Thinking About Markets Jude Wanniski August 30, 2002

Memo To: Website Students
From: Jude Wanniski
Re: Thinking About Markets August 17, 1993 and April 25, 1994

I’m getting many questions relating to the efficiency of markets, which are always under attack by those who insist that markets are basically inefficient and must be managed. How do we know a market is efficient? I spend a lot of my time thinking about markets and have written a thing or two in recent years that may stimulate discussion. The following client letter from 1993 is one of my favorites, inspired by a fellow named Jack Treynor and his jar of beans. A year later I wrote another “Thinking About Markets,” which is tacked on to the first. There is some repetition, but insights that ripened in the preceding year. Next weekend we will begin a new semester of SSU, one that stresses the politics of political economics.

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Thinking About Markets August 17, 1993

It first occurred to me nearly 20 years ago that there really isn't much of a difference between the market for goods and the market for ideas. Superior goods and superior ideas survive the test of the marketplace. New entrants are constantly trying to elbow their way into the commercial and political bazaars. Most initiatives fail early on, and of those that succeed early on, most fail over a longer run. All growth, including political growth, is the result of risk-taking. All success, in a sense, is the result of early failures. These are fairly broad generalities, and I developed them to a degree in The Way the World Works, but there is no end to what can be learned about markets, which is one of the reasons Polyconomics continues to thrive as we quietly celebrate our 15th Anniversary.

A few months ago, at a gathering of financial types at the Wigwam resort near Phoenix, I learned something very important about markets from Jack Treynor, former editor of the Financial Analysts Journal, a man who has been thinking about markets far longer than I. Treynor just happened to mention that, when he taught finance, he would pass a jar of beans among his students and ask them to guess the number. The guesses would vary wildly, but always, when the number guessed in total was divided by the number of students guessing, the result was within 3% of the correct number, he said. As there were 52 of us assembled, and a bowl of peppermint candies on the table, we tried the experiment. A low guess of 32 was recorded, a high of 71. The median guess was 46, the mean was 45. The correct total was 46, a number only one of the 52 had guessed.

This is a reminder that the essence of portfolio theory goes back to the old adage, "Don't put all your eggs in one basket." In this case, the more students available to guess the number of beans in the jar, the more reliable the forecast. At the Wigwam discussion, I pointed out that Treynor's experiment provided a proof of democracy. Years ago I suggested to William F. Buckley, Jr., that while he was smarter than any of 100,000 people he might interview on a New York street corner, their collective wisdom would dwarf his, which he could see if only the means could be found to tap into it -- which is, of course, what we do in the electoral process. If a way could be found to have 100,000 people guess the number of beans, there is zero chance a Buckley or Einstein could consistently outguess them. In coming to this conclusion, the history of civilization has passed from oligarchical and monarchical forms of governance to more and more refined forms of democracy -- which have extended the number of policies decided by democratic means, and also broadened the electorate to include as many "guesses" as possible.

Two great religions that have been among the longest to survive in the marketplace are western, both incorporating the philosophical identity of the "Good Shepherd," who will leave the entire flock to round up the one stray sheep. The difference between Christianity and Judaism is that the former is evangelical, the latter is not -- which means the Jewish flock is self-contained and, theoretically, the Jewish shepherd only leaves the flock to round up Jewish sheep. It is no coincidence, though, that Christ and Moses were of the humblest origins, the one born in a stable, the other abandoned in the bulrushes. History wants us to learn this particular lesson about the marketplace, i.e., the best investments may at first look like the worst. In the Christian faith, we're even told there were three wise men who traveled a great distance to add the infant to their portfolios.

There are two world-class investors I know, who sit side by side in the hedge fund they manage. They've both achieved remarkable returns in the dozen years I've known them, but the older of the two has been the more successful. The only stylistic difference I've detected is that the older man casts a wider net. Several years ago I asked the younger man why he doesn't invest in airline stocks, and he said he'd lost so much money over the years in airlines that he decided to blot them out of his vision. The older man told me that he too had lost fortunes on airlines, but things might change. In the last three years, the difference in performance between the two can be accounted for almost entirely by Southwest Airlines, which the older man bought heavily before it left the stable.

There are two century-class investors I know, men who finance entire companies. In this case, the younger man had been the more successful, and he indeed cast a wider net, but in recent years has been overtaken by the older. The stylistic differences I observed in this period were distinctive. The younger man provided financing for myriad enterprises, often it seemed favoring every entrepreneur who came into his field of view, perhaps on the theory that the few mega-successes would offset the failures. The older, more patient man would scrutinize a great many possibilities, but sometimes go for years without making a fresh investment. His investments were few, but spectacular, a pearl in every oyster. The other major difference between the two, which has had a telling effect, is that the younger man through his streak worked for an institution, which eventually cramped his style. The older man worked for himself, free to be patient.

In the political marketplace, the United States remains the wonder of the world, the kind of place where a babe born in a log cabin can grow up to be one of the greatest political leaders in recorded history, perhaps the greatest. Because we don't know which kid in which log cabin will look the best in the portfolio of history, we have to be attentive to all the kids in all the log cabins. Who would have thought a washed-up, "B" movie actor and a washed-up football player would team up in the 1980s to pull the country out of its tailspin? For the same reason, we can't dismiss the possibility that a particular man or woman who looks washed up at the moment will come roaring back. It is especially the people at the bottom of the pile, those who feel they have little or nothing to lose, who will take the biggest chances. The turnaround situation in politics or commerce yields the greatest gains. Chrysler Corp. was a dead duck in 1978. Richard Nixon, who was history in 1962, would not stay buried then or now. In 1987, I thought Alan Greenspan was absolutely the worst choice in the world to be Fed Chairman. He has proven since that he was a dandy choice. With that kind of experience, how can I give up so soon on President Clinton? George Mitchell? Even Ross Perot?

The thought jumped out at me late last month when Carol Moseley-Braun, the first black woman elected to the United States Senate, a liberal Democrat from Illinois, burst into the news. The issue involved the logo of the United Daughters of the Confederacy, which included a Confederate flag. For more than a hundred years, the club had been coming to the Senate every 14 years for renewal of the patent, and the Senate had routinely complied. This year, Sen. Moseley-Braun killed the request in the Judiciary Committee by a 13-2 vote, on the grounds that the flag represented a banner of slavery, slavery being the only reason the Confederacy was formed. Sen. Jesse Helms brought the issue up on the Senate floor and Republicans and Dixiecrats joined to reverse the committee vote. A distraught Moseley-Braun thereupon informed her colleagues she would not accept their reversal. The debate with racial overtones began heating up, until Sen. Robert Bennett, a freshman Republican from Utah, put a stop to it -- enlisting Senate Minority Leader Bob Dole and others who, like him, had voted with Helms, to reverse themselves on a motion to reconsider. I watched a tape of the episode in its entirety on C-SPAN and I realized Dole and Bennett had officially buried the GOP's Southern Strategy, which for a quarter century had been conceding the black vote to the Democrats. I also thought about Jack Treynor and his jar of beans, and a political marketplace that would inspire the people of Illinois to send a black woman to the U.S. Senate, to close a chapter of American history and begin another. A male black Senator might not have done it, as the issue would have been confused by the battlefield, and manly arguments over the valor of the young men who fought under the stars and bars.

Investors in the political or financial marketplace are advised to cast wide nets. I remember Irving Kristol telling me years ago that of all the people he meets, as a class he enjoys portfolio strategists the most, as they cannot afford closed thinking and therefore have lively minds. You can make myriad investments in myriad opportunities, or be agonizingly selective. But it doesn't make sense to rule out opportunities in advance -- like airline stocks, or Democrats, or black politicians, or junk bonds, or liberals, or businesswomen, or political women, or Mexicans or Chinese. There's no telling which knock will be opportunity, so you really have to answer all of them.

Thinking About Markets II April 25, 1994

We are, of course, thinking about the ebb and flow of the financial markets all the time. Once a year I attend the First Quadrant Corp. annual client conference as a member of its advisory board, and we focus on the philosophy and mechanics of markets. A year ago, I came away with Jack Treynor's wonderful story about jelly beans, which I reported to you in "Thinking About Markets," August 17, 1993. Treynor, former editor of Financial Analysts Journal, told us that when he taught finance, he would pass a jar of beans among his students and have them guess the number. As I wrote: "The guesses would vary wildly, but always, when the number guessed in total was divided by the number of students guessing, the result was within 3% of the correct number, he said. As there were 52 of us assembled, and a bowl of peppermint candies on the table, we tried the experiment. A low guess of 32 was recorded, a high of 71. The median guess was 46, the mean was 45. The correct total was 46, a number only one of the 52 had guessed." I pointed out that Treynor's experiment provided a proof of democracy, which is another way of saying it proves the efficiency of the political market, as well as of the financial markets.

Earlier this month, we assembled again in Bermuda, and at one point I cited Treynor's experiment -- whereupon Jack advised us that Peter Bernstein, the Wall Street guru who is the most senior of our group, had informed him that this discovery had been made a century ago. Peter then told us about Francis Galton, a Victorian genius, cousin of Charles Darwin, an inveterate measurer of things. At an English fair that Galton attended, he noted that more than 800 people had tried to guess the weight of a bull, the closest winning a prize. He added the total pounds on the 800-plus slips of paper, divided by the number of guesses, and found the mean was exactly the weight of the bull, to the pound. The irony is that Galton, who wrote Hereditary Genius, coined the term "eugenics," meaning by it the improvement of the race by selective parenthood. That is, the man most identified in his time with the notion that intelligence is an inherited characteristic is also the fellow who discovered that the ordinary people in aggregate are more intelligent than any of their component parts.

This struck me as pretty exciting stuff, especially as we proceeded to kick around the topic of the day: the suggestion that the stock market decline of recent vintage was caused by market participants known as "hedge funds," particularly those trading in derivatives. Is George Soros a hereditary genius, I wondered? And if so, how did the market outguess him to the tune of $600 million on the weight of the bull? It was useful to note that while Soros was winning his billion-dollar bets, he was all in favor of free markets. Now he hedges in testimony before the House Banking Committee. Maybe the government should keep an eye on derivatives and hedge funds, in the interests of protecting the unsophisticated (Procter & Gamble?) from the pitfalls of the market.

There was general agreement in our Bermuda discussions that derivatives are marvelous inventions of the marketplace. They began as a way of allowing people of humble means to buy a diversified portfolio (the best kind) with only a few dollars, i.e., mutual funds. In recent years, new versions have leapt out of the computers of Wall Street's whiz kids, who are continually finding seemingly "low risk" statistical correlations in various packages of securities. Many eventually prove to be high-tech fool's gold, when the correlations break down. The best of the derivatives are those that skirt government taxes and regulations that are skirtable -- with government buying the free lunch. Except for portfolio diversification, there is no other rationale for a derivative than to economize on government taxes and regulations, with the savings shared by private transactors. The market is so marvelously efficient that there really is no room for another financial device, except to exploit the loopholes left by the bureaucrats at Treasury or the SEC. There are even derivatives designed here to skirt foreign taxes and regs as well, to the benefit of the American investor. Are derivatives "good for the economy?" Without a doubt they are, inasmuch as in aggregate they always produce a positive return on investment -- or the efficient market would not allow them to exist.

My small contribution in this discussion was to relate this to the plain fact that it is no longer reasonable for an individual to purchase a new auto when it can be leased at a savings. I pointed out that companies are now springing up to lease even used autos! This began when the feds took away our right to subtract financing charges from gross income, for the purpose of paying income tax. Leasing companies are permitted to write off financing charges, so they strike a deal with me to share the tax savings. When the process began, leasing companies kept most of the savings, but the wonders of the marketplace are such that the latecomers have competed away most of the gains, to the benefit of ordinary folks -- who may not be so smart one-on-one, but in aggregate are unbeatable. A derivative, then, is a way in which an individual can lease a financial asset without owning it, with all the obligations that ownership entails. Chairman Henry Gonzalez of House Banking knows something funny is going on, and so do the bureaucrats at Treasury and the SEC, but they can't quite put their finger on it. Is the economy better off with auto leasing? Of course it is, and so is the government, for without this exploitation of a government loophole there would be fewer cars bought or made, fewer people employed in the process, and fewer taxes paid to federal, state and local governments.

Soros was good enough to inform Chairman Gonzalez not to worry about the effects on poor people when he loses $600 million in a fell swoop, or when P&G gets its clock cleaned with a leveraged financial detergent. When you are leveraged 100-to-1 and lose $600 million, it only means that 1 million people each win $600 (or at least they don't lose $600). These are the folks lined up on the other side of his original trade, people who can't afford the risks Soros can.

Why do people lose money so fast when they invest in certain kinds of financial instruments that are supposedly low risk? We are reminded of the Wall Street adage that "trees do not grow to the sky." Which brings us back to the whiz kids, whose computers discover "trends" that seem to be iron clad. Such as: Long-term bond yields have been falling for 13 years on a zig-zag path, and even when they zag, it's only by a small X amount. A derivative emerges from this finding and is peddled to a corporate CFO, who also has a high IQ, but is not prepared for a 2X mistake at the Federal Reserve. Alas, the tree that seemed to be growing to the sky is hit by a lightning bolt.

There are only two ways to beat the S&P 500, I think we decided in Bermuda last month: Either choose a basket of stock out of the S&P 500 that will outperform what you leave behind; or, buy the S&P 500 on its way up and sell it on its way down. Either way, you are going to need better research than your competitors, because, on balance, the more people who are guessing at the value of the S&P 500, the closer they will come to getting it exactly right, down to the penny. Or, in the case of Galton's prize bull, to the pound. The information gathered by this research is not to be found in computers, because the requisite information has not yet occurred. It will flow from the free will of individuals, either the free will of the S&P 500 CEOs and their employes, or the free will of, say, Alan Greenspan. When the bond market cracked, the only person who could truly say it was "overbought" was Alan Greenspan -- but only if he knew the market was betting on him and he could not deliver.

Thinking about the philosophy and mechanisms of markets is not very exciting stuff as a year-round activity. But like a Treadmaster, it can be a useful exercise. It reminds us that all markets -- political and financial -- are composed of everyone who is potentially available to guess the number of beans in a jar or the weight of a bull or the S&P 500 or the next President of the United States. There is room for experts in this process. It stands to reason that an individual who spends his life guessing at these questions will be better at it than those individuals who do not. And if you and I who do this kind of thing for a living do not produce a positive ROI for society, we will have to find other employment. No lifetime tenure here.