A question that has always intrigued me is “Why do some people read the markets much better than others?” Having observed those in the investment community who do have a genuine ability, my conclusion is that they are just that. Readers. Of a story, or narrative. They are not necessarily the smartest people in the room — often they seem quite unimpressive — yet they seem to have an intuition, a way of putting together the story, that is more true. This leads to another conclusion. That it is the reading (or creation) of stories that is at the heart of all financial analysis. Markets are not rational machines, they are giant narratives in which “the facts” are just details for the myth making. In a sense it is a statement of the obvious to say that humans have been, and always will be, moved mostly by stories, but the obvious has been forgotten, subsumed under mountains of quasi-scientific analysis.
So let us sketch out what these stories look and sound like. There are several levels:
1. The ideological story. This narrative starts from a kind of morality dressed up as historical insight. Markets are ipso facto good and all that is needed to create benefits for all is to let them operate unfettered. Governments are mostly useless and corrupt and should be confined to only the most basic of operations. From this it follows that democracy and markets are two sides of the same coin; two aspects of freedom. We are seeing the latest episode for this in the euro crisis. The evil or misguided socialists and corrupt governments in the south have created unsustainable levels of debt, unlike the rest of the developed world, creating terrible peril for the world financial system. It is interesting to look at the actual data. The US total debt relative to GDP (279%) is actually higher than Greece’s (267%). But the proportion that is government debt for the US (80%) is lower than Greece’s (130%). And of course everything governments do is ipso facto bad, while private activity is ipso facto good.
The ideological story does, of course, have a lot of underlying truth to it. But that is not what matters most; what matters most is the power of the story itself. In particular, the narrative has blinded people to two important points. One is that collecting tax is critical to sound government. If government is bad, taking tax must also be bad, because it funds governments and allows them to get bigger. This is being promulgated by the Republicans in the US at the moment with their insistence on only cutting spending, not too mention our own newly formed Tea Party here in Australia, the Liberal Party.
Trouble is, there is a very strong correlation between economies that function well and the effective collection of tax. Poor tax takes have been a feature of Latin American countries. China collects of 20% of GDP in tax while in India tax paying is only an option. Greece has very poor tax collection and so on.
The other blind spot produced by this story is that money can somehow operate independent of government. This is nonsense (literally) and the decades of “financial de-regulation” have created the havoc that could only come from such nonsense. Because money is rules, it cannot be separated from the rule makers. What happened is that governments, accepting for the most part the ideological story, have let traders make up their own rules, such as $700 trillion of derivatives. This should have been fine because governments were letting markets create freedom for all. It wasn’t, and we are seeing the consequences now, with governments desperately trying to save the rules of money. But the story remains as strong as ever, which is why so little has been learned.
2. The finance story. This narrative works on a kind of quasi-science. Because money can be recorded as quantities, then mathematics can be applied to it. If mathematics can be applied it must be possible to use the mathematics to predict how the system will behave. Ergo, if you are clever and well trained enough or have won a Nobel prize or once worked for the Fed or lost your job with NASA, then you will have some mysterious insight into the operating of the system. Or, even better, you can disapprove about how the system isn’t behaving as it should when your predictions are wrong.
What is wrong with this, is, self evidently, that the market is made up of people who are trying to use the same mathematics to predict what will happen in the system — activity which is never included in the mathematics. It cannot be. Which is why those who try to read the behaviour of those looking for the predictable (what is predicted according to the mathematical models) will tend to do better. Because they are reading the story, not looking at what the data is indicating or trying to apply a model. There cannot be a mathematical model that predicts human behaviour when the humans can understand the mathematical models. There is an implication that markets should balance because financial transactions are meant to balance (debt versus equity). But much of the time they either do not, or do not in an expected time frame. Even that circular argument does not work very well, although that does not stop legions of financial analysts from applying it.
3. The business story. Business stories are much more diverse, but one can say the ability to sell a story is key to any businesses’ success. That is what the difference between earnings multiples of two companies in the same industry represents: one company selling their story better than another. Business analysis is always confined to retrospective data; even the operators of the business do not know what the future holds. Yet business valuation is a projection of future performance. The only way to fill the gap is with stories.
In the film Margin Call the head of the investment bank, played by Jeremy Irons, says he is where he is for one reason and one reason only. His job is to hear what “the music is” to determine whether the game of musical chairs will go on. He decides he hears nothing, deciding that the game is over. This character is reading the story of markets. It is those readers who are the ones who tend to do well, not necessarily the most clever players.