The triumph of the Lowest Common Denominator in modern capitalism

[edit 7/7/2015: we wrote this back in December of 2014, then forgot about it, then discovered it by chance today. Its crazy to see how MKTSTK has evolved in just 7 months, we were so philosophical back then… Probably the effects of the winter]

Humans need assumptions to make sense of anything. Think of the axiom of choice in mathematics and other articles of faith that serve as foundational concepts in every field. In business circles, one of the most optimistic assumptions is if a collection of people strives to maximize each individual’s well-being they will also maximize their collective well-being. Put simply, the best thing for society is for each individual to maximize his own well-being.

Capitalism, red in tooth and claw, is truly something to behold. The future promise of a stack of paper (more accurately, an electronic credit) provides motivation to most of the 7.5 billion humans that currently occupy the planet. Money unlocks the Earth’s natural resources, deposited over millions of years, and speeds them across the planet — building cities and powering economies in the process.

In particular, the financial markets provide us with an unparalleled opportunity to see the full force of Capitalism in action. However, despite claims over the years that markets are efficient price discovery machines, prices continue to exhibit pronounced cycles of boom followed by bust. Anomalies persist for much longer than implied by efficient markets. Consider the persistent momentum effect which is one of the most documented examples of humans behaving in a manner inconsistent with the familiar homo economicus.

Modern econometrics has only just begun to rediscover what Kindleberger and Minsky new in the 1970’s: humans are fallible and prone to errors in estimation. Good times beget bad times; during good times volatility declines and leverage increases, leaving the system more susceptible to negative shocks.

“There is nothing more detrimental to one’s well-being than seeing a friend get rich”

– Kindleberger

A cottage industry has developed trying to shoe-horn the boom/bust cycle into the EMH: the so-called rational bubble. Really it is not necessary to square the existence of bubbles with the EMH: bubbles can be completely rational for each individual within the bubble. There is nothing more detrimental to one’s well-being than seeing a friend get rich. Seeing a friend or colleague get filthy rich from a risky bet is usually a moment of spiritual clarity when suddenly one’s concerns for risk are overcome by a competitive streak, greed, or a combination of the two. There is a point in every bubble where it sucks in the naysayers and converts them to believers. Indeed, when the whole world is insane the rational trader is a fool not to be crazy as well.

Is this what is best for the world as a whole? Is a rational investor doing the world a favor by allocating their capital to a rising market? What effect does disintermediation have on the world: in other worlds how does the fact that most people entrust their capital to “professional” managers effect the allocation of capital? If every manager is rationally chasing the same opportunities, are we allocating capital in the most beneficial manner for society, or are we choking the system of a normally productive resource? In a society where the government intervenes [or is expected to intervene] in large swathes of economic life, are we living in economic reality or a distortion created by financial repression?

We believe that policymakers are engaging in a tactic of successive bubble creation for the simple reason that a rising tide lifts all boats. Good investors make money; during a bubble, even bad investors make money. Bubbles don’t just enrich the best investors — bubbles provide a way to enrich even the lowest common denominator of investors. Put another way, since 2009 when the FOMC began its first round of quantitative easing, the following strategies would have made money:

  1. Write the numbers 1-10 on scraps of paper and put them in a hat. Everyday pull out a number, write it down, and put the number back. If the number is greater than 5, buy the S&P 500 index.
  2. Whenever the sky is blue, buy the S&P 500
  3. Everyday that ends in “y”, buy a little S&P 500
  4. Roll a set of dice; if the sum of the dice is even, buy the S&P 500
  5. Train a monkey to throw darts; buy some S&P 500 and run away before the monkey embeds a dart in your skull (or worse)

There are more examples but it would be beating a dead horse to list them. You get the idea that just about any strategy that included buying stocks would have made you money over the past half-decade. More complicated strategies might even be a hindrance: many hedge funds and professional managers have been trounced by S&P 500 returns since 2009. In this kind of environment, far from being a benefit, hedging risk is a complete waste of money.

The Fed, then, is far from engaging in something radically unorthodox (as most like to portray QE). In fact, in crafting monetary policy for the lowest common denominator (LCD) of investor they are engaging in one of the oldest tricks in Politics: give the people what they want.

It is clear from statements and speeches that the FOMC members believe they are doing what is right for society. But in their paternalistic meddling they have bought into a form of Capitalism that is fundamentally unable to take care of itself. Like a toddler, the market needs constant coaching and guidance to stop from toppling over. They have forgotten that Capitalism comes complete with its own form of self-regulation: the crash. 

But in delaying the crash — concocting successive bailouts and stimulus programs — are the world’s central banks really protecting society or just their own reputations? When rational individuals are presented with a one-way bet it is best for them to take it. At the same time, the higher the bubble rises the greater the potential pain for new entrants to the market. Many of these new entrants are younger people with less experience investing: the definition of LCD investors. As long as the central banks maintain control of the bubble, society’s wealth will grow.

In much the same way as Hollywood attempts to make audiences feel good by providing clear and positive movie endings (hero always wins, lives happily ever after, audience gets closure) central banks are attempting to remove all uncertainty or doubt from the market. This appeals intuitively to the lowest common denominator: he is profoundly troubled by the idea of having to make decisions amongst uncertainty. The LCD investor craves being told what to do, and cannot profit unless markets stick to the consensus.

Bailouts do not make the system stronger. By definition, the creation and subsequent bursting of a bubble creates the most pain for the largest number of people. This runs counter to the original assumption: that Capitalism maximizes societal well-being by maximizing individual well-being. Far from benefiting society as a whole, central bank bubble creation creates a dangerous dynamic whereby LCD investors believe that downside risk has been removed from the market by financial engineering. The important thing to realize is that as the market relies more on central banks, it becomes less and less an indicator of the economy and more a mirror unto which policymakers see their actions reflected back at themselves.

The more markets resemble this false monetary reality, the less value they provide to the overall economy. Stable markets are created out of uncertainty: prices stay in place only when supply is balanced with demand and many viewpoints are present in the market. Big moves in the market occur only when everyone is thinking the same way and tries to act at once. Far from providing stability, trying to remove all doubt is a recipe for volatility.

Want to learn how to mine social data sources like Google Trends, StockTwits, Twitter, and Estimize? Make sure to download our book Intro to Social Data for Traders

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Screenshot from SliceMatrix

Screenshot from SliceMatrix

Lead image licensed under CC-BY SA 3.0 from Wikiuser100000

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