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Financial Wizards vs. Scientific Geniuses

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By Russiangambit
December 22, 2009

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

I wrote this post to dispel the notion that you can simply put money in stocks and expect 7% on average other the years, be buy and hold and not worry about the thing. This is a look under the hood of things that are taken as axioms and are not questioned.

When we talk about some outstanding person of science we'd say he is a genius. But in finance the high achievers are often referred as wizards - the wizards of finance. Soros, one of said wizards, has a book "Alchemy of finance". Why the magical connotations when it comes to finance? Finance is a sort of modern alchemy where the wizards produce something from nothing. Huge wealth is produces by shuffling money around. Money produces more money, huge amounts of it, seemingly all on its own. At least, this is what the financial press will have you believe. Just put your money in the stocks index fund, no worries buy and hold and the money magically grows by 7% each year.

On the other hand science is the opposite of magic. Science explains the order of things and science can be replicated. Having background in science I almost never accept anything without questioning it. So, let's look under the hood of financial magic.

First of all, I think this subconscious treatment of finance as magic is deliberate. Otherwise, how do you get non-sophisticated people who don't know much about finance to put their hard earned money in stocks or bonds, something they don't understand?  

Another deliberate attempt is focusing on the money instead of the process of the wealth creation instead. This one is pretty recent phenomena and I think it is rooted in bubblenomics. If you can't logically explain why this or that stock should go up 10% a day, when clearly the company couldn't have increased the underlying profits at that pace just in one day, you focus on intangibles such as information and money flow. Yes, it is possible that new information came in today and we think a company will produce 10% more profits for the foreseeable future. But this explanation doesn't hold water when 90% of stocks in the market move up and down together. What it really comes down to is the money flow in and out of the markets, and has really little to do with the underlying process of wealth creation on short term basis. If there an abrupt stop of money flow like in fall 2008 you see a situation where even solid stocks go crashing 60-80% in just one month. When there is a sudden rush of money into the market, like at the start of QE in spring of 2009, stocks all go up together. In normal times it works the same, it is just the effects are more muted. So what we see is that the price of financial assets is not only a matter of fundamentals, but also very much influence by the money flow and supply of money in the economy. For this reason, fundamental analysis in itself can only work on multi-year time frames where the results of money flow gyrations are smoothed out. You need technical analysis on short term. It also doesn't help that money supply is yanked here and there by the FED whenever they feel like it. To me FED is not a smoothing out force, Fed is a destructive entity because they can never get it exactly right and they interfere with natural flow of things. My point here is, you can do all fundamental analysis you want but without understanding the role of the money flow you are hosed.

Money was originally invented as medium of exchange, a standard contract for - goods for goods or goods for labor. Without money commerce is pretty much is impossible. The money in itself cannot produce wealth, putting the money here or there can produce wealth in itself. Money is a representation of resources and behind all the money shuffling the movement and usage of resources has to take place. In short, money can be capital but it doesn't necessarily always is. To be wealth producing it has to be purposeful and profitable. When you invest in a stock and expect return, you need to make sure that the company is profitable, yet you don't overpay for profits. Some blue chip stocks are at the same price now they were 10 years ago, it is just today their P/E is at 15 and 10 years ago it was at 50. Clearly, 10 years ago people' expectations of growth were unrealistic and they overpaid for stocks. In my experience, high P/E stocks are almost never worth it because growth projections end up being too rosy. With one exception in my experience - Google. 

But let's get back to the original discussion of financial wizardry.

Investing in a stock, in a simplified way, you let the company to use your resources for future growth. In return you get a share of that future growth. Of course, you expect that return to respectable, may 5-7%.  Another way is to put money in bank and let the bank invest it for you. The bank is a middleman and will want to take a cut. Bank takes a cut from you, the lender and also from the borrower. It is a sweet business, being a middle man in finance, if you manage risk correctly. And that is where we enter the world of finance. At the bank level or stock exchange the money becomes a resource. The money literally produces money in layman's terms, but really it is resources/ capital producing profits which are represented as money. As the financial progress goes on, all kinds of financial instruments are created, which produce even more money with leverage if you guess the direction correctly.

However, step back and think - money represents resources, which could be put to use to do something productive. But it is not being used that way; it is being used to place financial bets. This money is tied up at the financial level and is not going back into industry or agriculture. So, as investments are taken away from the real world and put in the financial limbo, wealth creation slows down. Huge fortunes are created, but they are not value adding. They take the money /resources from others, who didn't place their bets correctly. As much as 20% of UK and US industry is financials.

Now, back to the question of the 7% average return. My argument is that past performance is no guarantee of future results and this is why - last several years we got addicted to easy money, low interest rates.  Looking at Japan, I think we are never going to give it up. Our politicians and Congress will never give it up. It used to be that bank's CDs paid 5-7% interest on your money, not anymore. Why? Because FEDs easy money is crowding you out.  Now, if you can't get 5% at the bank anymore for putting your capital at work why do you think you should expect 7% in the stocks?  

It seems that easy money policies basically destroyed fixed income instruments, when interest rates can't go any lower why invest in bond funds? It makes no sense. It might make some sense to buy actual bonds if you plan to hold them to maturity, but who'd want to do that?

Because fixed money instruments are not attractive, the money flows elsewhere right now - emerging markets, commodities, stocks. It is not fear of inflation that drives them, I think, it is the fact that there are no alternatives and all this new money needs to find home.

Still, to keep the remaining markets - stocks, commodities, going you need to have constant money flow. And here is the thing - if there is little new real wealth creation, only financial alchemy, there is little new capital to invest. FED will keep interest rates low now forever unless there is a full blown currency crisis. But they can't keep printing money at the same rate as last year or we'll really get the currency crisis. So, they will restrict the flow somewhat. That is not going to be good for stocks either.

Now, you may agree and disagree with my thoughts, they are still work in progress. And I didn't even talk here about risk and leverage, just the money flow.

This is just an attempt to illustrate you how incredibly complicated markets are. You can analyze them to death and still come up with a wrong answer. That is why most advisers rely on statistics. But to me statistics don't mean anything if the prerequisites are no longer the same. And I'd say the markets today are very different from markets 20 years ago. So, what good these statistics from 20 years ago are? They are not measuring the same thing.