Monday, February 4, 2013

Math and the market

Last week, Kunstler melted down at what passed for good news in The Master Meme.*
The gentlemen and ladies of the meme-o-sphere, where collective notions are birthed like sleet from clouds, have decided lately that the USA has entered a full-on broad-based bull market - a condition of general happiness and prosperity as far advanced beyond mere "recovery" as a wedge of triple-cream Saint-Andre cheese is advanced over a Cheez Doodle. It has become the master fantasy of the moment, following the birth of some junior memes such as... we have a hundred years of shale gas and the "housing sector" (i.e. the suburban sprawl-building industry) is "bouncing back." What a sad-sack nation of credulous twits we have become.
I bet he really melts down today, between the Super Bowl and the Dow hitting 14,000 for the first time in six years.  ABC News has the report.

This is the first time in since October 2007 that the Dow has hit that number.
I'm wary of this being as good news as people think it is.  The last time I recall hearing so much optimism was in June 2005.  The news on the radio trumpted record home sales and prices.  I took it as a sign of a market top and immediately drove to the nearest real estate office to my home in the Irish Hills and listed my house for sale.  The house sold in April 2006 and closed in May 2006, just as the bottom was about to fall out.  That was good news for both me and the deer.  That experience makes me suspect we're near a market top for now and that the Dow is more likely to drop 1,000 points than it is to rise to a new nominal record.

Speaking of spectacular drops in the market, Scientific American has recently published two articles on the misuse of mathematical formulas by brokers and analysts that allowed people to become overconfident in the runup to the global finacial crisis leading to the Great Recession.  Follow over the jump for them.

First, How to Lose $3 Million in 1 Second by Chris Arnade.
Finance now is a complex field buttressed by hundreds of mathematical models. At its heart is the Black-Scholes equation for pricing of options.

Published in 1973, it slowly revolutionized finance, leading to a boom in financial contracts and new way of looking at markets in terms of relative value and models. It also changed the type of person who worked on Wall Street. It became people like me, with a PhD in Physics, who could build models, like Black-Scholes, to price complex products like options.
Economists Fisher Black, Myron S. Scholes, and Robert C. Merton derived an equation that valued options on most assets. They did this by making the assumption that assets move over time in a continues motion with a given volatility, so that the future price of an asset was a probability distribution. By finding a strategy of buying and selling the asset that exactly replicated the ownership of the option they derived an equation that specified the value of an option. The sole undetermined variable was the asset’s volatility.

The Black-Scholes model was revolutionary for two reasons. Not only did it put an exact value on the option, but also more importantly, it did so by showing traders how to decrease their exposure to changes in the value of the option. Buying or selling options was now less risky.
I included the above excerpt in Overnight News Digest: Science Saturday (2012 one of ten warmest years).  Two weeks later, Chris Arnade returned to point blame at a more complex formula in The Real, and Simple, Equation That Killed Wall Street.
“If it weren’t for those meddling kids!” That was the punch line for every Scooby Doo episode. It also is the overly simple narrative that many in the media have spun about the last financial crisis. Smart meddling kids armed with math hoodwinked us all.

One article, from the March 2009 Wired magazine, even pinpointed an equation and a mathematician. The article “Recipe for Disaster: The Formula That Killed Wall Street,” accused the Gaussian Copula Function.

It was not the first piece that made this type of argument, but it was the most aggressive. Since then it has been a common theme in the media that mathematics, especially obscure advanced mathematics, is largely responsible for the catastrophe that doomed the world to the last five years of recession and slow growth.
In the comments to Overnight News Digest: Science Saturday (Groundhog Day 2013), where I used the above passage, one of the commenters noted that it wasn't the equations' fault, but that of the greedy people using them.  Duh.  If he had read the article, he'd have seen Anade say that.  Just the same, it was true then and it's just as true now.  Remember that the next time people cite the stock market as a sign of economic health.  A lot of the fundamental issues are still there, including overconfidence, greed, and lack of regulation.

*With a title like that, I was expecting something about I Can Haz Cheeseburger or Grumpy Cat, but Kunstler doesn't do anything so trivial except to mock the Kardashians.  That's an improvement.   A decade ago he was making fun of J-Lo.

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