Free Sony EBooks: Free ebook sample of "Capitalistic Musings" by Sam Vaknin (powered by Smashwords)

It is impossible to describe any human action if one does not refer to the meaning the actor sees in the stimulus as well as in the end his response is aiming at.
Ludwig von Mises

Economics - to the great dismay of economists - is merely a branch of psychology. It deals with individual behaviour and with mass behaviour. Many of its practitioners sought to disguise its nature as a social science by applying complex mathematics where common sense and direct experimentation would have yielded far better results.

The outcome has been an embarrassing divorce between economic theory and its subjects.

The economic actor is assumed to be constantly engaged in the rational pursuit of self interest. This is not a realistic model - merely a useful approximation. According to this latter day - rational - version of the dismal science, people refrain from repeating their mistakes systematically. They seek to optimize their preferences. Altruism can be such a preference, as well.

Still, many people are non-rational or only nearly rational in certain situations. And the definition of "self-interest" as the pursuit of the fulfillment of preferences is a tautology.

The theory fails to predict important phenomena such as "strong reciprocity" - the propensity to "irrationally" sacrifice resources to reward forthcoming collaborators and punish free-riders. It even fails to account for simpler forms of apparent selflessness, such as reciprocal altruism (motivated by hopes of reciprocal benevolent treatment in the future).

Even the authoritative and mainstream 1995 "Handbook of Experimental Economics", by John Hagel and Alvin Roth (eds.) admits that people do not behave in accordance with the predictions of basic economic theories, such as the standard theory of utility and the theory of general equilibrium. Irritatingly for economists, people change their preferences mysteriously and irrationally. This is called "preference reversals".

Moreover, people's preferences, as evidenced by their choices and decisions in carefully controlled experiments, are inconsistent. They tend to lose control of their actions or procrastinate because they place greater importance (i.e., greater "weight") on the present and the near future than on the far future. This makes most people both irrational and unpredictable.

Either one cannot design an experiment to rigorously and validly test theorems and conjectures in economics - or something is very flawed with the intellectual pillars and models of this field.

Neo-classical economics has failed on several fronts simultaneously. This multiple failure led to despair and the re-examination of basic precepts and tenets.

Consider this sample of outstanding issues:

Unlike other economic actors and agents, governments are accorded a special status and receive special treatment in economic theory. Government is alternately cast as a saint, seeking to selflessly maximize social welfare - or as the villain, seeking to perpetuate and increase its power ruthlessly, as per public choice theories.

Both views are caricatures of reality. Governments indeed seek to perpetuate their clout and increase it - but they do so mostly in order to redistribute income and rarely for self-enrichment.

Economics also failed until recently to account for the role of innovation in growth and development. The discipline often ignored the specific nature of knowledge industries (where returns increase rather than diminish and network effects prevail). Thus, current economic thinking is woefully inadequate to deal with information monopolies (such as Microsoft), path dependence, and pervasive externalities.

Classic cost/benefit analyses fail to tackle very long term investment horizons (i.e., periods). Their underlying assumption - the opportunity cost of delayed consumption - fails when applied beyond the investor's useful economic life expectancy. People care less about their grandchildren's future than about their own. This is because predictions concerned with the far future are highly uncertain and investors refuse to base current decisions on fuzzy "what ifs".

This is a problem because many current investments, such as the fight against global warming, are likely to yield results only decades hence. There is no effective method of cost/benefit analysis applicable to such time horizons.

How are consumer choices influenced by advertising and by pricing? No one seems to have a clear answer. Advertising is concerned with the dissemination of information. Yet it is also a signal sent to consumers that a certain product is useful and qualitative and that the advertiser's stability, longevity, and profitability are secure. Advertising communicates a long term commitment to a winning product by a firm with deep pockets. This is why patrons react to the level of visual exposure to advertising - regardless of its content.

Humans may be too multi-dimensional and hyper-complex to be usefully captured by econometric models. These either lack predictive powers or lapse into logical fallacies, such as the "omitted variable bias" or "reverse causality". The former is concerned with important variables unaccounted for - the latter with reciprocal causation, when every cause is also caused by its own effect.

These are symptoms of an all-pervasive malaise. Economists are simply not sure what precisely constitutes their subject matter. Is economics about the construction and testing of models in accordance with certain basic assumptions? Or should it revolve around the mining of data for emerging patterns, rules, and "laws"?

On the one hand, patterns based on limited - or, worse, non-recurrent - sets of data form a questionable foundation for any kind of "science". On the other hand, models based on assumptions are also in doubt because they are bound to be replaced by new models with new, hopefully improved, assumptions.

One way around this apparent quagmire is to put human cognition (i.e., psychology) at the heart of economics. Assuming that being human is an immutable and knowable constant - it should be amenable to scientific treatment. "Prospect theory", "bounded rationality theories", and the study of "hindsight bias" as well as other cognitive deficiencies are the outcomes of this approach.

To qualify as science, economic theory must satisfy the following cumulative conditions:

a. All-inclusiveness (anamnetic) – It must encompass, integrate, and incorporate all the facts known about economic behaviour.

b. Coherence – It must be chronological, structured and causal. It must explain, for instance, why a certain economic policy leads to specific economic outcomes - and why.

c. Consistency – It must be self-consistent. Its sub-"units" cannot contradict one another or go against the grain of the main "theory". It must also be consistent with the observed phenomena, both those related to economics and those pertaining to non-economic human behaviour. It must adequately cope with irrationality and cognitive deficits.

d. Logical compatibility – It must not violate the laws of its internal logic and the rules of logic "out there", in the real world.

e. Insightfulness – It must cast the familiar in a new light, mine patterns and rules from big bodies of data ("data mining"). Its insights must be the inevitable conclusion of the logic, the language, and the evolution of the theory.

f. Aesthetic – Economic theory must be both plausible and "right", beautiful (aesthetic), not cumbersome, not awkward, not discontinuous, smooth, and so on.

g. Parsimony – The theory must employ a minimum number of assumptions and entities to explain the maximum number of observed economic behaviours.

h. Explanatory Powers – It must explain the behaviour of economic actors, their decisions, and why economic events develop the way they do.

i. Predictive (prognostic) Powers – Economic theory must be able to predict future economic events and trends as well as the future behaviour of economic actors.

j. Prescriptive Powers – The theory must yield policy prescriptions, much like physics yields technology. Economists must develop "economic technology" - a set of tools, blueprints, rules of thumb, and mechanisms with the power to change the " economic world".

k. Imposing – It must be regarded by society as the preferable and guiding organizing principle in the economic sphere of human behaviour.

l. Elasticity – Economic theory must possess the intrinsic abilities to self organize, reorganize, give room to emerging order, accommodate new data comfortably, and avoid rigid reactions to attacks from within and from without.

Many current economic theories do not meet these cumulative criteria and are, thus, merely glorified narratives.

But meeting the above conditions is not enough. Scientific theories must also pass the crucial hurdles of testability, verifiability, refutability, falsifiability, and repeatability. Yet, many economists go as far as to argue that no experiments can be designed to test the statements of economic theories.

It is difficult - perhaps impossible - to test hypotheses in economics for four reasons.

a. Ethical – Experiments would have to involve human subjects, ignorant of the reasons for the experiments and their aims. Sometimes even the very existence of an experiment will have to remain a secret (as with double blind experiments). Some experiments may involve unpleasant experiences. This is ethically unacceptable.

b. Design Problems - The design of experiments in economics is awkward and difficult. Mistakes are often inevitable, however careful and meticulous the designer of the experiment is.

c. The Psychological Uncertainty Principle – The current mental state of a human subject can be (theoretically) fully known. But the passage of time and, sometimes, the experiment itself, influence the subject and alter his or her mental state - a problem known in economic literature as "time inconsistencies". The very processes of measurement and observation influence the subject and change it.

d. Uniqueness – Experiments in economics, therefore, tend to be unique. They cannot be repeated even when the SAME subjects are involved, simply because no human subject remains the same for long. Repeating the experiments with other subjects casts in doubt the scientific value of the results.

d. The undergeneration of testable hypotheses – Economic theories do not generate a sufficient number of hypotheses, which can be subjected to scientific testing. This has to do with the fabulous (i.e., storytelling) nature of the discipline.

In a way, economics has an affinity with some private languages. It is a form of art and, as such, it is self-sufficient and self-contained. If certain structural, internal constraints and requirements are met – a statement in economics is deemed to be true even if it does not satisfy external (scientific) requirements. Thus, the standard theory of utility is considered valid in economics despite overwhelming empirical evidence to the contrary - simply because it is aesthetic and mathematically convenient.

So, what are economic "theories" good for?

Economic "theories" and narratives offer an organizing principle, a sense of order, predictability, and justice. They postulate an inexorable drive toward greater welfare and utility (i.e., the idea of progress). They render our chaotic world meaningful and make us feel part of a larger whole. Economics strives to answer the "why’s" and "how’s" of our daily life. It is dialogic and prescriptive (i.e., provides behavioral prescriptions). In certain ways, it is akin to religion.

In its catechism, the believer (let's say, a politician) asks: "Why... (and here follows an economic problem or behaviour)".

The economist answers:

"The situation is like this not because the world is whimsically cruel, irrational, and arbitrary - but because ... (and here follows a causal explanation based on an economic model). If you were to do this or that the situation is bound to improve".

The believer feels reassured by this explanation and by the explicit affirmation that there is hope providing he follows the prescriptions. His belief in the existence of linear order and justice administered by some supreme, transcendental principle is restored.

This sense of "law and order" is further enhanced when the theory yields predictions which come true, either because they are self-fulfilling or because some real "law", or pattern, has emerged. Alas, this happens rarely. As "The Economist" notes gloomily, economists have the most disheartening record of failed predictions - and prescriptions.

Return

The Misconception of Scarcity

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

My love as deep; the more I give to thee,
The more I have, for both are infinite.

(William Shakespeare, Romeo and Juliet, Act 2, Scene 2)

Are we confronted merely with a bear market in stocks - or is it the first phase of a global contraction of the magnitude of the Great Depression? The answer overwhelmingly depends on how we understand scarcity.

It will be only a mild overstatement to say that the science of economics, such as it is, revolves around the Malthusian concept of scarcity. Our infinite wants, the finiteness of our resources and the bad job we too often make of allocating them efficiently and optimally - lead to mismatches between supply and demand. We are forever forced to choose between opportunities, between alternative uses of resources, painfully mindful of their costs.

This is how the perennial textbook "Economics" (seventeenth edition), authored by Nobel prizewinner Paul Samuelson and William Nordhaus, defines the dismal science:

"Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people".

The classical concept of scarcity - unlimited wants vs. limited resources - is lacking. Anticipating much-feared scarcity encourages hoarding which engenders the very evil it was meant to fend off. Ideas and knowledge - inputs as important as land and water - are not subject to scarcity, as work done by Nobel laureate Robert Solow and, more importantly, by Paul Romer, an economist from the University of California at Berkeley, clearly demonstrates. Additionally, it is useful to distinguish natural from synthetic resources.

The scarcity of most natural resources (a type of "external scarcity") is only theoretical at present. Granted, many resources are unevenly distributed and badly managed. But this is man-made ("internal") scarcity and can be undone by Man. It is truer to assume, for practical purposes, that most natural resources - when not egregiously abused and when freely priced - are infinite rather than scarce. The anthropologist Marshall Sahlins discovered that primitive peoples he has studied had no concept of "scarcity" - only of "satiety". He called them the first "affluent societies".

This is because, fortunately, the number of people on Earth is finite - and manageable - while most resources can either be replenished or substituted. Alarmist claims to the contrary by environmentalists have been convincingly debunked by the likes of Bjorn Lomborg, author of "The Skeptical Environmentalist".

Equally, it is true that manufactured goods, agricultural produce, money, and services are scarce. The number of industrialists, service providers, or farmers is limited - as is their life span. The quantities of raw materials, machinery and plant are constrained. Contrary to classic economic teaching, human wants are limited - only so many people exist at any given time and not all them desire everything all the time. But, even so, the demand for man-made goods and services far exceeds the supply.

Scarcity is the attribute of a "closed" economic universe. But it can be alleviated either by increasing the supply of goods and services (and human beings) - or by improving the efficiency of the allocation of economic resources. Technology and innovation are supposed to achieve the former - rational governance, free trade, and free markets the latter.

The telegraph, the telephone, electricity, the train, the car, the agricultural revolution, information technology and, now, biotechnology have all increased our resources, seemingly ex nihilo. This multiplication of wherewithal falsified all apocalyptic Malthusian scenarios hitherto. Operations research, mathematical modeling, transparent decision making, free trade, and professional management - help better allocate these increased resources to yield optimal results.

Markets are supposed to regulate scarcity by storing information about our wants and needs. Markets harmonize supply and demand. They do so through the price mechanism. Money is, thus, a unit of information and a conveyor or conduit of the price signal - as well as a store of value and a means of exchange.

Markets and scarcity are intimately related. The former would be rendered irrelevant and unnecessary in the absence of the latter. Assets increase in value in line with their scarcity - i.e., in line with either increasing demand or decreasing supply. When scarcity decreases - i.e., when demand drops or supply surges - asset prices collapse. When a resource is thought to be infinitely abundant (e.g., air) - its price is zero.

Armed with these simple and intuitive observations, we can now survey the dismal economic landscape.

The abolition of scarcity was a pillar of the paradigm shift to the "new economy". The marginal costs of producing and distributing intangible goods, such as intellectual property, are negligible. Returns increase - rather than decrease - with each additional copy. An original software retains its quality even if copied numerous times. The very distinction between "original" and "copy" becomes obsolete and meaningless. Knowledge products are "non-rival goods" (i.e., can be used by everyone simultaneously).

Such ease of replication gives rise to network effects and awards first movers with a monopolistic or oligopolistic position. Oligopolies are better placed to invest excess profits in expensive research and development in order to achieve product differentiation. Indeed, such firms justify charging money for their "new economy" products with the huge sunken costs they incur - the initial expenditures and investments in research and development, machine tools, plant, and branding.

To sum, though financial and human resources as well as content may have remained scarce - the quantity of intellectual property goods is potentially infinite because they are essentially cost-free to reproduce. Plummeting production costs also translate to enhanced productivity and wealth formation. It looked like a virtuous cycle.

But the abolition of scarcity implied the abolition of value. Value and scarcity are two sides of the same coin. Prices reflect scarcity. Abundant products are cheap. Infinitely abundant products - however useful - are complimentary. Consider money. Abundant money - an intangible commodity - leads to depreciation against other currencies and inflation at home. This is why central banks intentionally foster money scarcity.

But if intellectual property goods are so abundant and cost-free - why were distributors of intellectual property so valued, not least by investors in the stock exchange? Was it gullibility or ignorance of basic economic rules?

Not so. Even "new economists" admitted to temporary shortages and "bottlenecks" on the way to their utopian paradise of cost-free abundance. Demand always initially exceeds supply. Internet backbone capacity, software programmers, servers are all scarce to start with - in the old economy sense.

This scarcity accounts for the stratospheric erstwhile valuations of dotcoms and telecoms. Stock prices were driven by projected ever-growing demand and not by projected ever-growing supply of asymptotically-free goods and services. "The Economist" describes how WorldCom executives flaunted the cornucopian doubling of Internet traffic every 100 days. Telecoms predicted a tsunami of clients clamoring for G3 wireless Internet services. Electronic publishers gleefully foresaw the replacement of the print book with the much heralded e-book.

The irony is that the new economy self-destructed because most of its assumptions were spot on. The bottlenecks were, indeed, temporary. Technology, indeed, delivered near-cost-free products in endless quantities. Scarcity was, indeed, vanquished.

Per the same cost, the amount of information one can transfer through a single fiber optic swelled 100 times. Computer storage catapulted 80,000 times. Broadband and cable modems let computers communicate at 300 times their speed only 5 years ago. Scarcity turned to glut. Demand failed to catch up with supply. In the absence of clear price signals - the outcomes of scarcity - the match between the two went awry.

One innovation the "new economy" has wrought is "inverse scarcity" - unlimited resources (or products) vs. limited wants. Asset exchanges the world over are now adjusting to this harrowing realization - that cost free goods are worth little in terms of revenues and that people are badly disposed to react to zero marginal costs.

The new economy caused a massive disorientation and dislocation of the market and the price mechanism. Hence the asset bubble. Reverting to an economy of scarcity is our only hope. If we don't do so deliberately - the markets will do it for us, mercilessly.

Return

The Roller Coaster Market

On Volatility and Risk

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

Volatility is considered the most accurate measure of risk and, by extension, of return, its flip side. The higher the volatility, the higher the risk - and the reward. That volatility increases in the transition from bull to bear markets seems to support this pet theory. But how to account for surging volatility in plummeting bourses? At the depths of the bear phase, volatility and risk increase while returns evaporate - even taking short-selling into account.

"The Economist" has recently proposed yet another dimension of risk:

"The Chicago Board Options Exchange's VIX index, a measure of traders' expectations of share price gyrations, in July reached levels not seen since the 1987 crash, and shot up again (two weeks ago) ... Over the past five years, volatility spikes have become ever more frequent, from the Asian crisis in 1997 right up to the World Trade Centre attacks. Moreover, it is not just price gyrations that have increased, but the volatility of volatility itself. The markets, it seems, now have an added dimension of risk."

Call-writing has soared as punters, fund managers, and institutional investors try to eke an extra return out of the wild ride and to protect their dwindling equity portfolios. Naked strategies - selling options contracts or buying them in the absence of an investment portfolio of underlying assets - translate into the trading of volatility itself and, hence, of risk. Short-selling and spread-betting funds join single stock futures in profiting from the downside.

Market - also known as beta or systematic - risk and volatility reflect underlying problems with the economy as a whole and with corporate governance: lack of transparency, bad loans, default rates, uncertainty, illiquidity, external shocks, and other negative externalities. The behavior of a specific security reveals additional, idiosyncratic, risks, known as alpha.

Quantifying volatility has yielded an equal number of Nobel prizes and controversies. The vacillation of security prices is often measured by a coefficient of variation within the Black-Scholes formula published in 1973. Volatility is implicitly defined as the standard deviation of the yield of an asset. The value of an option increases with volatility. The higher the volatility the greater the option's chance during its life to be "in the money" - convertible to the underlying asset at a handsome profit.

Without delving too deeply into the model, this mathematical expression works well during trends and fails miserably when the markets change sign.

There is disagreement among scholars and traders whether one should better use historical data or current market prices - which include expectations - to estimate volatility and to price options correctly.

From "The Econometrics of Financial Markets" by John Campbell, Andrew Lo, and Craig MacKinlay, Princeton University Press, 1997:

"Consider the argument that implied volatilities are better forecasts of future volatility because changing market conditions cause volatilities (to) vary through time stochastically, and historical volatilities cannot adjust to changing market conditions as rapidly. The folly of this argument lies in the fact that stochastic volatility contradicts the assumption required by the B-S model - if volatilities do change stochastically through time, the Black-Scholes formula is no longer the correct pricing formula and an implied volatility derived from the Black-Scholes formula provides no new information."

Black-Scholes is thought deficient on other issues as well. The implied volatilities of different options on the same stock tend to vary, defying the formula's postulate that a single stock can be associated with only one value of implied volatility. The model assumes a certain - geometric Brownian - distribution of stock prices that has been shown to not apply to US markets, among others.

Studies have exposed serious departures from the price process fundamental to Black-Scholes: skewness, excess kurtosis (i.e., concentration of prices around the mean), serial correlation, and time varying volatilities. Black-Scholes tackles stochastic volatility poorly.

The formula also unrealistically assumes that the market dickers continuously, ignoring transaction costs and institutional constraints. No wonder that traders use Black-Scholes as a heuristic rather than a price-setting formula.

Volatility also decreases in administered markets and over different spans of time. As opposed to the received wisdom of the random walk model, most investment vehicles sport different volatilities over different time horizons. Volatility is especially high when both supply and demand are inelastic and liable to large, random shocks. This is why the prices of industrial goods are less volatile than the prices of shares, or commodities.

But why are stocks and exchange rates volatile to start with? Why don't they follow a smooth evolutionary path in line, say, with inflation, or interest rates, or productivity, or net earnings?

To start with, because economic fundamentals fluctuate - sometimes as wildly as shares. The Fed has cut interest rates 11 times in the past 12 months down to 1.75 percent - the lowest level in 40 years. Inflation gyrated from double digits to a single digit in the space of two decades. This uncertainty is, inevitably, incorporated in the price signal.

Moreover, because of time lags in the dissemination of data and its assimilation in the prevailing operational model of the economy - prices tend to overshoot both ways. The economist Rudiger Dornbusch, who died last month, studied in his seminal paper, "Expectations and Exchange Rate Dynamics", published in 1975, the apparently irrational ebb and flow of floating currencies.

His conclusion was that markets overshoot in response to surprising changes in economic variables. A sudden increase in the money supply, for instance, axes interest rates and causes the currency to depreciate. The rational outcome should have been a panic sale of obligations denominated in the collapsing currency. But the devaluation is so excessive that people reasonably expect a rebound - i.e., an appreciation of the currency - and purchase bonds rather than dispose of them.

Yet, even Dornbusch ignored the fact that some price twirls have nothing to do with economic policies or realities, or with the emergence of new information - and a lot to do with mass psychology. How else can we account for the crash of October 1987? This goes to the heart of the undecided debate between technical and fundamental analysts.

As Robert Shiller has demonstrated in his tomes "Market Volatility" and "Irrational Exuberance", the volatility of stock prices exceeds the predictions yielded by any efficient market hypothesis, or by discounted streams of future dividends, or earnings. Yet, this finding is hotly disputed.

Some scholarly studies of researchers such as Stephen LeRoy and Richard Porter offer support - other, no less weighty, scholarship by the likes of Eugene Fama, Kenneth French, James Poterba, Allan Kleidon, and William Schwert negate it - mainly by attacking Shiller's underlying assumptions and simplifications. Everyone - opponents and proponents alike - admit that stock returns do change with time, though for different reasons.

Volatility is a form of market inefficiency. It is a reaction to incomplete information (i.e., uncertainty). Excessive volatility is irrational. The confluence of mass greed, mass fears, and mass disagreement as to the preferred mode of reaction to public and private information - yields price fluctuations.

Changes in volatility - as manifested in options and futures premiums - are good predictors of shifts in sentiment and the inception of new trends. Some traders are contrarians. When the VIX or the NASDAQ Volatility indices are high - signifying an oversold market - they buy and when the indices are low, they sell.

Chaikin's Volatility Indicator, a popular timing tool, seems to couple market tops with increased indecisiveness and nervousness, i.e., with enhanced volatility. Market bottoms - boring, cyclical, affairs - usually suppress volatility. Interestingly, Chaikin himself disputes this interpretation. He believes that volatility increases near the bottom, reflecting panic selling - and decreases near the top, when investors are in full accord as to market direction.

But most market players follow the trend. They sell when the VIX is high and, thus, portends a declining market. A bullish consensus is indicated by low volatility. Thus, low VIX readings signal the time to buy. Whether this is more than superstition or a mere gut reaction remains to be seen.

It is the work of theoreticians of finance. Alas, they are consumed by mutual rubbishing and dogmatic thinking. The few that wander out of the ivory tower and actually bother to ask economic players what they think and do - and why - are much derided. It is a dismal scene, devoid of volatile creativity.

Return

The Friendly Trend

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

The authors of a paper published by NBER on March 2000 and titled "The Foundations of Technical Analysis" - Andrew Lo, Harry Mamaysky, and Jiang Wang - claim that:

"Technical analysis, also known as 'charting', has been part of financial practice for many decades, but this discipline has not received the same level of academic scrutiny and acceptance as more traditional approaches such as fundamental analysis.

One of the main obstacles is the highly subjective nature of technical analysis - the presence of geometric shapes in historical price charts is often in the eyes of the beholder. In this paper we offer a systematic and automatic approach to technical pattern recognition ... and apply the method to a large number of US stocks from 1962 to 1996..."

And the conclusion:

" ... Over the 31-year sample period, several technical indicators do provide incremental information and may have some practical value."

These hopeful inferences are supported by the work of other scholars, such as Paul Weller of the Finance Department of the university of Iowa. While he admits the limitations of technical analysis - it is a-theoretic and data intensive, pattern over-fitting can be a problem, its rules are often difficult to interpret, and the statistical testing is cumbersome - he insists that "trading rules are picking up patterns in the data not accounted for by standard statistical models" and that the excess returns thus generated are not simply a risk premium.

Technical analysts have flourished and waned in line with the stock exchange bubble. They and their multi-colored charts regularly graced CNBC, the CNN and other market-driving channels. "The Economist" found that many successful fund managers have regularly resorted to technical analysis - including George Soros' Quantum Hedge fund and Fidelity's Magellan. Technical analysis may experience a revival now that corporate accounts - the fundament of fundamental analysis - have been rendered moot by seemingly inexhaustible scandals.

The field is the progeny of Charles Dow of Dow Jones fame and the founder of the "Wall Street Journal". He devised a method to discern cyclical patterns in share prices. Other sages - such as Elliott - put forth complex "wave theories". Technical analysts now regularly employ dozens of geometric configurations in their divinations.

Technical analysis is defined thus in "The Econometrics of Financial Markets", a 1997 textbook authored by John Campbell, Andrew Lo, and Craig MacKinlay:

"An approach to investment management based on the belief that historical price series, trading volume, and other market statistics exhibit regularities - often ... in the form of geometric patterns ... that can be profitably exploited to extrapolate future price movements."

A less fanciful definition may be the one offered by Edwards and Magee in "Technical Analysis of Stock Trends":

"The science of recording, usually in graphic form, the actual history of trading (price changes, volume of transactions, etc.) in a certain stock or in 'the averages' and then deducing from that pictured history the probable future trend."

Fundamental analysis is about the study of key statistics from the financial statements of firms as well as background information about the company's products, business plan, management, industry, the economy, and the marketplace.

Economists, since the 1960's, sought to rebuff technical analysis. Markets, they say, are efficient and "walk" randomly. Prices reflect all the information known to market players - including all the information pertaining to the future. Technical analysis has often been compared to voodoo, alchemy, and astrology - for instance by Burton Malkiel in his seminal work, "A Random Walk Down Wall Street."

The paradox is that technicians are more orthodox than the most devout academic. They adhere to the strong version of market efficiency. The market is so efficient, they say, that nothing can be gleaned from fundamental analysis. All fundamental insights, information, and analyses are already reflected in the price. This is why one can deduce future prices from past and present ones.

Jack Schwager, sums it up in his book "Schwager on Futures: Technical Analysis", quoted by Stockcharts.com, :

"One way of viewing it is that markets may witness extended periods of random fluctuation, interspersed with shorter periods of nonrandom behavior. The goal of the chartist is to identify those periods (i.e. major trends)."

Not so, retort the fundamentalists. The fair value of a security or a market can be derived from available information using mathematical models - but is rarely reflected in prices. This is the weak version of the market efficiency hypothesis.

The mathematically convenient idealization of the efficient market, though, has been debunked in numerous studies. These are efficiently summarized in Craig McKinlay and Andrew Lo's tome "A Non-random Walk Down Wall Street" published in 1999.

Not all markets are strongly efficient. Most of them sport weak or "semi-strong" efficiency. In some markets, a filter model - one that dictates the timing of sales and purchases - could prove useful. This is especially true when the equilibrium price of a share - or of the market as a whole - changes as a result of externalities.

Substantive news, change in management, an oil shock, a terrorist attack, an accounting scandal, an FDA approval, a major contract, or a natural, or man-made disaster - all cause share prices and market indices to break the boundaries of the price band that they have occupied. Technical analysts identify these boundaries and trace breakthroughs and their outcomes in terms of prices.

Technical analysis may be nothing more than a self-fulfilling prophecy, though. The more devotees it has, the stronger it affects the shares or markets it analyses. Investors move in herds and are inclined to seek patterns in the often bewildering marketplace. As opposed to the assumptions underlying the classic theory of portfolio analysis - investors do remember past prices. They hesitate before they cross certain numerical thresholds.

But this herd mentality is also the Achilles heel of technical analysis. If everyone were to follow its guidance - it would have been rendered useless. If everyone were to buy and sell at the same time - based on the same technical advice - price advantages would have been arbitraged away instantaneously. Technical analysis is about privileged information to the privileged few - though not too few, lest prices are not swayed.

Studies cited in Edwin Elton and Martin Gruber's "Modern Portfolio Theory and Investment Analysis" and elsewhere show that a filter model - trading with technical analysis - is preferable to a "buy and hold" strategy but inferior to trading at random. Trading against recommendations issued by a technical analysis model and with them - yielded the same results. Fama-Blum discovered that the advantage proffered by such models is identical to transaction costs.

The proponents of technical analysis claim that rather than forming investor psychology - it reflects their risk aversion at different price levels. Moreover, the borders between the two forms of analysis - technical and fundamental - are less sharply demarcated nowadays. "Fundamentalists" insert past prices and volume data in their models - and "technicians" incorporate arcana such as the dividend stream and past earnings in theirs.

It is not clear why should fundamental analysis be considered superior to its technical alternative. If prices incorporate all the information known and reflect it - predicting future prices would be impossible regardless of the method employed. Conversely, if prices do not reflect all the information available, then surely investor psychology is as important a factor as the firm's - now oft-discredited - financial statements?

Prices, after all, are the outcome of numerous interactions among market participants, their greed, fears, hopes, expectations, and risk aversion. Surely studying this emotional and cognitive landscape is as crucial as figuring the effects of cuts in interest rates or a change of CEO?

Still, even if we accept the rigorous version of market efficiency - i.e., as Aswath Damodaran of the Stern Business School at NYU puts it, that market prices are "unbiased estimates of the true value of investments" - prices do react to new information - and, more importantly, to anticipated information. It takes them time to do so. Their reaction constitutes a trend and identifying this trend at its inception can generate excess yields. On this both fundamental and technical analysis are agreed.

Moreover, markets often over-react: they undershoot or overshoot the "true and fair value". Fundamental analysis calls this oversold and overbought markets. The correction back to equilibrium prices sometimes takes years. A savvy trader can profit from such market failures and excesses.

As quality information becomes ubiquitous and instantaneous, research issued by investment banks discredited, privileged access to information by analysts prohibited, derivatives proliferate, individual participation in the stock market increases, and transaction costs turn negligible - a major rethink of our antiquated financial models is called for.

The maverick Andrew Lo, a professor of finance at the Sloan School of Management at MIT, summed up the lure of technical analysis in lyric terms in an interview he gave to Traders.com's "Technical Analysis of Stocks and Commodities", quoted by Arthur Hill in Stockcharts.com:

"The more creativity you bring to the investment process, the more rewarding it will be. The only way to maintain ongoing success, however, is to constantly innovate. That's much the same in all endeavors. The only way to continue making money, to continue growing and keeping your profit margins healthy, is to constantly come up with new ideas."

Return

The Merits of Inflation

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

In a series of speeches designed to defend his record, Alan Greenspan, until recently an icon of both the new economy and stock exchange effervescence, reiterated the orthodoxy of central banking everywhere. His job, he repeated disingenuously, was confined to taming prices and ensuring monetary stability. He could not and, indeed, would not second guess the market. He consistently sidestepped the thorny issues of just how destabilizing to the economy the bursting of asset bubbles is and how his policies may have contributed to the froth.

Greenspan and his ilk seem to be fighting yesteryear's war against a long-slain monster. The obsession with price stability led to policy excesses and disinflation gave way to deflation - arguably an economic ill far more pernicious than inflation. Deflation coupled with negative savings and monstrous debt burdens can lead to prolonged periods of zero or negative growth. Moreover, in the zealous crusade waged globally against fiscal and monetary expansion - the merits and benefits of inflation have often been overlooked.

As economists are wont to point out time and again, inflation is not the inevitable outcome of growth. It merely reflects the output gap between actual and potential GDP. As long as the gap is negative - i.e., whilst the economy is drowning in spare capacity - inflation lies dormant. The gap widens if growth is anemic and below the economy's potential. Thus, growth can actually be accompanied by deflation.

Indeed, it is arguable whether inflation was subdued - in America as elsewhere - by the farsighted policies of central bankers. A better explanation might be overcapacity - both domestic and global - wrought by decades of inflation which distorted investment decisions. Excess capacity coupled with increasing competition, globalization, privatization, and deregulation - led to ferocious price wars and to consistently declining prices.

Quoted by "The Economist", Dresdner Kleinwort Wasserstein noted that America's industry is already in the throes of deflation. The implicit price deflator of the non-financial business sector has been -0.6 percent in the year to the end of the second quarter of 2002. Germany faces the same predicament. As oil prices surge, their inflationary shock will give way to a deflationary and recessionary aftershock.

Depending on one's point of view, this is a self-reinforcing virtuous - or vicious cycle. Consumers learn to expect lower prices - i.e., inflationary expectations fall and, with them, inflation itself.

The intervention of central banks only hastened the process and now it threatens to render benign structural disinflation - malignantly deflationary.

Should the USA reflate its way out of either an impending double dip recession or deflationary anodyne growth?

It is universally accepted that inflation leads to the misallocation of economic resources by distorting the price signal. Confronted with a general rise in prices, people get confused. They are not sure whether to attribute the surging prices to a real spurt in demand, to speculation, inflation, or what. They often make the wrong decisions.

They postpone investments - or over-invest and embark on preemptive buying sprees. As Erica Groshen and Mark Schweitzer have demonstrated in an NBER working paper titled "Identifying inflation's grease and sand effects in the labour market", employers - unable to predict tomorrow's wages - hire less.

Still, the late preeminent economist James Tobin went as far as calling inflation "the grease on the wheels of the economy". What rate of inflation is desirable? The answer is: it depends on whom you ask. The European Central Bank maintains an annual target of 2 percent. Other central banks - the Bank of England, for instance - proffer an "inflation band" of between 1.5 and 2.5 percent. The Fed has been known to tolerate inflation rates of 3-4 percent.

These disparities among essentially similar economies reflect pervasive disagreements over what is being quantified by the rate of inflation and when and how it should be managed.

The sin committed by most central banks is their lack of symmetry. They signal visceral aversion to inflation - but ignore the risk of deflation altogether. As inflation subsides, disinflation seamlessly fades into deflation. People - accustomed to the deflationary bias of central banks - expect prices to continue to fall. They defer consumption. This leads to inextricable and all-pervasive recessions.

Inflation rates - as measured by price indices - fail to capture important economic realities. As the Boskin commission revealed in 1996, some products are transformed by innovative technology even as their prices decline or remain stable. Such upheavals are not encapsulated by the rigid categories of the questionnaires used by bureaus of statistics the world over to compile price data. Cellular phones, for instance, were not part of the consumption basket underlying the CPI in America as late as 1998. The consumer price index in the USA may be overstated by one percentage point year in and year out, was the startling conclusion in the commission's report.

Current inflation measures neglect to take into account whole classes of prices - for instance, tradable securities. Wages - the price of labor - are left out. The price of money - interest rates - is excluded. Even if these were to be included, the way inflation is defined and measured today, they would have been grossly misrepresented.

Consider a deflationary environment in which stagnant wages and zero interest rates can still have a - negative or positive - inflationary effect. In real terms, in deflation, both wages and interest rates increase relentlessly even if they stay put. Yet it is hard to incorporate this "downward stickiness" in present-day inflation measures.

The methodology of computing inflation obscures many of the "quantum effects" in the borderline between inflation and deflation. Thus, as pointed out by George Akerloff, William Dickens, and George Perry in "The Macroeconomics of Low Inflation" (Brookings Papers on Economic Activity, 1996), inflation allows employers to cut real wages.

Workers may agree to a 2 percent pay rise in an economy with 3 percent inflation. They are unlikely to accept a pay cut even when inflation is zero or less. This is called the "money illusion". Admittedly, it is less pronounced when compensation is linked to performance. Thus, according to "The Economist", Japanese wages - with a backdrop of rampant deflation - shrank 5.6 percent in the year to July as company bonuses were brutally slashed.

Economists in a November 2000 conference organized by the ECB argued that a continent-wide inflation rate of 0-2 percent would increase structural unemployment in Europe's arthritic labor markets by a staggering 2-4 percentage points. Akerloff-Dickens-Perry concurred in the aforementioned paper. At zero inflation, unemployment in America would go up, in the long run, by 2.6 percentage points. This adverse effect can, of course, be offset by productivity gains, as has been the case in the USA throughout the 1990's.

The new consensus is that the price for a substantial decrease in unemployment need not be a sizable rise in inflation. The level of employment at which inflation does not accelerate - the non-accelerating inflation rate of unemployment or NAIRU - is susceptible to government policies.

Vanishingly low inflation - bordering on deflation - also results in a "liquidity trap". The nominal interest rate cannot go below zero. But what matters are real - inflation adjusted - interest rates. If inflation is naught or less - the authorities are unable to stimulate the economy by reducing interest rates below the level of inflation.

This has been the case in Japan in the last few years and is now emerging as a problem in the USA. The Fed - having cut rates 11 times in the past 14 months and unless it is willing to expand the money supply aggressively - may be at the end of its monetary tether. The Bank of Japan has recently resorted to unvarnished and assertive monetary expansion in line with what Paul Krugman calls "credible promise to be irresponsible".

This may have led to the sharp devaluation of the yen in recent months. Inflation is exported through the domestic currency's depreciation and the lower prices of export goods and services. Inflation thus indirectly enhances exports and helps close yawning gaps in the current account. The USA with its unsustainable trade deficit and resurgent budget deficit could use some of this medicine.

But the upshots of inflation are fiscal, not merely monetary. In countries devoid of inflation accounting, nominal gains are fully taxed - though they reflect the rise in the general price level rather than any growth in income. Even where inflation accounting is introduced, inflationary profits are taxed.

Thus inflation increases the state's revenues while eroding the real value of its debts, obligations, and expenditures denominated in local currency. Inflation acts as a tax and is fiscally corrective - but without the recessionary and deflationary effects of a "real" tax.

The outcomes of inflation, ironically, resemble the economic recipe of the "Washington consensus" propagated by the likes of the rabidly anti-inflationary IMF. As a long term policy, inflation is unsustainable and would lead to cataclysmic effects. But, in the short run, as a "shock absorber" and "automatic stabilizer", low inflation may be a valuable counter-cyclical instrument.

Inflation also improves the lot of corporate - and individual - borrowers by increasing their earnings and marginally eroding the value of their debts (and savings). It constitutes a disincentive to save and an incentive to borrow, to consume, and, alas, to speculate. "The Economist" called it "a splendid way to transfer wealth from savers to borrowers."

The connection between inflation and asset bubbles is unclear. On the one hand, some of the greatest fizz in history occurred during periods of disinflation. One is reminded of the global boom in technology shares and real estate in the 1990's. On the other hand, soaring inflation forces people to resort to hedges such as gold and realty, inflating their prices in the process. Inflation - coupled with low or negative interest rates - also tends to exacerbate perilous imbalances by encouraging excess borrowing, for instance.

Still, the absolute level of inflation may be less important than its volatility. Inflation targeting - the latest fad among central bankers - aims to curb inflationary expectations by implementing a consistent and credible anti-inflationary as well as anti-deflationary policy administered by a trusted and impartial institution, the central bank.

Return

The Benefits of Oligopolies

By: Dr. Sam Vaknin

Also published by United Press International (UPI)

The Wall Street Journal has recently published an elegiac list:

"Twenty years ago, cable television was dominated by a patchwork of thousands of tiny, family-operated companies. Today, a pending deal would leave three companies in control of nearly two-thirds of the market. In 1990, three big publishers of college textbooks accounted for 35% of industry sales. Today they have 62% ... Five titans dominate the (defense) industry, and one of them, Northrop Grumman ... made a surprise (successful) $5.9 billion bid for (another) TRW ... In 1996, when Congress deregulated telecommunications, there were eight Baby Bells. Today there are four, and dozens of small rivals are dead. In 1999, more than 10 significant firms offered help-wanted Web sites. Today, three firms dominate."

Mergers, business failures, deregulation, globalization, technology, dwindling and more cautious venture capital, avaricious managers and investors out to increase share prices through a spree of often ill-thought acquisitions - all lead inexorably to the congealing of industries into a few suppliers. Such market formations are known as oligopolies. Oligopolies encourage customers to collaborate in oligopsonies and these, in turn, foster further consolidation among suppliers, service providers, and manufacturers.

Market purists consider oligopolies - not to mention cartels - to be as villainous as monopolies. Oligopolies, they intone, restrict competition unfairly, retard innovation, charge rent and price their products higher than they could have in a perfect competition free market with multiple participants. Worse still, oligopolies are going global.

But how does one determine market concentration to start with?

The Herfindahl-Hirschmann index squares the market shares of firms in the industry and adds up the total. But the number of firms in a market does not necessarily impart how low - or high - are barriers to entry. These are determined by the structure of the market, legal and bureaucratic hurdles, the existence, or lack thereof of functioning institutions, and by the possibility to turn an excess profit.

The index suffers from other shortcomings. Often the market is difficult to define. Mergers do not always drive prices higher. University of Chicago economists studying Industrial Organization - the branch of economics that deals with competition - have long advocated a shift of emphasis from market share to - usually temporary - market power. Influential antitrust thinkers, such as Robert Bork, recommended to revise the law to focus solely on consumer welfare.

These - and other insights - were incorporated in a theory of market contestability. Contrary to classical economic thinking, monopolies and oligopolies rarely raise prices for fear of attracting new competitors, went the new school. This is especially true in a "contestable" market - where entry is easy and cheap.

An Oligopolistic firm also fears the price-cutting reaction of its rivals if it reduces prices, goes the Hall, Hitch, and Sweezy theory of the Kinked Demand Curve. If it were to raise prices, its rivals may not follow suit, thus undermining its market share. Stackleberg's amendments to Cournot's Competition model, on the other hand, demonstrate the advantages to a price setter of being a first mover.

In "Economic assessment of oligopolies under the Community Merger Control Regulation, in European Competition law Review (Vol 4, Issue 3), Juan Briones Alonso writes:

"At first sight, it seems that ... oligopolists will sooner or later find a way of avoiding competition among themselves, since they are aware that their overall profits are maximized with this strategy. However, the question is much more complex. First of all, collusion without explicit agreements is not easy to achieve. Each supplier might have different views on the level of prices which the demand would sustain, or might have different price preferences according to its cost conditions and market share. A company might think it has certain advantages which its competitors do not have, and would perhaps perceive a conflict between maximising its own profits and maximizing industry profits.

Moreover, if collusive strategies are implemented, and oligopolists manage to raise prices significantly above their competitive level, each oligopolist will be confronted with a conflict between sticking to the tacitly agreed behaviour and increasing its individual profits by 'cheating' on its competitors. Therefore, the question of mutual monitoring and control is a key issue in collusive oligopolies."

Monopolies and oligopolies, went the contestability theory, also refrain from restricting output, lest their market share be snatched by new entrants. In other words, even monopolists behave as though their market was fully competitive, their production and pricing decisions and actions constrained by the "ghosts" of potential and threatening newcomers.

In a CRIEFF Discussion Paper titled "From Walrasian Oligopolies to Natural Monopoly - An Evolutionary Model of Market Structure", the authors argue that: "Under decreasing returns and some fixed cost, the market grows to 'full capacity' at Walrasian equilibrium (oligopolies); on the other hand, if returns are increasing, the unique long run outcome involves a profit-maximising monopolist."

While intellectually tempting, contestability theory has little to do with the rough and tumble world of business. Contestable markets simply do not exist. Entering a market is never cheap, nor easy. Huge sunk costs are required to counter the network effects of more veteran products as well as the competitors' brand recognition and ability and inclination to collude to set prices.

Victory is not guaranteed, losses loom constantly, investors are forever edgy, customers are fickle, bankers itchy, capital markets gloomy, suppliers beholden to the competition. Barriers to entry are almost always formidable and often insurmountable.

In the real world, tacit and implicit understandings regarding prices and competitive behavior prevail among competitors within oligopolies. Establishing a reputation for collusive predatory pricing deters potential entrants. And a dominant position in one market can be leveraged into another, connected or derivative, market.

But not everyone agrees. Ellis Hawley believed that industries should be encouraged to grow because only size guarantees survival, lower prices, and innovation. Louis Galambos, a business historian at Johns Hopkins University, published a 1994 paper titled "The Triumph of Oligopoly". In it, he strove to explain why firms and managers - and even consumers - prefer oligopolies to both monopolies and completely free markets with numerous entrants.

Oligopolies, as opposed to monopolies, attract less attention from trustbusters. Quoted in the Wall Street Journal on March 8, 1999, Galambos wrote: "Oligopolistic competition proved to be beneficial ... because it prevented ossification, ensuring that managements would keep their organizations innovative and efficient over the long run."

In his recently published tome "The Free-Market Innovation Machine - Analysing the Growth Miracle of Capitalism", William Baumol of Princeton University, concurs. He daringly argues that productive innovation is at its most prolific and qualitative in oligopolistic markets. Because firms in an oligopoly characteristically charge above-equilibrium (i.e., high) prices - the only way to compete is through product differentiation. This is achieved by constant innovation - and by incessant advertising.

Baumol maintains that oligopolies are the real engines of growth and higher living standards and urges antitrust authorities to leave them be. Lower regulatory costs, economies of scale and of scope, excess profits due to the ability to set prices in a less competitive market - allow firms in an oligopoly to invest heavily in research and development. A new drug costs c. $800 million to develop and get approved, according to Joseph DiMasi of Tufts University's Center for the Study of Drug Development, quoted in The wall Street Journal.

In a paper titled "If Cartels Were Legal, Would Firms Fix Prices", implausibly published by the Antitrust Division of the US Department of Justice in 1997, Andrew Dick demonstrated, counterintuitively, that cartels are more likely to form in industries and sectors with many producers. The more concentrated the industry - i.e., the more oligopolistic it is - the less likely were cartels to emerge.

Continue reading this ebook at Smashwords.
Download this book for your ebook reader.
(Pages 1-38 show above.)