The Stock Market, Science, and History
discusses the nature of the stock market and of market societies.
This article discusses the nature of the stock market and of market societies.
Isaiah Berlin (1909-1997) was, perhaps, the most articulate spokesman for liberalism since John Stuart Mill. A political philosopher and the founder of Wolfson College at Oxford, he is less known in the United States. To read Mill is to traverse the sunlit meadows of what was to become Victorian optimism. To read Berlin is to traverse these meadows dappled by the wars of the early 20th century. Denying the absolutist claims of political ideologies, Berlin advocates “value pluralism,” the view that practical life at the level of society cannot be reduced to a single vision.
Berlin’s writings are a sometimes turbulent stream of sentences, some more than 120 words in length, replete with qualifiers, quantifiers, comparisons, and contrasts. It is definitely not Internet writing. Why are we discussing Berlin? It is because he makes outstanding common sense, stating two practical ideas useful to investors when dealing with real markets:
1) The necessity of preserving, in human affairs, an “imperfect equilibrium.”
(by means of error correction, if you will)
2) Having a personal set of principles to act in a complex environment.
In the following, we discuss the cyclical fed model in terms of these ideas, which ultimately relate the stock market to the modern social order.
The concept of equilibrium, that state to which all things tend, is crucial in economics, for it provides the order that makes classification and mathematics possible. However, we find that the real, error-correcting U.S. stock market can be estimated by an econometric equation only over the long-term, and that the market crosses the regression line at times rather than mean reverts.
A great deal can be learned from economics, but our contention is this: science simplifies and validly generalizes on an immutable (or long-term) basis. History, on the other hand as Berlin relates, is a chronicle in time of, “that which differentiates one thing, person, situation, age, pattern of experience, individual or collective, from another.”1 Put another way, there is a marked difference between the physics and history. Both fields have a respect for the facts, but whereas physicists seek from the empirical facts immutable and valid generalizations; historians seek from the empirical facts convincing explanations of people and situations in actual time.
Our study reveals that the error-correcting market has both aspects. The market has a long-term aspect that is measured by the OLS regression model that describes order. The market also has a short-term aspect which departs from this regression and which, moreover, correlates well with actual and timely events. From the data, it is quite possible to identify the real events that mark large departures from equilibrium - the stygian depths of OPEC despair, the market’s overreaction to the economic recovery of 1987, the New Era exuberance of the Internet, and the war in Iraq. (We wrote that article in 1999 before discovering dynamic error correction in the econometric literature.)
At this point, we can quite validly say that to understand the market is to deal with more than the long-term, but also to understand the market’s short-term reactions to history and politics. The skills for doing so are, as Berlin writes “synthetic,” “…it is an awareness of the interplay of the imponderable and the ponderable, of the ‘shape’ of things in general, or of a specific situation, of a particular character, which is precisely what cannot be deduced from, or even formulated in terms of, the laws of nature demanded by scientific determinism.”2 This kind of intuitive skill is found more often on the trading desks of Wall Street, where traders constantly deal with markets as a medium.
Although Berlin writes a lot more about disequilibrium than equilibrium, he points out that the latter, albeit imperfect, is necessary for society to remain in an “estimative state.” His view on how this is achieved is correct, “…the end of political action is not some static perfection, but the adjustment of interests and activities (our emphasis) as they arise; when they arise; since…it is natural to men to pursue different and, at times, incompatible ends; nor is this an evil, for diversity is the price – and perhaps the essence – of free activity.”3 Political consensus is also the source of institutions.
We’ve been asked why we discuss philosophy. The answer is twofold:
1) Philosophy provides a consistent set of principles with which to act in the complex market environment. In this traditional sense, philosophy is very practical: it helps people reflect upon their lives and the world. Consider this major investment inconsistency: You trade (the winners) when you think you are investing; then you invest (in the losers) when you think you are trading. By temperament, people are either value investors or momentum traders. It is a good idea to have an investment philosophy.
We are value investors, meaning that in the ordinary course of events, a drop in the price of a stock is a possible buying opportunity, provided the drop is not caused by a deterioration in business fundamentals, causing an intrinsic loss of capital.
2) The second reason is that philosophy can explain why there are value and momentum investors.
Markets, as our readers have ascertained, are complex - a major coordinating element in liberal societies, how could they be otherwise? The price of a stock is set by the constantly changing intersection of supply (sellers) and demand (buyers). A study of how this intersection behaves is our major concern. The complete answer to how markets behave is not to be found solely in equilibrium economics.
Berlin suggests that the history of human knowledge is, to a large degree, an attempt to shuffle all information into two major categories: the empirical (to which the physical sciences and econometrics correspond) and the theoretical (to which mathematics corresponds). The crucial test of whether knowledge falls into these two major categories is whether you know where to look for the answer.4 To find the answer to a question of fact, what is TCP/IP, you can do an Internet search or ask an expert. To find the answer to a math question, you can look in a math textbook. What happens, Berlin asks, when you are confronted with the questions: What is the relationship between free will and determinism? What is the meaning of the future? We might add, is the price of a stock likely to be higher tomorrow, in five years? To answer these kinds of questions, there is no single textbook or expert to turn to; philosophy studies the categorical frameworks, or organizing principles, that people use to answer these kinds of questions.
Consider two very different organizing principles. Sir Issac Newton (1642-1727) discovered the set of laws governing celestial and terrestrial mechanics, thus setting the standard for superior knowledge in other disciplines which began a like search for universally rational principles. The ensuing debate, as to what is the most valuable kind of knowledge, was brought to an end by the growth of studies in the nineteenth century that valued the particular and the past, such as history.
The integrating concept of our econometric market analysis, spanning these two opposite viewpoints, is time. Over a long period of time, due to the Fed’s countercyclical monetary policy, the equilibrium level of the U.S. stock market can be described by quantitative analysis (the fundamental kind), with scientific methods developed since the Enlightenment. The purpose of institutions is Newtonian, to increase societal predictability. Over a short period of time, the stock market’s excursions from equilibrium are affected by the momentum of business and historical trends, because these excursions are primarily traders’ reactions to actual events.
This article has shown that through error correction, the intersection of market supply and demand has both long-term and short-term components. We focus mainly upon the long-term value component, as it is in accord with our temperament. Value investors also look to short-term event catalysts, but as ancillary concerns.
These references are noted because we quote Berlin extensively. If any of our readers would like to peruse Berlin, we suggest his essays in The Sense of Reality ( 1997 ed. ). These essays are relevant to stock market investing because they are about the nature of judgment.
This article seems to have inspired some controversy. The main criticism is that we unrealistically condemn the use of military force in a violent world. This is not our opinion; our major point is that military force, whether justified or not, has real costs. Wars have both a direct cost in terms of blood and treasure and also an indirect cost of decreased public confidence in the future. More than 2700 years ago, the poet Homer made this explicit in the Illiad, describing the chaos of war as opposed to the benefits of peace5. Lest there be any doubt of this, in the New York Times 7/6/05 edition Thomas Friedman reports, “I was having coffee at a Gaza hotel on Saturday with a group of Palestinian and Egyptian businessmen when one of the Palestinans, half-serious, half-joking, gave me a stock tip. ‘Nablus.’ The Palestine Securities Exchange, located in the West Bank town of Nablus, has skyrocketed since the Israeli-Palestinian cease-fire went into effect in February.”
The command and control method of spreading the structures of democracy by war doesn’t work simply because the method contradicts its goal. Democracy is a peaceful way to resolve conflicts. It requires sound institutions, people with a democratic temperament, and at crucial times good leadership.
In the real world, the U.S. can best lead by positive example and encouragement. Above all, the development of democracy requires making perspicacious distinctions - not all countries are the same - and patience, when dealing with real people who are being asked to change how they deal with each other and with the world. This excellent documentary by the Washington Post (requiring patience to download 6) makes these points about the development of democracy in the Mideast. We would say the same about the development of democracy in the rest of the world.
Solon was elected chief executive officer of the Athenian state in 594 B.C. in order to end the civil strife between classes and restore cohesion to the polity. He was asked whether he had given the Athenians the best laws possible; he replied, “The best they would receive.”