Macro-view funnies

HAHAHA
ahhh... the vagaries of macroeconomic prediction

hedgefolios.com: You know you are a Permabull when……

· each time the market declines you declare it a “healthy pullback”

· sideways moves are actually just the market “taking a breather” or a “pause”

· missing earnings estimates is ok as long as management confirms next quarter’s guidance

· bad guidance is ok as long as last quarter’s earnings beat estimates

· you criticize any analyst that downgrades your stock from “Strong Buy” to “Buy”

· you applaud poor economic results as good for the market because this time they will cause the Fed to stop raising rates

· any negative market commentary is evidence of a huge “wall of worry” that the market needs to go higher

· you plead that a 10% decline is a “great buying opportunity”

· you blame any market decline on short sellers who just don’t understand

· oil declines to $60 and you expect that will cause the market to head higher

· oil increases towards $70 and you point out how the market has been able to absorb higher oil prices

· you quote the cliches “history repeats itself” for positive things and “it’s different this time” for negative ones

· an inverted yield curve doesn’t concern you at all…

---

bigpicture.typepad.com: You Know You are a Permabear When…

· Each time the market rallies, you declare it an “unhealthy sign of speculative excess”

· The great majority of chart patterns always appear to be either rallies in a bear market or an imminent major top.

· CNBC asks you to appear as balance to the optimistic Bull guests.

· Good economic results are bad for the market – it will cause the Fed to keep raising rates; bad economic results are bad for the market -- its proof of the coming recession;

· You worship at the alter of the holy trinity: Roach, Fleckenstein and Kass;

· Sideways moves are actually just “setting up the market for the next down leg”

· You still rail against Nixon for taking the US off the gold standard;

· Your colleagues think you should become a fixed income portfolio manager.

· All the anecdotal evidence you see reveals excessive bullishness;

· You have trouble sleeping when you take a long trade.

· You refer to the 1987 crash, and the NASDAQ collapse of 2000, as "the good 'ole days." Bonus factoid: The LTCM debacle actually made you money.

· You have a ready "tulip-bulb" joke to use at all times.

· On days when gold prices drop, it's due to a government conspiracy;

· When gold prices rise, it's because central banks have finally lost control of manipulating the gold market. Either that, or the masses have finally figured out their fiat currency is just paper.

· If gold drops again the next day, see #1.

· The move from Dow 7,000 to Dow 11,000 has “just been short covering”

· When companies make quarterly earnings estimates, its bad because a) its already built it, and b) its evidence of earnings management. Missing earnings, on the other hand, is bad, because, well, its bad.

· Your website links to Marc Faber (The Gloom, Boom & Doom Report), Grant's Interest Rate Observer, and the Ludwig von Mises Institute.

· You criticize any analyst that upgrades a stock from “Strong Sell” to “Sell”

· The Yield Curve Inversion is a sure sign of the coming recession; As the inversion flattens, however, you note out how negative higher 10 Year Yields are for stocks;

· Positive market commentary is evidence of “complacency” and proof that the market must go lower;

· Any 10% rise in an stock is a “great shorting opportunity;”

· You blame market rallies on ignorant bulls “who just don’t understand;”

· The market is trading at 5 times earnings with a 5% yield -- and you are calling for the “next leg down”

· Strong economic data is proof that the BLS/BEA is politically fixed -- weak economic data shows how much the economy is slowing;

· You short anything that is in your parents' retirement portfolio – and are determined to outperform.

· You insist that Robert Prechter is just misunderstood

Science rules

Finally, biology and engineering combine to make... biological robots!
http://www.reuters.com/article/topNews/idUSN2832706120070628?feedType=RSS

Economic Epiphany in an Easy to Read Chart

This chart is from a really cool book called Ahead of the Curve written by Joseph H. Ellis on the vagaries of economic prediction (no oxymoron intended). The book is very well written... brilliant even. One of the coolest concepts in there is something called asymmetrical circular causality. But he can explain that better than I can. Check it out!

Okay, well, if you're too lazy to check it out here's a good summary, written by the author:

* Personal income - largely wages and salaries - is the primary driver of consumer spending, by far the largest sector in the economy. Credit and borrowing play a role, but if we can identify the most important indicators of spending power through wages, we have a shot at forecasting consumer spending.

* Uptrends and downtrends in consumer spending drive advances and declines in manufacturing and services.

* In turn, the capital spending sector of the economy, which includes companies' spending on plants and equipment, follows, like clockwork, the trend set by production and services, and consumer spending before them.

* These three sectors of economic activity - consumer spending, industrial production and services, and capital spending - represent the core of corporate profits produced in the United States, so the dependence of corporate profits on consumer spending is also clear.

* The stock market, which advances and declines as a sensitive predictive mechanism reflecting corporate profits, is therefore also tied closely to consumer spending at the front end of the cycle. This makes it easier to understand the sequencing of the stock market in this chain of cyclical events, with major stock market advances and declines tending to occur at similar points in successive cycles.

* Because business hire or fire workers based on the respective rise or fall of sales and profits, employment - jobs - follows rather than leads the economy. Mastering this fact is one of the core hurdles in overcoming emotional but erroneous reactions to economic news.

"In other words, consumer spending is dominant in the economy as a whole to such an extent that it is, by itself, the sector that cyclically determines the direction of the overall economy. This being the case, carefully monitoring overall consumer spending - or, even more significantly, forecasting the direction of consumer demand - is the key that unlocks effective forecasting for most other developments and sectors in the economy."

Financial and Economic Cycles: A Short Story

A lighthearted note today... speculating on a hypothetical situation in a hypothetical world... where asset prices are going up-up and the perceived risks are going down down since its beginning. Let's call this hypothetical world: Omicron Ceti III (OC for short--star trek nerds will appreciate this), where a certain two groups of people interact in an imaginary economy, and establish economic exchange involving money. There were two clans in this world: The Klings and the Fergies.

The Klings were a nomadic hunter-warrior tribe before coming to OC. Honorable, proud, and sticklers for tradition, they are a hardworking people who have left their birthplace due to climatic changes and other acts of nature which forced them to find new sources of subsistence. The Klings were a very numerous people as women bore many children and men were prolific fathers. This eventually put strains on the environment when all their game were extinct. They had to move somewhere as many people were starving and had no food to eat.

The Fergies were in early stages of establishing agricultural surplus and an elementary economy before their coming to the OC. They have pride in their abilities to think beyond what's given in nature, and were superior to the Klings in education, intellect, and organization. They were also very resource minded and frugal, mainly because they were greedy. They established a very sophisticated system of social organization, and did not breed much and deliberately controlled breeding with complex systems of religion that promoted chasity. They wanted to conserve nutrients in their farmland and be frugal with what they know to be limited economic resources. They lived a rich life with a high standard of living per capita. Unfortunately, their military strengths were no match for a neighboring clan who has decided to invade them, and thus their trek to OC to find a new place where they can be left alone.

When the Klings and the Fergies met up in OC when both tried to settle in the land, the two chieftains who led the people at the time agreed to establish a democracy of equals, with the rule of law and property. The Klings were very impressed with Fergian knowledge of agriculture and political economy, and the Fergies needed badly the Kling dedication and experience with the "grunt work" and not to mention war-like activities to acquire and defend territory. Thus, generations have passed, and eventually both the Klings and the Fergies settled down and both called OC home. But of course, due to the Fergies previous intellect and experience with economic activities, and also due to their shrewdness and greed, they soon acquired significantly more wealth than the Klings. After a period of two generations, the Fergies were only 5% of the population, but controlled most of OC's vast amount of wealth and property. By then the economy has gotten relatively advanced. Not only were there a basic food and services industry that the people originally needed to survive, but tastes for consumer discretionary, finance, real estate, luxury goods, and the likes have also popped up on the backs of high population growth and a healthy labor market. Of course, it was mostly Fergies who had the bulk of the wealth to enjoy these amenities. Naturally, the Klings were unhappy with this, as their people were working very hard, but none could ever make as much as the Fergies. As the economy developed, up went the prices of assets such as land, shelter, and raw materials used to create the goods and services, and this meant it was very difficult for Klings to get in on the action with seemingly very meager wages. One day, a whole lot of Klings gathered and signed an official petition for a fairer distribution of wealth, and they protested and complained during a democratic council that the Fergies were guilty of manipulation and conspiracy to undermine the Kling people. This was the first time that the two groups of population had such problems since their founding.

Sensing danger of popular unrest, the democratic council tried very hard to figure out a solution. Around the same time, a secret committee of business and financial industry titans of the Fergie race convened in a secret meeting to try and figure out what to do to keep the Klings happy. The Fergies knew that the Klings were generally a proud and stubborn bunch who could in no way compare to the Fergie intellect and instinct for wealth accumulation, but they also did not think that this was a crime. These Fergies didn't look down upon the Klings, for they also needed the vast number of labor resources that the Klings provide for their civilization. They also realize that a Kling could kick a Fergie's butt any day in a physical match, which makes them dangerous if the Klings ever became politicized. The Fergie committee thought long and hard about what to do, and how to make the Klings feel richer without having to give up their own property and wealth that they've worked so long and hard to accumulate. But they just couldn’t figure it out, would they really have to give away their hard earned money and property in order to keep the social fabric from tearing apart?

Just then, a deus ex machina came and saved the day. A peaceful people known as the Chins sailed to OC from afar, with a caravan full of goods. They were very interested in opening up trade with OC, and the best part of it is that all they asked for in return for the ship full of goods were common shiny pebbles that were plenty to be found on a beach nearby. Apparently, where the Chins came from, these pebbles are very valuable.

The Fergies quickly capitalized on this opportunity and called in an emergency session with the democratic council on the island. The Fergies promised to fix the problem of income inequality by changing the money supply from the current rare gemstones to pebbles, and make available many assets in due time that Klings could purchase with these pebbles. The community built a 10 ft, heavily guarded wall outside of the beach, and established the first central bank in the OC. Of course, none of the Klings were smart enough to figure out what was going on, and the Fergies funneled enough pebbles into the pockets of Kling politicians to keep them happy enough to allow the Fergies to be the ones that controlled this seemingly endless beach full of pebble money. When the bank opened, all was welcomed to exchange their gemstones for these pebbles at a set rate of 50 pebbles per gemstone. The population quickly did so.

Trade with the Chins quickly heated up, and a vast surplus of goods and services were soon imported from the distant homelands of the Chins. A complex system of banking and finance sprang up as a result, where paper representing ownership of pebbles soon began circulating in the two-world economy. The Chins soon also incorporated bank-notes from the Fergies as a part of their currency back home, though they’ve always kept it tucked away as the Fergies didn’t export what they didn’t already have back home. The only thing that the Chins ever really wanted from the OC were the seemingly ubiquitous shiny pebbles and notes representing claims to these pebbles.

Soon, the food of goods from the Chins created a disinflationary effect on the economy of the OC, and the Klings, whereas before they could not afford the luxuries that the Fergies have enjoyed, quickly snatched up goods at cheap prices. The opening to foreign trade had allowed Fergie business owners to shift their production to low-cost foreign countries, outsourcing jobs once held by Klings. There were some complaints regarding job-loss, but in general, society in a very content state-of-being, everyone could purchase price-deflated consumer goods for cheap, and no one was hungry.

Of course, the Fergies who have outsourced labor overseas to the land of the Chins quickly found themselves able to earn very handsome margins on the products they shipped back home. Branded goods and services soon appeared, and an entire fashion and glamour industry sprang up on the backs of high selling prices. Voluptuous females, Kling and Fergie, paraded the catwalks and appeared in newly printed media advertising the new crowning consumerism, and urging the nouveau riche to splurge pebbles on luxury goods made widely available and affordable.

This worked pretty well for a while. The Klings were happy consumers, and could purchase more than they ever thought imaginable. And due to the flexibility of the Fergie dominated central bank, which has increasingly injected more and more pebbles and claims to pebbles into the money supply to pay for goods imported from the Chins, the Klings were able to enjoy very beneficial financing terms. They soon bought their own homes with very little down payment and mortgage debt with very little money down, low interest rates, and a terms of twenty-plus years. Despite the fact that more and more jobs were being shifted to the land of the Chins, in aggregate this was no problem because enough jobs were being created in the real estate, finance, and consumer retail industries in the OC to off-set job losses in hard-asset businesses. Nobody really worried about “real wages”, because inflation didn’t exist in this world of endless cheap Chin goods. Of course, all this prosperity have kick-started asset prices even more, and prices in the local stock exchange—once very illiquid and with only Fergie participation—has become very trendy among the new middle class Klings. Everyone was happy to see their home prices appreciate, and everyone was ecstatic when the value of their portfolios went up steadily day by day. This has created even more confidence in consumer spending, and the Klings were enjoying the seemingly unlimited wealth that the new banking/financial system created. Meanwhile, behind the scenes, the Fergie central bankers and central bank chairman Ulan Bluespan made sure that the system created enough pebbles and pebble denominated debt to sustain this asset inflation and the consumption binge.

And meanwhile, the Chins were increasingly worried that the pebbles and notes claiming pebbles would soon depreciate in value. After all, their economy is now flooded with pebbles, and they have been recently suffering a serious bout of deflation with more and more manufacturing capacity coming online with the easy pebbles available. However, the seemingly insatiable demand of the OCs were simply too profitable to ignore (at least in terms of what they thought was profit… more and more pebbles and pebbles denominated notes). Plus, the OCs were seen by the Chins as an economically and politically superior group of people. The Fergies, on the backs of a prosperous economy, had encouraged out-of-work young Klings to join in a new military expansion program—in the name of all that is good and just: freedom, liberty, and the pursuit of happyness. Over time, this military expansion program had lead to overseas expeditions known as freedom fights, and this showed off the OC economic and military might to the rest of the world, which significantly helped in the credit ratings of the OC central bank in the eyes of Chins and an increasing number of other societies.

All this has served to greatly increase the Klings satisfaction with the Fergie banking administration. Although the Fergies did not necessarily create real income equality, there was a standard-of-living equality that greatly satisfied the large Kling population, whom can now be largely considered “middle class”. At the same time, however, nominal income disparity widened further, as the original many Fergie asset owners, and a few Nouveau riche Klings accumulated an ever-increasing share of society’s wealth, so much that they had no idea what to do with it except to invest further into more assets and/or use them to flip stocks.

Abstract artists, once considered economically despicable in both the proud warrior-like Kling species and the practical Fergie race were soon making a good living tapping paint on a canvas and making random stories of feelings and heartbreaks. A canvas with three red dots were fetching on the market for as high as five hundred million pebbles. This mirrored the increases in securities markets and maybe even more.

However, the Fergies soon realized that this economic miracle would not be forever, and they soon started thinking about the downside to all this. The more they thought, the more they began to hedge themselves. The consumption binge and the seemingly endless asset inflation would grind to a halt if any trouble with the belief in the value of the pebble would come into question… but so long as the Chins and other nations impressed with the OC’s economic and military might were willing to take these pebbles and finance whatever account deficits and a growing national debt, and keep these in their foreign reserves and treat them as legal tender for possible future purchases, then the OC would be fine, and this binge would continue on and on. But all good things must end, and the fact remains that these pebbles were once just pebbles on a beach, and they hold no real value what-so-ever, and that sooner or later, there would be doubts to the real value of the OC pebble, and what goods and services that it might bring to the holder. The Fergies know this, and they are devising methods to try and shift the risk away from themselves.

Finally, the greediest among the Fergies would devise a method to enrich themselves one last time and still guarantee they would still come out alright. So, with a natural instinct for profit, and ever at a loss in finding ways to make money and keep money to themselves, the Fergies have devised very intricate financial innovations. The first of these innovations was asset securitization. The Fergies geniously devised a plan to extend even more credit to households that were not living the OC dream yet (they call this subprime pebble loans), and packaging these loans into fixed income securities called Mortgage Backed Securities. They also extended numerous loans to new start-up companies created by young, educated, and optimistic Kling entrepreneurs, and packaged the cash-flows to those and sold them off as Asset Backed Securities and Collateralized Debt Obligations. The Fergies loaned to whoever they could, and transferred the risk of default and asset depreciation to the investing public (whom by now are in a frenzy of asset purchases and speculation), and pocketed billions of pebbles worth of transaction fees and brokerage fees. Second, they began marketing various derivative instruments and packaged fixed income instruments to foreigners—in particular, the Chins, who were not as sophisticated as the Fergies in coming up with financial innovations, but were nevertheless eager to invest due to the strength of the OC pebble on the international currency exchanges. Third, the Fergies began to encourage leveraged products, as diminishing investment returns and low risk-return spreads plagued the rabidly greedy investors. This leverage allowed Fergies to pocket even more fees as they package ever increasing debt and sell them off to the public. As long as asset prices appreciated more than the interest on any of these loans that the Fergies made, then the investors were golden. Fourth, the Fergies began to create even more fervor among markets by organizing Private Equity funds, where they garner billions and billions of pebbles from investors, and take public assets private on the bank of billions of dollars in bank loans often at 20 – 30% premiums, and then IPOing these private equity funds back to the public at and even more mark-up.

Among all the frenzy in the markets, and everyone buying into the belief that the new financial innovations that the Fergies devised making investments permanently safer and more liquid, asset prices kept going up for a while. The Fergies have long gotten out of the game, while the Klings keep flipping and the Chins keep hoarding assets.

One day, out of the blue, the Chins decided that they now had enough pebbles and pebbles denominated debt to last them ad infinitum, so they started buying OC hard assets themselves (much like the Japanese did during their market bubble). The Klings also started selling these assets, and pretty soon, there was a rush of Klings wanting to sell and pocket their gains. Asset prices went down a bit, and margins on loans were called, and securitized products began losing some of their collateral. In other words, minor events and tremors in the system, and the subsequent asset price declines soon triggered several critical states in the economy. Those that had houses on subprime pebble loans began receiving rates that were beyond their payment capability, and they defaulted. Loans made on the backs of company products and equity securities were increasingly being called in. Klings and Foreigners across the board began losing money, and buying interest was taken out of the system by quite a bit.

And the Fergies central bank, in attempt to fix the problem, pondered two possible scenarios: lower borrowing costs, which will inject excess liquidity even more and support asset prices, but nevertheless will induce foreigners to sell pebbles, and will probably resulted in a run by the Chins on the existing pebble currency, where inflation hidden in years of disinflationary consumer products will finally kick in. Or, do nothing, which will create total illiquidity, where asset prices continue to tumble and across the board losses will occur with much of the value of pebble denominated assets wiped out—not to mention all the derivative products that were written to the public. Either way, however, the Fergies come out fine, due to their shrewd transfer of risk to the public, and their ability to buy back cheap assets when the markets tank.

Fergies 1, the rest 0. By now, the gems that were originally the money supply replaced by pebbles are now worth 600 pebbles per 1 gem. And the economy of OC is being plagued with an extended period of stagflation.

What will the Fergies think up next?

Complex Theory and Power Laws, With Philosophical/Economic Implications

An artist's depiction of fractals in complexity/chaos theory

These are concepts set out to replace linear causality. Instead of event A causing a response called event B, events A, B, C, D and so on act as either points, planes, or spatial objects, with or without mutual exclusivity, push and pull in tandem or in flux or with mutual influence but not to the full extent, either cause some other group of events to occur, cancel themselves out, or somewhere in between.

I suppose that's where things get complicated (thus, complex theory, what a cool name), but it is certainly a concept more befitting of economics than linear algebra--and not just economics either, but maybe existence itself too. Of course that's beyond what I'm trying to do in a blog entry. But what's amazing about complex theory is its scope of application, in back-testing of what's happend in the past, in understanding how we got to where we are now, and in setting a framework for any sort of art in predicting the future. After all, to make an example of a commonly known process: evolution, the beginnings of life were once considered humble and quite easy to understand. Now, to define life itself as an academic pursuit would take years of not decades of categorical work. As the theory goes, single celled organisms divided itself and combined with other organisms to form living beings planet earth is teemed with today. First with simple structures and organelles to sustain itself and reproduce--a cell wall to house cytoplasm, a nucleus to shelter chromosome, mitochondria to generate energy, and some endoplasmic reticulum to distribute resources. Then on to sexual reproduction and combination with the genetic codes of other cells to create intergenerational adaptation and evolution through the shared replication of superior genes. Then, as cells moved beyond being isolated phenomenons, vessels of massive size are created to house groups of cells who have found ways to co-exist under mutually beneficial arrangements--we can think of these as plants and animals at any given stage of evolutionary complexity. Some remain very simple as rudimentary genomes find no reason to evolve beyond what is necessary to survive in a simple, unchanging environment--phytoplankton, algae, and various other microorganisms. Some, in order to exploit changing circumstances and power over other organisms evolved into a complex entanglement of organs and biological fluids working together for the goal of common survival and reproduction. And some of these organisms even evolved an executive cell group created solely for the purpose of intellectual thought called the brain. And it didn't end there. Intellectual thought (at least only in humans on this planet) quickly became a means for what was once cellular organisms to go beyond biological fluids and structures, to create social interaction, common history, civilization as we know it recorded in the form of knowledge--the rise and fall of empires, the evolution of media and the press, religion, economics, politics, and most recently the creation of the most complex web of virtual ideas known as software. And who knows what the future holds. But what's clear to scientists and philosophers is that each stage of evolution and change can be traced and graphed as according to a secret order, and the magnitude and timing of each tipping point or critical state could be related back to a statistical power law. Changes of a certain magnitude will happen less likely the bigger these changes themselves are. The frequency of such revolutions in biology, science, knowledge, ways of thought will happen statistically less—as according to a power law, with some physicists and scientists pointing to a factor of four times as likely or not as likely. But these critical states of change happen in natural phenomena, and it gets quicker and more complicated with every branch of development expanding ever rapidly. It took longer for single-celled organisms to go from asexual reproduction to sexual reproduction, than for a moth to develop chameleon-like skin as according to their environment to avoid predators (a process that takes only a couple of generations, each lasting a couple of years). By the same token it took much longer for man to develop and pass on agriculture and basic technologies to the next generation, than for modern innovation to take a foothold in everyday life (remember the most daunting advancements in technology and social organization came about in the 19th and 20th century). This example of evolution, and the frequency of critical turning points in its progress (the second derivative), is just one of what modern intellectuals can attribute to complex theory and power laws--which, as the trend of our scientific times has determined, the origins of virtually everything on this planet, hardware and software, can be ascribed.

As any model goes, it serves very well as a framework for organizing and back-testing data collected on historical data and developments. Simple and seemingly linear progressions would start very easy, but accelerate into multifaceted networks of causality weighing on one another and create systems of stable equilibrium that expand infinitely. This is mathematically beautiful (I personally think so). You could look at the development of anything with a new perspective, from evolution as we've just mentioned, to the development of our current government (from townhouse meetings to national democracy to national committees and agencies to bureaucratic glut), the great monotheistic religions (from simple beginnings of monotheism to Judaism to the crucifixion of Christ and the spread of 'the word' by Paul to the arrival of Mohamed and the thereafter split between Sunni and Shia to the splits in Christendom of Eastern Orthodoxy, Catholicism, Coptic Christianity, Protestants, Evangelicals, and the arrival of Islamic fundamentalism), to why one should do well early on in school (from As in math, science, and english, to an A in subjects derived from these subjects, history and economics for example, and then knowledge of each subject in detail, which is virtually every subject from the beginning ones, and the detrimental effects of having to catch up if full understanding of simple origins of such knowledge is not achieved) to categories in science, politics, economics, philosophy, you name it. And all knowledge and existence could be related to a tree, with which metaphorical branches spawn even more branches, and it doesn’t stop. Sometimes branches get old and die, in existence and in knowledge, and when branches wither and fall from the tree the other branches fall with it—like an act of god or maybe the inability for the environment to support certain phenomena or without the environment going head-to-head against its very existence. And thus a web is disturbed. The example would be like a tiny moth going extinct due to an external factor such as human intervention to control their population, leading to certain smaller birds of prey unable to feed their young, leading to tree-dwelling mammals unable to find birds eggs as a source of food, and larger predators unable to secure a steady supply of these mammals as prey, and extinction occurs at the top of the food chain more often than the bottom, ect. Sometimes branches continue their upward and outward growth, far outpacing what its original host had intended, due to its prolific potential as a basis to develop offspring—knowledge, for one, has several of these: monotheism, mathematics, literature and philosophy, or even the more modern ones such as the Einstein’s theory of relativity, Darwin’s theory, game theory, critical state ubiquity (the most recent). Sometime knowledge could be destroyed or rarified in human knowledge, and rendered antiquated and useless—such as geocentric theory, medieval treatment of lunacy through exorcism, Zoroastrianism, countless languages from extinct tribes of people, and the list goes on.

To put it in a nut-shell, "complex theory" serves to describe an underlying order to what seems to be the complete chaos of modern day life, by first ascribing the origins of any categorical phenomenon under consideration and then, with a model--either scientific or philosophical, slowly branching out these origins and fitting more modern manifestations under these models, and be able to explain their evolution or destruction and the prospects of the “branch” going forward. The "power law" describes the speed and the frequency at which the branching out occurs—for example, outlining the occurrence of earthquakes and its statistical frequencies according to their magnitude—the famous Gutenberg-Richter theorem, or the accumulation of wealth being defined as being a certain power of more or less frequency as the amount of wealth increases or decreases by a certain factor in the individuals of a population, or just the normal curve under any statistical study delineating the expected normal occurrences spread across standard deviations—with events getting rarer as sigma grows.

Anyway, that was quite a bit of description, but hopefully one can see the implications that these theories can have on economic development, whether macro or micro, and the relevant policy or investment decisions might be derived from understanding such models. But, as any model, it's very good for hindsight. We should keep in mind the adage "Models do not provide answers, they only serve to detail questions". So what would this theory tell us in the world of finance and economics? Could we use something like this to learn more about how the world of practical matters such as money, employment, social security, empire building, etc.

Let’s leave that for another time.

Just another suggestion, pick up these books, they are insane and make you go "holy shit this kicks ass" with every page:

Ubiquity - Mark Buchanan, Deep Simplicity - John Gribbins, The Selfish Gene - Richard Dawkins

They may mention finance/economics only seldomly, but the concepts and simple truths delineated in the pages is something that everyone in perhaps every profession would benefit to know.

Fortune Favors the Bold?

These spreads are pitiful (yields of riskier credit securities compared to treasuries)...


In a nutshell, this chart shows how much investors of debt securities demand back in terms of yield. This chart relates a nice picture back to us regarding the general sentiments regarding risk, and how much return should compensate for that risk. The relationship of credit-spreads between what is considered "risky" and "riskless" shows very well the risk-reward expectations of the investing public. Basically the yellow and the red line compare how much "extra" return is expected when investing in securities other than the completely riskless U.S. treasuries market (the bonds issued by the U.S. government). Why does this picture scare me?

1.) People are no longer afraid of credit risk, expecting a measly 1% spread for barely investment grade securities and a little under 2% for emerging market sovereigns (usually considered pretty risky, but given the fact that "emerging market" has become a buzzword for growth and riches now-a-days, nobody really thinks about default or non-payment). With the easy availability of credit default swaps (derivative instruments that allow an investor to completely diversify out of default risk--provided the counter-party does not double-default... but who knows?) brunting the bulk of the uncertainties with investing in instruments of dubious integrity.

2.) To get the return required for yield hungry U.S. investors, institutions and money managers (alright alright, mostly hedge funds...dammit) have been using substantially higher leverage to capture ever decreasing returns. If you think credit spreads are bad, you should see how much people are willing to pay for equities these days (15-20x earnings on normalized businesses not unusual!) But yeah, here's a picture of how much hedge funds are levered. Prime brokers (firms who execute trades, lend money, and provide various other financial and administrative services to investment funds) have been literally giving money away since late 2003. Who can blame them? Money grew on trees as we were coming out of the tech bubble, all that extra cash needed to go somewhere, the new wonder-kids of finance at hedge funds are 'good' at making money all of a sudden because everything is going up, and the fees on these borrowings are not half bad.

3.) The justification for this complete negligence of investment sense is the circular argument that derivatives and credit default swaps has permanently made financial markets safer and more liquid, when the wide availability of these derivatives were a product of a secular bull-market driven by the wide availability of money supply in the first place. A paradox of the chicken and the egg is here. When I think about it, it makes my head hurt, because... first of all... would derivatives and credit default swaps be so easy to finance if it weren't for the fact that volatility was low and asset prices were perceived as sound? Second of all... would asset prices be sound and leverage/money be so easily dished out if it weren't for the fact that derivatives and credit default swaps has created "permanently" less risk and much more trading and liquidity? So, look at the two charts below... is it the chicken or the egg?




If I'm brilliant enough to call what's supposed to happen next as a result of this non-sense, I would be making millions of dollars right about now (if not billions)... I don't claim I know what's going on, but I do know that somebody has to be getting the short end of the deal. When there's a winner that has diversified away all his/her default risk and volatility risk, somebody else is taking it on--even if that somebody else has diversified that risk away themselves, then that somebody else's somebody else will be the one brunting the blow. Even if it comes full circle, somebody will probably have to default if things get bad enough.

I just wanna see what happens in a bear market, when liquidity suddenly dries up and trading grinds to a slow. When everyone wants to sell, you can bet this scenario of permanently lower volatility/risk/returns, higher leverage, and the happy-go-lucky world of record-high dow closings and never-ending LBO/M&As will be less enthusiastic.

Fortune doesn't favor the bold these days, it favors everybody. Virgil wouldn't be quite as poignant on courage if he saw what's happening today. Bankers winning on fees and investment funds winning on returns forever and ever seems like a utopia, but utopias are never quite so economically viable--for an extended period of time anyway.

How Loose Monetary Conditions (not economic) Affect Stock Market Returns, and Why I'm Still A Bear

Before I begin a long-winded thought jot-down that was long before due regarding my views on the economic and investment outlook that I personally hold regarding the future, I'd like to say right now that I am not assigning any time-line to when I think my views would come to pass. Any economic view on the market, despite the potential inevitability that views suggest, are by no means ever imminent--as the market is still after-all a voting machine that is run by human psychology rather than the fundamental truths that might be of consequence. I've been bearish on the state of the U.S. economy and stock market for a while now, but that doesn't necessarily mean I want the stock market to fall, and for people to lose their jobs, or for America to lose its economic supremacy in time. What I am is worried, and I worry because I need to know where money can be made in the finance world if making money was the cause of a lot of fundamental disequilibriums in the first place. The problem of excess liquidity (I'm probably one of very few on the street that think excess liquidity is a problem rather than a solution)  have weighed heavily on real returns, and the illusion of capital gains are paid on the backs of an unending quest to build capacity in Asia and the ebullient view of a neverending consumer binge that drives what it means to be American today. Nevermind the fact that the performance of the S&P has been caused mainly by the rise of financial stocks and consumer stocks, and nevermind the reason that much of the core growth in corporate earnings actually came from abroad in the form of a weakened dollar. The question that must be addressed is how America's chronic deficit spending, and the economic liberalization of the previous Greenspan regime effected our futures as investors and every day citizens going forward. And why we should be worried about a potential pitfall in investing in America if things go unaddressed. Difficulties in curbing inflation (i.e. things getting more expensive and our retirements getting more difficult) will be the challenge of the Fed and central bankers around the world as they try and figure out how this financial frenzy of today will affect money supply and velocity, where people give three cheers for M&A activity that make little to no sense simply because it drives stock returns, and where the wealthy simply give money away to anybody with a business plan for a (fill in the blank) fund. One can cite countless deals that have happend over the last few years done by private equity or investor consortiums that have investment yields thinner than Victoria's Secret models, and how if wealthy people really wanted to throw away money they might as well throw away money at kids starving around the world rather than down a black hole of greed and expectations comforted only by the scant hope that maybe someone else will buy the investment at a higher price (because, there's enough liquidity, duh).

Before anything, here's a very interesting piece courtesy of Marc Faber of the GBD Report and John Paul Koning of Pollitt & Co in Toronto:

The Zimbabwe Stock Exchange is growing some three times faster than consumer prices. This relative outperformance versus general prices is a result of stocks being a chief entry point for the flood of newly created money. Keep Zimbabwean dollars in your pocket, and they've already lost a chunk of their value by the next day. Putting money in the bank, where rates are pithy, is not much better. Investing in government bonds is the equivalent of financial suicice. Converting wealth into foreign currency is difficult; hard currency is scarce, and strict rules limit exchangeability.

As for capital improvements, there is little incentive on the part of companies to invest their already-losing enterprises since economic prospects look so bleak. Very few havens exist for people to hide their wealth from the evils created by Mugabe's policies. Like compressed air looking for an exit, money is pouring into shares of ZSE-listed firms like banker Old Mutual, hotel group Meikles Africa, and mobile phone firm Econet Wireless. It is the only place to go. Thus the 12,000% year over year increase in the Zimbabwe Industrials.

Our Zimbabwe example, though extreme, demonstrates how changes in stock prices can be driven by monetary conditions and not changes in GDP. New money gets spent or invested. In Zimbabwe's case, because there are no alternatives, it is stocks that are benefiting.

This sort of thinking can be applied to the stock markets in the Western world too. Though western central banks have not been printing nearly as fast as their Zimbabwe counterpart, they do have a long history of increasing the money supply. It forces one to ask how much of the growth in Western stock marekts over the preceding twenty-five yeras has been created by a vastly increasing money supply, and how much is due to actual wealth creation. Perhaps stock prices have increased faster than goods prices for the last twenty-five years because, as in Zimbabwe, Western stock markets have become one of the principal entry points for newly printed currency.

This example really hit me, it describes a whole lot of what's going on around the markets in a more extreme manner. The emphasis in bold is mine, and what it's suggesting hints at how any investment return--viewed in absense of a perspective on the general monetary conditions of an economy--is at best illusory and at worst stupid. One might view the 12,000% returns in Zimbabwe industrials as very attractive, but in light of the horrible inflation and the lack of general investment options to preserve capital enough for a meal the next day is scary. Of course, the current inflation in the United States might be viewed as benign in comparison to much of the developing world (some 2.0%+ annualized), and compared to the 20%+ returns in the S&P500 over the last year or so this is a very good deal for anyone that has gotten into the markets, for their wealth in real dollar terms have increased by quite a bit.

But what does it really mean to hold wealth? What is money? To the average joe, the more money the better, and the more things money can buy, the merrier, if only everybody in the world could have money then every problem we have would go away. This is a fantasy not far off from what perhaps 95% of the population would agree with. However, for economists and interested investors, this is far from true. Economics 101 would tell you that if everyone in the world could make fast money, and build wealth in nominal dollars, and have a fatter bank account that grows day by day for some reason or another--with the awesome money their mutual fund managers and their mutual fund manager's fund managers makes--then there would be a case of increasing prices so that everybody loses purchasing value year after year and no "real" wealth is built at all. Certeris Paribus, $100 dollars that used to buy a coffee machine will now only buy a pack of coffee machine filters. Of course, the real world isn't ceteris paribus, but enough empirical evidence has already given us signs of danger that the next recessionary pressure we feel will surely be stagflationary, in consequence to lagging consumer spending, job loss, much higher commodity and raw material prices, and a weakening dollar. So we must ask ourselves is inflation truly under control? Prices in the United States have stayed stable, but any traveler can tell you that staying in other places around the world (developing economies excluded) have become much more expensive. Americans, as usual, are pretty complacent spending their evenings at home and not thinking outside of their own continents--but people really should be more concerned about the falling value of the U.S. dollar, and what implications on inflation it actually has at home.

While stock prices and house prices (until recently) have continued their upward climb slowly but confidently, driven primarily by the reflexive success of financial and consumer markets on the back of increasing asset prices that becomes its own grandpa, the rest of the world seems to have begun a bleek view on the fate of American status and the strength of the American Dollar (once pinnacled as the currency of dicipline and value preservation). A comparative glance at several currencies considered relatively "hard" against the dollar--meaning more fiscal dicipline and less monetary expansion--can tell you something about "true" inflation, in terms of how much it actually costs an American to live in the world (as opposed to his couch in surburbia).

How much Euros to buy one dollar



How much British Pounds to buy one dollar



How much Swiss Francs to buy one dollar


How much Austrailian Dollars to buy One Dollar



How much Korean Wons to buy One Dollar



For any of these foreigners to have invested in American assets in the last five years would have been difficult due to the falling to flattish real returns they would have earned on average (say in the S&P or treasury markets). The story of real inflation for Americans haven't hit home quite yet due to the still relatively cheap goods and cheap capital that is available in China and Japan, respectively. In China, manufacturing capacity and saturation have literally reached its limits, and the endless supply of labor have since cooled the price of consumed goods in America while under normal circumstances Americans would have certainly felt heat. But the China problem (the one that US politicians and economists keep talking about) might have found a solution yet--a gradual appreciation of its currency to reflect global norms and correct trade deficits.

The biggest draw back in the case of China is that, although "lowering our deficits to China" and "help save our jobs" sounds good to Americans now, the actual consequences will be dire in the form of much higher prices. China has acted as a cooling engine in world inflationary pressures in consumer goods (a cost that has arguably been passed on to increases in raw materials, energy, food and commodity prices that they are continuing to drive up), and this has enabled many societies around the world to live with relative comfort and still be frugal. Now I say Americans will feel heat, because while China has enabled a much cheaper manufacturing environment and thus cheaper goods to be enjoyed by everyone, Americans have been overspending even in light of this. A quick glance at the household savings rate and the household debt level (manifested primarily in credit cards, auto-payments, and mortgages) in Amerca will tell you the story:






But in light of these increasing pressures in actual finances of the consumer, it's still "okay" to buy the new playstation and the wii because the stock market or the value of the house is going to pay for it. The stock market, specifically, has continued its run over the last two years, and is coming closer to the levels reached in the Tech Bubble--only this time around, it's the consumer-spending-on-frothy-assets-and-financial-stocks-on-M&A Bubble as a result of easy credit expansion and the exponential growth in derivatives that "hedge-out" risk (provided that nobody defaults). A self-reinforcing phenomenon occurs here with two factors: (1) consumer spending and financial returns based on rising asset values (2) rising asset values based on increased consumer spending and financial returns.

Nominal S&P returns in the last 5 years


Nominal S&P returns in the last decade (tech bubble included in 2000)


Again, I repeat, foreigners (who fundamentally would view the dollar as an important consideration in investment decision making, and those more keen to inflationary pressure and American froth than we Americans) have seen little appreciation in the value of their investments if one were to adjust market returns in terms of their currency (look at the charts of dollar value of other currencies above). This tells a true story about the "real" wealth actually being built in the United States.

And the bit going around the market talking about how a "weak" dollar will help the American economy is declaring ignorance of the painful short-term effect of a continuing weak dollar. Namely, a slow-down in consumer spending, and a flatting and falling asset market that Americans pride itself on. Longer-term, the macroeconomy will adjust, and maybe we can see the United States actually making something "tangible" again in the future instead of just shuffling money and intellectual property, but nobody can predict when this long-run is. The case in point is that inflation in Ameica will hit sooner or later, and the factors have already been set in motion: (1) calls for a weaker Chinese Yuan that will increase consumer prices across the board (2) falling real estate prices and defaulting mortgages hurting consumer spending and financial returns over the next year or two (3) drying liquidity as capital loses value in the form of less trading, less M&A, and unwinding of the Yen carry-trade (4) yields too low to chase--which eventually but surely must happen unless the entire investment community collectively lose their minds.

All the money that's been spent in the Iraq War and the war against terrorism, and all of the money funneled into foreign central banks (such as China's and Japan's) will also play a role in increasing the money supply in the US. Although the velocity of these "eurodollars" are not enough to create rampant inflation in their current idle state, it would be interesting to see if any of them would make their way back into the states eventually as the dollar continues to weaken and money floods back to buy American goods. We would all be much poorer when that happens if we don't invest appropriately...

Whatever lessons this situation could tell us paints a picture of much uncertainty in the future. Stock prices will not increase forever, and macroeconomic conditions, although benign currently, are starting to slow. Making "real" money is difficult, but money in large doses as according to hedge funds and private equity funds still is performance since inflation doesn't hit that hard in its current manifestation. The investment outlook of any prudent investor should be one of caution as we move forward. Nobody can predict the timing of the unwinding of this seemingly stable disequilibrium (if it even unwinds in our career), but an investor can always protect against these events by going into foreign markets, and investing in sound businesses uncorrelated with the market at large that are cheap (something that calls for much more qualitative research in the microeconomic perspective). Just don't buy into the easy solution of investing in whatever grows that will most likely continue to grow so long as the economy is doing well and excess liquidity never stops.

w00t, that sure was long-winded. Probably would have tons of grammatical mistakes and concept left out if i were to go back to read it too... but that's my two cents, for whatever its worth (which will probably turn into one cent sooner than we think)

S&P is falling down... doo da... doo da...

Yes! 3.0%+++ fall! Finally, some sense in the markets... could this be the beginning of cheap stocks again? :D *crosses fingers*

Bernstein argues CAPM

'Capital Ideas' Or 'CRAP'?
Peter Bernstein Takes Up Cudgels To Defend CAPM Against Behaviorists

A cordial but pointed letter hit my inbox not long after w@w's Dec. 1, '06 interview with Dresdner Kleinwort's James Montier appeared. None other than Peter L. Bernstein was taking exception to potshots James and I had aimed at the Capital Asset Pricing Model during our chat. Not the least of which was James' suggestion that CAPM should be renamed "CRAP," for "completely redundant asset pricing." And his charge that "an awful lot of the pseudo-scientific revolution in finance is...based on some very fraudulent assumptions."

Peter, the author of the financial classic, Capital Ideas, and a forthcoming sequel, called Capital Ideas Evolving, which is due to hit bookstores this Spring, quite naturally sprang to the defense of the financial theories that are, in considerable measure, his intellectual charges. "Your readers should understand," wrote Peter, where CAPM "fails and where it works." How could I refuse to give him the floor? I quickly read the partial manuscript Peter kindly sent to me, and arranged a conference call with James. Listen in.

KMW

I've enjoyed reading the selections from your new book that you sent, Peter. When will Capital Ideas Evolving actually be published?

Peter: We're hoping to get it out during April. There is a CFA Institute conference at the end of April at which I'm speaking and they have asked to have the book available. Wiley is going crazy to get it all done and so am I.

A publisher is actually rushing a book into print?

Peter: Yes. Of course, there's a cash register at the end of the line. Seriously, Wiley is a great publisher. I love them. This will be my fourth book with them.

James, you're also in the throes of authorship--

James: I am indeed. Also with Wiley, and I haven't got a bad word to say about them, either. So there's a deeply worrying consensus that they're quite competent.

Peter: Good for you.

Peter, correct me if I'm wrong, but your work-in- progress seems to be about how the theoretical underpinnings of finance have changed since your bible, Capital Ideas, was published--how long ago?

Peter: In 1992.

So 15 years later you feel a new book is necessary to defend the Capital Asset Pricing Model, and all the rest of the Efficient Market Theory, against the predations of behavioral finance theorists--like James?

Peter: Two thoughts at once: The original book was really about the development of the theory and only incidentally presented a few little illustrations of how it was being implemented. Since that book came out, and really since before that, since the options pricing model came out in 1973, there have been no new developments in the theories. But there has been an explosion in implementation, and that's what this new book is about.

Even the theorists who were described in the original book (the ones still alive) are all still active in business in one form or another. And they're all involved in implementation now. As Robert C. Merton, the Nobel Prize winner (he got his Nobel Prize for his work on the options pricing model) says, "I'm not really interested in theory anymore. I'm a plumber and I'm interested in putting all of this stuff to work." So the theme of the new book is that the ideas are alive and well, though not exactly as they were described in theory. They have profoundly influenced the way people manage money today. Our views of markets, our views of how to allocate resources, our views of how to manage risk, indeed, our views of the centrality of risk to the whole investment management decision, are colored by this literature. Nobody says that the world works the way the theory described it. But we view the world of investing today entirely differently from the way we viewed it before 1952, when Harry Markowitz wrote "Portfolio Selection." It's just a total break and these ideas infuse the strategies, the allocations, the risk; everything that active as well as passive managers are doing is colored by this. That's the theme of the new book.

Don't you write, at one point, that the influence what you call "capital ideas" have had is ironic, since their intellectual underpinnings have been shown, time and again, not to work? You say even Professor Markowitz expressed serious misgivings about the assumptions behind CAPM.

Peter: Nobody, nobody claims that the theories work. In particular, the Capital Asset Pricing Model has been proven, over and over again, even as far back as by Fischer Black, to not "work." But I think the best quote in my book is from a man named Louis Menand, a Pulitzer Prize-winning author and professor of English at Harvard University, who wrote an introduction to a new edition of Sigmund Freud's classic, "Civilization And Its Discontents." What Menand said about Freud I think exactly applies to Capital Ideas. Which is, "The grounds have entirely eroded for whatever authority it once enjoyed as an ultimate account of the way things are, but we can no longer understand the way things are without taking it into account." I think it's exactly the same case here. We know things about how markets work and the centrality of the risk/reward trade off and diversification and so forth that just weren't part of the investment process before these ideas were set forth.

Just to make sure no one's confused, when you talk about "capital ideas," you're referring not just to CAPM, but--

Ideas such as the dominance of risk in decision-making, the pricing of assets in competitive markets, the power of diversification, the huge hurdles involved in efforts to outperform the markets, and the giant step forward provided by the development of the options pricing model. In short, I use "capital ideas" to refer to Markowitz's work on portfolio selection, Franco Modigliani and Merton Miller's revolutionary views about corporate finance and the behavior of markets, the Sharpe-Treynor-Mossin-Lintner Capital Asset Pricing Model, Eugene Fama's explication of the Efficient Market Hypothesis, and the options pricing model of Fischer Black, Myron Scholes, and Robert C. Merton. They established the basic structure. So even though things aren't priced that way and the market isn't completely efficient or any of that stuff, they're the benchmarks by which we make judgments. That's how we can take the track record of a manager and say, did this guy perform or didn't he perform? In the old days, they just said that he beat (or didn't beat) the market. Today we have a more interesting and more thorough and more profound way of making a judgment about a money manager's performance.

More complex, certainly. But the human mind is also incredibly complex and still poorly understood, and I suspect George Soros is onto something when he talks about "reflexivity," and the ways in which our interpretations of reality actively shape that reality. If we start out from a theoretical base in CAPM and the Efficient Market Theory--which have been proven not to work in practice--how can we have confidence in the convoluted structures of modern finance that have been built atop them? The layers upon layers of derivatives markets, for instance, with all of their mechanisms for diffusing risk, upon which we now so heavily depend? What does that say about those markets?

Peter: Well, I can't in any way dispute what you just said and I have plenty of worries about those things. It's a little like the Sorcerer's Apprentice. We've gotten a toy and we began to do all sorts of things with it and now we don't know whether we can control it. There is a very important point that I emphasize in my new book, something that Paul Samuelson said in a dialogue with Robert Schiller: Markets are, to a large extent, micro-efficient. The market is hard to beat. Nobody says it isn't. But the markets are macro-inefficient and this means that risk and return for the market as a whole can go haywire. I don't think anybody disputes that. You can't, because reality shouts that back at you. And there is nothing in these ideas that says that markets won't go haywire, because there are human beings out there making the buy and sell decisions. My very first chapter is called, "The Behavioral Attack." There's no question that the analysis of irrationality in making decisions and the heuristics and so forth that behavioral finance has pointed to are for real. But it is also true that these behavioral theories are, in a way, making the market more efficient; making the basic theories closer to truth.

How so?

Because they present new opportunities for active managers to seek alpha. And the more mangers who find ways to seek alpha, or to try to beat the market; the more difficult it's going to be to do it. Throughout the new book, I cite major players in the market with great track records, like Jack Treynor, like David Swensen at Yale or Barclays Global Investors or Goldman Sachs. They all say that it's becoming increasingly difficult to beat the market. There are so many smart people out there.

Isn't that kind of a de rigueur demurrer?

Peter: Excuse me?

Isn't it pretty much pro forma for them to say something like that before going on to boast about what they've done?

Peter: Well, I think that it is true. It is increasingly difficult to beat the market. And the competition is fierce. The phenomenal growth of hedge funds is a very interesting development in this sense--because hedge funds are much less constrained in what they can do than somebody who's given a mission to beat the S&P 500 or beat EAFE or whatever. Most hedge funds are free to do whatever they want. This means that they can wander around the markets, wherever they see opportunities--and this means that opportunities are being closed because they are grabbing them. When I spoke with Bob Litterman at Goldman Sachs, he just kept repeating over and over again that the markets are not in equilibrium--but that's where they're heading all the time because people are trying to seek out returns where, relative to risk, they can do better. I also believe--and this comes directly out of the Capital Asset Pricing Model--well, let me step back a minute. In the 1970s, Fischer Black, who developed the option pricing model, and Jack Treynor, the longtime editor of the Financial Analysts Journal, wrote an article together on how to use all this stuff in securities analysis. They made the point that there is a profound difference between your asset allocation decision--how much you want to have in stocks, bonds and whatever--and deciding which particular items to include in each asset class. These are completely separate decisions. Two people could have entirely different views on the outlook of the market--I'm a bear and you're a bull--and yet we could still agree that whatever assets we have in the stock market should be invested in the same stocks. Because these decisions are so separate. It's from that idea that we've now developed a lot of strategies called "portable alpha," in which the whole search for performance that beats the market is entirely separate from the people who are doing the asset allocations. This is a big step forward in management and I think it's again something that will tend to make markets more efficient--because it exposes the opportunities in a way that we never thought about them before.

Or less efficient, if you're a real cynic like me. Because now you can add layers upon layers of consultants.

Peter: I agree! Layers of consultants do not add to market efficiency. Not all of them, anyway. There are some I would be happy to consult with. But are there a lot out there that specialize in BS? Yes. They create opportunities for the smart guys.

James: Can I jump into this conversation at this point?

That's why we invited you.

James: Yes, absolutely, the consultants create opportunities. But Peter has said several things that struck me. He mentioned Bob Litterman and his notion that markets are driven towards equilibrium. This strikes me as a fatally flawed idea--very few institutional managers stood up against the tech bubble; most decided to ride it (many in a cynical fashion, knowing what they were doing was "wrong" but keen to deliver short-term performance). If the arbitrageurs don't arbitrage then equilibrium has no real meaning. I would also question whether Samuelson was right about the market being micro-efficient but macro-inefficient. If that were the case, value managers wouldn't be able to outperform over the long term. So I think the evidence suggests that markets are both micro and macro inefficient.

Another of the things that has struck me is that Peter started off with a discussion on Freud. I find that most intriguing because modern-day psychology, as Peter identified, has quite clearly turned its back on Freudian thinking. Or, to be more precise, academic psychologists have moved a long way beyond Freud, and yet practitioners haven't. There are still an awful lot of clinical psychologists who allow themselves to use a Freudian framework for their analysis. I think the parallel is similar to the one that Peter is trying to draw. But it is just slightly different, in as much as CAPM and the whole idea of alpha or beta, it seems to me, are still really being taught. CAPM is still the only thing that is taught in business schools around the world--perhaps with arbitrage pricing theory, but the central formula is the same there. So students still come out with their MBAs, having been drilled in CAPM, and practitioners still use these models. Yet I can't help but think that the behavioral critiques that have been leveled at a lot of your "capital ideas" do actually invalidate the use of CAPM, for instance, in all sorts of ways.

Another of the points that Peter made was about the difference between a constrained and an unconstrained manager in reference to hedge funds versus, let's say, traditional long-only managers. Yet the constraints themselves really grow out of CAPM. Then too, whilst Peter is emphasizing the benefits that CAPM has provided in terms of alpha and beta separation, I suspect those benefits are probably clearer on paper than they are in practice, put it that way. But even if we accept that there are benefits from alpha and beta separation, it should also be recognized that CAPM has delivered some very undesirable side effects.

What sort of nasty side effects?

James: Take Wall Street's obsession with benchmarking. That undoubtfully comes from CAPM, as well as the constraints themselves. The ideas of benchmarking and of relative performance; this obsession with following a capitalization-weighted index falls out of CAPM. Also the whole idea of tracking error and of professional fund managers worrying more about tracking error than they worry about delivering positive returns. So whilst CAPM may have generated benefits, it has also generated some pretty severe problems for the financial system.

Peter: I can't disagree with that. But I'm not making a value judgment. I'm trying to say how the world works and making the observation that it works differently now. I still think this is a better way to think about investing than--I mean, I came into this business in 1951, which is not exactly yesterday--

No one will dispute that, either!

My point is that when I think of how we approached investing-- We did believe in diversification and there was a Benjamin Graham coloration to what we did. But otherwise, there wasn't any system beyond sort of trying to be diversified, which was a good idea. Yes, there were "businessmen's" stocks and "widows and orphans" stocks, but there was no systematic way of thinking about it. You can reject "capital ideas," and say, "I'm not going to run my portfolio this way," but CAPM and the rest provided a place to begin. Just as clinical psychology would not be what it is today if there hadn't been Freud, and just as we wouldn't think about savings and investments and fiscal policy in the same way if John Maynard Keynes hadn't been there--even if a lot of what Keynes wrote about how the economy works is not necessarily relevant today. So that's my point, the notion that these ideas give us a way of thinking. We can accept them or reject them or try to beat them or get around them, but they're there. We can't think about these things without CAPM.

My question--

If I could just go on to make one more point. There's a big step forward that I think came out of these "capital ideas," quite aside from the details. I'll just tell a short anecdote. When I was working on Capital Ideas, the first person I went to see, after Samuelson, who is a very old friend, was Harry Markowitz--because he started the whole thing in 1952 when he wrote about the trade off between risk and return. Markowitz had been in operations research; he didn't know anything about the stock market. Somebody suggested he should do his thesis about applying operations research to the stock market, so he went to his professor and asked, "How do I learn about the stock market?" The professor said, "Well, there's a book by John Burr Williams called, The Theory of Investment Value. Read that, it is a wonderful book." Well, John Burr Williams says that you should buy the one stock that has the greatest value. When Markowitz read that, he said to himself: Yes, but you have to think about risk as well as return. You can't just think about return. You have to think about risk at the same time. This was a thunderclap. From that point forward, sophisticated investors wouldn't make decisions without thinking about risk. Indeed, we have no control over return. Risk is the only element in the portfolio management process that we can control. When I think back to my early days in the business, in 1951, we used the word "risk" only casually. But now it is central to every sophisticated investment decision. That's like Freud. It's part of a huge leap forward. Risk is a very simple four-letter word but it has changed the investment process.

Not to denigrate Prof. Markowitz's contribution in putting risk front and center, but earlier investment thinkers, such as Ben Graham and Gerald Loeb, also considered risk. They perhaps also had a better grasp of the multifaceted nature of market risk.

Peter: Yes, that's what gives their works lasting importance. They talk about the consequences of being wrong and how you deal with that. That's what risk is really all about. I think risk control was more central to Gerald Loeb's thinking, because he says you should only invest a little bit of your money, but invest it very aggressively. So his consideration of risk is much more built-in than it is with Graham. Granted, Graham says one of the attractions of value investing is that it's a low-risk strategy, but that's different. Loeb had a very big impact on me when I first read him--more than Benjamin Graham did.

James: I just finished writing a paper on Keynes and Graham, looking at some of the similarities and differences between the two when it came to investing. This aspect of risk is interesting. What I would say is that Ben Graham defined risk in a way that is still used by deep value investors, like Tweedy Browne. In The Little Book of Value Investing, Christopher H. Browne talks a lot about how risk is defined in terms of business risk. It is the risk of buying a bad business. Whereas I think the problem with a lot of the financial theory is that, in it, risk is equated to price volatility. It's that--the equation of price volatility to risk--that is probably one of the worst aspects of modern finance. It's why risk really is a four-lettered word as it's used in finance, because it misleads. Price volatility is, of course, what creates the opportunities for us--as well as, obviously, inhibiting a large number of investors from actually exploiting those opportunities.

Peter: I both agree and disagree.

James: What a very balanced man you are, Peter!

Peter: Yes, I'm a balanced manager. There are two sides to it. You're right, volatility presents opportunities. But the meaning of risk itself is opportunity. It means we don't know what's going to happen, but just because we don't know doesn't mean that what's going to happen is necessarily bad. So risk-taking is a positive step, risk management is a negative step, but both things are going on there and I don't think that there has to be a confusion between them. For a longer-term investor, volatility is opportunity, no question about it. For a trader, it's a problem if he's wrong. But there's another element of volatility that I think is important. It is a proxy for risk in the sense that it hits you in the gut. When the market is jumping around, it's a lot different owning stocks than owning Treasury bills. It is an entirely different experience. If the market gets more volatile, we worry. "What's going on? Somebody knows something more than I do." So while I agree that volatility was made a proxy for risk because it works mathematically, I think it works in the gut, too. No matter how calm you are, no matter how a long-term an investor you are, no matter what your horizons, when the market is jumping around, you feel uncertainty in your gut and it's hard to resist that. So I don't think volatility is an altogether irrelevant proxy for risk, even though--to a cool, dispassionate investor with a long-term time horizon--volatility is wonderful.

Shouldn't you refine that a bit, Peter? Volatility only hits you in the gut when it's going against you.

Peter: Yes, that's true.

James: And if you're a short-side manager, that leaves you worrying about upside risk.

Peter: Yes, it can be either way. But I don't think that takes away from my point--that volatility hits you in the gut. Aside from its mathematical malleability, which has been very useful to the theorists, volatility creates a greater sense of uncertainty than you have when things are smooching along and you think, "Oh, everything is fine." So I don't think volatility is irrelevant.

Not irrelevant. But it's a poor--misleading--definition of risk. After all, volatility is the lifeblood of all of the great investors and traders you profile in your new book. Whether we're talking about a trading firm like Goldman or a hedge fund manager like Cliff Asness, they need the action.

Peter: Yes, I mean, Litterman at Goldman is rhapsodic about volatility. But Litterman's every other phrase is "risk management." It's one thing to say, "This is where I'm going to make my goodies," but you can't just jump in and do it blind. Volatility puts a greater need on you to be able to manage the thing. You're in boiling waters, so you have to be sure you know what you're doing. That just proves my point: If you're a manager who eats volatility like ice cream, you've got to control yourself, too, and be sure that your portfolio as a whole is not subject to the kind of volatility that you have in your individual holdings.

But is that really possible? If all those calculations are based on assumptions that are, at bottom, bankrupt--like equating risk and volatility--aren't we just using all of those fancy models to delude ourselves that we're controlling risk? All of Goldman's computer programs quite evidently give it an edge--for now. But something always goes haywire where humans are involved.

Peter: If you're going to seek out volatility because that's where opportunity is, you don't want your entire portfolio to be volatile, you only want to make volatile bets within it. You have to be sure that there's some systematic arrangement of the bets that you make so that the portfolio risk in the total portfolio is not as volatile as the individual components. One of Markowitz's great insights was precisely that. That you can take a lot of high-risk bets--as long as they're not correlated--and come out fine. I don't see what's fraudulent about trying to do that.

Fraudulent may be too strong a word. The problem is with the measurement of "risk" and with the correlations. All sorts of "normally" uncorrelated bets have a way of becoming correlated at precisely the wrong time.

Peter: Well, this is what Litterman gets paid for, but this is the risk that any investor takes. Suppose you're not Litterman; suppose you're Joe Blow. You're exposed to that risk all the time. As I said, the markets are macro-inefficient. They can go haywire. That is a matter that you deal with through your asset allocation in the first place, so that you don't get killed if the totally unexpected hits you in the face. But I don't think that the existence of that macro-inefficiency negates what Litterman is trying to do. I'm sure that Goldman's asset allocation is very carefully done with that possibility in mind. Any rational investor would do that. My own affairs are run that way because I know that extreme outcomes can happen and I don't want to get killed. But that doesn't mean that I'm not making bets in the middle of the portfolio somewhere.

James: I have a wonderful quote here, if you're interested, from Ben Graham, and another one from Maynard Keynes. It always strikes me when I look at this that Ben was a little bit more wordy than Maynard Keynes. I'm not going to put that down to Ben being an American; I can't get away with that because effectively they were both English. But Ben once said, "The investor with a portfolio of sound stocks should expect their prices fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of, or to be ignored." I think people do get hooked up on what prices are doing, perhaps far too hooked up, or maybe we've reached a sort of final state of informational deluge where we actually can't separate out noise from news anymore. But here's the quotation from Keynes, which as promised is much shorter: "It is largely the fluctuations which throw up the bargains, and the uncertainly due to the fluctuations which prevents other people from taking advantage of them." That one, to me, just sums up the whole essence of the investment problem. In order to actually be a half-decent investor, you have to do something that is different. Far too many people today are busy worrying about their tracking error and their distance from benchmarks, rather than worrying about whether they're buying good or bad businesses at reasonable prices or at ridiculous ones.

Peter: The source of the tracking error problem is not the portfolio manager, but the client.

James: Yes, that's a fair point; absolutely a fair point.

Peter: This is a point I didn't make in the new book but I probably should have: That clients are the villains of the piece all-too-often and, as Kate suggested, consultants. They are the villains to a much greater extent than the managers, who would love to be freer. But both these statements, which are extremely wise and wonderful, relate to capital that has no liquidity needs, and a lot of capital does have liquidity needs in one form or another. I mean, a pension fund maybe has a longer horizon than a brokerage prop desk. But particularly in an era like the present, where the current cash return (the dividend returns and interest rates) is low, spenders do have to think about liquidity needs. So it's not irrelevant to care what prices are--because you may have to make use of them. Sure, if you don't have to make use of prices, if you're locked up or if it's a pool that has no claims on it, then--I'm a consultant to a very big family trust--it's in the billions of dollars--that was set up so that it could not distribute the principal for a very long time to the family. Actually, it's based on the life on an individual who has turned out to live to 102 years old, so far. So everybody is sitting around waiting for this poor lady to meet her maker.

I hope she employs a taster!

Peter: She is just fine. This trust was set up in the early 1970s. They put the money 100% into common stocks and said: We don't care what happens between here and there, because liquidation is a long way off and we want to be sure we can beat inflation and have an income stream that rises. They've been religious about this and perfectly happy and they see market declines as opportunities because they can take lower capital gains if they want to make a change to the portfolio. But that sort of investor is a very rare bird. In particular, the steadfastness with which these people have held to their policy is extremely rare. And it is beginning to weaken now because the lady is 102.

James: At that age, I'm sure. But I have always thought the world would be a much better place if all fund managers were forced to ask themselves, would they do something in their own portfolio. If the answer is no, then why are they doing it for clients?

Peter: They've got another 10 years before they have to distribute, but it's going to change the flavor of the portfolios.

Clearly, liquidity needs vary all over the map. Yet hasn't much about the way modern portfolio "science" evolved conspired to push investors into short-term strategies? Now that portable alpha and active management have supplanted passive indexing as the styles du jour, we have the spectacle of pension funds with very long-term liabilities rushing into hedge funds employing very short-term strategies--often while tying up chunks of their assets in highly illiquid investments. All because that's what David Swensen did so successfully 15 years ago. And there's no small element of truth in the complaints of corporate-types that shareholders' relentless pursuit of short-term performance hobbles their ability to manage their businesses.

Peter: I agree with what you're saying. But I don't think you can blame that on portfolio theory. And, in part, there is some diversification element to all this which is positive. I don't know whether it's true that we live in a time when we're going to have low returns. But certainly, on the basis of the pricing in the markets and so on, we are in a period of low expected returns--without any diminishing in the liabilities that we have to meet. So there is pressure to find returns in places that we didn't find them before. Whether this is a good set of choices and whether the pension funds, for instance, can execute on them, I don't know but--

Want to place a bet?

Peter: I agree that what David Swensen did at the beginning of his tenure at Yale, when it was easy to pick the good alternative investments, and when he was very welcome in that space, is very different from the situation today. I'm uncomfortable about this and have expressed that, too. Sometimes it's better--if it's a period of low expected returns--to be patient. Because that's not going to be the case all the time. But again, I don't think you can pin this on "capital ideas."

What would you pin it on instead?

Peter: Just how the hell do we make a living when dividend yields are less than 2% and long-term interest rates are under 5%; when real rates are this low? Where are we going to make a buck? That's a fair question to ask. Whether today's answer to it is the optimal one, we'll only know in time. Somebody as thoughtful and skilled and, I think, as brilliant as Marty Leibowitz [of Morgan Stanley] feels that there's enough diversification in the alternative investment area to justify doing it. Sure, you have to limit to how far you go, but that is a perfectly decent place to go. Just putting assets into the bread and butter stock market is not always the best decision, either. So I don't see any reason not to mix it up. But to think that it is easy; that going into alternative asset classes is easier than picking stocks or that the managers of those things have some inherent ability that somebody else lacks, is an oversimplification. On that, I certainly agree, but the scheme is not a crazy one.

James: I guess the problem is the one you identified. There is almost a first-mover advantage in these markets. That is what someone with the foresight of a David Swensen recognized. Now, the very great problem is that everybody is doing exactly the same thing.

Peter: Yes.

James: And the correlation amongst hedge funds themselves has soared. It's .7 or .8 on a range of strategies supposedly as diverse as convertible arbitrage and emerging market equities. Obviously, these things should have zero correlation, but they don't, because everybody is doing the same thing.

Hedge fund managers are theoretically unconstrained but in reality they're just as much a part of the herd as everyone else.

James: Yes.

Peter: Yes. Clearly, this was not the vision when it began and I have not had the chance to go back to Swensen and ask him how he feels about the little monster that he's created. He was a pioneer when he said that the only way to have a successful institutional portfolio is to make uninstitutional decisions. But those uninstitutional decisions have now become institutionalized, yes.

One of the scourges of modern life is that the crowd very quickly catches up with innovators. In fact, I'm wondering if the ubiquity of the computer isn't more responsible than "capital ideas" for the changes we've been talking about in finance, Peter.

Peter: I think they go together. The computer is--I can't find the word. The magnitude of its influence is pretty obvious. The computer has provided the means for implementing some of these "capital ideas" in ways that you couldn't have imagined with a slide rule. The real thing about computers is the speed at which they work and the volume of information that they can process. The other day I was reading the new Wall Street Journal. They now say: We have this free internet page for you if you want to see what's happening in the market. When I clicked on that thing, I thought: "My God, who needs Bloomberg? This is unbelievable." So my view is that the development of "capital ideas" and the introduction of ever-more powerful computers have gone hand in hand.

But haven't computers allowed a lot of models to be implemented, in size, without--necessarily--a whole lot of thought? (Something that we humans tend to be all-too-happy to do without.)

Peter: They screwed up pretty good before the computer too--

Yes, but everything happened much more slowly. And had many fewer zeros attached.

Peter: After all, 1929 and 1962 and 1974 were all events that took place before the computer. The computer just adds different ways of doing it.

But those train wrecks happened in relatively slow motion. Even crises like Penn Central and Drysdale Government Securities that I recall from early in my career unfolded at a pace I'm sure my kids would consider antediluvian.

Peter: Well, there's an even bigger difference. In every one of those financial crises, some big financial institution went bust, or New York City nearly went bust. There were major bankruptcy problems in every one of them. I'm not sure that I'm secure about this as a prediction, but just consider that the crash in 2001 was a big shock. The market decline started from a very high level. God knows, there had been a lot of crazy speculation--and yet no financial institutions blew up. The only companies that blew were things like Enron, where they were doing crappy accounting, and those failures didn't matter. They were independent events. That's pretty amazing. I don't know whether it's going to be that way the next time. But when you think about the magnitude, the suddenness, of that crash and the number of people who were involved in the market in some way, and that no institution blew--well that took me by surprise. I was waiting for it any minute. It's very interesting.

That surprised me, too. But I'm still not certain that some sort of systemic crisis or washout hasn't merely been postponed.

Peter: I'm not nearly as secure about the next one, whenever it comes, because the derivatives business has gotten so much more complex and involved and financial institutions--I'm talking about the banks, who used to be in the business of collecting deposits and lending money--are now deep into derivatives and the whole mortgage business is a derivatives business. How that will hold up when the heat gets into the boiler next time, I'm not nearly as confident. To say nothing of the world's currencies and what goes on there.

You didn't gather any particular insights into that while working on your new book--any reassurance or lack of assurance?

Peter: The book didn't provide the answer to that, no. But I have been preaching for several years that we don't know what's going to be the trigger. Nonetheless, the conditions are in place for extreme outcomes, particularly in the dollar, and these have to be hedged. You can do all the normal kinds of investing you want in the center of your portfolio, but the outsides of your portfolio should have hedges against these extreme outcomes. The necessary conditions are there. I still don't know whether it's going to happen. But if I knew when, I wouldn't just be hedged, I'd have a whole different portfolio. It's like the story about the man in the lunatic asylum who receives a visitor, and the visitor says, "You don't have any clothes on." The crazy man replies, "Well, nobody ever comes to see me." Then the visitor says, "But you have a hat on." To which the crazy man retorts, "Well, somebody might come." I think this as a very good investment lesson.

James: The power of the option.

Peter: Yes, the power of the option.

Assuming you believe someone will make good on it.

Peter: This is why Gerald Loeb is basically in my soul.

So at the same time that you're celebrating the whole financial construct built on "capital ideas," you're standing back and saying, "But don't trust it."

Peter: I don't see any contradiction there. I mean, the markets can go crazy. Nobody can deny that. But what I'm saying is that the way we think about investments and the way we lead up to our decisions and the kinds of judgments that we make are the not the same as they were before all these ideas came to the fore. What I call "capital ideas" have opened insights and opportunities to people that they probably would not have seen before. God knows, the options pricing model, which was the last of these ideas to be developed and grew out of all of the others, has changed the world. In many ways, it has done so for the better because it has opened so many different kinds of opportunities for risk management. But it also has, like everything in life, the seeds of its own destruction within it. Somebody has referred to the option-pricing model as a bombshell and that really describes it.

James: The problem with bombshells is that they tend to explode.

Peter: But I don't see how that dilutes my theme. The theme is not that everything is going to be benign and wonderful because of Harry Markowitz and his followers, but that the ideas they promulgated have changed the way that people invest in a very profound way. "Capital ideas" have, in many ways, exposed opportunities and means of dealing with risk that people didn't think about before. They've made risk a central part of the investment equation. For sophisticated investors, risk is the beginning and the end of every investment decision.

But there's the rub, Peter. If we're using a definition of risk that elegantly fits mathematical models but doesn't begin to capture true investment risk, what does that say about the investment processes and all of the convoluted financial structures built on top of it?

Peter: I didn't say that you have to define risk in terms of beta volatility. I define it in terms of the consequences to me if I'm wrong; that's how I measure risk. If I make a decision that turns out to be wrong, how much do I care?

How much can you lose, you mean?

Peter: Yes, What are the consequences to me?

But you're an extraordinarily clear-eyed practitioner--while legions of portfolio managers and institutions hang their hats on much more simplistic definitions of risk.

Peter: I do not cheer that. You don't have to buy beta as the definition of risk to manage risk. But it depends what your client wants. In my case, I am my own client. I brought up that family trust because they clearly understood what their risks were. But very few investors do. That's true. Nonetheless, there is no law that says, because you have to think about risk as well as return, that you have to define the word "risk" only in the sense of volatility. I mean, covariance is an important part of risk. In fact, that's really where Harry put his emphasis: That diversification is the beginning of risk management. Indeed, that's my religion. Diversification is an explicit statement that I don't know what's going to happen. Nobody knows what's going to happen. If they act as though they know what's going to happen, they're going to get screwed. That's where the truth lies.

James: Part of the problem is that all of these terms, "diversification," "risk," have so many different interpretations. One interpretation is a very narrow one, which is the one from the academic literature: "Risk equals price volatility, diversification, covariance and correlation." However, the way you are talking about interpreting them, Peter, is in a much broader sense.

Much richer.

James: Yes, a much deeper sense, which is probably right. In many ways, it is the same way that some of the all-time great value investors have also defined risk. They run concentrated portfolios, say of 20 or 30 stocks, but they are diversified in terms of the industries that those firms are operating in and so forth. So they have a degree of diversification there, which would not come up in the traditional academic sense of diversification. The problem is that there is a tendency to follow the mathematical attraction of the simplistic definitions of risk and diversification, which sort of bedevils our industry as a whole, whereas a broader perception of the concepts is probably more important to grasp than the technical details of the calculations. But too many people in our industry prefer math over thinking.

Peter: I guess. How many of them really use the math and how many think the other way, I don't know. But I agree that math does not provide answers. It may provide insights, start you going someplace, but it can't rule the decisions--unless you do a particular strategy where it works. You can't be in the options business without doing math--

James: That's the reason I'm not in the options business!

Peter: But when it comes to stock picking or bonds--well, bonds are all math. But what's going to happen to the rate of inflation, which is really where the bond business starts, is not a matter of math.

Doesn't it come down to this: The super investors you're writing about are people who've been able to take your "capital ideas" and profitably turn them on their heads, in one way or another, before anyone else?

Peter: Yes, yes.

While the great unwashed, all the portfolio managers who dutifully apply the calculations they learned in school, produce at best mediocre returns?

Peter: Yes.

James: That's something that we're all agreed on.

It's not a particularly grand insight--

Peter: But there's a bigger insight than the one you just expressed. Portfolio theory says that the market is the dominant influence on returns. So those people may screw up and may not beat the market, or maybe they get lucky and beat it, but ultimately the market is going to determine how they come out. The market is the dominant influence. It's a simple idea but a very, very important one.

But what is "the market," Peter?

Peter: What do mean, what is the market? If the market goes up, I get wealthier. Whether I get as wealthy as I would have liked or as wealthy as I expect or anything like that is secondary. I am wealthier today than I was a year ago, without even trying, if the market is up 15%.

Only if you were in the market, "without really trying," or passively. And only because of price movements that were produced by the collective actions of active investors--and of whoever you delegated to manage your passive investments. The market is an auction.

Peter: Yes.

With prices set when bids and asks meet, usually, but not necessarily, along a relatively orderly continuum.

Peter: Well, I commented to my wife yesterday about how well we had done this year and she said that's because I have such a great manager. I said, "Don't thank me, thank the nice people who are willing to pay higher prices for the assets we own." That's really how it works.

I used to have a client when I was managing money who loved to give money away and he'd tell me, "Thank you so much for what you've done to enable me to do this." I would say, "Don't thank me, I'm not the guy who pushed the prices up so you could do it, it's the other investors out there who are willing to pay more for what you own. They're your friends." That's a very important lesson: your wealth is in many ways dependent upon what other people will pay for your assets.

James: It's an interesting point you raise, Kate: "What is the market?" Because going all the way back to where we started, with CAPM, there is a very precise definition of "the market" embedded in CAPM. According to CAPM, the market is the capitalization-weighted index. That is the efficient market that everybody is supposed to hold under CAPM. But that means, to my mind, that you get a blurring of alpha and beta and that's why I'm not yet convinced that these concepts are terribly helpful to investors. When you look at things like Rob Arnott's [of Research Affiliates LLC] work on fundamental indices, where he re-weights the index using dividends and earnings and sales and so forth and adds 2% to 3% to performance with less volatility than the capitalization-weighted benchmark--that makes no sense in a CAPM world because in a CAPM world, the cap-weighted benchmark is the mean variance-efficient benchmark.

Peter: That's right.

James: It intrigues me that you can blur the line between alpha and beta quite as easily as Rob has managed to do. Some of the work around CAPM, I think, almost distracts from the fundamental problem in the investment business, which is how do we generate returns for the ultimate investor?

Peter: Rob Arnott doesn't claim that his fundamental index represents the market. He says this is a different way to do a passive investing fund without doing the capitalization weighting. There are problems with cap weighting. But Rob doesn't say this is the market. He is simply saying this is a different way to index or to be passive, and that's a different kind of statement. The market is the market. Exxon has got the biggest capitalization in the world. And some pipsqueak company has the smallest capitalization. You can't argue with that. If investors took a little drug company and gave it the capitalization of Exxon, it would have Exxon's weight in the market.

Well, look at Google--

Peter: Well, yes, right. So that's what the market says. That's what investors have said and--

Is that rational? The basis of CAPM and the rest of the "capital ideas," is that these are rational decisions. But since when are human decisions rational, especially about money?

Peter: Nobody claims it's rational, but there is this: It is not a crazy idea that the market knows more than any individual knows. This is a very basic idea and it's an important one. All the information is there in one form or another and I don't have it all. Now, I manage my affairs accordingly, with humility. But the market--this is what the market says. It doesn't necessarily mean it's right or wrong. This is what the market says and experience shows that the number of people who can consistently outperform that bogey is a small group. It doesn't say that there is nobody who can outperform the market. Whether they are identifiable or not is a question. But they are a very small group. We talk about them all the time as being counted on the fingers of one hand or two hands. In any event, these are not contradictory ideas and Rob is not saying that his fundamental index is the market. He's just saying that it is a better way to do passive investing--and I think he's right.

James: I guess my problem is that his re-weighting of the benchmark improves on the benchmark's performance, which in CAPM is theoretically impossible.

Peter: Well, he's earning an alpha--

James: He's earning an alpha by re-weighting passive investing, which is beta, which why I think these things are not as clear as perhaps some people make them. Because alpha and beta can be blurred in this fashion.

Peter: I know, you say beta and I say beta.

You say tomato and I say tomato.

Peter: You're right. I just can't train myself to say it that way. We have a Greek associate who assures me that the correct pronunciation is beta, but I was educated in America. And now I've lost my train of thought. What were you saying, James, about beta?

James: The whole idea that you can create alpha by re-weighting beta seems to me to just demonstrate that the nature of alpha and beta can be blurred. Another example, if you like, is hedge fund replication, the fact that some of the investment banks have launched clone funds of hedge funds. Again, the supposed alpha engines are now being duplicated with six-factor effectively beta-style models. So I doubt that alpha and beta are as distinct as CAPM says.

Peter: I think they are distinct but there's no law that says if somebody is generating an alpha and other people begin to copy it, it doesn't turn into beta. There's no question about it. Alpha is very ephemeral and transient in a market that is, if you'll pardon the expression, as efficient as we have. Everybody is looking for opportunities like crazy and you've got computers transmitting these great volumes of information, so it's very likely that alphas will turn into betas. And if enough people-- Rob is very aware of this, we're close friends; had dinner just the other night--if a lot of people copy fundamental indexing, then the character of fundamental indexing is going to change. No question. If everybody did it, it would become the market. I met years ago a guy named Jonathan Berk, who is now the Sylvan C. Coleman Chair in Finance & Accounting, at the Haas School of Business, UC Berkeley. He wrote an article pointing out that small-cap stocks are not necessarily small companies. They're very often the depressed stocks of larger companies. This was the genesis of Rob's idea that the market capitalization and the size of the company aren't necessarily identical and they surely aren't.

James: Yes.

That says to me that the market is as imperfect and inefficient as the people making the buy and sell decisions. Still, we all have great hopes for how "the market" will perform this year.

Peter: Yes.

James: Well, apart from me. I am, as always, perennially bearish.

That doesn't mean that you don't hope for better.

James: That's true. Being a pessimist is a wonderful thing. I always get surprised on the upside.

Do you want the last word, Peter?

Peter: I've had a wonderful opportunity to discuss "capital ideas" and the arguments have been terrific. I'm so glad there were three of us in on this conversation.

Well thanks, then, to both of you.