that drive and motivate markets—such a challenge? It is
because people make up both economies and companies.
“Ah, but economics is about rules, such as the law of diminishing
returns, efficient market theory, and portfolio theory,”
you may say. Well, yes and no. Such so-called laws are merely
attempts to generalize about patterns of economic activity that
have arisen in the past. But people are emotional, and they also
learn and evolve. Therefore, patterns of behavior alter and
evolve in an organic fashion. It would require a perfect understanding
of the motivation and thinking of people in today’s
society to make a fully accurate assessment and forecast of an
economy. Rather a daunting task, I would suggest. Hence, the
natural inclination to oversimplify—which is all very well as long
as we recognize this process for what it is so that we can see the
opportunity from a trading perspective that is then created.
Reductionist Theory and the Reality of Fundamental Economics
Today’s markets are complex, to say the least. Some of the people
who make up an economy are also directly involved in markets
(all are indirectly involved), and the level of participation in
markets is at a historical high. All participants in a market affect
that market’s price action, and as participation is higher than
ever and patterns of behavior continue to evolve, new patterns
of economic behavior and market price action are also continually
emerging.
Hence, the study of one aspect of this complexity—economic
activity data—is simply not enough. Economic data are historical
and therefore backward looking by definition. While such
data undoubtedly give clues to the likely forward path, they do
not represent the future at all. As such, any analysis locked too
tightly into such a perspective cannot succeed. This is why the
practitioners of pure economic theory applied to the latest run
of data typically have a modest forecasting record. Yet this is precisely the form
of analysis that tends to dominate all media reporting on fundamental developments
and drive the consensus view.
Most economic models are useful in polite conversation, but they cannot compete
with the cut and thrust of market realities. Indeed, this is not just a theoretical
affliction facing the economic world. Quantum physics has demonstrated that
reductionist philosophy—that is, the idea of reducing any subject
of study to its smallest constituent components—is flawed.
For instance, Einstein’s theory of relativity works most of the
time but not all of the time, and at some levels not at all. Such
attempts will ultimately lead to a severe disconnect between
expectations and actual events, as the reasoning deduced from
the model conflicts with the reality of that future.
Let me explain. As discussed, it is people who make up the
economy, not numbers. The confusion among contemporary
economists on almost any aspect of any economy is due to the
arguably flawed nature of current economic theory. All contemporary
economists are schooled in an approach to the subject
that is essentially derived from scientific method. This theory is
reductionist philosophy. Essentially, this is a means of understanding
whereby, when looking at competing theories or explanations
for a phenomenon, it is the simplest theory that should
be selected. The predominant approach to a subject is then to
break it down, reduce the subject to the smallest possible components,
and so derive a greater understanding of the subject
and a concrete mathematical model to explain it—all in the
belief that there is a model that explains what is going on. The
reality of markets is that no such model exists. Scary perhaps,
but true nonetheless. The warrior trader’s willing acceptance of
this point allows him or her to respond to fresh developments in
a market away from the consensus view more rapidly than other
participants, and even to prepare an attack strategy in advance.
The reductionist method is commonly used for predictions
and forecasting, based on the explanations derived from prior
happenings. Its emphasis is basically on a microscopic approach
to understanding, looking to derive a general understanding
from the features of a particular.
As the advantages of reductionist philosophy, which certainly
greatly accelerated scientific advances in the initial phases,
dawned on people, its use quickly spread to the humanities.
However, perhaps it is now being too widely applied.
The introduction of this philosophy and methodology of
explaining reality (or the micro) in terms of a reasoning derived
from specific and largely isolated theories diverted attention
away from some home truths that quantum physicists, in whose
field reductionist philosophy has been used most successfully,
are increasingly recognizing. In our complex market reality, all
things are connected and cannot be successfully approached in
isolation. This is exactly what almost all economic theories that
have been taught for decades do. They focus on one particular
aspect of economic or fundamental behavior in isolation. They
then perceive and prove a degree of correlation with another
aspect. This is not the full picture of what is going on, however,
and a strict adherence to a particular economic principle will
only end in market trading losses.
Further, once a subject is exposed to thought and discussion,
its behavior is altered by that very analysis. Any group of human
beings who begin to question themselves, in particular, why they
respond in a certain way to a particular set of events is unlikely to
respond in the same way in the future once the self-examination
has occurred.
Such is also the case in the field of economics, and particularly
so when looking at financial markets. Economic theorists striving
to understand, in greater and greater detail, the various
machinations of modern economies have accomplished only one
thing: the sleight-of-hand skill that seemingly enables historically
constructed models to follow an economy or market with
such rapidity that they seem to be keeping pace with real-world
developments—or even to be forward looking. This is not actually
the case, however, despite the mass false impression that is
achieved through the use of modern communication technology
to quickly analyze and explain real-time events. Rarely does such
analysis lead the real-time event, however—a subtle yet awakening
distinction that few market participants seem to recognize.
Almost all economic analysis and market analysis of an event
that is distributed to the clients of all the banks and brokerage
houses the world over is actually in hindsight. It therefore can
only come across to the reader as being particularly accurate
and insightful in nature. These qualities impress the reader and
give the individual confidence in dealing with that bank or broker
when trading in these markets. In fact, it is often the case
that the research produced is so perfectly formatted, presented,
in-depth, and generally impressive that many clients believe it
gives them an advantage over other traders and will do almost
anything to get that research. Such research has its place in
providing the warrior with a broad knowledge of what has
occurred recently and historically, but the warrior does not make
the mistake of interpreting such analysis as in any way an accurate
forecast of the future. There are three main types of human
creatures in banks and brokerage dealing rooms: economists/
researchers, traders, and salespeople. There is one distinction
the managers of such organizations never forget, unless to their
peril. That is to keep researchers away from trading, and traders
away from research. They are different activities. One is backward
looking; one is forward looking. It is important not to
confuse the two perspectives. Market view and trading are two
distinct activities.
Read More: THE REALITY OF FUNDAMENTAL ECONOMICS
