THE BLOG

On Smoking Cannabis, Cavemen, Giants and Predicting Stock Markets

03/28/2008 02:48 am ET | Updated May 25, 2011

Once upon a time, in a land far far away, lived a hairy caveman. After a long hard day of hunting mammoths and avoiding saber-tooth tigers, he scratched his nose and it started raining. He didn't think much of it at first and ran back to his cave into the arms of his loving cavewoman. The next day he scratched his nose again and voila! It rained again. The caveman came to an important conclusion: "if" he scratches his nose, "then" it rains. Sometimes it worked, sometimes it didn't, but at least he had a way to cope with the randomness of nature and had assurance that he had some control over the arbitrary events of his life. He spent the rest of his days devising an intricate system to optimize the results of his nose-scratching activity. It was the birth of the "science" of prediction.

Randomness is scary, and unfortunately we all have a little bit of caveman in us. We would like to think that "if" something happens "then" something else will happen. We are so afraid of randomness that we are willing to pay exorbitant fees to ivy-league educated Wall Street suits to tell us "if xyz happens then you should buy abc." Would you pay a caveman to tell you that "if" you scratched your nose "then" it will rain? Eric Hoffer, an American social philosopher, said:

Creativity is the ability to introduce order into the randomness of nature.

As I've mentioned in THE PANELIST, statistics, which aim to introduce order to randomness, is often an act of creativity and not always one of science. Given the amount of statistical "facts" and their wide spread exploitation by the mass media, it surely pays to be at least aware of the dangers.

Whenever you are faced with a statistical claim, remember that CORRELATION DOES NOT IMPLY CAUSATION! Sometimes changes in two correlated quantities are both the result of a third factor. A few examples might be useful:

1. Children with bigger feet spell better. Does this mean "if" a child has bigger feet "then" he/she will spell better? No! children with bigger feet spell better because they're older, not because they have bigger feet.

2. People who sleep with their shoes on tend to wake up with a headache. Does this mean "if" I go to sleep with my shoes on "then" I will wake up with a headache? Of course not! If you fall asleep with your shoes on, chances are you had one too many drinks and passed out. Happy hangover!

3. People who use cannabis have a higher prevalence of psychiatric disorders. Does that mean "if" I smoke cannabis "then" I will go crazy? Statistically this isn't correct. All the relationship tells us is that people who use cannabis are more likely to develop a psychiatric disorder, and there could be a third factor influencing the relationship.

With the above examples in mind, let's move on to one of the stock market's quirkiest - but most accurate - "indicators." The Super Bowl Predictor of stocks has called the right direction of the Dow Jones Industrial Average for the year following 33 of the 41 bowls, or an astonishing 80.5% success rate. Blogger David Gaffen explains:

In short, whenever an 'original' National Football League team wins the big game, the market rises; but it falls when the winner is a team like the New England Patriots that joined the NFL after the league's merger with the American Football League in 1970.

He adds:

Last year, the indicator worked yet again. The Indianapolis Colts, an original NFL team based on their roots as the Baltimore Colts, won the game -- and the stock market had a winning year.

In other words, "if" the Giants had to win Sunday's Superbowl, "then" stocks will go up over the next year (go Giants!)

Nothing I have written so far is new. Given the vast amount of literature dedicated to these ideas, I find it puzzling that the Wall Street choir always sings "if" the Fed cuts interest rates "then" the stock market will go up. But the beat goes on, and the choir has a lot of cheering to do after the Fed cut interest rates by 1.25% a few days ago.

It's NOT a certainty that lower interest rates will automatically lead to stock market gains. "Flow follows performance," says Charles Biderman of Trimtabs.com. "Also has, always will. If stocks go down, money will leave equities, even if interest rate is zero. Japanese investors ignored Japanese stocks for a decade even as Japanese interest rates hovered around 1%." With the U.S. mortgage market in tatters, will there be enough pricing power to push stock markets higher? For a more thorough analysis of this idea, click here.

Disclaimer: The caveman metaphor comes from Fooled by Randomness, a great book written by Nassim Nicholas Taleb. Read it!