Beliefs, Lessons, Full Moons, and Mr. Market

Quotable

“The demand for certainty is one which is natural to man, but is nevertheless an intellectual vice.”

Bertrand Russell

Commentary & Analysis

Beliefs, lessons, full moons, and Mr. Market

I was made privy to some analysis recently disseminated by an analyst who resides at a newsletter firm.  And though not surprised given the nature of the newsletter business, I noted a degree of confidence in his analysis that screamed more loudly than usual, “I know more than Mr. Market.  Period!”   So I thought I would share with you my rambling story, true story, of how my first trading disaster began the process of exorcizing my belief system.

When I first started trading currencies seriously (currency futures actually) I was very fired up; ready to make my millions and then move on to conquer the rest of the world (youth is great that way). As you would expect, I knew little about trading, and of course didn’t know just how little I knew.  But I did one thing very right at the time; I read what could still be the best single book ever written about the currency markets: The Way of the Dollar, by John Percival.

Mr. Percival doesn’t know this, but he was the only mentor I had in this market. I read his book from cover to cover to cover … pages are falling out … highlighted and notes everywhere. His book provides more insight every time you go back to it. And I go back to it often.

Mr. Percival made a key point in the book that struck me–my belief in what matters when it comes to markets has little to do with trading success.  I believed I was well armed given my freshly-minted MBA in finance and economics.  I had already worked as a financial analyst and even did a stint in the never-never land of corporate strategic planning (talk about being paid to do absolutely nothing of value). Anyway, Mr. Percival’s book opened my eyes a bit, but at the time I still didn’t understand just how valuable his advice was.

After years of trading and barking up all kinds of analytical trees, with major failure and moderate success in currencies, I went back to Mr. Percival’s book.  This time I appreciated what was right there in the introduction:

Finally one had to see if there were other relationships which had any predictive value for currencies like inflation, trade, money supply, oil prices, economic growth, et al. So far, the conclusion is that few such relationships and none of the relationships that most observers seem to rely on are useful for predicting the dollar.

Say what? I thought to myself. Heck, I have all these so-called analytical skills and education and now I’m effectively being told by Mr. Percival if you want to trade currencies and make money, you better pack up that degree and see the market for what it is, not what you think it is with your left brain dominance.

I still make the mistake of assigning causality to factors where none really exist. I think this is a common mistake. Often I receive emails from readers telling me the dollar can never rally or things can’t happen because of some relationship which is perfectly clear.  But is it really ever clear?  And are the important things ever sitting right there in front of us?  After coming across the great  economist Frederic Bastiat years ago, I try to keep in mind the wisdom he shared in his essay “What is seen and What is Not Seen,” it’s application to trading seems fitting:

  • In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.
  • There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
  • Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.

From a general talking financial heads stand point, we often hear non-traders tell us just how much a currency will be impacted by the countries “overwhelming” debt load.  I use this example as it seems a common lament.  Granted, too much debt is a very serious problem and not one to be taken lightly by any means when considering your investment positions. But when it comes to currencies, over time (or with the common trading/speculation time frames) there has been very little correlation between debt and the movement in the underlying currency (considering the major traded currencies).  But debt’s impact on currencies is a repeated mantra in the financial press; so there must be some truth to it.  Well, at a point in time when a crisis is triggered by debt, sure, it matters.  And no doubt there are those interrelationships between debt and things we don’t see that motivate real people to move money.  But most of the time it isn’t a direct relationship that helps us as traders, and yet the belief in such is strong.

Why we cling to Beliefs

Karl Popper was a German philosopher whom I began reading back in 1988 thanks to finding reference to him in Mr. George Soros’ great book: “The Alchemy of Finance.”  Mr. Popper’s arguments have impacted me ever since and I think helped me become a better trader.

Popper referred to the black swan in his 1953 essay on The Problem with Induction. Induction application in the financial world is best known as “back testing.”  With the gift of hindsight we now all know how dangerous back testing can be in the real world.  Reading Popper gives one a deeper understanding of why we cling to beliefs so tightly and assume we can confidently project our expectations into the future and be confident we will be right.

Popper was fond of Hume and used his reasoning for much of the basis of his argument about induction, carrying it further. Popper wrote:

But Hume held, at the same time, that although induction was rationally invalid, it was a psychological fact, and that we all rely on it.

Thus Hume’s two problems of induction were:

1) The logical problem: Are we rationally justified in reasoning from repeated instances of which we have had experience to instances of which we have had no experience?

Hume’s unrelenting answer was: No, we are not justified, however great the number of repetitions may be. And he added that it did not make the slightest difference if, in this problem, we ask for the justification not of certain belief, but of probable belief.Instances of which we have had experience do not allow us to reason or argue the probability of instances of which we have had no experience, any more than to the certainty of such instances.

2) The following psychological question: How is it that nevertheless all reasonable people expect and believe that instances of which they have had no experience will conform to those of which they have had experience? Or in other words, why do we all have expectations, and why do we hold on to them with such great confidence, or such strong belief?

Hume’s answer to this psychological problem of induction was: Because of custom or habit; or in other words, because of the irrational but irresistible power or the law of association. We are conditioned by repetition; a conditioning mechanism without which, Hume says, we could hardly survive.

Okay! I realize this is getting thick, hang in there, almost there.

Popper agreed with the first part of what Hume talked about; the logical problem. But neither Popper, nor Bertram Russell, a disciple of Hume, could accept the irrationality of the second part—the psychological problem.

It is here were we get to the black swan.

Popper posed that yes we must use experience of past instances to advance our knowledge but we must accept the fact that just because so many past instances were effectively consistent, or the same, it does not therefore mean a theory based upon those past instances has been proven. The reason he says this is because there may be some future instance out there that invalidates all that has come before it, and it only takes one such instance to do that. Therefore, all theories can be falsified, but they cannot be proven simply by past experience.

…Or in other words, from a purely logical point of view, the acceptance of one counter instance to the view that, “All swans are white,” implies the falsity of the law “All swans are white”—that law, that is, whose counter instance we accepted. Induction is logically invalid; but refutation or falsification is a logically valid way of arguing from a single counter instance to—or, rather, against—the corresponding law.

This logical situation is completely independent of any question of whether we would, in practice, accept a single counter instance for example, a solitary black swan in refutation of a so far highly successful law. I do not suggest that we would necessarily be so easily satisfied¡¦ we might well suspect that the black specimen before us was not a swan. And in practice, anyway, we would be most reluctant to accept an isolated counter instance. But this is a different question. Logic forces us to reject even the most successful law the moment we accept one single counter instance.

Thus, the theory, or law, that all swans were white was falsified once a black swan living in Australia was discovered. Till then, everyone knew all swans were white. Done deal!

Of course everyone knew Triple AAA-rated tranches of securities were safe. Everyone knows municipal bonds will be fine because the default rate has always been low in the past. Everyone knows that gold is the only real money. Everyone knows inflation is a monetary phenomenon. Everyone knows the dollar must go down. Everyone knows that China will rule the world soon.

We could go on and on into infinitum with what everyone thinks they know. But interestingly, the things we seem to think we know often don’t even have the consistent instances of induction in their favor. We cling to ideas in the financial world that have been falsified before but seem to gather a second life. This isn’t even close to the word logical.

A Kernel of Knowledge – Sentiment

I think this is why the kernels of real knowledge in financial markets seem to be centered on the understanding markets are driven by irrational expectations; therefore sentiment is where one should maintain focus. [This gives some theoretical backing to also using technical analysis, as price is the price action personified regardless of the irrationality or false rationales. It is also likely why the field of behavioral economics will likely obsolete much of what we have been taught about the dismal science with its rational man cornerstone.]

Now back to Percival, again from his introduction to The Way of the Dollar:

Because the systems constituent parts are mostly based on human behaviorwhich doesn’t change, not on fashion, we can be confident it will continue to work.

The financial markets, as anyone familiar with them knows, are deeply paradoxical. They have a logic of their own which is why in a way the opposite of normal logic. Hence the market adage “sell on the news” applies to good news not bad news. Hence other bits of market lore like “a bull market climbs a wall of worry: a bear market flows down a river of hope.” Markets do whatever they need to do to confound the greatest number of people.

This happens because prices reflect expectations. If everyone expects unemployment to rise, or a trade balance to fall, or inflation to remain steady, there is no intrinsic reason why they should be wrong: the expectation doesn’t affect the outcome. But if everyone expects shares to fall, or the dollar to rise, there is every reason why they should be wrong: because current share price levels already reflect the expectations of lower prices, and the current level of the dollar already discounts a rise.In other words, the expectation vitiates the outcome.

You can see why Mr. John Percival is an excellent mentor. One more interesting thing Mr. Percival wrote in his book, which he later said he wished he left out [which I like] was this:

Active traders have little to lose and much to gain by observing the following maxim: distrust price action ahead of a full moon, trust the action after it.

Rationalize it as you please: the impression is that market action tends to be primitive, dim, and emotional before full moons, and more collected and rational after them; and that there is sometimes a periodicity in currency fluctuations which can be almost as reliable as the tide!

Loony sounding I know, but there is a key point we shouldn’t miss here.

…successful trading is not about being a genius, but about constantly exploiting the little edge.

So, back to the “funny story” I started with earlier… when I first got started focusing on currencies, I did my best to think only about what Percival talked about in his book and push out all the smart rational analytical skills I was confident I had already learned. As I said, at the time I didn’t realize the quality of this little book I stumbled upon; it was a true gem in the world of investment book wasteland where most reside, or should. I went on to do extremely well with my first real trading account. However, I cringe in retrospect thinking of how much risk I was taking on and had no clue. But we all know the end of the story. [I have made this mistake since then, but do all I can to never make it again.]

“The most dangerous moment comes from victory,” a quote attributed to Napoleon. After my initial “big success” of doubling the account in two days with my long potion Japanese yen futures, I realized I could just as easily replicate my trading “smarts” in all kinds of markets.  So why not jump into German bunds, and French Pibor (come on, French Pibor?), and orange juice (after being lock-limit down in my OJ contracts for a couple of days I realized just because I grew up in Florida I knew nothing about orange juice.  But that experience gave me a better feel of this stuff called risk). In less than six months, I gave back all of my “big success” and then some…I was well on my way to eventually blowing out the account entirely.

Anyway, my smart rational side of analysis took over once I got cocky. Nothing new there for any of us that have been down this long path of learning and re-learning and learning and re-learning.

So, to end this long ramble, I guess we need to sum it up like this: We all can and should have reasons and rationales in our mind about why we have taken our positions; it is a must in order to have enough confidence to push us over the edge and pull the trigger on a trade.   But I think we need to understand our beliefs, whether based on induction or not, are subject to being falsified by the market at any moment. And the real danger comes when we too fervently argue said beliefs; at least that is my experience.