Bill Werner is an Engineer in Missouri City, Texas. The following is his attempt to Encapsulate All of Modern Economic History (with a bonus push to the future) in one easy to swallow red pill. Turn away and think what you like. Or swallow this red pill leading down the rabbit hole to see another aspect of what I call “The Vast Matrix of Models of Mind-stuff” we abide in.

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“Credit-default swaps… have become mainly side bets on whether some company, or some subprime mortgage-backed bond, some municipality, or even the United States government will go bust.”
-Michael Lewis & David Einhorn in How to Repair a Broken Financial World (2009)

“‘The good part is that no matter whether our clients make money or lose money Duke & Duke get the commissions.’
‘Well, what do you think, Valentine?’
‘Sounds to me like you guys are a couple of bookies.’”
-Trading Places (1983 movie about the commodities market)

“The one thing every trader fears more than death itself is another crash like the one in ’29. They say it could never happen again because of all the safe guards that have been set up… but in our heart of hearts no trader believes it.”
-Martin Schwartz, 1998 “Pit Bull: Lessons from Wall Street’s Champion Trader”

Wall Street hates to be compared to gambling. If one reads the stock fundamental analysts reports and diversifies or buys an index fund, and diversifies further with some agency rated investment grade bonds, investing was said to be a sure fire way to retirement riches. That model is now in serious jeopardy after last year’s credit and stock market meltdown. A quick look at a chart of the Dow corrected for inflation quickly dispels any remnants of that myth.

via Dogs of the Dow

It is shocking to see the Dow, when corrected for inflation, sitting at the same level in 1995 as in the peak of 1929. That is, when inflation is factored in, the Dow was finally breaking even 65 years after the crash of 1929. With the Fed pumping eye glazing sums of money into the economy to combat the present deflation this inflation corrected chart which includes the deflationary 1930′s may be back to the future.

Being presented with both present experience and historical data demonstrating that buying and holding stocks even with diversification is not a sure thing we have no rational choice but to acknowledge we are at risk of losing some of our investment even over a period of many years. Considering the very real possibility of rampant inflation a couple of years out, we could lose it for decades if we are not careful. Take another look at that inflation corrected chart and notice the inflation infested seventies effect on actual market wealth. And then compare it to the standard non-inflation corrected chart for the same period. The standard Wall Street stock market story versus the actual stock market wealth story for that period is a slap in the face now but could be a body blow in a couple of years. It also makes it obvious why the inflationary seventies is when high interest CDs and money markets became popular investments. In other words we are dealing
with deflationary risks we have not seen since the 1930′s and possible inflationary risks we have not seen since the 1970′s. Our models of what is happening will need to be adjusted accordingly.

Just how risky the markets are was well known on Wall Street at least by the traders on the front lines. As Market Wizard Marty Schwartz put it a decade ago, when it comes to the market having crash proof safeguards “in our heart of hearts no trader believes it.” With the advance of a cornucopia of advanced instruments such as options, futures, securitized debt, swaps and other assorted custom derivatives adding both complexity and risk, Wall Street started hiring physicists and mathematicians called quants to evaluate the risk inherent in these derivatives.

The most sophisticated physicists were trained in quantum physics, the bizarre sub-nano world where particles do not have a solid form but are rather waves of probability distributions. In other words the financial derivatives became quarks. The financial quarks exist in waves of Value at Risk (VaR in quant speak) probability distributions.

Any time you are dealing with probability distributions you are gambling. But in finance it is even worse because not only the operating environment for the product is changing but also the rules (government intervention) and products themselves are always changing. Therefore there will never be enough data on the actual circumstances to construct a model with the accuracy we would like. But even if there was enough data a manager somewhere will get greedy and order the “outliers” (unexpected data) be thrown out of the model.

In finance it is as if sometimes the jokers are left in the deck and sometimes not. And when the jokers are in the deck sometimes they are wild cards and some times they are dead cards and many times the player does not know until he plays the hand. Even for financial markets with more or less stable rules and products the fact that they do not have a normal distribution but have fatter tails (higher kurtosis in quant speak, more extreme events for the rest of us) than a normal distribution increases the risks (and rewards) by definition.

For the sake of simplicity let’s assume a best case scenario where we have a market with stable rules and products and a nice neat normal distribution. Even under those ideal (and unrealistic) circumstances not having a risk of ruin component separate from the normal operating model is pure negligence. The reason finance does not take risk seriously is because they always assume a “regression to the mean” will takes place (things will return to normal) and save them, not to mention a deep faith in government bailouts, golden parachutes, master of the universe bonuses etc. Besides the concept of risk of ruin comes out of gambling and Wall Street will never admit to gambling with retirement savings.

Back in the old world of production and plants the rules are different and often more severe. In industry the risk of ruin component in a plant is called an Emergency ShutDown System (ESD, aka Safety Instrumented System (SIS)) and is always separate from the process control system controlling production. The ESD is typically double or triple redundant and much thought goes into making these systems idiot (and manager) proof. This is especially helpful if it is your turn (or my turn) to make an idiot move (or be the manager). If industry behaved like finance Three Mile Island nuclear accidents (1979), Bhopal toxic releases (1984) and Texas City refinery explosions (2005) would be common place.

And if all gamblers behaved like Wall Street firms there would be no professional gamblers. The same could also be said for independent traders. In finance, trading and investing the Emergency ShutDown (ESD) System is typically stop loss orders but can also be hedges such as options, inverse ETFs etc. Remember if you lose half your money you will have to double the remaining half to break even. And if you try doubling up on risk to get your money back and end up losing half of the remaining half you will have to quadruple your remaining money to break even. As Market Wizard Ed Seykota once put it “There are bold traders and old traders, but no bold and old traders.” So take your risks but honor your stops at Casino Wall Street and Laissez les Bons Temps Rouler (Let the Good Times Roll)!

Category: Bailouts, BP Cafe, Credit, Derivatives, Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

11 Responses to “CASINO WALL STREET”

  1. Graphite says:

    I think that you must include dividends when trying to make your case about the hazards of investing in the stock market. Which is not to say that that would negate your thesis, not at all … in fact, it would demonstrate that the *only* point in owning stocks is ultimately to receive dividends, not to cash in on some great fool through capital gains.

  2. Matt SF says:

    Traders who do well use well placed stop loss orders way above 50% losses. Many use 1% stops since the best trades pay off quickly. And if not, they generally decide to reverse their position if the market tells them otherwise.

  3. gloppie says:

    Interesting parallel with quantum mechanics;
    The uncertainty principle definitely applies to market value….the observer’s gaze alone influences the observed quanta, like if we knew the content of the FDIC’s list of troubled banks for instance, or when the SEC shows up at the door…..oh wait, nobody cares about those guys anymore.

  4. Mike M says:

    “It is shocking to see the Dow, when corrected for inflation, sitting at the same level in 1995 as in the peak of 1929. ”

    Not at all. Stocks are a way of preserving your wealth. They are an inflation hedge. Including dividends would provide a real return.

  5. ManoLA says:

    Yes, you need to include dividends (since stocks are actually claims on future cash flow) and also you have to account for the deeply flawed and unscientific construction of the Dow index over time. The Dow, with only 30 components, chosen more or less in a random fashion or according to the current market fads, is useless. I would tend to say that the S&P is not exempt of the similar flaws either. So-called fundamental-weighted indexes are much, much better (see Dimensional and the CRSP). So I’d like to see what these non-traditional indexes look like, corrected for inflation.

  6. victor says:

    To ManoLA,

    you are absolutely correct; but most people still don’t understand the difference between investing and speculating…too bad, because the market can be very unforgiving with these people; here is a prescient old saw: “if you do not know yourself well, the stock market is the wrong place to find out”. Articles like this one tend to appear; during bull markets, the whining stops, replaced by…bragging rights. I tell my friends to follow John Bogle’s advise about where to invest their financial assets: steady as she goes, 50% total stock market index fund, 50% total bond market index fund, period. As for risk, well, it is EVERYWHERE, yes, including in the equities markets!!! Risk CANNOT be completely eliminated from any man made endeavour; but “up there”, who knows?

  7. ManoLA says:

    Not to mention that no-one should use the Dow as a proxy for the market (or the S&P for that matter). An asset allocation based on a blend of index funds (foreign, domestic, small-cap, large cap, bonds) is the correct way to manage risk over time and to capture the long term upside in the market. It’s pretty well known by now that most of your returns over time derive from allocation (and regular rebalancing), NOT market timing. The Wall Street firms are out there to sell you Alpha because they’re fee-based businesses. They know the drill and they know the data – over time you will lose out, but they will retain their fees. All the financial scholarship out there points to the fact that Alpha is not worth the risk taken to get it. That is, if you’re a limited partner. On the other hand, as a managing partner, well, 2+20 is definitely worth the risks you take with your clients’ money. The best gig in town actually.

  8. Porsche87 says:

    @ManoLA & victor
    Sorry, but I have to disagree. Diversification is a fraud foisted upon investors by fund managers. Look at Gates or other billionaires, they didn’t achieve their wealth through diversifying their investments. Let your winners ride and stop out your losers. If you look at horse racing or poker, the intensity of research is close to what the market requires, and the winners put in the time and effort. If you are not willing to do the time, then your advice fits, sort of like playing the odds on blackjack. You won’t win big, but shouldn’t lose big either. I do have to agree with ManoLA, investing with your client’s money with a percentage off the top is the best gig in town.

  9. Deflator says:

    Even apart from the issue of dividends, this chart can’t be accurate. Prices fell about 30% from 1929-33, meaning that real losses on the Dow were about 30% less than nominal losses. The chart, however, shows real and nominal prices dropping in tandem during that period. Only when prices start to reflate is there a divergence. Same thing seems to be happening during the briefer deflation of 1937-38. If the base is 30% higher, that would make the equality point (not counting dividends) somewhere around 1955.

    What is scarier is that the chart shows (not counting dividends) that the Dow didn’t regain its 1965 level in real dollars until about 1995.

    However, Dow dividends have been substantial over the period — a quick check on the web (not verified) has estimates of 2.3% or 4.6% over long periods depending on the exact years. Dividend yields rise and fall inversely with the market , providing further insulation from CPI swings. According to Wikipedia, http://en.wikipedia.org/wiki/Dividend_yield#Dow_Industrials, the dividend yield on the Dow was 15% in 1932, and on the S&P was 6.7% in 1982.

  10. Scott says:

    Asset allocation is medicore/lazy/fraudulent strategy during bull markets (hard to lose in that environment) and a bad/destructive strategy for bear markets… asset allocation is a simple (idiot proof) concept easy for advisors (salesmen) to explain (sell) to clients… the passive buy-and-hold, one-size-fits-all asset allocation marketed to the masses for the benefit of the street is broken.

    Active, competent, knowledgeable management is needed now…

  11. topquark says:

    …the financial quarks exist in waves of Value at Risk… Trust me, this is too bizarre even for “bizarre sub-nano world” :)

    But I agree that low-risk long-term investing, diversification, and most of the conventional financial “wisdoms” is an intentional deception coming from those who benefit and then converted to mantra by the brainless majority of financial “experts”