Tuesday, 15 July 2008

Snapshots From Traders' Family Album

In more than one occasion in this blog I have written about the consequences of the genuflection of theorists to businessmen. The root of the problem is an improbably philosophical one, pertaining to the validation of theory. As a theory is a conceptual explanation of the working of the real world, it must coherently and consistently explain and foretell the real world event that it aims to explain. There is no other way to judge the accuracy of a theory.

For reasons well outside the scope of this blog, this self-evident truth was gradually turned on its head by a group of philosophers and economists in the West. Milton Friedman was the most outspoken proponent of this school (hence his fame). He elaborated his ideas in a small pamphlet called The Methodology of Positive Economics. In Vol. 1 of Speculative Capital, I spent some time on this subject:
The Methodology is a manifesto of superficiality which has cast aside its self-conscious defensiveness and assumed an aggressive posture. It is an in-your-face crudeness of unthinking, pushing to impose itself on the unsuspecting reader under the guise of philosophical thought. In it, Friedman strove to create a theoretical framework for a “pure economics,” or an economics for its own sake. The new discipline had to be independent of social constraints: He wrote: “Positive economics is in principle independent of any particular ethical position or normative judgments.”

But if ethical positions and normative judgments were to be set aside, how was one to construct or test economic theories? Economics had always been a social science. Normative issues, ethical positions and social aspects could not simply be ignored. For that, too, Friedman had an answer. He wrote:
Complete “realism” is clearly unattainable, and the question whether a theory is realistic “enough” can be settled only by seeing whether it yields predictions that are good enough for the purpose at hand or that are better than predictions from alternative theories. Yet the belief that a theory can be tested by the realism of its assumptions independently of the accuracy of its predictions is widespread and the source of much of the perennial criticism of economic theory as unrealistic.
By saying that the realism of assumptions did not matter in a theory, Friedman granted economists carte blanche to assume anything they wished as long as their theory produced “accurate predictions.” But how was one to know that the predictions of a theory were accurate? Well, the prediction could be checked against what was observed, i.e., what was given–the status quo. In the highly charged ideological atmosphere of the Postwar era, the implications of this reasoning went far beyond economics. Instead of starting from the observed evidence and arriving at a conclusion which could be unpleasant and controversial, Friedman espoused starting from the accepted system and then making whatever assumptions were needed to justify it.

In subordinating the realism of assumptions to predictions, Friedman turned scientific inquiry on its head. What he said, in essence, was that anything was permissible in economic theory as long as the theory produced acceptable results. The acceptable result was the confirmation of what was already in place. But if the assumptions of a theory did not matter, one could assume ghouls, ghosts and angels to explain economic phenomena. And in a way, that is what happened in the following years.
Friedman’s reasoning put the test of the validity of a model on a slippery slope. Little wonder, then, that the process went downhill immediately until it reached its logic nadir in the hand of theorists of Modern Finance who made the trade as the proxy for the "real world" and proceeded to weave a theory around his actions. The cult of trader worship which was the domain of financial journalist, spread to Modern Finance, a development that set the stage of its demise.

I remembered this history partly because I was working on Vol. 4 of Speculative Capital but also because in the past couple of weeks four traders came into my ken who were in the news under very different circumstances. Ordinarily, in the financial publications, I only come across stories about the Sage of Omaha and the Man Who Broke The Bank of England. Both these gentleman leave me strangely unmoved, as I know one is the cut-throat businessman behind the Geico business model, his folksy pretenses notwithstanding, and the other is the author of George Soros on Globalization, his intellectual pretenses notwithstanding!

Of the four traders, two were on their way to prison. One was dead, and one is alive and well in the pinnacle of his career. Yet, they all have something in common that we will be well advised to understand. Let us first meet the characters.

Sam Israel: Failed Faker

Sam Israel co-founded a hedge fund and from the get-go looted it to finance a lavish life style. He was not a good investor either and soon began losing money. To cover the losses, he produced fake audits and fake report. When the dust was settled, he had swindled $450 million from his investors. Convicted of fraud and sentenced to 20 years in prison, he jumped bail by faking his suicide. After a month of being a fugitive from justice, he turned himself in on the advice of his mother and also because he realized “that God didn’t want me to do that”.

What grabbed my attention more than Israel’s communication with God was his mental capacity as revealed in planning the fake suicide. He parked his car on a bridge, wrote "suicide is painless" in the dust on the hood and got away in his girlfriend's car that was waiting nearby.

I don’t have great expectations. I did not expect Sam Israel to plot like a character from a pre Berlin Wall Le Carre novel or hint at his suicide by drawing the first bar of Chopin’s Funeral March. But even accounting for his duress, the plan was downright embarrassing; a 12-year old with interest in crime stories could have done better. What is more, in post 9/11, post FISA world, he thought he could run and hide.

This man raised $450 million from investors.

Sir John Templeton: The Man Who Understood the True Character of Stock Markets

Sir John Templeton created the Templeton Fund in 1954 and sold it in 1992 for $400 million. In between, he delivered average annual return of 15% to his investors.

Sir John was a religious man. He started his business meetings with prayer “to clear the minds”. He engaged in philanthropy, created a fund to expand the frontiers of religion and started a foundation to support spirituality, giving money to spirituals like Mother Teresa and Billy Graham.

Iranian king gives a pile of gold to his vizir to distribute among the capital’s spiritual men. Sometime later, the vizir returns the gold, saying that he had not been able to find one. “How could it be?” asks a perplexed king, “I am told there are 10,000 spiritual men in this city.” “Your Majesty,” answers the vizir, “the spiritual men refused the money. And those who did not were not spiritual men.”

Money Magazine had called Sir John “arguably the greatest global stock picker of the century”.

Financial Times obituary described him as “the renowned investor and philanthropist who is credited with some of the best-known investment adages”. The paper went on to give an example of those adages:

  • Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria. (This, according to Financial Times, was the proof that Sir John “understood the true character of stock markets”.)
  • ‘It’s different this time’ are the most expensive words in the English language, has become a maxim for investors.
  • To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest reward”.
Sir John said and did all those things before he died of pneumonia at age of 95.

Jeffrey Epstein: Multi-talented Jew

Jeffrey Epstein is not nearly as famous as Sir John. In fact his “angle” was to promote himself as a low key operator, of the kind you have to look hard and be somebody to find. He was in the news in relation with his conviction for prostitution involving an underage girl. The venerable Alan Dershowitz of Harvard Law School is being paid to represent him.

If Sir John started the meetings with a prayer, Jeffrey Epstein “starts his mornings with a secret-ingredient bran muffin prepared by his chef,” The New York Times informed its readers. Some like to clear their minds; some, their bodies.

The paper also said the following about “Mr. Epstein”:
His business is something of a mystery. He says he manages money for billionaires, but the only client he is willing to disclose is Leslie H. Wexner, the founder of Limited Brands.

As Mr. Epstein explains it, he provides a specialized form of superelite financial advice. He counsels people on everything from taxes and trusts to prenuptial agreements and paternity suits, and even provides interior decorating tips for private jets. Industry sources say he charges flat annual fees ranging from $25 million to more than $100 million.

As it became clear that he was headed for jail, Mr. Epstein has tried to put on a brave face. “Your body can be confined, but not your mind,” he said in a recent interview by phone.
Rumi himself could not have said it better.

Mohamed El-Erian: Greenspan-inspired Asinine

You cannot get more successful than John Templeton in fund management business, and you cannot get more successful than Mohamed El-Erian in both, practical fund management and markets analysis. For years, he was the president and chief executive of the Harvard Management Company, as well as a faculty member at the Harvard Business School and deputy treasurer of the university, where he delivered outstanding results to Harvard endowment fund. Last year, he left for Pimco, where he is now the co-CEO and co chief investment officer. Hardly a month goes by without him writing or talking about grave financial matters in some major publication.

I remembered him because there he was again, in today’s Financial Times, offering opinion about the current crisis in financial markets.

To say that it is difficult to understand what El-Erian is saying is to be charitable. The man has a knack for making the darkness opaque. Here is an entirely typical sample quote from the Financial Times (with the British spelling preserved):
The price shock will serve to undermine real incomes in the US and lower imports. On the policy front, it will accentuate the tug of war that the Federal Reserve faces on account of its now conflicting inflation and employment objectives. Emerging economies face greater inflation in the context of their buoyant liquidity conditions. Several will see their real effective exchange rates appreciate, by means including measures to allow the nominal exchange rate to appreciate markedly against the dollar. In Europe, growing demands for wage increases may force companies to step up structural reforms and will cause the European Central Bank to increase its hawkish rhetoric.
No fortuneteller ever spawned so much general nonsense. But even in this short paragraph he manages to show his ignorance of a critical point about the working of the Fed when he talks of “conflicting inflation and employment objectives” of the Federal Reserve. He is referring to Humphrey-Hawkins Act that mandates the Fed “to translate into practical reality the right of all Americans who are able, willing, and seeking to work to full opportunity for useful paid employment at fair rates of compensation.”

El-Erian probably heard of it back in school days precisely because then it was a topic of discussion. The Act is still on the books but the Fed simply ignores the part pertaining to the employment. The chief investment officer of a bond fund company, of all places, should know that.

This was not a one-time slippage. Here is El-Erian on the Fannie Mae and Freddie Mac crisis:
“The key is to stop the equity price debacle … from morphing into a full funding crisis for the two institutions,” Mohamed El-Erian, co-chief executive at Pimco, the bond fund manager, told the Financial Times.
It is astounding how a well-educated fund manager who, by virtue of his job, has his fingers on the pulse of the market, can get something so obvious about Fannie Made and Freddie Mac so fundamentally wrong. The equity price debacles is the consequence of the funding crisis, not the other way around. That is true for all corporations and not just financials: first the company runs into trouble, then the stock price drops.

The point here is not to critique El-Erian. I mention him precisely because he is among the best and brightest the real-life finance offers. Yet, this successful trader/fund manager/educator has nothing to offer us by way of insight into markets. That is what he has in common with the other characters in this story. A downright crook in communication with God, a multi-talented Mr. Epstein offering superelite advice for $25–$100 million a year and a knight who imagined the stock market as nothing but the result of the psychological state of investors (and dispensed banalities to that effect), all these men are the blind agents of a force that remains hidden from them. Their experiences are valuable as the instances of the manifestation of that force and its false reflection in the human mind. But that is the extent of the utility of such experience. Afterwards, abstract reasoning must carry us forward.

In unquestioningly and uncritically taking the actions of these men as its foundation and the starting point, the way the Times unquestioningly accepts the claim of $100 million a year superelite advice, Modern Finance set itself up for failure.