Broad Views on Markets Part 1 – Blog Post 0028

Point 1 – Markets are Complex and Therefore Unpredictable

Markets are not complicated but instead extremely complex. This is an important distinction and one that should not to be taken lightly or skimmed over. The state of a complicated system is predictable far into the future if enough computational resources are applied to generate the forecast. This differs with a complex system, the state of which cannot be accurately predicted far into the future, regardless of your computational resources. As an example, think about predicting who the president of the United States will be in the year 2070. There is absolutely no way to accurately do this. The person who will be president of the US in the year 2070 might not have been born yet. You don't know if the position of president will still exist in the year 2070 and you don't know if the United States will still be a country. There are simply too many variables that are subject to change to make any meaningful prediction possible. And to make things worse, there are variables that don't currently exist but might be of the utmost importance in deciding who the president will be in 2070. For these very same reasons, it would be foolish to try to predict the state of the US stock market or the price of the British Pound even one year into the future. Charlatans sometimes make these types of predictions but are always wrong in at least one dimension of their predictions.

A Sidenote on Forecasting

There are three dimensions that should be addressed with any financial forecast. Dimension one is direction; will the instrument rise, fall or remain flat? Dimension two is time; when will the event begin and when will the event end? Dimension three is magnitude; what is the size of the movement in percentage terms? If a forecaster does not address all three of these dimensions, they are not making a meaningful prediction.

Point 2 – Geopolitics and Intra-National Legislation are the Biggest Contributors to Market Complexity

The biggest contributing factors to the complexity of markets are geopolitics and intra-national political legislation which has the potential to massively disrupt, skew, create and destroy markets. With the swipe of a pen, governments can increase or decrease taxes on capital gains, promote or inhibit certain types of industrial activities, reward or punish market participants for taking risk or stock-piling gold. In a true democracy, there is no way to know what the government will do in the future and when they will do it. And since we are no longer isolated from the rest of the world, there is no way to know what actions other countries might take in the future and how those actions will impact local and global markets. The best one can do to manage this type of risk is to truly diversify one’s investments and keep abreast of geopolitical developments that are relevant for one’s investment strategy.

Point 3 – Markets are Not Perfectly Efficient and Cannot Be Perfectly Efficient

Markets are not perfectly efficient and cannot be perfectly efficient because markets are not static entities and the rules (laws) and incentives for market participants change over time. To compare the US stock market of the 1950's to the stock market of the 2010's would be a fool's errand since those two markets are almost nothing alike. The rules, stocks, indexes, trading technologies and legislation have massively evolved over the last 60 years and as a result, the markets have evolved into completely new entities. As an example, to carry out an analysis on the S&P 500 for a period longer than its constituent companies are part of the index is misguided since there is an assumed investment strategy already built into the analysis in the form of the way the S&P 500 is compiled.

What one CAN say is that some markets are more or less efficient than others. For example, the currency market is currently much more efficient than any other market in the world. And zooming in on specific currencies, one can say that the EUR/USD market is much more efficient than the USD/RUB market. The US real estate market is substantially less efficient than the US stock market, which is substantially less efficient than the US treasuries market. The difficulty comes in quantifying levels of efficiency and comparing markets to one another.

Gradation of relative market efficiency is important because it will determine the types of strategies that could be successful in each type of market. For example, the frictional costs involved in trading real estate are extremely high and offer opportunities for one to make substantial money from simply being the middleman (broker) in a transaction. In the used car sales market, one makes money from having asymmetrical information (inside information) because the dealers know much more about the inventory than the buyers.

Scroll Up