Wednesday, October 28, 2009

Taipan Daily: Planet Real Versus Planet Paper – My Biggest Lesson of 2009

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Wed., October 28, 2009
Taipan Daily: Planet Real Versus Planet Paper – My Biggest Lesson of 2009
by Justice Litle, Editorial Director, Taipan Publishing Group

“Essentially, all models are wrong – but some are useful.” That noted quote comes from Dr. George E.P. Box, a grand old man of science and statistics.

It can be disconcerting to embrace the idea that “all models are wrong.” Especially when the insight comes from a legendary statistician!

It makes sense, though, because useful models are simple by definition. Think of a map. What you really need from a good city map is the layout of intersections and streets. A certain level of detail is okay, and even useful. But the more detail that gets added, the more cluttered the map becomes. A map that tried to do too much would cease to become useful at all.

In this sense, the map is “wrong” because it doesn’t give a 100% accurate picture. But, oddly, it is wrong on purpose. It has a very specific purpose and intent, and intentionally leaves things out.

Market models – that is to say, different analogies, metaphors, and ways of observing or thinking about the market – are similar. Like a good city map, the right market model can be extremely useful in terms of aiding trading and investing decisions.

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In the spirit of continuous improvement, your editor is always seeking to refine, improve and upgrade his market models. Sometimes this means a small change. Sometimes it means a big change. Sometimes it means discarding a model entirely, or coming up with something entirely new.

In that context, here is one of your editor’s most important lessons learned in 2009...

“Real” and “Paper” Are Different Worlds

Let’s break down the insight in market model terms.

To begin, when it comes to trading and investing, there is the “real” economy and the “paper” economy. The real economy represents what is really and truly happening – the cut and thrust of Main Street, of jobs and wages, of boots on the ground and day-to-day life. The paper economy, in contrast, tracks what’s happening on Wall Street (as reflected in equities, bonds, commodities and currencies).

One can break out the two as follows:

Key Drivers for the “Real” Economy

Key Drivers for the “Paper” Economy

  • Jobs, Wages and Unemployment
  • Liquidity Levels
  • Debt Loads/Balance Sheet Quality
  • Investor sentiment
  • Trade Balances
  • The “Expectations Game”
  • Main Street (small business and consumers)
  • Wall Street (megabanks, connected interests)
  • Realistic Long-Term Outlook
  • Idealized Short-Term Outlook
  • Negative Government Impact
  • Positive Government Impact
  • Looking at the factors listed in the table above, it is easy to say, “Duh.” None of these factors are especially new. In fact we’ve talked about them all at one time or another.

    But sometimes major realizations are subtle. The market model shift is not always dramatic. Sometimes a small adjustment leads to a game-changing insight.

    It is a further irony that big breakthroughs often have a whiff of “duh” to them. This is because a truly useful insight is, more often than not, simple. And sometimes the gain is in reweighting priorities – changing the recipe without changing the ingredients, so to speak.

    In this case, the gist could be summed up like this: The real economy and the paper economy are not just “different,” they are different worlds... and thus should be thought about separately and distinctly.

    Back to the mental model thing again...

    Think of two planets, one slightly larger than the other. These two planets have a relationship. Each holds the other within a mutual gravitational pull.

    But, because the relationship is not stable, the distance between the planets changes over time. When there is convergence, the planets move closer to each other. When there is divergence, they move apart.

    One of these is “Planet Real.” The other is “Planet Paper.” And thus, if it sometimes seems that the “Real” folks are living on a different planet than the “Paper” folks... that’s because it is more or less true.

    A Sharp Disagreement

    This market model – seeing “real” and “paper” as distinct worlds to be analyzed separately – is controversial for a number of reasons. Those who embrace standard economic theory, for one, would reject such a model entirely.

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    Standard theory says that the real economy and the paper economy are very closely linked... that the stock market is both a barometer of health for the real economy and a leading indicator for the real economy’s future direction... and that the main purpose of the market is to allocate capital, i.e. to funnel cash to worthy enterprises and thus aid the real economy.

    Your editor has always been skeptical of academic types. As a result of all that’s happened in 2009, his skepticism has morphed into full-on rejection of these common assertions put forth in grad school finance classes. In other words:

    • Equity markets are NOT reliable leading indicators as to the health or future direction of the real economy. This would be far more true in an unmanipulated, ungamed free market system, but that is not what we have.

    • The primary function of equity markets is NOT efficient allocation of capital (getting investment dollars to businesses that need them). Again, this is the market’s hypothetical function in a free market system. But to the degree that the system is gamed, subject to intervention and coercion, this assertion is not true.

    • Efficient market theory has little basis in empirical observation. Why “should” the markets be efficient? Just because academia says they are? Just because we want them to be? Why “should” the markets be rational allocators of capital, when strong influences make them otherwise?

    • The “manipulated market” charge is easily supported by visible evidence, and does not require an embrace of conspiracy theory to be shown true. The evidence for efficient markets doesn’t really exist. But the evidence for manipulated markets is plain as day. We see it in the government’s actions. We see it in central bank officials’ openly stated intent. We see it in the actions and disclosures of the major Wall Street players. In other words, we observe evidence of legally sanctioned manipulation most everywhere we look.

    • The major benefactors of the “paper” economy are incentivized to make large short-term profits... NOT to sustain logical market valuations. What are equities truly worth? What should they be worth? What is a sober and rational valuation for the market? The streetwise answer is, “Who cares???” That isn’t what the game is about. Economics is supposed to be all about incentives, and yet economists refuse to make the obvious connection. It seems plain that the mutually overlapping incentives of Washington and Wall Street favor markets going as high as the gamers can take them. This has nothing to do with rational valuation. When it comes to incentives for the paper crowd, the real economy is a restraint rather than a guide.

    Where the Rubber Meets the Road

    So what is the point of all the above in terms of hard-nosed trading and investing? How does this distinction between “real” and “paper” apply to protecting and building wealth?

    First, thinking about the “real” economy and the “paper” economy separately can help avoid a number of future pitfalls. If one recognizes that there is a direct correlation between government intervention and market distortion, then one will be more likely to take positive “paper” results with a grain of salt (being aware of how quickly such gains can be spirited away). This realization could lead to better hedging techniques or other methods of protecting near-term capital gains.

    What’s more, we are set up to see a LOT of government intervention in the coming years. Not just in the United States, but in Europe, China and elsewhere. 2009 may have only been a preview in that respect.

    So the sooner one realizes that such intervention will lead to ever greater market distorting effects, the better... especially when tempted by the analysis of those who present the goings on of the real economy and the paper economy as if they are the same (or otherwise more tightly coupled than they really are).

    On the flip side – and this is where your humble editor eats a plateful of crow – distinguishing between the two worlds can also help one avoid the trap of being prematurely gloomy in regard to the nominal direction of asset prices. The moneyed interests driving the paper economy can be extremely powerful... so powerful that they can present the illusion of stocks going up, even as the real (inflation-adjusted) value goes down.

    Those who were bearish and cynical from the March lows (including yours truly) were, ironically, not cynical enough.

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    Opportunity and Turmoil

    For many of us, it is a game that must be played (and a game that can still be quite fun, albeit dirty). When Wall Street and Washington have the ability to majorly impact your nest egg for the worse – and when most every central banker in the world is playing some version of the same game – there is no real way to opt out.

    The alternative, then, is to “game the gamers” and set about making as much money as possible (what trading and investing is all about). In that respect, the “two worlds” model represents the presence of both opportunity and turmoil.

    Think about the convergence and divergence idea again. Sometimes the planets (paper versus real) are rapidly increasing their distance from each other. But then gravity’s pull reasserts itself, causing the planets to reverse course and converge with frightening speed.

    This is analogous to the swings between inflationary and deflationary sentiment we can expect moving forward, perhaps for a number of years. Government intervention and Nash-Equilibrium-style market movements will lead to euphoria, i.e., divergence, as Planet Paper moves away from Planet Real. But then the artificial boosters will run out of gas (as happened time and again with Japan), and the two planets will violently recouple.

    For your editor, there will be many trickle-down impacts from this adjustment. Not least will be the conviction to never again confuse the natures of “Planet Real” and “Planet Paper”... sometimes converging but never the same, with distinct and separate drivers for each.

    Warm Regards,


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