Author Archive for Robert Seawright

Ideological Through-and-Through

By Bob Seawright, Above the Market

Homo economicus is a myth. This alleged “rational man” is as non-existent as the Loch Ness Monster, Bigfoot and (perhaps) moderate Republicans. Yet the idea that we’re essentially rational creatures is a very seductive myth, especially as and when we relate the concept to ourselves (few lose money preying on another’s ego). In fact, we tend to think that we’re almost superhuman in our ability to invoke reason to our advantage.

Think of Hamlet (Act II, scene 2), for example (with Sir Kenneth Branagh as the melancholy Dane in the clip here).

“What a piece of work is a man! How noble in reason! how infinite in faculty! in form, in moving, how express and admirable! in action how like an angel! in apprehension how like a god! the beauty of the world! the paragon of animals!”

Of course, there are some very good reasons to stand awestruck at what human reason can accomplish, particularly in the areas of science, technology and engineering. But you might also recall what became of Hamlet. We are much less rational than we assume.

We love to think that we’re like judges, objective and rational actors carefully examining and weighing the available evidence in order to reach the best possible conclusions. Instead, most of the time we’re much more like lawyers, running around in search of something (anything!) that we can manipulate to the advantage of our preconceived notions while ignoring or denying any and all contrary evidence.

If we aren’t really careful, we will remain convinced that we routinely see things the way they really are when the truth is much more complex. Most of the time we see things the way we really are.

We are ideological through-and-through. The existence and prominence of both right and left-wing news channels on American television, each of which proclaims that it offers truth while the other is biased (their viewers agree, of course), should be more than enough evidence to make the point. As CBS President and CEO Les Moonvestold CNN’s Brian Stelter Sunday about television news, “people like to see people who agree with them.”

But there’s more.

A new study from Duke University (where I went to school) finds that we evaluate evidence – even scientific evidence – based on whether they see its policy implications as ideologically palatable. If we don’t, we tend to deny the problem even exists. As study co-author Troy Campbell, a Ph.D. candidate at Duke’s Fuqua School of Business, points out, “The cure can be more immediately threatening than the problem.” Moreover, “The more threatening a solution is to a person, the more likely that person is to deny the problem,”according to co-author Aaron Kay, an associate professor at Fuqua.

The researchers conducted experiments on three different issues – climate change, air pollution, and crime. The climate change experiment tested why more Republicans than Democrats seem to deny its existence, despite strong scientific evidence that supports it. Participants in the study read a statement asserting that global temperatures will rise 3.2 degrees in the 21st century and were then asked to evaluate a proposed policy solution to address it. When the policy solution emphasized a tax on carbon emissions or some other form of government regulation, only 22 percent of Republicans said they believed the temperatures would rise at least as much as indicated by the statement they read. But when the proposed policy solution instead emphasized the free market, such as with innovative green technology, 55 percent of Republicans (two and a half times more!) agreed with the warming statement.

This finding will not surprise Democrats, who have long argued that reality skews leftgenerally and that Republicans have a long history of being willing to deny the obvious about climate change and otherwise. In other words, they draw a distinction between the “reality-based community” and Republican ideologues, who are guilty of “epistemic closure” in that they remain “worryingly untethered from reality as the impetus to satisfy the demand for red meat overtakes any motivation to report accurately.” It’s a consistent trope among active Democrats who see themselves as superior in that respect.

However, and consistent with the research of Yale’s Dan Kahan on motivated reasoning, the solution aversion found by Campbell and Kay cuts across ideological lines. It’s a harsh realm, but even liberals are lamestain members of the tom-tom club only wishing we could be swingin’ in the flippity-flop with the cool kids (so to speak).

In the gun control study, participants were told either that they would read an article arguing that “strict gun control laws prevent homeowners from getting guns that they could use to protect themselves from intruder violence” and then read an article espousing this pro-gun rights ideal or they were told that they would read an article arguing that “loose gun control laws lead to more gun violence by intruders and more homeowner deaths” and then read an article espousing this pro-gun control ideal.

Participants were then asked to read about “Intruder violence — the act of breaking into a home and attacking the resident, usually as part of a robbery. Intruder violence often ends in the death or injury of the resident.” Consistent with the solution aversion expressed by Republicans concerning climate change, liberal participants who had a strong pro-gun control ideology indicated a significantly higher belief in the severity of intruder violence when the solution was gun control friendly than when it was friendly toward the possibility of arming civilians.

I frequently note that investing successfully is very difficult. And so it is. But the reasons why that is so go well beyond the technical aspects of investing itself. Sometimes it is retaining honesty, lucidity and simplicity – seeing what is really there – that is what’s so hard. That inconvenient truth tends to inhibit the understanding of all of us, irrespective of ideology. That’s because, despite what we want to think, we’re hardly rational. We’re ideological through-and-through.


Facts (and Minds) are Stubborn Things

By Robert Seawright, Above the Market

When making his defense of some British soldiers during the Boston Massacre trials in December of 1770, John Adams (later the second President of the United States) offered a famous insight. “Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passion, they cannot alter the state of facts and evidence.”  Legal Papers of John Adams, 3:269. In a similar vein, Sen. Daniel Patrick Moynihan once said that “[e]veryone is entitled to his own opinion, but not to his own facts.”

I have often warned about our proclivity to and preference for stories to the exclusion of data (for example, here, here and here). Because stories are so powerful, we want the facts to be neatly packaged into a compelling narrative. Take a look at John Boswell‘s delightful send-up of this technique in the TED context below.

We crave “wonder, insight [and] ideas.” Facts?  Not so much. As Evgeny Morozov puts it:

Today TED is an insatiable kingpin of international meme laundering—a place where ideas, regardless of their quality, go to seek celebrity, to live in the form of videos, tweets, and now e-books. In the world of TED—or, to use their argot, in the TED “ecosystem”—books become talks, talks become memes, memes become projects, projects become talks, talks become books—and so it goes ad infinitum in the sizzling Stakhanovite cycle of memetics, until any shade of depth or nuance disappears into the virtual void. Richard Dawkins, the father of memetics, should be very proud. Perhaps he can explain how “ideas worth spreading” become “ideas no footnotes can support.”

Felix Salmon’s excellent discussion of this argument in the context of Jonah Lehrer’s sad case (interestingly put into context here), which decries the use of “remixed facts in service of narrative,” establishes clearly (if unsurprisingly) that the facts are frequently too stubborn to fit neatly into a narrative-driven format — whether TED talk, blog post or bestseller. According to Seth Mnookin and reiterated by Salmon, “Lehrer had “the arrogance to believe that he has the right to rejigger reality to make things a little punchier, or a little neater.” Felix perhaps goes beyond Morozov to argue “that TED-think isn’t merely vapid, it’s downright dangerous in the way that it devalues intellectual rigor at the expense of tricksy emotional and narrative devices.”

To be clear, I am entirely in favor of using narrative to illustrate concepts. I am also in favor of making difficult concepts, and science in particular, more accessible. Moreover, there are many TED-talks I find inspiring, illuminating and useful. However, the issue and the danger is in forcing uncooperative (“stubborn”) facts, what Morozov calls “messy reality,” into a glib narrative in ways that simply don’t fit.

We are so susceptible to this problem (and our overarching bias blindness generally) that we fall prey to it often and don’t recognize it. Indeed, Snopes would not exist without our propensity for not letting facts get in the way of a good story. But even ascertaining the bare facts is far more difficult than we tend to think. As William James put it in The Will to Believe (1897): “Roundabout the accredited and orderly facts of every science there ever floats a sort of dust cloud of exceptional observations, of occurrences minute and irregular and seldom met with, which it always proves more easy to ignore than to attend to.”

We are utterly convinced that our senses are open windows through which we experience the real world as it truly is. But all of what we see, hear, touch, taste and smell is a re-creation by our brains – a useful model (guess) about what things “out there” are really like. To paraphrase neuroscientist Chris Frith, each of us is an invisible actor at the center of his or her world, which is designed to be a “map of signs about future possibilities.” Therefore, “[w]hat you’re experiencing is largely the product of what’s inside your head,” says psychologist Ron Rensink. “It’s informed by what comes in through your eyes, but it’s not directly reflecting it.”

In other words, the brain uses a variety of shortcuts to “sift through [the] superabundance of detail” around us (per V.S. Ramachandran and Susan Blakeslee). “At any given moment in our waking lives, our brains are flooded with a bewildering array of sensory inputs, all of which must be incorporated into a coherent perspective that’s based on what stored memories already tell us is true about ourselves and the world.” Accordingly, our default structure is to invent narratives to live by (initially) and then interpreting our experiences in light of these pre-existing narratives. These stories provide easy-to-remember frames of reference wherein we are typically exceptional, heroic, moral and right. Whenever necessary, we misinterpret “facts” or even invent facts out of whole cloth to fill-in the gaps in our knowledge or to explain what we don’t understand.

Sufferers of Korsakoff’s syndrome provide a marvelous (if unfortunate) example of this phenomenon. These people suffer from the inability to transfer short-term to long-term memory due to a thiamine deficiency, often related to excess alcohol intake. When asked a question, they simply invent wonderful and often entirely plausible answers which change each time the question is asked, because they don’t remember what story they told previously.

Cognitive psychologist Richard Warren from the University of Wisconsin recorded himself reading the sentence, “The bill was passed by both houses of the legislature,” cut a middle part of it out of the recording and replaced it with static. When played for subjects, nearly everyone reported hearing both static and the full sentence. Moreover, they couldn’t report when the static had occurred. The auditory system in the brain filled in the missing piece so that the sentence seemed uninterrupted. You don’t perceive blackness every time you blink, do you?

As reported in New Scientist, “We’ve known since the 1960s that memory isn’t like a video recording — it’s reconstructive,” according to psychologist David Gallo of the University of Chicago. The concept of “autobiographical memory” is not a true and accurate record of your past — it is more like a jumble of the remembrances of others, old yearbook and diary entries, photographs and newspaper clippings. “Your memory is often based on what you’ve seen in a photograph or stories from parents or siblings rather than what you can actually recall,” said Kimberley Wade, a memory researcher at the University of Warwick.

Within days of the atrocities of September 11, 2001, psychologists at the University of Illinois at Chicago asked a sampling of people where they were, what they were doing, how they heard the news and who they were with at that time. A year later they asked them again. More than half of the participants had changed their story on at least one count — while still expressing supreme confidence that their memories were accurate.Other studies confirm these results.

None of us starts our thinking or even our observing with a blank sheet of paper (so to speak). As Quine has shown philosophically (using his metaphor of the “web of belief”) and as vast quantities of research have shown practically, anyone sufficiently motivated to hold onto a conviction can always do so and usually will. All of our fact-finding and analysis is done in connection to our overarching beliefs and viewpoints — the stories we live by and the ways we see the world. Our attitude is often on the order of “Don’t bother me with the facts; I’ve already made up my mind.”

This problem is hardly a new one. More than half a century ago, Stanford psychologist Leon Festinger described the issue pretty clearly in the opening lines of his book, When Prophecy Fails. “A man with a conviction is a hard man to change. Tell him you disagree and he turns away. Show him facts or figures and he questions your sources. Appeal to logic and he fails to see your point.”

To wax philosophical for a moment, there is a longstanding dispute on the nature of truth. Correspondence theory asserts that something is true to the extent that it corresponds to reality (from Aquinas). That’s pretty much the way we usually think about truth to the extent we actually think about it. Unfortunately, even straightforward facts require interpretation to have meaning (as my masthead proclaims, information is cheap; meaning is expensive). Worse, most things in life — including most of the really important things, like morality and justice — cannot be established to any degree of relative certainty. They must be argued for.

In that context, a coherence theory of truth makes sense.* Truth is ascertained by its level of coherence to a set of specified propositions. Thus one who values equality over freedom generally will tend to favor a policy that increases equality even if and when it inhibits freedom. However, the trouble here is that there is no way to come up with a set of foundational propositions without using correspondence and, more fundamentally for practical purposes, no way to adjudicate disputes about truth in this context, even in theory (why should one necessarily favor equality over freedom or vice versa?). In other words, our undergirding propositions (often narratives and beliefs) can be and often are wrong and usually disputed, throwing a monkey wrench into the whole works. Moreover, because reality is so “messy” we ought to be extremely skeptical about very high levels of coherence. I tend to doubt anyone who spins every item of fact into a neat little package supporting his or her point of view.

And therein lies the rub. Our brains are designed to operate using coherence theory without requiring that the underlying propositions be true (even to the extent possible). We start with narrative and belief and spend our time trying to cram the facts (as we see them) into our preconceived notions about the way the world works. Facts may well be stubborn things essentially, but our mental mindset ( a less redundant concept than you might think) means that they are not nearly stubborn enough. That’s because our minds are far more stubborn still.


* The pragmatic theory of truth (from James) holds that true statements are those that work for us and meet our needs better than their alternatives. For these purposes, this approach has the same difficulties as coherence theory.

A much earlier and shorter version of this piece appeared here.


Beguiled by Narrative

By Robert Seawright, Above the Market


The photograph above, taken at the Brooklyn waterfront on the afternoon of September 11, 2001 by German photographer Thomas Hoepker, is now one of the iconic images of that horrible day. In fact, the Observer New Review (London) republished it in 2011 as the 9/11 photograph. In Hoepker’s words, he saw “an almost idyllic scene near a restaurant — flowers, cypress trees, a group of young people sitting in the bright sunshine of this splendid late summer day while the dark, thick plume of smoke was rising in the background.” By his reckoning, even though he had paused but for a moment and didn’t speak to anyone in the picture, Hoepker was concerned that the people in the photo “were not stirred” by the events at the World Trade Center — they “didn’t seem to care.” Hoepker published many images from that day, but he withheld this picture for over four years because, in his view, it “did not reflect at all what had transpired on that day.”

In 2006, the image was finally published in David Friend’s book, Watching the World ChangeFrank Rich wrote a 9.11 fifth anniversary column in The New York Times, framed by the photo, which he called “shocking.” Rich claimed that the five New Yorkers were “relaxing” and were already “mov[ing] on” from the attacks. Rich described those in the photo as being on “what seems to be a lunch or bike-riding break, enjoying the radiant late-summer sun and chatting away as cascades of smoke engulf Lower Manhattan in the background.” Indeed, Rich’s explanatory narrative is hardly complimentary.

Mr. Hoepker’s photo is prescient as well as important — a snapshot of history soon to come. What he caught was this: Traumatic as the attack on America was, 9/11 would recede quickly for many. This is a country that likes to move on, and fast. The young people in Mr. Hoepker’s photo aren’t necessarily callous. They’re just American.

It was a plausible — if utterly speculative — interpretation based upon the photograph alone. More importantly, it framed Rich’s desired narrative perfectly. But even though a picture may well be worth a thousand words (1,506 in this case, to be exact), those words aren’t necessarily all that accurate.

Daniel Plotz quickly came forward with an alternative interpretation that disputed Rich, calling Rich’s reading of the image a “cheap shot.” In Plotz’s view the five had not ignored or moved beyond 9.11 but had “turned toward each other for solace and for debate.” To his credit, Plotz emphasized that he didn’t “really know” what the pictured people were doing and feeling and called upon them to contact him so as to set the record straight. Two did, and they repudiated Rich’s narrative in the strongest of terms.

The first to respond was Walter Sipser, a Brooklyn artist and the man on the far right in the shot. “A snapshot can make mourners attending a funeral look like they’re having a party,” he wrote. “Had Hoepker walked fifty feet over to introduce himself he would have discovered a bunch of New Yorkers in the middle of an animated discussion about what had just happened.”

Chris Schiavo, a professional photographer, Sipser’s then-girlfriend and second from the right above, also responded. She criticized both Rich and Hoepker for their “cynical expression of an assumed reality.” As a “third-generation native New Yorker, who knows and loves every square inch of this city,” whose “mother even worked for Minoru Yamasaki, the World Trade Center architect,” she stated that “it was genetically impossible for [her] to be unaffected by this event.”

So much for the accuracy of Rich’s story.

We love stories, true or not, almost from the cradle. Stories are crucial to how we make sense of reality. They help us to explain, understand and interpret the world around us. They also give us a frame of reference we can use to remember the concepts we take them to represent. Whether measured by my grandchildren begging for one (or “just” one more), the book industry, data visualization, television, journalism (which reports “stories”),the movies, the parables of Jesus, video games, or even country music (“every song tells a story”), story is perhaps the overarching human experience. It’s how we think and respond. We always want to know what happens next.

Stories are culture’s way of teaching us what is important. They are what allow us to imagine what might happen next – and beyond – so as to prepare for it. We are hardwiredto respond to story. A good story doesn’t feel like a story – it feels exactly like real life, but most decidedly is not like real life. It is simplified and otherwise altered. We prefer rhetorical grace and an emotional charge to the work of hard thought. Because we are inveterate simplifiers, we prefer clean and clear narrative to messy reality. A famous book by Karl Popper, The Poverty of Historicism, pretty well demolished the popular notion that history was a narrative, that it had a shape, a progression, and followed laws of development. But we believe that it does (or devoutly wish to believe that it does) anyway.

Still, because it feels so true (“It can’t be wrong when it feels so right”), it isn’t hyperbole to say you’ve been lost in a story. Story turns us into willing students, eager to learn the story’s message. It’s how we sift through the raw data of our lives to ascertain what matters. Our brains are designed to analyze the environment, pick out the important parts, and use those bits to extrapolate linearly and simplistically about and into the future.

Ultimately, the key to a good story isn’t just what happens or to whom it happens. AsRoger Ebert so eloquently put it, broadened ever so slightly, a story “is not about what it’s about; it’s about how it’s about it.” Stories are about how the protagonist changes and how we react to those changes and ourselves change. We can “see” the world as it isn’t.(yet) and as it might become.

The best stories are simple, easily communicated, easily grasped and easily remembered. Perhaps most significantly, we inherently prefer narrative to data — often to the detriment of our understanding. To do math, neither maturity nor knowledge of human nature and experience are required. All that is required is the ability to perceive patterns, logical rules and linkages. But because of the enormous sets of random variables involved in real life, patterns, logical rules and linkages alone do not solve any actual puzzles. Correlation does not imply causation. Information may be cheap but meaning is both expensive and elusive.

As Nassim Taleb explains in The Black Swan, the narrative fallacy addresses our limited ability to look at sequences of facts without weaving an (often erroneous)explanation into them or, equivalently, forcing a logical link, an arrow of relationship upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity often goes wrong is when it increases our impression of understanding.

Frank Rich — I’m looking at you.

Five years after the towers came down, Frank Rich had a story to tell. It was a story of a “divided and dispirited” America that had lost touch with the horror of 9.11, of a forgetful nation desperate to move on, a divided nation insufficiently stirred. It was also the story of a callow, fear-mongering President with a selfish and secret partisan agenda far removed from committed sacrifice for the common good. It was a story of a once-great country that had moved on but not ahead. And he thought he had found the perfect picture to illustrate that story.

As a journalist, Rich had an obligation to check the facts of his story. By all appearances, he did not. Perhaps he thought it was “too good to check.” If so, he was dreadfully and blatantly wrong. Perhaps he tried and was unsuccessful or that Hoepker’s description was enough to go on. If so, he didn’t try hard enough and also had an obligation to be forthright about what he knew and what was mere speculation. That he did not was an egregious error, an error that would make him look silly when the truth came out, as it so often does.

Many of our foibles (narrative and otherwise) are the result of our laziness. Sometimes the laziness is overt. Other times it is simply a function of the various shortcuts we take, sometimes reasonably, to make life more manageable. Rich took a variety of shortcuts in writing his story, shortcuts that perverted the truth of what the Hoepker photograph actually portrayed. His facts were wrong, plain and simple.

We like to think that we are like judges, that we carefully gather and evaluate facts and data before coming to an objective and well-founded conclusion. Instead, we cut straight to the chase. We are much more like lawyers, grasping for any scrap of purported evidence we can exploit to support our preconceived notions and allegiances. Doing so is a common cognitive shortcut such that “truthiness” — “truth that comes from the gut” per the comedian Stephen Colbert — seems more useful than actual, verifiable fact. Whatreally matters is that which “seems like truth – the truth we want to exist.” That’s because “the facts can change, but my opinion will never change, no matter what the facts are.”

The concept even “became a lexical prize jewel” for Rich himself (see here, for example), allowing him (of course) to criticize his political opponents for offering only “a thick fog of truthiness” such that they presented “a bogus alternative reality so relentless it can overwhelm any haphazard journalistic stabs at puncturing it.” Rich has expounded on the idea a number of times in print and even on The Oprah Winfrey Show. Of course, he always directs the analysis outward rather than inward. Oh the delicious irony.

This concept of “truthiness” captures how, as cognitive psychologist Eryn Newman puts it, “smart, sophisticated people” can go astray on matters of fact. Newman’s research has shown that the less effort it takes to process a factual claim, the more accurate it seems. In one classic study, for example, people were more likely to think a statement was true when it was written in high color contrast as opposed to low contrast. Easy-to-pronounce ticker symbols (such as KAR) perform better in the markets than their difficult-to-pronounce counterparts (such as RDO) — even after just one day of trading. And, astonishingly, claims attributed to people with easy-to-pronounce names were deemed more credible than those attributed to people with difficult-to-pronounce names. Assummarized by Slate recently: “When we fluidly and frictionlessly absorb a piece of information, one that perhaps snaps neatly onto our existing belief structures, we are filled with a sense of comfort, familiarity, and trust. The information strikes us as credible, and we are more likely to affirm it — whether or not we should.”

Due to our affinity for like-minded people, we seek out the people like us to provide echo chambers for our own claims, claims that perpetuate themselves every time we hear them reverberated back to us. We are neuro-chemically confirmation bias addicts. As such, we tend to reach our conclusions first. Only thereafter do we gather purported facts and, even then, see those facts in such a way as to support our pre-conceived conclusions. When it fits with our desired narrative, so much the better. Writing op-eds forThe New York Times provided Rich with a heady and exclusive echo chamber, but an echo chamber nonetheless. Keeping one’s analysis and interpretation of the facts of a story reasonably objective — since analysis and interpretation are required for data to be actionable — is really, really hard in the best of circumstances, even when one has gotten the facts close to right.

Megan McArdle summed things up nicely earlier this week.

We like studies and facts that confirm what we already believe, especially when what we believe is that we are nicer, smarter and more rational than other people. We especially like to hear that when we are engaged in some sort of bruising contest with those wicked troglodytes — say, for political and cultural control of the country we both inhabit. When we are presented with what seems to be evidence for these propositions, we don’t tend to investigate it too closely. The temptation is common to all political persuasions, and it requires a constant mustering of will to resist it.

Frank Rich — I’m looking at you.

Once we have bought-in to a particular narrative, it becomes increasingly more difficult to falsify, even (especially!) when presented with contradicting fact. Take the example of parents who choose not to vaccinate their children and the pediatricians who try to convince them otherwise. When presented with unequivocal information that autism diagnosis and vaccinations were not linked, the strategy backfired and parent became more set in their ignorance. In other words, the disconfirming facts offered actually (in effect) turned up the volume inside the echo chamber such that the truth could not be heard.

The more we repeat and reiterate our explanatory narratives, the harder it is to recognize evidence that ought to cause us to re-evaluate our prior conclusions. By making it a careful habit skeptically to re-think our prior interpretations and conclusions, we at leastgive ourselves a fighting chance to correct the mistakes that we will inevitably make. As with everything in science, each conclusion we draw must be tentative and subject to revision when the facts so demand. As John Maynard Keynes famously stated, “When the facts change, I change my mind. What do you do, sir?” Indeed, what do you do?


Note: This post is a much-expanded version of one that appeared here.

Trouble in Paradise

By Robert Seawright, Above the Market

It’s a problem that is now — finally — discussed and sometimes dealt with. Increasingly, investors of various type are questioning high-cost, high-risk strategies (often purveyed by hedge funds) because they have performed so poorly. Indeed, hedge funds as a class have performedmuch worse even than U.S. Treasury bills. As a consequence, few can expect to achieve success in that market, as I have argued repeatedly (see hereherehere and here, for example). Calpers, the public pension giant here in California, is a leader in this trend that is demanding accountability, putting new investment proposals on hold while weighing whether to exit or substantially reduce bets on commodities, actively managed company stocks and hedge funds.

The general problem is well illustrated right here in San Diego and outlined in a terrificcolumn in the San Diego Union-Tribune yesterday by Dan McSwain. Many cities have a pension crisis. San Diego’s is particularly bad, as outlined definitively by the great Roger Lowenstein in While America Aged. McSwain’s piece does an excellent job of examining how the City is responding to the problem in terms of investment management and contrasting the City’s efforts with what the County of San Diego is doing with its pension dollars. 

To be sure, the City’s pension crisis is much more a matter of political mistakes — mostly by promising too much to City workers — than investment mistakes, as Lowenstein so clearly explains. However, it is still good to see that the City now invests fairly prudently and carefully, with no leverage. And, over roughly the past five years, the City has earned 13.6 percent annually, essentially equivalent to a standard 60:40 portfolio over that same period. That’s very good news.

The County, on the other hand, uses hedge fund-type strategies (almost anything is fair game) newly spiced up by leverage of up to 100 percent and wrapped in an extremely high fee structure (well over $100 million in fees during fiscal 2013). What could go wrong? For a clue to the answer, take a look at another Roger Lowenstein book, When Genius Failed. Not surprisingly, performance to date has lagged badly using this approach. Over the roughly five-year period during which the City earned 13.6 percent, the County paid a lot more and earned a whole lot less — only 9.7 percent — in thriving bull markets for both stocks and bonds. To make the magnitude of the problem a bit clearer, a $10 billion portfolio (that’s about the size of the County’s pension fund today) that earns 13.6 percent over five years grows to over $19 billion. Meanwhile, a $10 billion portfolio that earns 9.7 percent over that same period grows to nearly $16 billion, over $3 billion less. That’s three b-i-l-l-i-o-n dollars.*


As a citizen and taxpayer of both the City and the County, I hope both pension funds succeed spectacularly. Taxpayers will have to fund any shortfalls after all. From an investment standpoint, the City looks to be doing a pretty good job. The County — not so much. Sadly, this isn’t likely to turn out well for the County, and we taxpayers will be left holding the (empty) bag.


* To be clear, I don’t mean to suggest that the County’s opportunity cost was necessarily $3 billion. The County had substantially less than $10 billion in its pension fund five years ago and made contributions to it between then and now.  But the investment scheme the County utilized still came with enormous opportunity costs in terms of returns and risk and the added leverage/risk that has been newly approved makes things even worse. It’s essentially impossible to make a reasonable case justifying it.

Proof Negative

By Robert Seawright, Above the Market


I have regularly argued that in investing, as in most things in life, disconfirmation is more valuable than confirmation (see here, for example). In other words, we learn more from what doesn’t work than from what does. That’s largely because induction is the way science advances.

We want deductive proof, but have to settle for induction. That’s because science never fully proves anything. It analyzes the available data and, when the force of the data is strong enough, it makes tentative conclusions. But these conclusions are always subject to modification or even outright rejection based upon further evidence gathering. The great value of data is not so much that it points toward the correct conclusion (even though it does), but that it allows us the ability to show that some things are conclusively wrong.

In other words, confirming evidence adds to the inductive case but doesn’t prove anything conclusively. Correlation is not causation and all that. Thus disconfirming evidence is immensely (and far more) valuable. It allows us conclusively to eliminate some ideas, approaches or hypotheses.

That said, we don’t like disconfirming evidence and we tend to neglect the limits of induction. Few papers get published establishing that something doesn’t work. Instead, we tend to spend the bulk of our time looking (and data-mining) for an approach that seems to work or even for evidence we can use to support our preconceived notions.

We should be spending much more of our time focused upon a search for disconfirming evidence for what we think (there are excellent behavioral reasons for doing so too). But we don’t, as illustrated by the following question (a variation of the Wason selection task).


Most people answer with E and 4, but that’s wrong. For the posited statement to be true, the E card must have an even number on the other side of it and the 7 card must have a consonant on the other side. It doesn’t matter what’s on the other side of the 4 card. But we turn the 4 card over because we intuitively want confirming evidence. And we don’t think to turn over the 7 card because we tend not to look for disconfirming evidence, even when it would be “proof negative” that the given hypothesis is incorrect. In a variety of test environments, fewer than 10 percent of people get the right answer to this type of question.

I suspect that this cognitive failing is a natural result of our constant search for meaning in an environment where noise is everywhere and signal vanishingly difficult to detect. Randomness is difficult for us to deal with. We are meaning-makers at every level and in nearly every situation. Yet, as I have noted often and as my masthead proclaims,information is cheap while meaning is expensive and elusive. Therefore, we tend to short-circuit good process to get to the end result – typically and not so coincidentally the result we wanted all along.

As noted above, science progresses not via verification (which can only be inferred) but by falsification (which, if established and itself verified, provides relative certainty only as to what is not true). Thank you, Karl Popper. In the investment world, as in science generally, we need to build our investment processes from the ground up, with hypotheses offered only after a careful analysis of all relevant facts and tentatively held only to the extent the facts and data allow. Accordingly, we need always to be on the look-out for disconfirming evidence — proof negative — even though doing so is oh so counterintuitive pretty much all the time.

Above the Market’s Leading Investment Indicators

By Robert Seawright, Above the Market

This fifth edition of Above the Market’s Leading Investment Indicators is for mid-year 2014 and the first since last July. Earlier iterations are hereherehere andhere. As I always note, in economics, leading indicators are measures that typically change before the economy as a whole changes, thus providing some predictive power with respect to what lies ahead. For example, the Conference Board publishes a Leading Economic Index intended to forecast future economic activity.

My intent has been and still is to derive some Leading Investment Indicators. Unlike leading economic indicators, these were not designed as short-term or even intermediate-term predictors. The strength of these metrics is as a tool to measure potential real long-term returns. Thus they are better used as longer term indicators of value, risk and expected returns. They in no way should be used as any sort of timing mechanism. The stock market can continue higher or lower regardless of what any metric of valuation is showing. These indicators are designed to be a tool to help shape an overall investment thesis and process as well as to separate short-term and long-term concerns, not to dictate trading decisions.

My previous conclusions suggested that the market was not long-term cheap. I think they are worth re-visiting in light of recent events (or lack thereof) and as we pass the mid-point of 2014. But I won’t bury the lead (or even the lede). Stocks remain rich and the secular bear market continues (despite the long cyclical bull market rally, fueled by the Fed). Fed activity, as intended, makes stocks look much more attractive than they otherwise would — sort of like being the skinniest kid at fat camp.

As I have noted repeatedly, trying to fight the Fed hasn’t been a very productive approach over the recent past. If you’re going to play (and the risks of sitting things out are big too), please be careful and consider putting on a hedging strategy of some sort. So here goes….

1. PE10. The largest overall contributing factor to equity returns is the P/E ratio. The expansion or contraction of the broad market P/E ratio creates secular bull and bear markets. The chart below from Crestmont Research breaks down the components of total return for the S&P 500 for ten-year rolling periods. As of this writing, P/E is 19.71, well above the mean of 15.51, the median of 14.56 and last year’s level of 18.18..


Yale Professor Robert Shiller’s 10-year Average Inflation-Adjusted PE Ratio, also known as CAPE, Shiller PE or PE10, provides the best longer-term market gauge available. PE10 is the stock index price divided by the average real earnings from the previous 10 years – the time period is designed to smooth out near-term noise in the data. The basis for this approach is the finding that earnings valuation ratios provide predictive power for long-term stock market returns. Campbell & Shiller, “Valuation Ratios and the Long-Run Stock Market Outlook.” Journal of Portfolio Management 24, 2 (Winter 1998), pp. 11–26.

The long-term mean CAPE as calculated by using Prof. Robert Shiller’s datais 26.48. In January 1921, PE10 was 5.12, the lowest value of any January in the historical period. Meanwhile, PE10 in January 2000 was 43.77, the highest January level in history. It is 26.48 today. well above the reading of 23.00 a year ago, suggesting that stocks remain significantly overvalued. Historical S&P 500 PE10 is charted below.


Source:, using Prof. Shiller’s data

2. DY10. The dividend-price ratio or dividend yield (DY) is another predictor of the subsequent 10-year real returns on stocks, although this approach has its problems. Historical S&P 500 DY is charted below and also suggests that stocks are significantly overvalued today.


Source:, using Prof. Shiller’s data

3. Tobin’s Q. The Tobin’s Q is the ratio of price to replacement cost, which is in many ways similar to book value. See Tobin & Brainard, “Asset Markets and the Cost of Capital,”Economic Progress, Private Values and Public Policy (1977). The most current Q ratio can be calculated from September’s release of the Flow of Funds report for Q2 2011. It is calculated by dividing line 35 of table B.102 by line 32. The historical data is also available on the St. Louis FRED website. However, because the Flow of Funds report is released long after the quarter end, getting a relatively current level takes a bit of extrapolation.

When equity as a percentage of GNP is above-average then total real returns for U.S. equities have a high probability of being below average. When equity as a percentage of GNP is below-average then total real returns for U.S. equities have a high probability of being above-average. Another use for Q is to determine the valuation of the whole market in ratio to the aggregate corporate assets. The Q ratio is a statistical measurement of the market’s value; fair value for Q is 0.65, primarily because capital stock is routinely overstated leading to a larger denominator in the Q equation. See Smithers & Wright,Valuing Wall Street : Protecting Wealth in Turbulent Markets and Doug Short’s excellent analysis here).

Per Doug, the average (arithmetic mean) Q Ratio is about 0.68. The all-time Q Ratio high at the peak of the Tech Bubble was 1.78 — which suggests that the market price was 153 percent above the historic average of replacement cost. The all-time lows in 1921, 1932 and 1982 were around 0.30, which is about 57 percent below replacement cost. Based on the latest Flow of Funds data, the Q Ratio through the end of the second quarter of 2014 was 1.15, up from the 1.05 level I noted a year ago. Doug’s current estimate puts the ratio about 70 percent above its arithmetic mean and 83 percent above its geometric mean, a good bit higher than when we last checked in. By this measure too, then, the market remains overvalued.

4. Market Cap to GDP. Market Capitalization to GDP has been described by Warren Buffet as “probably the best single measure of where valuations stand at any given moment.” It compares the total price of all publicly traded companies to GDP. This metric can also be thought of as an economy wide price to sales ratio. The data here is from theSt. Louis FRED. However, because the data is quarterly, data for the other months have been entered using the prior ratio adjusted for the change in stock prices. As charted below, this metric suggests that stocks are significantly overvalued and overvalued as compared to previous editions of this post in October, 2011, August, 2012, January, 2013 and June 2013 (.96, 1.01, 1.03 and 1.17 compared to the current 1.27).


Source: Vector Grader

5. Bond Yields. Returns on bonds depend on the initial bond yield and on subsequent yield changes. Low bond yields tend to translate into lower returns because of less income and heightened interest-rate risk. As Warren Buffett has pointed out (although he is not alone in this), “interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset. …If interest rates are, say, 13 percent, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4 percent.” As charted below, despite recent volatility and pressure, long-term interest rates have been generally declining for more than 30 years and remain near record low levels, despite routine calls for a “bond bubble” over the past several years, suggesting that all assets are at risk going forward.


Source: The Big Picture (for a more limited period, the U.S. Treasury data is available for charting here)

These measures all confirm that, from a longer-term perspective, the market remains overvalued and, if anything, somewhat more overvalued than it was when I last ran these numbers a year ago. As I have been saying for a long time (for example, herehere and especially here) – we are (since 2000) in the throes of a secular bear market, subject to strong cyclical swings in either direction. I continue to encourage investors to be skeptical, cautious, and defensive yet opportunistic. I suggest that they look to take advantage of the opportunities that present themselves while carefully managing and mitigating risk, which should remain their top priority.

The Halftime Report

By Robert Seawright, Above the Market

“To err is human,” wrote Seneca. “To persist in it is diabolical” (Errare humanum est, Perseverare diabolicum). As 2014 opened, pundits expected interest rates and stocks to go higher, with more certainty about the former than the latter. They also expected the economy finally to turn the corner after five years of sub-par performance. Now that the midway point to the year has been reached and stocks, bonds and commodities have all posted gains together for the first time since 1993, my ongoing and deeply held cynicism about forecasts and forecasters has yet again been confirmed. In other words, be leery about fighting the Fed, fade forecasts and be sure to diversify.

The halftime scoreboard shows that rather than rising 50bp or so, the benchmark 10-year U.S. Treasury note has rallied by roughly that amount while the long-end of the curve has seen double-digit returns. Global bonds as an asset class have performed admirably (FWDB up 6.45 percent) while domestic bonds are nothing to complain about either (AGG up 3.75 percent). Taking on extra credit risk didn’t really pay, as high yield (HYG) advanced 4.96 percent while investment grade corporates returned roughly 100bp more.

Despite historically high valuations, the S&P 500 index has already jumped 7 percent this year and was up for the sixth straight quarter while small caps have lagged (IJS up 4.16 percent). Going overseas didn’t pay, either in large (EAFE up 4.31 percent) or small caps (EEM up 4.54 percent). Utilities (up 18.65 percent) and domestic REITs (IYR up 16.18 percent) were the leading domestic sectors. The worst was consumer discretionaries (up only 0.6 percent, but still up). Obviously, financial market volatility has remained extremely low.

Meanwhile, the U.S. economy was reported to have shrunk by the highest level since the dark days of 2009 last week (GDP off a whopping 2.9 percent, bad weather or no). If that’s turning the corner, I’m mighty concerned about what we’ll find once the turn is complete. The print was so bad that concerns about recession are back on the table. Moreover, the Citigroup Economic Surprise Index, which tracks how various economic data points are faring relative to expectations, has turned down sharply. Other data points aren’t so negative, as jobless claims have dipped, consumer confidence is up to its highest level since 2008, and a classic Monet sold for $54 million, for example. Accordingly, most economists expect GDP to improve markedly in the second quarter.

As one might expect from a maturing economic recovery, Fed policy is in transition. The Fed will likely continue to taper its bond-buying program – designed to drive investors to stocks – by $10 billion per FMOC meeting, which should lead to an exit from the program altogether by the end of 2014, and begin to raise interest rates by late 2015. That schedule assumes that the economy tracks closely to the Fed’s forecast of near 3.0 percent GDP growth for 2014 and 2015, the unemployment rate declines steadily to roughly 5.5 percent, and inflation moves a bit higher but remains modest at around 2.0 percent. However, since a wide variety of Fed forecasts have been wrong pretty consistently, I see little reason to think the Fed’s forecasting ability will suddenly improve. Remember – fade forecasts.

Among the analysts I respect, such as Seth KlarmanRobert Schiller and Jeremy Grantham, most are concerned about stocks, despite calls among economists for 3 percent GDP growth in 2Q (see below), more stock buybacks and ongoing Fed easiness.


Source: GMO

But, as ever, fighting the Fed is a dangerous proposition indeed.  The cumulative annualized return for the S&P 500 over the last three calendar years has been an astonishing 16 percent and has approached that level so far in 2014 despite an economy that has been tepid at best. That means that money in the market on January 1, 2010 and left there has roughly doubled since. Everybody wants a piece of and nobody wants to be non-correlated to that. Moreover, economic difficulty and stock market weakness are hardly correlated (see below).


Source: Marginal Idea; J. Lyons Fund Management

As a matter of economic (Fed) policy (and in the words of Tomáš Sedláček), we keep shorting stability to try to buy growth. Fiscal policy is a trick, pretending there is demand when there is none. Monetary policy is also a trick, pretending there is liquidity when there is none. Still, we keep pretending (or at least hoping) that the Fed’s new clothes are indeed lovely. It’s bad policy, surely, but there is little reason to try to oppose it with our investment dollars. As Augustine prayed (Confessions, Book 8, Chapter 7): Da mihi castitatem et continentiam, Sed noli modo (a rough paraphrase is “Make me pure, but not yet”). Our investment approach needn’t be consistent with our favored policies. Trick or no, investment returns since 2009 have been both remarkable and real. It’s wise to fade Fed forecasts but fading Fed policies hasn’t worked well.

More specifically, investors with longer-term time horizons can withstand nearer-term difficulty (see below) if, indeed when it happens. It is helpful to recall (as the great investorPeter Lynch pointed out) that far more money has been lost trying to avoid market downturns than in the downturns themselves.


Source: Fidelity

One of the best investment managers out there, Seth Klarman,, who founded the Baupost Group a Boston-based private investment partnership (and whose book, Margin of Safety, sells used for thousands of dollars) , says that we should worry top-down but invest bottom-up. As I have noted consistently in my weekly commentaries of late, there is a lot to worry about in the markets today. Worrying top-down is important because nobody wants to be hurt by some adverse macro, sectoral circumstance. Moreover, the macro environment has to impact the bottom-up analysis – especially as it relates to determining valuation and thus relative value.

But there is still no good way to time the market consistently and investing is required if an investor seeks to outperform inflation and meet longer-term financial goals. Accordingly, in all environments, investors must simply do the best job they can to identify specific, bottom-up opportunities to deploy the available funds. Moreover, the longer the investor’s time horizon, the less important the “top-down” environment becomes. Even so, today’s environment demands caution. I agree with Klarman that the Fed’s adventure into uncharted territory is likely to end badly. What is unsustainable tends to stop. Fantastic deep value investors like Klarman have a long history of being right – but also early. When will this happen? “Maybe not today or tomorrow, but someday,” Klarman writes.

There won’t likely be any sort of signal when the tide finally and inevitably turns. Yet it needn’t be anytime soon either. “Someday: could be a long ways away. Until then, fight the Fed at your peril.

My Top Ten Non-Investing Books for Investors

By Robert Seawright, Above the Market

Last week, other bloggers and I provided favorite reads for Tadas Viskanta and his terrific site, Abnormal Returns. There are a lot of good and helpful suggestions offered there. But I am seldom asked about books in a broader context — books that changed my overall thinking and thus necessarily changed how I view investing and the markets. The ten books shown in the gallery below did just that. They were (and are) particularly illuminating. I highly recommend them.