Thinking about Markets II Jude Wanniski April 25, 1994

We are, of course, thinking about the ebb and flow of the financial markets all the time. Once a year I attend the First Quadrant Corp. annual client conference as a member of its advisory board, and we focus on the philosophy and mechanics of markets. A year ago, I came away with Jack Treynor's wonderful story about jelly beans, which I reported to you in "Thinking About Markets," August 17, 1993. Treynor, former editor of Financial Analysts Journal, told us that when he taught finance, he would pass a jar of beans among his students and have them guess the number. As I wrote: "The guesses would vary wildly, but always, when the number guessed in total was divided by the number of students guessing, the result was within 3% of the correct number, he said. As there were 52 of us assembled, and a bowl of peppermint candies on the table, we tried the experiment. A low guess of 32 was recorded, a high of 71. The median guess was 46, the mean was 45. The correct total was 46, a number only one of the 52 had guessed." I pointed out that Treynor's experiment provided a proof of democracy, which is another way of saying it proves the efficiency of the political market, as well as of the financial markets. 

Earlier this month, we assembled again in Bermuda, and at one point I cited Treynor's experiment -- whereupon Jack advised us that Peter Bernstein, the Wall Street guru who is the most senior of our group, had informed him that this discovery had been made a century ago. Peter then told us about Francis Galton, a Victorian genius, cousin of Charles Darwin, an inveterate measurer of things. At an English fair that Galton attended, he noted that more than 800 people had tried to guess the weight of a bull, the closest winning a prize. He added the total pounds on the 800-plus slips of paper, divided by the number of guesses, and found the mean was exactly the weight of the bull, to the pound. The irony is that Galton, who wrote Hereditary Genius, coined the term "eugenics," meaning by it the improvement of the race by selective parenthood. That is, the man most identified in his time with the notion that intelligence is an inherited characteristic is also the fellow who discovered that the ordinary people in aggregate are more intelligent than any of their component parts.

This struck me as pretty exciting stuff, especially as we proceeded to kick around the topic of the day: the suggestion that the stock market decline of recent vintage was caused by market participants known as "hedge funds," particularly those trading in derivatives. Is George Soros a hereditary genius, I wondered? And if so, how did the market outguess him to the tune of $600 million on the weight of the bull? It was useful to note that while Soros was winning his billion-dollar bets, he was all in favor of free markets. Now he hedges in testimony before the House Banking Committee. Maybe the government should keep an eye on derivatives and hedge funds, in the interests of protecting the unsophisticated (Procter & Gamble?) from the pitfalls of the market.

There was general agreement in our Bermuda discussions that derivatives are marvelous inventions of the marketplace. They began as a way of allowing people of humble means to buy a diversified portfolio (the best kind) with only a few dollars, i.e., mutual funds. In recent years, new versions have leapt out of the computers of Wall Street's whiz kids, who are continually finding seemingly "low risk" statistical correlations in various packages of securities. Many eventually prove to be high-tech fool's gold, when the correlations break down. The best of the derivatives are those that skirt government taxes and regulations that are skirtable -- with government buying the free lunch. Except for portfolio diversification, there is no other rationale for a derivative than to economize on government taxes and regulations, with the savings shared by private transactors. The market is so marvelously efficient that there really is no room for another financial device, except to exploit the loopholes left by the bureaucrats at Treasury or the SEC. There are even derivatives designed here to skirt foreign taxes and regs as well, to the benefit of the American investor. Are derivatives "good for the economy?" Without a doubt they are, inasmuch as in aggregate they always produce a positive return on investment -- or the efficient market would not allow them to exist. 

My small contribution in this discussion was to relate this to the plain fact that it is no longer reasonable for an individual to purchase a new auto when it can be leased at a savings. I pointed out that companies are now springing up to lease even used autos! This began when the feds took away our right to subtract financing charges from gross income, for the purpose of paying income tax. Leasing companies are permitted to write off financing charges, so they strike a deal with me to share the tax savings. When the process began, leasing companies kept most of the savings, but the wonders of the marketplace are such that the latecomers have competed away most of the gains, to the benefit of ordinary folks -- who may not be so smart one-on-one, but in aggregate are unbeatable. A derivative, then, is a way in which an individual can lease a financial asset without owning it, with all the obligations that ownership entails. Chairman Henry Gonzalez of House Banking knows something funny is going on, and so do the bureaucrats at Treasury and the SEC, but they can't quite put their finger on it. Is the economy better off with auto leasing? Of course it is, and so is the government, for without this exploitation of a government loophole there would be fewer cars bought or made, fewer people employed in the process, and fewer taxes paid to federal, state and local governments.

Soros was good enough to inform Chairman Gonzalez not to worry about the effects on poor people when he loses $600 million in a fell swoop, or when P&G gets its clock cleaned with a leveraged financial detergent. When you are leveraged 100-to-1 and lose $600 million, it only means that 1 million people each win $600 (or at least they don't lose $600). These are the folks lined up on the other side of his original trade, people who can't afford the risks Soros can. 

Why do people lose money so fast when they invest in certain kinds of financial instruments that are supposedly low risk? We are reminded of the Wall Street adage that "trees do not grow to the sky." Which brings us back to the whiz kids, whose computers discover "trends" that seem to be iron clad. Such as: Long-term bond yields have been falling for 13 years on a zig-zag path, and even when they zag, it's only by a small X amount. A derivative emerges from this finding and is peddled to a corporate CFO, who also has a high IQ, but is not prepared for a 2X mistake at the Federal Reserve. Alas, the tree that seemed to be growing to the sky is hit by a lightning bolt. 

There are only two ways to beat the S&P 500, I think we decided in Bermuda last month: Either choose a basket of stock out of the S&P 500 that will outperform what you leave behind; or, buy the S&P 500 on its way up and sell it on its way down. Either way, you are going to need better research than your competitors, because, on balance, the more people who are guessing at the value of the S&P 500, the closer they will come to getting it exactly right, down to the penny. Or, in the case of Galton's prize bull, to the pound. The information gathered by this research is not to be found in computers, because the requisite information has not yet occurred. It will flow from the free will of individuals, either the free will of the S&P 500 CEOs and their employes, or the free will of, say, Alan Greenspan. When the bond market cracked, the only person who could truly say it was "overbought" was Alan Greenspan -- but only if he knew the market was betting on him and he could not deliver. 

Thinking about the philosophy and mechanisms of markets is not very exciting stuff as a year-round activity. But like a Treadmaster, it can be a useful exercise. It reminds us that all markets -- political and financial -- are composed of everyone who is potentially available to guess the number of beans in a jar or the weight of a bull or the S&P 500 or the next President of the United States. There is room for experts in this process. It stands to reason that an individual who spends his life guessing at these questions will be better at it than those individuals who do not. And if you and I who do this kind of thing for a living do not produce a positive ROI for society, we will have to find other employment. No lifetime tenure here.