Schroedinger's Cat Revisited: Why It's Impossible to Predict the Markets

“I do not know which makes a man more conservative – to know nothing but the present, or nothing but the past.” – John Maynard Keynes, ‘The End of Laissez-faire’.

It is sometimes useful and always amusing to look back at one’s earlier thoughts. The following piece was originally published two years ago (June 2, 2006, to be precise) – an altogether more innocent age, and from the vantage point of Autumn 2008, seemingly aeons ago. I have made no alterations (other than omissions for the sake of brevity) to the original and current, languidly ironic, commentary is added in parentheses in a jaunty orange.

At the level of the very small, making accurate statements about “reality” is fraught, and may indeed be impossible. According to Heisenberg’s Uncertainty Principle, in sub-atomic physics we can know the path an electron takes, or we can know where it is at any given moment, but we cannot know both. The very act of observation disturbs location. Take Erwin Schroedinger’s hypothetical cat, sitting in a box with one radioactive atom attached to a vial of hydrocyanic acid. If the particle degrades within an hour, the vial will break and the cat will die. If not, the cat will live. As Bill Bryson indicates in his endearing Short history of nearly everything (Doubleday, 2003), "But we could not know which was the case, so there (is) no choice, scientifically, but to regard the cat as 100% alive and 100% dead at the same time."

Similarly, at the level of the very large, making accurate statements about “reality” is comparably fraught. In Bryson’s words again, we live in a universe whose age we can’t quite compute, surrounded by stars whose distances from us and each other we don’t altogether know, filled with matter we can’t identify, operating in conformance with physical laws whose properties we don’t truly understand.

So what does all this have to do with the markets? At the risk of stretching an analogy to breaking point, making any kind of explanatory declaration – even about past market conditions, let alone current or future ones – is comparably fraught, to the extent that there are too many market participants of too many distinct types, all possessing an array of varied emotional, psychological, temporal, aspirational and fundamental approaches to investments, for any one firm or process to begin to describe the markets with anything more than a tenuous hope of capturing ephemeral “reality”. Or to use Stephen Hawking’s words, "one cannot predict future events exactly if one cannot even measure the present state of the universe precisely!"

And Hawking at least has the benefit of scientific laws and the scientific method on his side. Investors have to do what they can with their best sense of informed pragmatism.

In trying to explain why, during the month of May, equities, commodities and emerging markets all fell dramatically, there has been no shortage of publicly discussed culprits. To cite one proposed answer: “political convulsions in Iran... enormous new increases in oil prices... limited progress in developing an effective energy policy in the US... reacceleration of inflation...” Each of these factors may indeed have played a part, but the conclusion is hardly novel, given that the testimony comes from 1979, when former Federal Reserve chairman Arthur Burns gave a lecture entitled “The Anguish of Central Banking”.

And if central bankers were anguished in the 1970s, their lot has barely improved since. With economic data robust and inflation risk rising (though perhaps by less than some recent, late-to-the-party inflationists are shrieking), the Fed looks suspiciously behind the curve, whether or not its new chairman chooses to give private briefings to newsreaders. US headline inflation could easily re-test 4% year-on-year and so any pause in the monetary tightening process ought to be temporary [inflation! higher policy rates! remember those?]. And while European and Japanese fundamentals put less pressure on central bankers for dramatic tightening, more tightening evidently lies ahead. It is difficult to get overly enthused about bonds in such an environment [now it is difficult not to].

In trying to account for May’s market lurches, some commentators have put the blame on Japan, after its recent announcement of an end to qualitative easing and the resultant pressuring of carry trades funded with cheap yen. Some have pointed the finger at fears over resurgent inflation.. Some have blamed new public offerings for Chinese banks for sucking capital away from US markets and threatening the US dollar. Some, inevitably, attribute the market’s slide to hedge funds – handy whipping boys at the best of times in the absence of any brighter ideas [no change there then]; others, to sheer complacency, or to the fact that some kind of correction was simply overdue.

Strategist Barry Ritholtz offers perhaps the most ironic justification for recent market weakness: bull markets don’t typically end until the last bears throw in the towel. And in early May, the bearishly inclined Richard Bernstein of Merrill Lynch and Stephen Roach of Morgan Stanley did exactly that. [Note also that Albert Edwards of SocGen and Jeremy Grantham of GMO are now conspicuously less bearish than they have been for years.]

In the end, I favour the Murder on the Orient Express solution: they all did it. Looking for scapegoats after market weakness is admittedly something of a fool’s errand. What matters is assessing whether the market environment has changed profoundly (fundamentally, however, it feels difficult to argue that it has) – but if it has (time will tell, and sentiment has certainly taken a beating), we should re-examine how best to protect investment portfolios and prepare for the future.

First, there seems little point in fighting hostile central banks. In a global environment of enhanced trade competition and generally subdued inflation outside the commodity sector, there will come a time to increase bond duration but we are probably not there quite yet [I feel the same way now, but for different reasons: multiple Niagaras of sovereign debt issuance to help bail out the banks, and anticipated slashing of policy rates to previously unseen levels, make a compelling case for sheltering at the front end of government bond yield curves].

Second, in an environment of suddenly re-sensitized investors, it makes sense to pare back equity exposure to more defensive themes. Third, taking unnecessary foreign currency risk (read: to the US dollar in particular) seems like a dangerous luxury. [180° turnaround now required: the USD is the only game in town, in part because it’s the only global reserve currency in town.]

Whether the recent correction remains relatively benign or turns into something altogether worse, one should bear in mind that it has made all sorts of assets suddenly cheaper. Some of those “assets” will undoubtedly turn out to be falling knives, but some will turn out to be shrewd purchases in coming months. Lower prices in isolation – particularly if one struggles to find a compelling smoking gun – are no reason to flee the market.

As in October 2008, I only have one thing to add. If one’s portfolio asset allocation was sensible and prudently diversified before the Crash of 2008, it is probably sensible and prudently diversified now. There is obviously a premium for holding cash (and cash proxies including short-dated high quality government bonds), because such a policy a) conserves precious capital and b) will allow patient investors to wade in and start carefully to scoop up bargains as the savage bear market rolls on. In some cases in the equity market, we are already comfortably into bargain territory. The caveat here is that there will be plenty of investors, particularly those suffering from quite urgent time horizon constraints, eager to sell into rallies to make up for precious losses.

So expect bounces, but don’t expect an effortless retracement to the markets’ former highs. We are unlikely to see their like for quite some time yet – another reason to view the equity market extremely selectively.

Comments

[Moon Kil Woong:]

How about avoid them all together until trading halts start happening. I suppose you can consider that quantum tunneling of prices. That is when the real black box Schrodenger's creepiness starts. Who can say where the price will bore its way to after the close lol. in 1987 it was up after the market close.

2008 Oct 27 11:55 PM

[vodka_tonic:]

it's uncanny but sometimes i can absolutely tell if the market is going to go up or down for a brief period of time....everything makes sense.....but, then again i'm a daytrader :)

i don't get schroedinger and i wouldn't put much stock in what you have written, in another 20 years they will have it all figured out....

2008 Oct 28 04:09 AM

[john s. gordon:]

interesting parallel with quantum mechanics. of course an electron is not a thing, it is a probability distribution therefore every electron in the universe affects every other electron in the universe to some degree, and we have action at a distance. application to day trading ? ?
>jhack

2008 Oct 28 08:14 AM

[flow5:]

First, there is no ambiguity in forecasts. In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise” (1) nominal GDP is measured by monetary flows (MVt); (2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits, demand deposit turnover) that matters; (3) “money” is the measure of liquidity; & (4) the rates-of-change (roc’s) used by the Fed are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;



Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.



The lags for monetary flows (MVt), i.e. proxies for (1) real GDP and the (2) deflator are exact, unvarying - respectively. Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact; as demonstrated by a scatter plot diagram).



Not surprisingly, adjusted member commercial bank "free/gratis" legal reserves (their roc’s) corroborate/mirror, both lags for monetary flows (MVt) –-- their lengths, or frequency, are identical -- (as the weighted arithmetic average of reserve ratios remains constant) -- (analogous to Max Planck's constant in quantum physics).



The lags for both monetary flows (MVt) & "free/gratis" legal reserves are indistinguishable. Consequently it has been mathematically impossible to miss an economic forecast (bubble, etc.). There are no inaccuracies, just some non-conforming & unavailable data (e.g., revisions have been overlaid & lost, flawed deposit classification, data discontinued, etc.). This is the “Holy Grail” & it is inviolate & sacrosanct.



The BEA uses quarterly accounting periods for real GDP and deflator. The accounting periods for GDP should correspond to the economic lag, not quarterly.



Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP. Note: roc’s in nominal GDP can serve as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.



Because of monopoly elements and other structural defects which raise costs and prices unnecessarily and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 percentage points. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.



Some people prefer the devil theory of inflation: “It’s all Peak Oil's fault.” This approach ignores the fact that the evidence of inflation is represented by "actual" prices in the marketplace. The "administered" prices of the world's oil producing countries would not be the "asked" prices were they not “validated” by (MVt), i.e., validated by the world's Central Banks ( i.e., as Friedman maintained "inflation is always and everywhere a monetary phenomenon")

2008 Oct 28 10:13 AM

[carey_jim:]

A Random Walk Down Wall Street

Burton Malkiel,

2008 Oct 28 02:54 PM

[short WFC:]

gobbledygook, a parallel between quantum mechanics (one of lthe least understood theories of all time) with investing is hardly likely to help anyone accomplish anything,

2008 Oct 28 06:14 PM