Trader’s Narrative

For economic and market news and to see what interesting reading you may have missed last week, check out the list below. To see it all, go to news.tradersnarrative.com:

• Wall Street’s New Gilded Age
• NASDAQ’s own sentiment tool: Velocity & Forces
• Our Lost Decade
• Lehman Had to Die So Global Finance Could Live
• Get a FREE Subscription to Futures Magazine (limited time for US residents only)
• Be Cautious About Joining the Gold Band Wagon
• What exactly did the Fed do with $2 trillion?
• Reports of the US Dollar’s Demise Are Premature
• Get the free 47-Page eBook: How to Spot Trading Opportunities (limited time offer)
• The Theory of Interstellar Trade
• Keep an Eye on the Big Picture (long term Fibonacci levels)

For the complete list, follow the graphic link below to news.tradersnarrative.com:

And remember to check back regularly since there are interesting links added throughout the week. If you are a twitter user, add the Trader’s Narrative news twitter stream to get the updates in real time.

The Week Ahead

By Robert Folsom

The following article discusses Robert Prechter’s view of the Efficient Market Hypothesis. For more information, download this free 10-page issue of Prechter’s Elliott Wave Theorist.

When a maverick idea becomes vindicated, there’s a good story to tell. It usually involves a person (or small group of people) who courageously challenge the orthodoxy of the day — and, over time, the unorthodox yet better idea prevails.

A “good story” of this sort has surfaced during the current financial crisis. A chapter of the story appeared in a recent New York Times article, “Poking Holes in a Theory on Markets.” The theory in question is the efficient market hypothesis (EMH), which the article suggested is so hazardous that it “is more or less responsible for the financial crisis.” This quote tells you most of what you need to know:

“In the last decade, the efficient market hypothesis, which had been near dogma since the early 1970s, has taken some serious body blows. First came the rise of the behavioral economists, like Richard H. Thaler at the University of Chicago and Robert J. Shiller at Yale, who convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices — meaning that perhaps the market isn’t quite so efficient after all. Then came a bit more tangible proof: the dot-com bubble, quickly followed by the housing bubble. Quod erat demonstrandum.”

In case your Latin is rusty, Quod erat demonstrandum means “which was to be demonstrated.” Its abbreviation (QED) appears at the conclusion of a mathematical proof. In this case, the massive financial bubbles of recent years are the proof that refutes the efficient market hypothesis, which argues that markets move in a “random walk” and are not patterned.

Similar articles in the financial press have reported the demise of the EMH. Just this week an Economist magazine blog included this bold declaration:

“No one has yet produced a version of the EMH which can be tested and fits the evidence. Thus, the EMH must logically be discarded, as a valid hypothesis must be testable.”

QED, indeed — I agreed years ago that the random walk was implausible. But I didn’t come to this view because of behavioral economists, although their work over the past decade has certainly been valuable. Instead, I was persuaded by the work of someone who first challenged the financial orthodoxy more than three decades ago, specifically April 1977. As a young technical analyst at Merrill Lynch in New York, his research circulated among several of Merrill’s clients. His name for these studies was the Elliott Wave Theorist: the April ‘77 study was a detailed analysis of the 1975-76 stock market, which offered this comment on the random walk model:

“If market moves are arbitrary (as the random walk proponents suggest), then internal components would rarely ‘make sense’ mathematically, and then only by statistically insignificant fluke occurrences. However, there seems to be enough evidence that mass psychology, as recorded in the Dow Jones Industrials, form patterns that are uncannily interrelated….At least this much can be fairly reliably stated as a result of this work: This idea that the market is a ‘random walk’ is probably false.”

Robert Prechter left Merrill soon after; he has published the Elliott Wave Theorist in every month since. Every issue has, in one way or another, “convincingly showed that mass psychology, herd behavior and the like can have an enormous effect on stock prices.”

So while there may be a good story to tell about behavioral economists, I trust you see why I believe there is a vastly better one to tell.

The “enormous effect” of “mass psychology” and “herd behavior” is exactly what explains the financial downturn that began in late 2007. Prechter’s Elliott Wave Theorist anticipated the crisis and warned subscribers beforehand. Likewise, he alerted them to the bear market rally that began last March.

For more information from Robert Prechter, download a FREE 10-page issue of The Elliott Wave Theorist. It challenges current recovery hype with hard facts, independent analysis, and insightful charts. You’ll find out why the worst is NOT over and what you can do to safeguard your financial future.

Related:

• Did Overconfidence Cause The Financial Crisis?

Here’s an interesting video from the recent The New Yorker Summit featuring Malcolm Gladwell talking about the financial crisis:

After Gladwell’s recent book “Outliers: The Story of Success” which inspired the Definitive Guide to Trading Mastery & Success - I was hoping that he would turn his considerable attention to the current financial crisis. What are the underlying forces behind it, how did it happen, why did so many things go wrong in a cascade effect?

We get a glimpse of that in his brief talk but I’m rather disappointed at his shallow take on things. He suggests three possible reasons why things happened as they did:

1. Regulatory Failure: A lack of rules or the absence of their enforcement
2. Cognitive Failure: Dumb people making dumb mistakes
3. Psychological Failure: Overconfidence

He brushes aside the first option and then the second, saying that the players on Wall St. are anything but dumb. Then he zeroes in on the third, concluding that overconfidence is the real culprit.

Gladwell defines overconfidence as “certainty in the presence of expertise” which leads to two main fallacies: miscalibration and illusion of control. Referring heavily to William D. Cohan’s book House of Cards: A Tale of Hubris and Wretched Excess on Wall Street, Gladwell builds his case that at the root of the financial crisis is the culture of overconfidence on Wall St.

While I don’t doubt that this is the prevalent culture of finance today, I think Gladwell has missed the mark and in doing so, perhaps inadvertently, treated the guilty parties with undeserved deference.

The weakening of the regulatory framework, such as the repealing of the Glass Steagles Act, as well as regulators who were for the most part, incompetent, ineffective and chummy with the financial industry played a major role. It was the frayed fabric of regulation that failed to keep the ‘cowboy’ culture of Wall St. from running roughshod over Main St.

Believe it or not, there was a time when banking was a staid, boring job. There was no way you could pick up a hot chick by flaunting your job as an investment banker. Of course, that was before you could leverage your equity 40 times or more and pretend you were running a hedge fund, instead of a vital service for society.

The failure of government to properly guard the industry from rot created a “tails I win, heads you lose” game. Who wouldn’t be overconfident to play such a rigged game? If you can nuke a whole industry and take the global financial system to the precipice… and then still walk away with hundreds of millions of dollars in salary and bonuses… would you be overconfident? Of course!

If every time you got into a jam, you knew from precedent (S&L crisis, LTCM, etc) that the government would always be there to socialize your losses, wouldn’t you want to take as much risk to gain the maximum private profits? Of course! You would be an idiot not to. So it clearly isn’t a case of ‘overconfidence’ but rather a rigged game from the get go.

Here’s a more substantive take on things from Prof. Shiller and the enfant terrible of this bear market, Nassim Taleb, author of The Black Swan:

Shiller mentions his recent book: Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism which dovetails nicely with Gladwell’s thesis but unfortunately it is only Roubini who ends up making real sense. As always, Roubini is unapologetically abrasive. If we want our progeny to avoid a similar fate down the line we need more Roubinis making decisions and fewer insiders like Paulson and Geithner.

Lincoln said it best 172 years ago:

These capitalists generally act harmoniously, and in concert, to fleece the people, and now, that they have got into a quarrel with themselves, we are called upon to appropriate the people’s money to settle the quarrel.

Finally I’ll leave you with this ditty which was written by Colin Negrych:

Yea though I walk through the Valley of the Shadow of Debt
I shall fear no default rates; for thou art with me
Thy printing presses and thy stress tests comfort me
Thou preparest a bull market for me in the presence of Roubini, Taleb, and Grant
Thou anointest my portfolio with liquidity; my wallet runneth over

Surely bonuses and bailouts shall follow me all the days of my life
And I will dwell in the house in Greenwich forever.
A-Ben

There are just a few more days left in the Hedge Fund Operational Due Diligence book giveaway. Follow the link and submit your email for entry into the draw.

Here are a few highlights from the past week’s reading list at news.tradersnarrative.com:

• The Role of Naked Short Selling in Financial Crisis
• Doug Kass: Unapologetically Bullish
• Lex Luthor Needs a Bailout
• AIG Continues to Bite the Hand That Feeds it
• Krugman Doesn’t Like Geithner’s Bailout Plan
• Short Term Top - Bear Market Rally Hits Resistance
• Significance of recent 9-to-1 up days
• The Real AIG Scandal
• Gold Timers Run for the Exit

And remember to check regularly since there are new links added everyday.

Book Giveaway
If you haven’t already, throw your name into the hat for a giveaway of:
Hedge Fund Operational Due Diligence (follow link and submit comment)

The insistence of AIG to pay $450 million in bonuses dominated the news today. There are a few things that can unite Republicans, Democrats and even libertarians. Well, pretty much every sentient carbon based lifeform in the US is seething.

While the villains of the hour are clear, it is important to remember that at this critical junction in US history, we also have quite a few heroes. Take for example, Beth Israel Deaconess Medical Center. While we want to (rightfully) vilify AIG, we also should to celebrate the heroes.

So how can the Obama administration prevent AIG from awarding taxpayer funded “bonuses” to a handful of AIG executives and traders for nuking the global economy?

Before AIG can be held accountable, the US government needs to grow a pair. Or as the Italians call it coglioni quadrati - literally, square balls. Here are just a few humble suggestions for the Obama administration:

• use the government’s 80% ownership stake to force executives to “voluntarily” give up the bonuses
• introduce a very special tax that would target the bonuses - they get paid but they are then taxed 100% right back to the taxpayer
• buy out remaining 20% - in effect, nationalize it temporarily, then clean house before flipping it
• “leak” the names of all the executives that are clawing for bonuses
• give AIG immunity from any lawsuits that may result by withholding bonuses
• hire some Wall St. type corporate lawyers to find loop-holes
• as a last resort, or just for shits and giggles, send Dick Cheney’s death squad after the lot of them

I’m sure there are other, more creative solutions, so let me know yours.