Riffing & Ranting on Moonshine, Sunbeams & Mentos

The beauty of the market: it tests ideas. Good, bad, all can get financed by true believers (or at least believers that others will believe). The ones that are right (or lucky) after taking the leap of faith get riches—though those can be temporary as what Mr. Market giveth, Mr. Market can taketh away. The others get regret: longer lasting (alas, chemical emotions effect on physical memory). Of course bad ideas can and often do force the hand of check-writers if those ideas are proffered by persuasive proselytizers—mental alchemy. Only time will tell if the ideas are solid gold or dead lead. But boy do we all love a good story.

As I’m fond of saying, Mother Nature can't be fooled—but people can. Government galvanizers and energy evangelists can only temporarily lead you to misunderstand the laws of physics—fortunately they cannot alter them.

I predict we will look back on this “Inconvenient Period” as one of naïve ignorance superimposed on greed, wrapped in moral authority. It’s not the first time many have shown an abdication of reason in response to a good story. It surely won't be the last. More in a moment…

But before I riff and rant further: it appears the Great Unwinding is underway in accordance with the Mentos theory of risk management. Plop one in a soda bottle and keep your hand on it and everything is fine, for as long as you keep your hand on top. There’s no shortage of Great Unwindings:

Davos dignitaries debate dollop of the dollar and the delusion of "decoupling". Speaking of dollars: whoever hearts Huckabee doesn't heart him enough as he's running out of greenbacks—and needs to put his faith on that old slogan on the back of the green.

The Dark Night has taken Heath Ledger—all over general society news. And society general's ledger is—well, over. History doesn't repeat but this Rogue Trader is rhyming—through an amplifier. If the US slows, China slows. If China slows, high-priced, high- expectation plays drop fast and far. Commodities drop. Oil drops. Levered speculators drop.

Some smart people might even decide to go back and make an honest living: as doctors and dentists. So the less honest can take their cash. As is said when a man with money meets a man with experience. The latter walks away with the money, the former with the experience.

Which leads me back to my riffing and ranting. Nearly a year ago, I lamented the march of the biofools. I predict they shall soon see their reckoning. Let me say it again now: so as to not be noise later when popular passions shift as they're apt and oft to do. I name no names and I point no fingers. Your inferences and interpretations are your own.

Some capitalist cum-hippies have been using pension plan and retirement dollars entrusted to them to chase Moonshine and Sunbeams (ethanol and solar) sending 100 proof to our pumps and the cosmos to our cable boxes. The doctors and dentists duped (and possibly defrauded) by some investors—drawn by those investors past successes (see: Halo Effect) have paid a pretty penny to price up private rounds. The only investment that seems like a sure thing is backing the possible class action suits brought on by law firms like 'Snaggum, Dupem & Burnham.' Surely the ailing economy will be blamed as culprit for the colossal collapse of the biofool bandits. It will be shown that those doctors and dentists who abide by the Hippocratic oath (First, do no harm) hath been overpowered by the Hypocrite Oath—as defined by Ambrose Bierce, “One who, professing virtues that he does not respect, secures the advantage of seeming to be what he despises.” Shave with Occam’s Razor, take an honest look in the mirror and the two answers are clear: nuclear power, electric cars.

Meanwhile, the markets gyrate like a hula girl and the likes of Bill Miller, Warren Buffett, Bill Nygren, Seth Klarman, Mason Hawkins, Wilbur Ross and other value vets are at the Luau licking their chops and waiting to feast. Klarman's 'avalanche of opportunity' seems here. Fear and despondence seem to pervade all. Everything that worked for the first half of 2007 continued to work in the second half (price momentum, high expectation, high growth, emerging markets)—and the cheap stuff got cheaper.

Speaking of Miller, a few months ago he was quoted in a Toronto paper and pointed out one of the behavioral biases I’m fond of writing about: recency bias—the vividness of recent events that are often out of proportion with the actual risks. It explains why insurance premiums skyrocket after a hurricane. Quoting Miller, “A few years ago when a couple of German tourists were killed in Miami, attendance at Disney World fell way off, because that was dramatic-even though more people are killed driving to Disney World from Miami. The point is that when you see events which are dramatic, recent and cause people to lose money, you can be sure that individuals will overreact. And therefore, they typically would provide good opportunities in the market.”

Sound advice, indeed. Lastly, watch out for a paper making the rounds, called “Walk Versus Wait: The Lazy Mathematician Wins” done by researchers at Harvard and Caltech. They derived an (imperfect) formula that shows its better to wait for the bus than walk to the next stop on a regular route—as you risk the bus passing you by or wasting energy. The same holds for the market. Patience is a virtue—and as my rant above implores, ignorance is not.

Foxes, Hedgehogs, Hussein & Hendrix

Quick note of interest from last week’s column: a reader pointed out that planned economy like the former-USSR had horrible washing machines, but exceptional MiG Jet fighters. The reason: competition. There was no capitalistic competition to produce better washing machines to win the wallets of consumers. But there was immense competition in the cold war to make sure Russia’s pilots had the absolute best. Found that interesting.

Today’s topic: the more I learn, the more I learn that nobody knows nothing. People have horrible forecasting accuracy.

Do you know what you do and don’t know? As Mark Twain said, “it ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” We’re guided mostly by what we know: the past (and even that we sometimes get wrong). Patrick Henry said, “I have but one lamp by which my feet are guided, and that is the lamp of experience. I know no way of judging the future but by the past.” But that doesn’t stop people from making lots of wrong predictions.

UC Berkeley psychology professor Phil Tetlock has empirically found that how you think is more important than what you think and that there is one thing you can do to make better predictions: be a fox instead of a hedgehog. Over 500 years ago, Archilocus said, (Multa novit vulpes, verum echinus unum): “The fox knows many things, but the hedgehog knows one big thing".

Foxes are skeptics and less confident in making predictions and build a latticework of mental models. Hedgehogs are more enthusiastic (especially about what they know) and more confident in making predictions and then pushing those predictions into all domains. As you’ll see, the quick brown renaissance Fox jumps over the staunchly opinionated Hedgehog.

Good decision making is about judgment under uncertainty. If you’re judgment is really well calibrated it means your assignment of the odds that something happens is really close to its actual frequency. So if you think something will occur 100% or 75% or 0% of the time—how often does that thing in fact occur? If you’re intellectually honest, you keep track over many predictions.

The experimenter equivalent of Tetlock on TV is The Daily Show’s John Stewart—whose video clips capture pundits (and presidents) proselytizing and predicting on the outcome of the primaries and then backpedaling to rationalize and justify why their prediction failed to materialize; only to go on with yet more soon-to-be-proven-inaccurate predictions. Tetlock has found the same held true with the prediction of the rise of Gorbachev; the fall of the Soviet Union; the Iraq war, Long-Term Capital Management; and current election predictions. As Tetlock says, ““Partisans across the opinion spectrum are vulnerable to occasional bouts of ideologically induced insanity.” Stewart Brand wrote of this, “The political expert who bores you with a cloud of “howevers” is probably right about what’s going to happen. The charismatic expert who exudes confidence and has a great story to tell is probably wrong.”

Consider the recent assassination of Benazir Bhutto. George Friedman brilliantly wrote in a recent Stratfor piece, “The murder of a major political leader is always hard to unravel. Confusion reigns from the first bullet fired in a crowd. The first account of events always turns out to be wrong, as do the second through fifth accounts, too. That is how conspiracy theories are spawned. Getting the facts straight in any murder is tough. Getting them straight in a political assassination is even harder. Paradoxically, more people witnessing such incidents translates into greater confusion, since everyone has a different perspective and a different tale. Conspiracy theorists can have a field day picking and choosing among confused reports by shocked and untrained observers.”

Sound like anything else you know? The Market. Even Larry Summers, in a 1989 research study, “What Moves Stock Prices?” showed that nobody knows nothing. All the post facto accounts of what caused a major stock market move failed to convincingly explain the moves. Robert Folsom recapped the following headlines and the time they occurred.

Hussein's Capture Seen Boosting U.S. Stock Market
(Sunday, Dec. 14, 6:42pm ET)
Stocks Rise in Morning Trading on Hussein News
(Monday, Dec. 15, 10:18am ET)
Stock Indexes Continue Rally at Midday on Hussein Capture
(Monday, Dec. 15, 12:21pm ET)
Stocks Close Sharply Lower Despite Hussein's Capture
(Monday, Dec. 15, 4:59pm ET)

Every day financial pundits explain yesterday’s events with great certainty. Try to explain today’s events with great uncertainty and even greater confidence. Rinse, repeat.

Some hedgehogs are often seen to predict big extreme changes. Not because they are more prescient, but they are tend to be in a minority of opinion holders for an outlandish outcome. But those outlandish outcomes are important to have out there. Hedgehogs cling to very extreme assignment of odds to something: i.e. it absolutely will never happen: 0% or it is certain to happen: 100%. As the saying goes, even a broken clock is right twice a day. The cost of being a hedgehog is a lot of false positives. They constantly predict some certain outcomes, but they are more often wrong as most do not ever occur: (remember Dow 36,000?). Hedgehogs are also more likely to be on TV as talking heads because they are more confident, more assertive and assign higher probabilities to low frequency events—which also make them more interesting to watch than someone who is more reserved.

It’s almost like Hendrix was a Hedghog singing, “Foxy/ You make me wanna get up and scream/ Foxy/ Ah, baby listen now / I’ve made up my mind / I’m tired of wasting all my precious time”

Foxes are the intellectual equivalent of a Web 2.0-mashup—(sorry, my own eyes just rolled as I wrote that)—taking pieces from all the hedgehogs who staunchly advocate one big idea and turning it into a latticework of mental models. Remember to the man with a hammer, every problem looks like a nail. And study after study has shown that diverse teams and diverse ideas have better predictive accuracy. Tetlock found that not only do foxes have more accuracy in their predictions; they are also more accurate in the odds they give to their predictions being correct.

I’ll leave Tetlock with the last word: “We live in an inherently probabilistic world. Nobody is expecting omniscience. It turns out that a somewhat contrarian, self-critical style does translate into more realistic subjective probabilities being assigned to possible futures. And if you think that good policy—or making money--depends on assigning more realistic probabilities to possible futures—that’s probably a result worth taking into consideration.”