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Jiber Jaber at the Stock Market
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By TMFRoZany
July 31, 2007

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Jiber Jaber at the Stock Market
It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. - Mark Twain

We had a little correction in the market Thursday attributed to large investors reassessing risk as described on the front page of the WSJ on Friday. Major indexes dropped sharply as the day of reckoning on the housing sector and concern over corporate lending weighed more heavily than the strong earnings from techs and two Dow components.

"Going forward, we have to consider what's really at the root of the market fears. The market has behaved in schizophrenic fashion over the last month in search of clues that the consumer has suffered or will suffer from housing-related stress," writes Andrew Wilkinson at Forbes.

In his newsletter Jeremy Siegal, "the Wizard of Wharton," sees the sell-off as an over-reaction to the sub-prime crises, the DOW will be going back up to 14,000, but he views the dollar as a conundrum. Wharton's interview: OPEC is noted as not wanting to let oil get too high. "We don't really know how hedge funds are doing . . . we have over a $1.5 trillion worth of investment fund in the last five years that has flowed to these hedge funds and out of the equity market, looking for better returns."

Sell-off
The financial sector, in addition to housing, was hit especially hard by credit worries, Citigroup and J.P. Morgan being the majors making business loans, LBOs, benefiting from mergers and acquisitions and stock buybacks. Could the sell of become disorderly as high-yield investors refuse to buy bonds at the yields and terms the banks want?

Anxiety reigned during a healthy correction that was not an example of author Nassim Nicholas Taleb's Black Swan, a metaphor for a highly improbable and unpredictable event with a massive impact. But do we really know why it occurred? The pat answer is sub-prime chaos.

Not so fast say Michael Mackenzie and Anuj Gangahar of the Financial Times as they quote Alan Ruskin, chief international strategist at RBS Greenwich Capital. "The credit story is still too opaque and evolving at too rapid a pace for anyone to seriously take a shot at counter-trading this into the weekend, and any big move is much more likely to come from a further slide in risky assets than a recovery today."

"If there are a few ingredients worth remembering, it is that credit events are not one-day, one-week or even one-month wonders."

Tax laws - an unanticipated factor in equity markets
An event described Nassim Taleb's book, The Black Swan is that we all labor under "the illusion of understanding or how everyone thinks he knows what is going on in a world that is more complicated (or random) than they realize." Taleb says we have far too much information to digest accurately.

"Ask most risk professionals today why the U.S. equity markets have been rising steadily and most would answer that cheap, plentiful credit courtesy of the Federal Reserve Board is the chief factor, an explanation repeated by the sheep in the big media over and over again.

"But our friend David Kotok of Cumberland Advisors suggests that the prospective changes in tax laws may be a bigger -- and largely an unanticipated factor -- in driving US equity markets lower. It seems that US corporations have been offshore cash balances to fund the nearly $1 trillion in stock repurchases since mid-2004, cash balances for which no US tax has been paid.

"Until last week, stock buybacks were considered routine," Kotok writes. "Not much attention had been paid to the source of the funds. Then IBM (NYSE:IBM) announced a $12.5 billion stock buyback. That changed everything. The Internal Revenue Service (IRS) realized that IBM was using money from its foreign subsidiaries to fund the buybacks. This money has not been taxed by the US. Normally foreign subsidiary income does not get taxed by the IRS until it is repatriated. IBM estimated they were saving $1.6 billion by using this method."

"The IRS moved quickly and by surprise," Kotok continues. "IBM announced its plan on May 29th. The IRS publicized the regulatory change on May 31st. IBM is the last large American company to get under the wire."

". . . risk professionals and regulators alike rely upon tools based upon statistical simulations and market data which do not adequately describe or measure credit and market risk, much less operational risk events like changes in tax law."

Narrative fallacy
From the author of Buffett: The Making of an American
Capitalist,
Roger Lowenstein reviews The Black Swan : The Impact of the Highly Improbable, (TBS) " I know a money manager who can always tell a story to explain where markets are supposedly heading. He is a good storyteller, though a rather poor investor. He is a victim of what author Nassim Nicholas Taleb (N.N.T) calls the narrative fallacy: the human desire to see the order in everything--to make a sensible yarn of what might, in reality, be unpredictable or random.

"Historians figure highly among his targets, for they impose a logical design on events that, as lived, were actually chaotic. You want to know how history truly unfolded? Watch an ice cube melt into water. Okay. Now look at the puddle left by a piece of melted ice and try to determine with certainty the shape it had before melting. So much for retrieving the past, so much for historians. As for journalists, they are doubly guilty--of relentlessly narrating and inferring (unknowable) causations." [The ice cube story is one from N.N.T. and I believe takes some real thought.]

N.N.T. writes about the traps of logic, the formalized thought patterns that snare most of us.

Book preceding TBS
In the world of business and life, professional trader in years gone by and mathematics professor, Nassim Nicholas Taleb, first wrote, ,Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets where he examined what randomness means and how human beings are prone to mistake dumb luck for consummate skill.

Chris Anderson, author of The Long Tail, tells us why we should read this book when he says ""The book says that you can't predict anything--that when things happen, you try to construct a narrative around what happened, and that narrative is almost always wrong. Why is the market up today? Because home sales did such and such. It's almost never why, but we need to have an explanation. If managers can check themselves from making those all-too-tempting efforts to construct narratives, fundamentally they will have an advantage over the rest of us."

What we have here are two books on how we perceive and deal with luck in business and life by an author with a philosophic bent identified by some reviewers as arrogant to the point of puffery.

'Black Swan blindness"--those cognitive biases that limit our understanding of the role of chance in life and history
From TBS dust cover:
N.N.T's newest book, one that I have not read, The Black Swan, a book that should cause us to reflect on the state of things in the world of risk management. Taleb calls himself a "skeptical empiricist."

"A black swan is a highly improbable event with 3 principle characteristics: its unpredictability; its massive impact; and, after it has happened, our desire to make it appear less random and more predictable that it was. The astonishing success of Google was a Black Swan; so was 9/11."

N.N.T. says some investments are prone to negative black swans, e.g., banking and insurance. In the world of Finance and Insurance the Black Swan of consequence of magnitude can destroy finances in one day. Taleb says analysts don't get it when it comes to the consequence of affordable failure. Some are not affected by black swans. And other investments are prone to positive black swans, e.g., pharma, book publishers, game software, movies.

Michael Allen writes, ". . . for me, one of the key ideas of this book, namely that we fail to appreciate the asymmetry in our perception of events. We attribute our successes to our skills, and our failures to external events outside our control, namely to randomness. (Eight-four per cent of Frenchmen think that their lovemaking abilities put them in the top half of French lovers.)"

From
Slate's Tyler Cowen, "Taleb explains why you should not mimic Casanova (he was lucky to escape the danger inherent in each romantic adventure he took), why venture capitalists make more than inventors (inventors pursue black swans, but they often die too soon to see the biggest payoffs), why you should become a speculator rather than a prostitute (the former is more scalable, in case your career really takes off), and why the self-critical Montaigne is the most important philosopher (he is one of the few writers who understood the limitations of human knowledge).

State of things in the world of risk management
N.N.T has many cautionary tales related to 'Black Swan,s' a metaphor, an outlier, an event that lies beyond the realm of normal expectations. Taleb explains, 'Most people expect all swans to be white because that's what their experience tells them; a black swan is by definition a surprise. Nevertheless, people tend to concoct explanations for them after the fact, which makes them appear more predictable, and less random, than they are."

Market crashes are black swans. Markets will never spot the black swan in advance. Winning at blackjack is not a black swan as the odds in casino games are known.

"Because of hindsight bias, he says, histories of economic life and scientific discoveries are written with straightforward story lines: someone set out to do something and succeeded, it's all about intention and design. But in truth, "most of what people were looking for, they did not find. Most of what they found they were not looking for." (the ice cube story)

From the book:
"What we call a Black Swan (and capitalize it) is an event with the following three attributes.

First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable.

"Why are we so bad at understanding this type of uncertainty? It is now the scientific consensus that our risk-avoidance mechanism is not mediated by the cognitive modules of our brain, but rather by the emotional ones. This may have made us fit for the Pleistocene era. Our risk machinery is designed to run away from tigers; it is not designed for the information-laden modern world."

Moving to the Biotechnology/Pharma industry, there are some insights that should help from his book to understand biotechnology/pharma discovery. First, determine the consequence of magnitude of the Black Swan event. In biotech, the consequence of magnitude is great and good, we want that blockbuster. The losses are not as big of a deal and are small when compared to the big win.

Serendipity is on our side, look at what Viagra did for Pfizer. Black Swan's are far more in the positive than in the negative realm.

How about the microwave oven that came about when a candy bar melted in a scientist's pocket when he was testing a new vacuum tube called a magnetron. http://www.gallawa.com/microtech/history.html

Taleb points out especially in your financial decisions, it's best not to confuse the frequency of an event with the magnitude of its consequences.

Prediction of discovery
Three monumental discoveries with great consequence, found by accident. Black Swans change lives.
1. The laser for one was a fluke; no one knew what to do with it when it was discovered. Lasers were referred to as a discovery awaiting a problem. http://nobelprize.org/educational_games/physics/la...

2. The internet was designed for a military application. "Late in 1978 or so, the operational military started to get interested in Internet technology. In 1979 we deployed packet radio systems at Fort Bragg, and they were used in field exercises." http://virtualschool.edu/mon/Internet/CerfHowInter...

3. Penicillin was a chance observation, made in 1928 by Fleming, for the discovery of penicillin. However, the discovery and isolation of penicillin - a process which involved a series of chance events spanning at least half a century and building on knowledge gained as early as 1500 BC. http://www.accessexcellence.org/AE/AEC/CC/chance.h...

We are not good at predicting discovery that changes lives. We cannot predict market failure. We cannot know the future. We can be victims of false sense of security and illusions of knowledge. I find it comforting to know that Philip is fully aware of pitfalls of the mind in behavioral finance and willing listens to others.

A Few Comments on Taleb's books
Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein is recommended by TMFMillerTime. Risk management is a topic of concern to investors and deserves understanding and reflection. Bernstein comments on Taleb's Fooled by Randomness, "The book is, in a word, fascinating. Stick with it: Taleb will grab you. As a non-random consequence, your understanding of life (and your money) will expand exponentially."
--Peter L. Bernstein, President, Peter L. Bernstein Inc.

From the Wall Street Journal, ". . .The problem, insists Mr. Taleb, is that most of the time we are in the land of the power law and don't know it. Our strategies for managing risk, for instance--including Modern Portfolio Theory and the Black-Scholes formula for pricing options--are likely to fail at the worst possible time..." http://thinkingonthemargin.blogspot.com/2007/05/bl...

Roger Lowenstein in his review comments, ". . . But Taleb's insights about probability are worthy even when applied--as in this volume--beyond the narrow realm of markets. This is an eye-opening book, one that teases our intelligence. Hidden at the edges of the pond of our daily lives, black swans linger, more prevalent than we suspect." http://www.portfolio.com/culture-lifestyle/culture...

James K. Glassman. "The lesson here for investors is powerful and frightening. How much can you rely on the track records of investment advisers, mutual fund managers, newspaper columnists, or even the market as a whole in making decisions about your investment portfolio? Not nearly as much as you probably think." http://www.nationalreview.com/nrof_glassman/glassm...

John Mauldin (Bull's Eye Investing) writes in his latest newsletter, "Before we get to the predictions, let's look at a few quotes from Nassim Taleb's new book, The Black Swan. I am slowly digesting this remarkable work and suggest that any serious student of the market do so as well. I will be doing a more lengthy review at some point in September, but you should get the book.

Let's look at a few selected paragraphs from the beginning of the book: "The inability to predict outliers implies the inability to predict the course of history, given the share of these events in the dynamics of events.

"But we act as though we are able to predict historical events, or, even worse, as if we are able to change the course of history. We produce thirty-year projections of social security deficits and oil prices without realizing that we cannot even predict these for next summer - our cumulative prediction errors for political and economic events are so monstrous that every time I look at the empirical record I have to pinch myself to verify that I am not dreaming. What is surprising is not the magnitude of our forecasts errors, but our absence of awareness of it. This is all the more worrisome when we engage in deadly conflicts: wars are fundamentally unpredictable (and we do not know it). Owing to this misunderstanding of the casual chains between policy and actions, we can easily trigger Black Swans thanks to aggressive ignorance-like a child playing with a chemistry kit.

"...To summarize: in this (personal) essay, I stick my neck out and make a claim, against many of our habits of thought, that our world is dominated by the extreme, the unknown, and the very improbable (improbable according our current knowledge) - and all the while we spend our time engaged in small talk, focusing on the known, and the repeated. This implies the need to use the extreme event as a starting point and not treat it as an exception to be pushed under the rug. I also make the bolder (and more annoying) claim that in spite of our progress and growth, the future will be increasingly less predictable, while both human nature and social "science" seem to conspire to hide the idea from us."
http://www.frontlinethoughts.com/pdf/mwo072707.pdf

Whether you agree with Mr. Taleb or not, his books will leave you with many opinions and questions on his theory. He describes himself as a fool (small f) and that most likely explains his take on Warren Buffett. With all that money, why does Buffett live as a monk queries N.N.T? He isn't able to explain Mr. Buffett and makes desperate remarks that will irritate some followers of Mr. Buffett, but none mentioned by Roger Lowenstein.

In N.N.T.s words, "In brief, the book is a map on how to live in a world we don't fully understand - and enjoy it. . . I equate randomness with human frailty in knowledge - it is not incompatible with religion or belief in agency. As I hinted, TBS is about how not to be a sucker - in things that carry consequences. In brief, the book is a map on how to live in a world we don't fully understand - and enjoy it."

Inside Value Community
My fear in this market is based in that of Warren Buffett's admonition a couple of years ago - derivatives. He also does not listen to hourly TV reports on the stock market.

No one has the foggiest notion as to the real story in those nicely wrapped Speculation and Derivative Securities - CDOs, CDSs, and other alphabet soup where a lot of sweeping under the rug goes on. That and Black Swan's means I need to look to a couple of gurus who understood risk in investing, that is one reason I love the Fool.

I like being in the company of fellow admirers of Benjamin Graham, "The Father of Security Analysis," who drew a sharp distinction between investment and speculation. We may have thought that Graham would condemn speculation as something to be avoided entirely, he did not. His admonition, "but there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose."

Incidentally, another favorite of mine, Philip Fisher a proponent of long term holding and also admired by Warren Buffett, list of five don'ts rate a mention here:
1. "Don't buy into promotional companies."
2. "Don't ignore a good stock just because it is traded 'over-the-counter.'"
3. "Don't buy a stock just because you like the 'tone' of its annual report."
4. "Don't assume that the high price at which a stock may be selling in relation to its earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price." (Or put simply, price to earnings isn't everything.)
5. "Don't quibble over eighths and quarters." (Don't stress out over a few cents difference in price.)

Sharing investing perceptions and experience is invaluable in an investing journey. It is reassuring to have others checking out our reality. We have an opportunity to ask questions and learn from others, especially in our newsletter filled with opportunities for learning about stock investing.

Isn't it great to have a stock risk categorized for us here with a frequent reminder that investing requires patience? We have reference to recommended stocks assigned to ranks of Admirals, Vice Admirals, Lieutenants, and Captains tempered by the 'reality' of Philip, Alex, Mike and Jean. And now we get weekly updates.

Doesn't mean that I will ignore buying Taleb's book once I manage the rest of Charlie Munger's Poor Charlie's Almanac. I have never of recent seen so much discussion, pro and con, of a book.

Why? "As the world gets more connected, Black Swans are becoming more consequential." I need some insight on where to be fool (small f) and when not be a fool.

Right now, I just stick with my fellow Fools, thank you very much.

Regards,
Ro

Selected References:
Nassim Nicholas Taleb's (N.N.T.) homepage http://www.fooledbyrandomness.com
Books:
The Black Swan http://www.amazon.com/Black-Swan-Impact-Highly-Imp...
Fooled by Randomness http://www.amazon.com/Fooled-Randomness-Hidden-Cha...
Quote from the book http://www.powells.com/biblio?show=ELECTRONIC:MICR...
A book review http://www.platformonomics.com/BookReviewTheBlackS...

"Stocks Plummet on Credit Worries"
http://online.wsj.com/article/SB118544957845978812...
"Options Schizophrenia" http://www.forbes.com/finance/2007/07/27/options-v...
Jeremy Siegal interview, registration required. http://knowledge.wharton.upenn.edu/article.cfm?art...
"Wall St falls amid credit concerns" Federal times.
http://biz.yahoo.com/ft/070727/fto0727200716482967...

"Black Swan Hunting: Equity Markets and Random Events." Christopher Whalen. [This one is a very interesting read.] http://usmarket.seekingalpha.com/article/38766http...
"Two surprise tax changes: headwinds for U.S. stocks?" http://www.cumber.com/commentary.aspx?file=061707....
"Chaos is underrated," Roger Lowenstein. http://www.portfolio.com/culture-lifestyle/culture...
"Nobody Expects the Spanish Inquisition--or Do They?"
http://www.slate.com/id/2167993 /
http://grumpyoldbookman.blogspot.com/2007/07/nassi...
Arlene Goldbarb Blog, great summary of Taleb's ideas.
http://arlenegoldbard.com/2007/05/09/my-new-crush

N.N.T. - "Much of everything - and that's the idea I hold here - much of everything in history is completely dominated by the exception of the black swan. History, socio-economic life, our lives, our personal lives, but we don't know it. To take an example, take the book business, okay? You've had years, in 1997, where five books out of 10,000 literary fiction books in the English language, five books represented 70 percent of the sales."
http://www.pbs.org/kcet/tavissmiley/archive/200706...

"If 100 random people gather in a room and the world's tallest man walks in, the average height doesn't change much. But if Bill Gates walks in, the average net worth rises dramatically. Height follows the bell curve in its distribution. Wealth does not: It follows an asymmetric, L-shaped pattern known as a "power law," where most values are below average and a few far above. In the realm of the power law, rare and extreme events dominate the action." WSJ book review. http://www.opinionjournal.com/la/?id=110009979

"What's going to get us is the unexpected. Maybe it's globalization, he suggests, which creates "interlocking fragility, while reducing volatility and giving the appearance of stability." Listen up folks. Taleb thinks we may be living under the threat of a global collapse. And where will it come from? From the consolidation of global banks into "gigantic, incestuous bureaucratic banks.

I think Taleb is wrong. The increased concentration in banks all obsessed with risk control will not be the cause of a massive financial crisis. But Taleb thinks this could be the "improbable" event that drives the Dow into a panic of selling."
"Is a black swan in the way of the DOW 14,000?" http://www.forbes.com/opinions/2007/07/18/croesus-...

"The problem, insists Mr. Taleb, is that most of the time we are in the land of the power law and don't know it." "Shattering the Bell Curve. http://www.opinionjournal.com/la/?id=110009979

Taleb on Black Swans http://www.econtalk.org/archives/2007/04/taleb_on_...

"Is Investing success just luck?" Randomness in the stock market. "Analysts failed to predict these random events (that's why they're random), and earnings for the companies suffered," wrote Richard McCaffery on the Motley Fool Web site."Random events are an intricate part of life in the business world, and these events make it very difficult for investors, whether professionals or not, to predict earnings and find winning investments."
http://www.fool.com/news/foth/2000/foth001130.htm

NYT review of Black Swan by Gregg Easterbrook (Registration required) http://tinyurl.com/3cu86h
Taleb responds NYT review of his book. Taleb wipes the floor with this reviewer, you will see first hand his disdain for book reviewers who aren't on target. http://www.fooledbyrandomness.com/easterbrook.pdf


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