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Can we predict frauds by observing a debate?

|Includes: China MediaExpress Holdings, Inc. (CCME)

The recent debate over the CCME puzzles me and provokes an interesting question for me: Can we predict truth with extremely asymmetrical information? Can we rationalize what we observe even if we are as ignorant as an idiot?

So here is an more approachable interpretation of the question. In cases of security fraud, ordinary investors are extremely uninformed about the true state of water, no matter how hard he or she tries to see through the muddy waters. What our poor investor, if there ever exist a creature called retail investor, can observe is an effort to convince them from both sides. Thus their essential problem is to come up with an educated guess about the state of the world by observing the efforts from both side.

I believe it is possible to tell the state the world, based on a set of extremely unrealistic assumptions that only economists and game theorist can be comfort with. It may be a perfect topic for my term paper in the advanced game theory next year, with more juice from an solid empirical research on SA.

Assumption 1. There are only two kinds of investors. Informed and uninformed. Informed investor knows the true state for sure but they may be profitting from either betting on the true state or doping the uninformed investor to bet otherwise.

Assumption 2. They love profit and hate risk. Beyond these two, they don't care a dime about anything else. It implies that every bit of information out there is driven by the self interest not by the concern of collective well beings. However, one caveat of the model is that it also fails to consider the utility of self image because pride and honor is also betting on the table.

Assumption 3. There are only three stages.
Stage one, informed investors make bets, which is unobservable to the uninformed investor and send a signal.
Stage two, uninformed investor see the signal (they may send their too), do the analysis, and then make the bets. Informed investors could adjust bets in this stage as well.
Stage three, true state comes out and everyone have a pay off only with respect to the bets they made. the first implication is that the nature of the game is a zero sum. The second implication is that liars can get away with whatever BS they produce.

Assumption 4. Once bet is made, there is no cost to carry them forward.

Based on these assumptions, what can we assume about the optimal behavior for each players?
For informed investors, if he is betting on the true state. His optimal strategy is to remain silent and buy the fucking dip. He can gain nothing by giving more information about the true state of the world, because eventually it will come out. He will never lose. Furthermore, he could even go out and distribute fake information. Because it is a zero sum game, the more panic outthere, the more profit he will make at the day of reckoning.
In contrast, if he is going to exploit the uninformed suckers, his best strategy will be as loud as possible so as to claim as much victims as possible to dump his previously positions.

Consequently, our poor retail investors are helpless because informed investors will either remain silent or keep bull shit. It is a classical example of adverse selection, or otherwise known as the Lemon market.

I would not go on to analyze uninformed investors here because the intuition I derived is more complicated and thus more fragile. However, it is sufficient to say, if the cost of signaling is not zero (they have a life or something else to do), they will either signal little in case they remain uninfomed, or they will act just like informed investor once they become, or at least they believe they become, informed investors.

So the bottom line, when most investors are behind the veil of ignorance, whatever prevailing is wrong.

Final words.

For one thing, elegant as the hypothesis is(I shameless claims so as a nerd with a hobby to develop complicated models), it never explains why there will be whistle blowers. The culpit in the model are the assumptions that the day of reckoning will come inevitably and all investors can keep their positions without contraints. Or, more cheerfully, there are people who offer a public good of truth at a private cost of time, energy and a less favorable position.

For another, who prevails in the current debate? I will leave my peer poor uninformed investors to make the call. Of course, the implication from a rudimentary model without empirical evidence does not consitute a investment advise.

Disclaimer: A short with a neligible small position of bearish put.