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Myths of Wall Street, the Sequel: Fat Finger Fandango

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By now everybody but one tribesman deep in Borneo's heartland knows that the Dow Jones industrial average tumbled nearly 10 percent in just a few minutes on May 6, 2010. During the chaotic collapse of almost 1000 points some stocks dropped to near zero value.

Color me simply shocked that hubris, greed, wishful thinking, willful ignorance, weak regulations and blatant fraud create a poor foundation for financial strength. No, the interesting story of the May 6th debacle is not the market collapse and quick recovery but our rather pathetic attempt to explain away the problem. We are like parents confronted with a pregnant teen, wondering if we should talk to our daughter about birth control. Perhaps a little chat will make the pregnancy will go away like a bad dream? Our response is too little, too late, inappropriate, ineffective, delusional, and completely missing the point.

Blind Determinism

The real point is that our society suffers from a terrible disease known as blind determinism, making us vulnerable to "surprising" disruptions like Thursday's market meltdown. We need to understand and confront this affliction if we ever hope to improve our lot.

Human beings are predisposed to believe that an event caused by discernable prior events always leads to a knowable outcome. That false and dangerous assumption is blind determinism. The ailment is rooted in our hard-wired notion that we can "determine" the future if we sufficiently document the past; that the cause of any event can be traced back through an unbroken series of antecedents; that if we know enough about the past we can predict the future.

But the real world is not so accommodating. We know, for example, that microscopic eddies caused by a butterfly's delicate flight over a field in France could in theory initiate a chain of meteorological events that conclude with a monster storm in the Pacific two years later. By watching our butterfly we could never predict the storm nor could we in witnessing the storm ever trace back through the trillions upon trillions of possible paths to the original causative puff of air in southern Europe. The storm truly is deterministic (an event causally determined by prior events) in that the hurricane winds really were the consequence of a beating butterfly wing, but indeterminable because in practice the cause can never be discerned.

In our fevered delirium of blind determinism we make the fatal mistake believing that because events have known causes we can therefore extrapolate from past to future. Nowhere is this vulnerability and false belief more evident than in trading on Wall Street. To see this clearly we first must review what we know and do not know about Wall Street, and how our mix of knowledge and ignorance impacts our expectations and behaviors.

What We Know

Major stock exchanges are openly manipulated to favor large investment banks and brokerage houses at the expense of tax payers and individual investors. Note that you missed out on the trillion dollar bailout offered to Wall Street's biggest banks and brokers. Your risk is privatized while their losses are socialized. Bluntly put, Wall Street is institutionalized fraud, an elaborate scam sanctioned by a society eager to believe in financial miracles. A stock exchange is in the end nothing but a casino rigged against small players sold false hope by unscrupulous companies authorized by government to deceive and bilk customers. Unconvinced? Let's see what we know as fact.

We know that the trading system is inherently corrupt, weighted in favor of brokers who only make money by encouraging more trading. But something more sinister than just commission padding is involved. The SEC now alleges, for example, that Goldman Sachs deliberately misled gullible and trusting clients by selling them mortgage securities that Goldman Sachs was itself shorting. The media is full of wild and ridiculous analogies, but we can do better in three easy steps using the fictional auto company "GMS" as an example to explain the scam: 1) GMS built a car with fatal flaws intentionally integrated into the design so that the car would blow up a few blocks from the dealer lot; 2) GMS sold the car fraudulently to a faithful buyer as brand new, reliable, and long-lasting; 3) GMS had the car insured so that when the vehicle inevitable self-destructed after the sale GMS would earn a huge payout. GMS made money when selling the car and made money when the car exploded, which GMS knew it would because the car was designed specifically to do so. Only the buyer was hurt. He purchased an automobile from a dealer he trusted, confident in his choice, unaware that the car was rigged for a short life on the road and clueless that his investment was worthless. GMS created a double win by engineering a guaranteed loss for the duped client. Such behavior would be clearly illegal in car sales, not to mention highly unethical. But this might not be illegal under current regulations on Wall Street.

We know that dubious ethical behavior is embedded into the fabric of Wall Street. In the case of Goldman Sachs, peddling rotten mortgage securities was not a first foray into problems selling short. The company paid a fine of $450,000 to settle SEC allegations (without admitting wrongdoing) for violating short-selling rules in 2008 through 2009. That trifling amount does not even constitute a hand slap and predictably, in the face of such miniscule fines, no lesson was learned.

We know that even giant Goldman Sachs is just a tiny drop in a vast sea of corruption, just the latest in an unbroken chain of malfeasance to make the news. Does the name Bernard Madoff or the amount of $50 billion ring a bell? Remember Kenneth Lay, Andrew Fastow, and Jeffrey Skilling of Enron? How about Dennis Kozlowski, Tyco's ex-chairman and chief executive? Remember WorldCom? That company had the fine distinction of perpetrating accounting fraud that led, at the time, to one of the largest bankruptcies in history. Let us not forget the Rite Aid executives who were accused of securities and accounting fraud that forced the drugstore chain to restate more than $1 billion in earnings. Executives at the company were charged with colluding in overstating Rite Aid's income in every quarter from May 1997 to May 1999, forcing the company to restate results by $1.6 billion, the largest restatement ever recorded at the time, according to the SEC. And who can forget the Adelphia Communications scandal? In that sordid case, the company inflated earnings to meet Wall Street's expectations, falsified operations statistics, and concealed blatant self-dealing by the founding family, the Rigas, who collected $3.1 billion in off-balance-sheet loans backed by Adelphia.

We know that six years ago Morgan Stanley, promoting a staid image of conservative trustworthiness, agreed to pay $50 million to settle federal charges that investors were never informed about compensation the company received for selling targeted mutual funds. Dick Strong of the Strong Funds admitted to skimming his investors to benefit himself. What was his punishment? Strong was allowed to sell his fund business for hundreds of millions of dollars.

We know that, in all, almost two dozen firms were implicated in scandal in 2004. Mutual fund firms agreed to fines totaling more than $2.6 billion in more than 100 settlements, almost none of which was returned to shareholders. The SEC settled with Putnam Investments, at the time the fifth largest mutual fund company, which allegedly had allowed a select group of portfolio managers and clients to flip mutual fund shares to profit from prices gone flat. Other mutual funds allowed the favored few to buy and sell shares in rapid-fire fashion. Oddly, this practice is actually legal, but harmful to innocent shareholders not lucky enough to be included in the game. You and I do not get to play. In a preview of the trillion dollar bailout five years later, wealthy clients were given special treatment. Perhaps most annoying, the practice that led to the mutual fund scandal in the first place was never addressed by regulators, even as the foundation was collapsing underneath them. Well-connected investors still had the chance to trade after the market has closed long after the scandal broke. Any effort to increase shareholder power was and is vigorously fought. A proposal that would force the SEC to give shareholders a greater voice in selecting board members was defeated in October 2004. Commissioner Harvey J. Goldschmid, an advocate of the proposal, said "The commission's inaction at this point has made it a safer world for a small minority of lazy, inefficient, grossly overpaid and wrongheaded CEOs." Nothing has changed since. Witness now the avalanche of lobbyist-funded wrath directed against Obama's efforts to tighten regulations.

We know that other forms of favored trading are common as well, designed to benefit insiders. Fund shares, unlike stocks, are priced only once daily at their 4 p.m. closing price. That is true for you, but not for those favored clients who keep getting special bennies. Some funds allowed a few big clients to lock in the closing price after 4 p.m., letting them profit from late-breaking news. That is the ultimate insider trading. Sure, even companies have the presumption of innocence until proven guilty, but the list of firms tied to the 2004 mutual funds investigation was impressive, and included Janus, Strong, Bank of America's Nations Funds, Bank One's One Group funds, Alliance Capital, Prudential Securities, Fred Alger Management, Merrill Lynch, and Wilshire Associates.

Corruption is not a rare anomaly on Wall Street, but the norm, a constant thread throughout history, but we continue to pretend otherwise. How can anybody review this truncated list of fraud and abuse on Wall Street and dismiss corruption as the outlier? Yet almost everybody does. Fascinating.

What We Do Not Know

We do not know what caused Thursday's market collapse. Pasty-faced pundits offered at first the "fat finger" scenario in which a trader meaning to sell a million shares of one stock accidentally sold a billion. When that theory did not pan out, at least at first glance, the talking heads brought out the usual litany of ex-post facto explanations of, choose one, the uncertain outcome of the British election, Greece's debt crisis, the threat to Euro's stability, concern about persistent unemployment here and abroad, the rising U.S. debt and deficit, the threat of inflation, or pending legislation to enforce stricter regulations on financial institutions. Or we have mechanical explanations like computerized trading going haywire. We should throw in as possible explanations "none of the above" and "we do not have a frickin' clue, but will make anything up to sound like we do."

We do not know what the future holds. We constantly pretend otherwise, looking to "experts" to tell us what stocks to buy, meaning we believe such experts can, on average, predict the future. They cannot. We ignore improbable events that, when they occur, overwhelm our assumptions and invalidate all of our neat predictions. Like a computer glitch causing the market to lose 10 percent of its value in five minutes for example. Not one single expert anywhere on Earth predicted such a collapse this week, this month or this year.

Delusions About the Future

We only think the future is predictable because we are fooled by the fallacy of averages. In our peek to the future we exclude from our analysis anything outside average. We ignore in our analysis the possibility of an asteroid impact or a monster tsunami on the eastern seaboard. If an asteroid hits, our predictions about the housing market and projected federal deficit will be invalid, widely off the mark. But events need not be so extreme. The attack on 9/11 rendered moot for that year every economic forecast made prior to that day. The collapse of banks in the 1980s created losses that exceeded the sum of all prior earnings, invalidating all projections of growth no matter how sophisticated the models. Nobody predicted the impact of the Internet on commerce, social networking or globalization. These events are not "exceptions" but in fact the driving forces in our lives; and they are inherently and deeply unpredictable in both time and magnitude. The future is inherently unpredictable since these outliers drive events and by definition such outliers cannot be predicted. The "average" is the exception! The average is an illusion that should be ignored completely. But instead, it is this average on which we base all our hopes, dreams... and predictions. And hence our predictions are doomed to fail.

This conclusion that unpredictable outliers drive our future has real impact. For one, everything you know about Wall Street and trading is wrong. The only valid investment statement is: buying U.S. Treasury bonds is relatively safer than any other financial instrument on earth. Whatever else you hear from Wall Street about anything more specific concerning future performance is a blatant bald-faced lie. All the sophisticated models, statistics, performance predictions, fundamentals, research, analysis, charts, strategies, risk assessments, pro forma statements, and annual report projections are complete, utter, absolute nonsense with no value except to make you feel good. Wall Street is a grand delusion that survives only because people willingly accept the false idea of a predictable future based on normal distributions that do not exist in the real world. We pretend that asteroids, tidal waves, loose nukes, oil spills, violent storms, terrorist attacks, computer glitches and Wall Street corruption cases are anomalies that can be ignored. They cannot.

The fallacy of averages is sadly not the only problem leading us to blind determinism. We next must understand the problem of obsessive focus. Following the World Trade Center attack, we reasonably diverted our collective attention to the issue of terrorism. But we soon unreasonably went too far. The event was beforehand an outlier beyond our comfortable norm, and therefore ignored in our predictions of the future. But soon afterward we fell into the trap of shifting to the opposite extreme, making terrorism the new average, the new norm, when it is nothing of the sort. We quickly lost all perspective, and therefore lost sight of where we remain most vulnerable to future attacks. An outlier remains so even when it happens; it does not define a new set point; it was always there. We just made the mistake of pretending otherwise. Blind to the possibilities of the unknown, we react in panic when something outside our comfortable norm hits. As a consequence we divert resources from threats of greater dimension. We have spent more than $1 trillion in Iraq, a country not even remotely involved with the 9/11 attacks. We take our shoes off in the airport security line. The evil act taking 3,000 lives on that terrible day in New York represents a threat to society no greater than that from smoking, obesity, train crossings, or H1N1 but our obsessive focus elsewhere diverts our attention. And danger lurks that we will focus obsessively, and inappropriately, on the 1000 point drop.

Finally, we must understand the consequences of deterministic obstructionism. We just saw how we set ourselves up to overreact when an outlier occasionally but significantly impacts our lives. We create a false new average instead of understanding the unanticipated event for what it really is, an outlier that was always present as a threat. But we also do damage by appealing to blind determinism in the other direction as well: demanding incontrovertible proof of an outlier's impact before we take any ameliorating action. This is the untenable position of those who oppose actions to address climate change. These folks are so convinced of our ability to predict the future, on the basis of determinism, that they demand precision in those predictions. (But fail to demand that same predictive precision before supporting missile defense systems or invading Iraq). The problem is that in disparaging uncertainty, they ironically willingly ignore the uncertain and potentially disproportionate consequences of inaction. We can, after all, reasonably anticipate that something will be bad without knowing the details. I know that eating uncooked food from street vendors in Mumbai would likely make me sick. I do not know what specific vendors would cause me harm, or how sick I would become, or exactly what form the illness would take on, but I know enough even with that great uncertainty to avoid street foods.

The World's Greatest Scam

The precipitous and presently inexplicable drop of nearly 1000 points in just a few minutes can now be more readily understood and responded properly to as an outlier, akin to a tsunami, a threat that was always there, big in consequence but rare in occurrence. Our norm, our delusional average, simply and erroneously excluded this possibility. So when the outlier event happened, however improbably, all of our predictions based on an average that dismissed such an outlier were rendered useless. Nothing about the 1000 point drop should be surprising or even alarming (given the fraudulent nature of the entire enterprise). But we react in shock because we remain victims of our blind determinism, pretending that our exclusionary norm describes the real world. We continue to pretend that outliers can be ignored, excluded from our models, shunted aside as mere annoyances, and that by relegating outliers to exile we can safely predict the future. May 6th is yet another reminder that we do so only at our peril.

If outliers exist, and they obviously do, then Wall Street must be a big lie. Securities trading is based entirely on the idea that the future is predictable. Investors buy specific stocks on the belief that their value will increase based on some theory, model, research or tip. But the future cannot be predicted because an outlier by definition will have unknowable consequences, often catastrophic, of unknown duration, at an unknown time. Excluding that reality, hoping that such an event will not occur, is not a basis for prognostication - only a recipe for shock and dismay when stuff happens.

Wall Street is based fundamentally on a false premise, is corrupt, and has a long history of fraud and abuse. The market is battered by unpredictable events like hurricanes, volcanoes and runaway computerized trading. So do all the research and analysis you possibly can. Then wad it all up in a big ball and chuck in the nearest trash can. Next time you hear that annoying commercial from T. Rowe Price that they offer "Proven Performance That Has Stood The Test of Time" change channels, pick up a set of darts and select your next stock purchase; when you hear Sam Waterston for TD Ameritrade, hands steepled thoughtfully together, solemnly promise "objective research to elevate your comfort level" or offer "expert guidance from trained investment consultants" run the other way with your hand on your wallet. You're nothing but a mark in the world's greatest scam. Remember that the next time the bottom falls out of the market, or a corruption scandal brings down an otherwise perfectly good company, or yet another insider trading scheme is revealed or a trillion dollars of hidden debt comes to light or brokers market securities they are themselves shorting or mutual funds are found to be rigged to favor special investors or a company knowingly overstates earnings by $ 1 billion or automated computerized trading paralyzes the market. You are a fool if you let the thieves of Wall Street take your money. You're the mark.

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