A Socratic Rancher 5-17-10 | TheFencePost.com

A Socratic Rancher 5-17-10

“The stock market is like using artificial insemination to breed an artificial cow, and expect a real calf on the ground the next day.” That’s what my old rancher friend Ed claims, and all I can say for sure is that it’s a breeding program that doesn’t consistently throw bull calves!

The 998-point drop in the Dow Industrials recently, followed by a 600-some bounce, all inside of an hour, made the market look more like a casino roulette wheel than an orderly forum for capitalizing the world’s business. Some said it was worries about Greece (a country with an economy roughly the size of Michigan), others said it was “contagion concerns” to the little PIIGS nations (Portugal, Italy, Ireland, Greece, Spain), still others said it was all caused by algorithmic trading schemes. Algorithmic trading? What the heck is that?

A little history is worth noting here. As far back as the 1880s, people have been trying to figure out ways of predicting markets, and the stock market has received more than its fair share of attention. Interestingly, the major players in market analysis and prediction were mathematicians. Perhaps, as underpaid teachers domiciled in a slow, dry area of academia, they meant to use their knowledge to increase their paycheck in the stock market by out-smarting it.

Yale mathematician Irving Fisher was perhaps one of the first to work on the Theory of Efficient Markets (TEM), published in 1906, in response to the “almost regular” periodicity of financial panics that occurred throughout the 1800s in the U.S., some of which had no apparent basis in the fundamentals on the ground. As testament to Fisher’s grasp of the stock market, he lost his entire fortune (both inherited and earned) in the Crash of 1929.

The Crash confirmed that markets could not be predicted, but mathematicians remained fascinated with various patterns of analyses, a trend that really took off when computers came along in the 1960s. Again, mathematics professors, who originally came up with probability schemes for beating the casinos in Vegas, eventually went to Wall Street “where there was real money, and no one who would break your legs if you won.”

This group of mathematicians became know as The Quants, or the quantitative traders. They did not care about earnings, price ratios, supply and demand, world conditions. They cared only about price, and created computer programs that conducted daily trading without the interference of human emotion. Many of these systems made huge fortunes during times when the market conformed to the TEM – that is, when price variations fell within the norm of a bell curve. The computers searched the daily price of hundreds, perhaps thousands, of stocks in a sector, determined which were overpriced to the norm and which were underpriced to the norm and went long and short accordingly on large blocks of the various stocks. Computer driven strategies became ever more complicated, involving statistical arbitrages (simultaneous buy-sell at a small gain), and other highly technical “systems.”

As someone who has been a producer all his life, it is hard for me to see any social or economic utility or benefit in price-oriented trading. True, these traders provide liquidity to the market for hedgers and retail investors, but they often provide so much liquidity that the market experiences bubbles that inevitably burst, as we recently saw with the massive de-leveraging of the subprime mortgage instruments: a case where the alchemy of speculator liquidity blew up.

When I described all this to my old rancher friend Ed, he said: “You can’t expect to make money off other people’s work.”

This is good advice for all of us. Perhaps.

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