Thursday, January 31, 2008

Wisdom of Crowds? Yeah Right

Every once and a while I come across something so stupid/crazy that I have to do a little research just to prove to myself that my intuition is still sound. Recently, I read something very stupid/crazy while visiting The Big Picture. (Barry Ritholtz pointed out a Bloomberg story about Barton Biggs' new book).

The book, "Wealth, War and Wisdom", tries to argue for the wisdom of crowds. How is this done? Here is a segment of the article.

The ``wisdom'' in the alliterative title refers to the spooky way markets can foreshadow the future. Biggs became fascinated with this phenomenon after discovering by chance that equity markets sensed major turning points in the war.

The British stock market bottomed out in late June 1940 and started rising again before the truly grim days of the Battle of Britain in July to October, when the Germans were splintering London with bombs and preparing to invade the U.K.

The Dow Jones Industrial Average plumbed ``an epic bottom'' in late April and early May of 1942, then began climbing well before the U.S. victory in the Battle of Midway in June turned the tide against the Japanese.

I could not believe such wild claims and suspected that Biggs had made the mistake of using "20/20 hindsight" and a poor understanding of the way markets move to reach totally ridiculous conclusions. Ok, there is my hypothesis. What does history say?

Below I have the weekly chart of the Dow 30 during World War II. Let's follow the time line of events. First you have the invasion of Poland. Due to a treaty, Britain and France respond with a declaration war, but neither want to fight and we enter the "Phony War" period. It looks like the market doesn't believe that a full-scale war will be fought as the Dow just meanders sideways (So much for the wisdom of crowds here). What happens next is the surprise invasion of France, which is promptly followed by a massive sell-off on huge volume.

This is the point where some understanding of how markets move is required. The most important fact is that markets never go up forever and they never go down forever (quote of Tom O'Brien). The reason why is quite simple. There are only a finite amount of shares and a finite amount of money out there. This fact is reflected in the volumes. When volume dries up at tops there is no more money to buy, when it dries up at bottoms, there are no shares to sell. During fast and furious sell-offs the market can quickly exhaust the amount of shares and bottoms are reached in a short period of time.

Ok, back to the chart. Look at the period after the invasion of France. The volume quickly dries up (selling exhaustion), resulting in bounce. So yes the market rose during the Battle of Britain, but this was merely a counter-trend bounce on light volume back up to the 50 period moving average. More selling would come, especially since the world's future looked very bleak.

The next big event was Pearl Harbor, resulting in another huge sell-off as America entered the war. All through the early part of 1942, while America struggled to learn how to fight in Africa and the Pacific, the market continued to fall on ever decreasing volume. Just like the markets always do, it started a counter-trend bounce when things look the darkest, this time just weeks before the decisive Battle of Midway. This was an obvious turning point of the war in the Pacific and gradually the markets began to gain confidence.

The funny thing is, the volumes, and thus crowds, do not significantly increase until months after the Battle of Midway. So much for the "wisdom of crowds". Moreover, the "epic" bottom can only be defined after several years of perspective, well past the point where the outcome of World War II was in doubt. Just because there was an exhaustion in selling pressure and a counter-trend bounce just weeks before Midway does not mean that the markets predicted the war's outcome.

It almost seems silly to point all of this stuff out because it is so obvious. It looks like Biggs was fooled by randomness.

One last thing, Biggs says that the markets "then began climbing well before the U.S. victory in the Battle of Midway in June turned the tide against the Japanese. " I really don't think one month or 20 trading days can be considered "well before" an event, especially when Biggs is defining it as a multi-year bottom. What a joke.

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