consideration only their own well-being when forming preferences or making decisions; well, then the student of psychology must first ask him- or herself whether this is a normative or a descriptive theory; second, whether this behavior being perceived as normative is something to be desired; and, third, if this behavior is also supposed to be descriptive, then beings of which planet, exactly, are being described.

That economics needs to do some soul-searching is not necessarily well accepted in the academic discussions about economic theory. Some accept as normative the rationality posited in economics and point out that human decision makers deviate from this posited rationality in a systematic and predictable manner; others claim that the deviations from rationality that are observed and discussed in much of the behavioral literature are either: a) artifacts of the population; b) artifacts of the (tricky) methodology used; c) not important because irrational actors are driven from the market by rational actors so that only rational outcomes prevail; or, d) not important because the rationality posited in economics is neither normative nor descriptive but rather a methodological stance. These disagreements are fundamental and irreconcilable but not necessarily the only two ways of looking at the issue at hand.

The heuristics and biases approach to decision making that has developed around the work pioneered by Daniel Kahnemann and Amos Tversky seems to accept as normative the rationality posited in economics while aiming to provide a better descriptive theory of decision making by pointing out that humans are loss averse, susceptible to anchoring or framing effects, affected by the representativeness bias, and in general do not make decisions in a manner that conforms to the rationality posited in economic theory because they are prone to deviate from this rationality due to an extended list of heuristics and cognitive and behavioral biases that lead to sub-optimal outcomes. This school of thought has blossomed into the relatively new field of behavioral economics, with the application of the insights gleaned therefrom leading to the even newer fields of behavioral finance and behavioral corporate finance. These disciplines aim at providing the theories of economics and finance with more realistic behavioral foundations by utilizing more realistic assumptions about the behavior of economic agents. That is, behavioral economics accepts as normative economic rationality but argues that because it is unrealistic descriptively better assumptions about how people behave are needed. While the finding that “people are sometimes irrational” may not strike one as being too profound, it is a mark of progress that has been achieved only after decades of argument.

The reason why behavioral economics was slow to catch on at first is because economic theory was under the spell of the representative rational agent. Standard neo-classical economic theory is based on a series of special assumptions. If the assumptions of the standard economic model were true, then there would be no need for any further psychological research since: “economic agents are rational, economic agents are motivated by expected utility maximization, an agent´s utility is governed by purely selfish concerns, in the narrow sense that it does not take into consideration the utility of others, agents are Bayesian probability operators, agents have consistent time preferences according to the discounted utility model, [and] all income and assets are completely fungible" (Wilkinson 2008, p5). These assumptions might strike one as being somewhat unrealistic but in his The Methodology of Positive Economics Milton Friedman (1953) famously set forth the view that the realism of the assumptions does not matter as long as the predictions generated by the model are useful. This became known as the “as if” approach. That is, it does not matter whether people actually behave in the manner postulated or whether the assumptions made are realistic since if the results in the aggregate fit the hypothesis, then it can be assumed that people have to behave “as if” they were only rationally pursuing their enlightened self-interest (that is, by taking into account all available information in order to arrive at the decision that most maximizes their subjective expected utility), because if they did not, then they would be driven from the market by rational agents who did indeed behave in the manner dictated by standard economic theory.

Berg and Gigerenzer (2010) raise a fundamental question that not only undermines behavioral economics’ claim of greater psychological realism but neo-classical economics’ normative claim of rationality and selfish expected utility maximisation as well: Is there any evidence that people who behave rationally in the economic sense do better than those who do not behave in a manner that conforms to the rationality of neo-classical economics? In addressing this question they point out that “[t]he discussion of methodological realism with respect to the rational choice framework almost necessarily touches on different visions of what should count as normative.  It is a great irony that most voices in behavioral economics, purveyors of a self-described opening up of economic analysis to psychology, hang on to the idea of the singular and universal supremacy of rational choice axioms as the proper normative benchmarks against which virtually all forms of behavior are to be measured.  Thus, it is normal rather than exceptional to read behavioral economists championing the descriptive virtues of expanding the economic model to allow for systematic mistakes and biased beliefs and, at the same time, arguing that there is no question as to what a rational actor ought to do” (Berg and Gigerenzer 2010, p23). Furthermore, what they call the tension between “descriptive openness and normative dogmatism” is interesting precisely because “almost no empirical evidence exists documenting that individuals who deviate from economic axioms of internal consistency (e.g., transitive preferences, expected utility axioms, and Bayesian beliefs) actually suffer any economic losses” (Berg and Gigerenzer 2010, p24). Most importantly, then, neither do those who deviate from rational choice theory earn any less money, nor are they any less happy or live shorter lives. This most important finding has been overlooked or disputed for too long.

Berg and Gigerenzer thus point the way towards an ecological rationality that is not only more realistic than rational choice theory but also more human. According to Rieskamp and Reimer (2007, p1) “[h]uman reasoning and behavior are ecologically rational when they are adapted to the environment in which humans act. This definition is in stark contrast to classical definitions of rationality, according to which reasoning and behavior are rational when they conform to norms of logic, statistics, and probability theory.” Thus, according to this definition, behavior is rational if it suits the purpose at hand, with the normative aspect of neo-classical economics’ rational choice theory being dispensed with, and no further sleep being lost worrying whether preferences are ordered or transitive.    

Instead of accepting as normative rational choice theory and simply characterizing the manner in which people actually make decisions as anomalies or biases a movement towards ecological rationality would mean, then, that a new standard of rationality of correspondence or fit between the demands of the situation and the behavior of the person would be set, and this new standard of rationality is not only computationally and thus energetically parsimonious, but also evolutionarily plausible and probable. By taking into account philosophy -- what is rationality -- and psychology -- how do people actually behave -- economics as a discipline will no longer be an exercise in mathematical obfuscation but will once again concern itself with people going about their business, its original intent.

References

Andrews, Edmund L. (2008). ‘Greenspan Concedes Error on Regulation’. The New York Times October 23, 2008. Available at: http://www.nytimes.com/2008/10/24/business/economy/24panel.html [accessed May 28, 2010]

Berg, Nathan and Gigerenzer, Gerd (2010). ‘As-If Behavioral Economics: Neo-Classical Economics in Disguise’ History of Economic Ideas, Vol. 18, No. 1, pp. 133-166, 2010. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1677168 [accessed May 28, 2010]

Friedman, Milton (1953). ´A Methodology of Positive Economics´. Ch. 7 in Hausman, Daniel M. ed.  (2008). The Philosophy of Economics: An Anthology, 3rd edition. New York, NY: Cambridge University Press

Rieskamp, Jörg and Reimer, Thorsten (2007). Ecological Rationality. Max Plank Institute for Human Development, Berlin, Germany. Available at:
http://web.ics.purdue.edu/~treimer/Rieskamp_Reimer_2007.pdf [accessed May 28, 2010]

Wilkinson, Nick (2007). An Introduction to Behavioral Economics: A Guide for Students. New York: Palgrave Macmillan

Economists never learn: or "It is difficult to get a man to understand something when his salary depends upon his not understanding it."

Yves Smith of nakedcapitalism.com/ fame has another awesome post demolishing economists' dogma. In The Sorrow and the Pity of Economists (Like DeLong) Not Learning from Their Mistakes she takes apart an argument by one of the few economists who is actually willing to admit to mistakes, and is to be respected for that, but is unfortunately stuck in a world of models that have nothing to do with the real world and misrepresent what the founder of macroeconomics said anyway. 

Delong says: There is only one real law of economics: the law of supply and demand. If the quantity supplied goes up, the price goes down

Unfortunately for the discipline of economics this is not true: Steve Keen's lectures on behavioural finance are a great place to become disabused of the notion that there are any laws of economics and the lectures provide an enlightening and insightful introduction to a more realistic approach to economics and finance. 


But back to Yves: 

No, it’s NOT the law, it’s a belief and it often is not operative...DeLong then argues that he and presumably his colleagues ignored the notions of John Hicks, the English economist who formalized the idea of Keynes’ General Theory and turned it into a special case of neoclassical economics. Keynes himself repudiated it, as did Hicks in his eighties....

Why would Keynes not like this treatment? Keynes, himself a successful speculator, did not think financial markets had any propensity to equilibrium, and there is separately reason to think the equilibrium assumption that the discipline has embraced to make its mathematics “tractable” is bollocks. The equilibrium assumption (more accurately, ergodicity) makes it impossible to incorporate any phenomena that are destabilizing, such as ones with positive (self-reinforcing feedback loops. Yet as we discuss short form in ECONNED (and George Cooper gives an elegant layperson treatment in The Origin of Financial Crises: Central Banks, Credit Bubbles, and the Efficient Market Fallacy), financial markets have no propensity to equilibrium. They are inherently prone to boom-bust cycles.

Even though Hicks’ story, via DeLong, bears some resemblance to Keynes’ liquidity preferences idea, it posits different causal channels that render them fundamentally different. In really simple terms, there is a “loanable funds” market in which borrowers and savers meet to determine the price of lending. Keynes argued that investors could have a change in liquidity preferences, which is econ-speak for they get freaked out and run for safe havens, which in his day was to pull it out of the banking system entirely. Hicks endeavored to show that the loanable funds and liquidity preferences theories were complementary, since he contended that Keynes ignored the bond market (loanable funds) while his predecessors ignored money markets.

But that’s a deliberate misreading. Keynes saw the driver as the change in the mood of capitalists; the shift in liquidity preferences was an effect. (In addition, Keynes held that changes with respect to existing portfolio positions, meaning stocks of held assets, would tend to swamp flow effects captured by loanable funds models.)

Making money cheaper is not going to make anyone want to take risk if they think the fundamental outlook is poor. Except for finance-intensive firms (which for the most part is limited to financial services industry incumbents), the cost of money is usually not the driver in business decisions, Market potential, the absolute level of commitment required, competitor dynamics and so on are what drive the decision; funding cost might be a brake. So the idea that making financing cheaper in and of itself is going to spur business activity is dubious, and it has been borne out in this crisis, where banks complain that the reason they are not lending is lack of demand from qualified borrowers. Surveys of small businesses, for instance, show that most have been pessimistic for quite some time.

If you want to put it in more technical terms, what is happening is a large and sustained fall in what Keynes called the marginal efficiency of capital. Companies are not reinvesting at a rate sufficient rate to sustain growth, let alone reduce unemployment. Rob Parenteau and I discussed the drivers of this phenomenon in a New York Times op-ed on the corporate savings glut last year: that managers and investors have short term incentives, and financial reform has done nothing to reverse them. Add to that that in a balance sheet recession, the private sector (both households and businesses) want to reduce debt, which is tantamount to saving. Lowering interest rates is not going to change that behavior. And if you try to generate inflation in this scenario, when individuals and companies are feeling stresses, all you do is reduce their real spending (and savings power) and further reduce demand (and hence economic activity).

So what Keynes thought important was to get investors to stop being "freaked out", decrease their liquidity preference, and again see the marginal efficiency of capital as sufficient to warrant further investment. 


Back to Yves: 

Marshall Auerback, by e-mail, points out that liquidity trap thinking is based on the idea that banks lend out of bank reserves. It has been shown empirically that banks lend first and reserve creation follows (that is, when needed, central banks accommodate loan creation):

The liquidity trap idea seems to be predicated on the silly idea that banks lend out reserves and failure to do so is symptomatic of a liquidity trap. But idea that the build up of bank reserves represent a pot of funds that the banks will eventually loan out completely misunderstands the role of bank reserves. But as Randy Wray, Bill Mitchell, Scott Fullwiler, Stephanie Kelton and a host of others have noted before banks do not loan out reserves. Reserves facilitate the payments system – that is, the system that assures the millions of transactions between banks (as customers write cheques and deposit them throughout the banking system).

Banks do not make loans on the basis of the reserves they hold. They respond to demands from credit-worthy customers and have in mind what it will cost them to make the loans under current conditions. When the transactions that follow the creation of a loan transpire it might be that the is short of reserves to ensure the payments clear. It has various options. It can seek funds from wholesale markets (other banks or other lenders), use deposits (not an overnight option really) or, ultimately, it can source the funds from the central bank.

The point is that you can get various levels of bank reserves depending on how the central bank pursues its liquidity management in order to hit its target policy rate. None of those levels have any particular operational significance.

The mainstream then argue that if the central bank mops up these reserves it will be less inflationary than if it leaves them in the system. This view is based on the spurious – banks lend reserves argument. The inflation risk associated with government spending is the same whether the government issues debt to match its deficit or not. The inflation risk arises from the impact of the spending on the state of capacity in the economy.

This is why fiscal stimulus is vastly more effective than monetary policy at times like these: it has a direct impact on overall conditions, by stimulating demand. Government spending creates more income for businesses and ultimately, consumers. Everyone’s income is ultimately someone else’s spending. If government increase spending, it will increase the incomes of at least some people in the economy, and the improvement in their fortunes (if they believe the new income level will be sustained) will lead them to spend more, improving the affairs of yet more people.

So the stimulation of demand is to be achieved by an improvement in overall conditions and this can best be done through fiscal policy, the aversion to which is not a matter of economics but ideology as pointed out by  Edward Harrison from creditwritedowns.

But the important point is that because his General Theory was unfortunately written in a manner that few could understand too well, the wrong lessons have been drawn from Keynes and propounded all these years. It is my contention that Keynes was not only the founder of macroeconomics, but also a behavioral economist, and his insights into the psychology of investors and the economy are invaluable and should be taken to heart. 


In my post on Hyman Minskys financial instability hypothesis there is a long quote from Keynes's 1937 article in the Quarterly Journal of economics, where he explained his views more clearly: 

Actually, however, we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even tho time and chance may make much of them. But sometimes we are intensely concerned with them, more so, occasionally, than with the immediate consequences.

Now of all human activities which are affected by this remoter preoccupation, it happens that one of the most important is economic in character, namely. Wealth. The whole object of the accumulation of Wealth is to produce results, or potential results, at a comparatively distant, and sometimes at an indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders Wealth a peculiarly unsuitable subject for the methods of the classical economic theory. This theory might work very well in a world in which economic goods were necessarily consumed within a short interval of their being produced. But it requires, I suggest, considerable amendment if it is to be applied to a world in which the accumulation of wealth for an indefinitely postponed future is an important factor; and the greater the proportionate part played by such wealth-accumulation the more essential does such amendment become.

By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealthowners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to he summed.

How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men? We have devised for the purpose a variety of techniques, of which much the most important are the three following:

(1) We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.

(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.

(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average. The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment.

Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface.

Perhaps the reader feels that this general, philosophical disquisition on the behavior of mankind is somewhat remote from the economic theory under discussion. But I think not. Tho this is how we behave in the market place, the theory we devise in the study of how we behave in the market place should not itself submit to market-place idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future.

I daresay that a classical economist would readily admit this. But, even so, I think he has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be led.

So this is the crux of Keynes's theory and even an ostensibly Keynesian economist such as Brad DeLong unfortunately fails to draw the correct lessons from the theory. As pointed out by Yves and many others who contribute to the current discussion of the dismal state of the dismal science, it is confidence and lack thereof that determines economic recovery or depression, and not the sacred cows of supply and demand.

But at the end of the day: "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"      

Buy this book! Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism

Make sure you get the upcoming book from my friend Yves Smith of www.nakedcapitalism.com fame.

Countdown 3/2/10: Excerpt from Econned
Folks, the time has come when I must start shamelessly promoting my book, Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, which is being released March 2, 2010.

I thought the extract below would give readers an idea of what the book is about, with one caveat. Econned goes into some detail about crisis mechanisms (as in why it got as bad as it did) and has unearthed a heretofore unexamined hedge fund trading strategy that turned the subprime mania into the detonator of the global debt bomb (and yes, we have the goods).

Enjoy!

In 1776, Adam Smith published The Wealth of Nations. In it, he argued that the uncoordinated actions of large numbers of individuals, each acting out of self-interest, sometimes produced, as if by “an invisible hand,” results that were beneficial to broader society. Smith also pointed out that self-interested actions frequently led to injustice or even ruin. He fiercely criticized both how employers colluded with each other to keep wages low, as well as the “savage injustice” that European mercantilist interests had “commit[ted] with impunity” in colonies in Asia and the Americas.

Smith’s ideas were cherry-picked and turned into a simplistic ideology that now dominates university economics departments. This theory proclaims that the “invisible hand” ensures that economic self-interest will always lead to the best outcomes imaginable. It follows that any restrictions on the profit-seeking activities of individuals and corporations interfere with this invisible hand, and therefore are “inefficient” and nonsensical.

According to this line of thinking, individuals have perfect knowledge both of what they want and of everything happening in the world at large, and so they pass their lives making intelligent decisions. Prices may change in ways that appear random, but this randomness follows predictable, unchanging rules and is never violently chaotic. It is therefore possible for corporations to use clever techniques and systems to reduce or even eliminate the risks associated with their business. The result is a stable, productive economy that represents the apex of civilization.

This heartwarming picture airbrushes out nearly all of the real business world. Yet uncritical allegiance to these precepts over the last thirty years has produced a world in which corporations, especially in finance, are far less restricted in their pursuit of profit. We show in this book how this lawless environment has led the financial services industry to pursue its own unenlightened
self-interest. The industry has become systematically predatory. Employees of industry firms have not confined their predation to outsiders; their efforts to loot their own firms nearly destroyed the industry and the entire global economy. Similarly destructive behavior by other players, often viewed through a distorted lens that saw all unconstrained commercial behavior as virtuous, added more
fuel to the conflagration.

Some economists have opposed this prevailing ideology; indeed, comparatively new lines of inquiry focus explicitly on how economic actors can fool themselves or others into making poor, even destructive, choices.

But when the economics profession has used the megaphone of its authority to dominate discussions with policymakers and the public, it has spoken with one voice, and the message has been the one described here. We therefore confine our criticism to these particularly influential ideas.

Theories that fly in the face of reality often need to excise inconvenient phenomena, and mainstream economics is no exception. Idealizing the rational aspects of business decisions means refusing to notice behavior that is predatory, destructive, criminal, or simply stupid. Believing that risk is manageable through mechanical systems has required not just unrealistic assumptions but also willful
blindness to clear signs of danger.

We offer here another point of view. This book lays bare both the actions leading to the credit crisis and the economic constructs that defended, facilitated, and even exacerbated this behavior. Our case makes clear that if our economic system is to harness the self-interest of individuals to achieve the general
good, it must be supervised within a democratic society and responsive to criticism by outside voices of those who are unafraid to think independently.

Robert Shiller on Inefficient Markets and Behavioral Finance

Robert Shiller is perhaps best known for his Case-Shiller home price index and for having correctly identified the previous bubble in financial markets in his 2000 book Irrational Exuberance . Shiller is concerned with risk and uncertainty in human affairs and has never been a proponent of the orthodoxy which either claims that bubbles do not exist(!) or that markets should be left to themselves since they instantly and efficiently incorporate all known information, something known as the Efficient Market Hypothesis .
Barry Ritholz discusses the hubris of economics in a must read post, and over at Washington´s Blog another great post points out that economists had a incentive to be wrong.
Now Robert Shiller´s criticism of prevailing economic orthodoxy may not be as acid but it is nevertheless a damning indictment. Below is his lecture on Behavioral Finance and a very informative article on the decline (one would hope) of the Efficient Markets Theory and the rise of Behavioral Finance.





From Efficient Market Theory to Behavioral Finance

Steve Keen on the economy: On the Edge with Max Keiser

Steve Keen is one of the few economists who predicted the financial crisis and he is not at all impressed with the government response arguing that texboox economics failed to predict the crisis and are also not going to solve the problems we are facing. His outlook is less than rosy to say the least.

Consumer sentiment...

This guy pretty much sums it up just fine.

Quantitative Momentum Investing vs. Fundamental Value Investing and (IN)efficient markets

After reading about Bill Miller´s Value Trust fund, two thoughts spring to mind:

Past results are no guarantee for future performance , therefore I would be careful about using any investment strategy for too long if the underlying economic reality and fundamentals have changed.

And

The market can stay irrational longer than you can stay solvent. John Maynard Keynes

Bill Miller was bullish on financials and homebuilders in 2006 and has progressively increased his positions and thereby his losses by consistently underestimating the depth, breadth and extent of the crisis. He declared in April 2008 that the crisis was over, and his bullishness, to me, is indicative of wishful thinking which is being used to rationalize expended energy, lost money and being wrong in calling the market bottom, his claims to the contrary notwithstanding.

http://seekingalpha.com/article/89233-bill-miller-s-value-trust-fund-runs-into-a-tough-market

That being said, Bill Miller´s value investing strategy has been burying quantitative momentum funds in the recent rally. From Zero Hedge:

Bill Miller is patting himself on the back for "burying" quant funds as this just released Bloomberg article notes: its timely appearance is critical as this is easily the most important theme in the current market dislocation, and thus Zero Hedge will post it in its entirety... Bill, after the worst year in his career, may be careful with the timing of his self-congratulations though...
IQS Commentary for March 2009

Summary

The IQS model was down -16.8% over the past 5 weeks, while the sector-neutral model was down 16.9%. [TD: discussion with the appropriate people indicate that April is on par for even worse performance, which is why Zero Hedge has been sounding the clarion call for normality - if market neutral Quants drop 40% in two months, it is truly game over]
•
Balance Sheet and Value added to performance, Improving Financials underperformed slightly, while Sentiment and especially Momentum underperformed.

What Happened?

What does it mean when momentum stops working? The stocks that lost the most over the past few months (dogs of the Dow and S&P 500?) outperform the most. (See IQS S&P pdf report for astonishing examples and IQS analysis.)

Without an economic catalyst, fundamentals based model would not predict (nor should they) this “dead cat” bounce. Are we witnessing a sustainable rally for these stocks? It’s possible, but not very likely. Some of these companies are financials, and the “risk” to this industry changes daily, but remains high. However, some of these companies are not financials, and investors are buying up these low priced stocks with the hope that the economic turnaround has started and will continue to improve. With reporting season upon us, guidance will help determine the direction and magnitude of the market during this period. If financials show an improvement, the market may take off. If most companies continue to post low or negative earnings without a clear picture of a turnaround, the market may retract.

Weights

The IQS dynamic weighting system made small changes this month to the weights. With the market and economic conditions still weak.

Some weight was added to Improving Financials (mid), while a little weight reduced Momentum (mid), from Value (low), Balance Sheet (mid).

What is the IQS Model telling us about Sectors? No significant changes from last month.

Best – Aerospace, Retail, Medical, Utilities, Consumer Staples

Middle –Business Services, Oils/Energy, Industrial Parts, Transportation, Technology, Basic Materials

Worst – Autos, Finance, Construction, Conglomerates, Consumer Discretionary
We are at a critical crossroads for the future of efficient markets. If the bear market rally persists, Bill Miller and 401(k) holders will be happier temporarily, however the end result would be a broken market. Readers who took offense to the photo of the Challenger explosion earlier, should wake up and realize that we are on the verge of the very same event occurring within the fabric of the free and efficient market system. The threat to the equity markets is not being exaggerated. If the powers that be are intent on rising stock prices one day at a time continually, then even as retail investors enjoy another day of moderate gains, in a few short days/weeks markets will reach a point of no return, and the resultant collapse in confidence in the free market system will force the majority of investors to forever depart from investing in equity markets. The consequences of this would be beyond the scope of even this blog.

http://zerohedge.blogspot.com/2009/04/bill-miller-correct-value-funds.html

To many this may seem alarmist and overly pessimistic given the “green shoots” everyone is talking about; only time will tell. My reason for posting this, though, is to illustrate that relying on only the value investing strategy would have led to huge losses in the past two years and to gains since March 9, and that relying on quantitative momentum strategies in the same time frame would have led to gains by being short exactly Bill Miller´s favorite sectors, as John Paulson was and managed to earn $3.6 billion for himself in 2008, and to losses in the current rally. Diversification, in my mind, means not only different asset classes, but also using strategies that adapt to changing circumstances.

Bill Miller does not share this view:

From Bill Miller´s April Commentary:

Our portfolios, it should be stressed again, are not built based on macroeconomic forecasts, or expectations about the direction of equity markets in the next few months. They are constructed based on long-term considerations of value under average expected conditions over the next several years. That means that we believe the economy and the stock market will grow over the next few years, even if they do or don’t this year, and that businesses will earn returns on capital consistent with their competitive advantages, the underlying economics of their industries, and the capability of their managements.

http://www.leggmason.com/INDIVIDUALINVESTORS/documents/insights/D7407-Bill_Miller_Commentary.pdf

To me, it seems that Miller assumes an underlying objective economic reality that is independent of the actions and expectations of the actors. I would point to Keynes´s Paradox of Thrift and Fisher´s Debt Deflation Spiral as reasons why market conditions may not conform to “average expected conditions.”

http://www.eurointelligence.com/article.581+M5a44f3fb3ec.0.html

To say nothing of the lurking bad loans on banks´ balance sheets and their fictitious valuation of “troubled assets” which are once again based on their hubris laden overreliance on risk management models which may not apply given that the fundamental assumptions they are based on have changed or will do so dramatically in the near future. I would further urge Miller and, indeed, all investors, to take a good look at George Soros´s Theory of Reflexivity:

“

I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend towards equilibrium, and on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy.” I did not have time to expound my theory before Congress, so I am taking advantage of my captive audience to do so now. My apologies for inflicting a very theoretical discussion on you.

The theory holds, in the most general terms, that the way philosophy and natural science have taught us to look at the world is basically inappropriate when we are considering events which have thinking participants. Both philosophy and natural science have gone to great lengths to separate events from the observations which relate to them. Events are facts and observations are true or false, depending on whether or not they correspond to the facts.

This way of looking at things can be very productive. The achievements of natural science are truly awesome, and the separation between fact and statement provides a very reliable criterion of truth. So I am in no way critical of this approach. The separation between fact and statement was probably a greater advance in the field of thinking than the invention of the wheel in the field of transportation.

But exactly because the approach has been so successful, it has been carried too far. Applied to events which have thinking participants, it provides a distorted picture of reality. The key feature of these events is that the participants’ thinking affects the situation to which it refers. Facts and thoughts cannot be separated in the same way as they are in natural science or, more exactly, by separating them we introduce a distortion which is not present in natural science, because in natural science thoughts and statements are outside the subject matter, whereas in the social sciences they constitute part of the subject matter. If the study of events is confined to the study of facts, an important element, namely, the participants’ thinking, is left out of account. Strange as it may seem, that is exactly what has happened, particularly in economics, which is the most scientific of the social sciences.

Classical economics was modeled on Newtonian physics. It sought to establish the equilibrium position and it used differential equations to do so. To make this intellectual feat possible, economic theory assumed perfect knowledge on the part of the participants. Perfect knowledge meant that the participants’ thinking corresponded to the facts and therefore it could be ignored. Unfortunately, reality never quite conformed to the theory. Up to a point, the discrepancies could be dismissed by saying that the equilibrium situation represented the final outcome and the divergence from equilibrium represented temporary noise. But, eventually, the assumption of perfect knowledge became untenable and it was replaced by a methodological device which was invented by my professor at the London School of Economics, Lionel Robbins, who asserted that the task of economics is to study the relationship between supply and demand; therefore it must take supply and demand as given. This methodological device has managed to protect equilibrium theory from the onslaught of reality down to the present day.

I don't know too much about the prevailing theory about financial markets but, from what little I know, it continues to maintain the approach established by classical economics. This means that financial markets are envisaged as playing an essentially passive role; they discount the future and they do so with remarkable accuracy. There is some kind of magic involved and that is, of course, the magic of the marketplace where all the participants, taken together, are endowed with an intelligence far superior to that which could be attained by any particular individual. I think this interpretation of the way financial markets operate is severely distorted. That is why I have not bothered to familiarize myself with efficient market theory and modern portfolio theory, and that is why I take such a jaundiced view of derivative instruments which are based on what I consider a fundamentally flawed principle. Another reason is that I am rather poor in mathematics.

It may seem strange that a patently false theory should gain such widespread acceptance, except for one consideration; that is, that all our theories about social events are distorted in some way or another. And that is the starting point of my theory, the theory of reflexivity, which holds that our thinking is inherently biased. Thinking participants cannot act on the basis of knowledge. Knowledge presupposes facts which occur independently of the statements which refer to them; but being a participant implies that one’s decisions influence the outcome. Therefore, the situation participants have to deal with does not consist of facts independently given but facts which will be shaped by the decision of the participants. There is an active relationship between thinking and reality, as well as the passive one which is the only one recognized by natural science and, by way of a false analogy, also by economic theory.

http://www.geocities.com/ecocorner/intelarea/gs1.html

Here is a great quote from Keynes that I find as relevant now as it was when he wrote it.

Actually, however, we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts. Sometimes we are not much concerned with their remoter consequences, even tho time and chance may make much of them. But sometimes we are intensely concerned with them, more so, occasionally, than with the immediate consequences.

Now of all human activities which are affected by this remoter preoccupation, it happens that one of the most important is economic in character, namely. Wealth. The whole object of the accumulation of Wealth is to produce results, or potential results, at a comparatively distant, and sometimes at an indefinitely distant, date. Thus the fact that our knowledge of the future is fluctuating, vague and uncertain, renders Wealth a peculiarly unsuitable subject for the methods of the classical economic theory. This theory might work very well in a world in which economic goods were necessarily consumed within a short interval of their being produced. But it requires, I suggest, considerable amendment if it is to be applied to a world in which the accumulation of wealth for an indefinitely postponed future is an important factor; and the greater the proportionate part played by such wealth-accumulation the more essential does such amendment become. By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to he summed.

How do we manage in such circumstances to behave in a manner which saves our faces as rational, economic men? We have devised for the purpose a variety of techniques, of which much the most important are the three following:

(1)We assume that the present is a much more serviceable guide to the future than a candid examination of past experience would show it to have been hitherto. In other words we largely ignore the prospect of future changes about the actual character of which we know nothing.
(2) We assume that the existing state of opinion as expressed in prices and the character of existing output is based on a correct summing up of future prospects, so that we can accept it as such unless and until something new and relevant comes into the picture.
(3) Knowing that our own individual judgment is worthless, we endeavor to fall back on the judgment of the rest of the world which is perhaps better informed. That is, we endeavor to conform with the behavior of the majority or the average.

The psychology of a society of individuals each of whom is endeavoring to copy the others leads to what we may strictly term a conventional judgment. Now a practical theory of the future based on these three principles has certain marked characteristics. In particular, being based on so flimsy a foundation, it is subject to sudden and violent changes. The practice of calmness and immobility, of certainty and security, suddenly breaks down. New fears and hopes will, without warning, take charge of human conduct. The forces of disillusion may suddenly impose a new conventional basis of valuation. All these pretty, polite techniques, made for a well-panelled Board Room and a nicely regulated market, are liable to collapse. At all times the vague panic fears and equally vague and unreasoned hopes are not really lulled, and lie but a little way below the surface.

Perhaps the reader feels that this general, philosophical disquisition on the behavior of mankind is somewhat remote from the economic theory under discussion. But I think not. Tho this is how we behave in the market place, the theory we devise in the study of how we behave in the market place should not itself submit to market-place idols. I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future. I daresay that a classical economist would readily admit this. But, even so, I think he has overlooked the precise nature of the difference which his abstraction makes between theory and practice, and the character of the fallacies into which he is likely to be led.

Keynes, John Maynard (1937). `The General Theory of Employment`, Quarterly Journal of Economics, 51. cited in Shaw, G.K. (1988). The Keynesian Heritage: Volume I. pp.11-13

So, I am inherently skeptical of any theory which holds that it is in possession of the truth, especially those which have thinking humans as participants and are based on unrealistic axiomatic assumptions. Furthermore, I am in favor of what Arthur Koestler called open systems which can be changed and adapted as needed, as opposed to closed systems which profess to explain everything. Not even physics manages to explain everything at the macro or cosmological level and the micro or quantum level in a unified theory; therefore, I am even more doubtful that investment or economic theories can accomplish the feat of being always valid at every level.