Market Accuracy

In major league baseball, statistics can literally control the game. Managers have been known to wait to use their closers in situations that will credit them with a save, instead of the situation that will maximize the likelihood of winning games. Analogously, managers do their best to allow the starting pitcher to go at least five innings if the team has an early lead so that pitcher may pick up the win. Empirically, analysts such as Bill James, Derek Zumsteg, and myriad others have decried the outward tunnelvision of the former and the arbitrary accounting methods in face of statistics that measure value more effectively.

Managers, players, announcers, and the fourth estate have frequently defended continuing this behavior. Perfectly plausible and perfectly nonscientific explanations of the importance of a closer-centric bullpen include the notion that relief pitchers are better able to prepare mentally for a game when they know which events will bring them in. While no evidence has ever really been offered to support this conjecture beyond the anecdotal, that does not mean it is not true or important. These groups have similarly felt vindicated since seemingly no playoff team in recent decades has used a “closer by committee”. Despite the lack of evidence and the conclusions of sabermetric, theoretical models, the “preparedness” factor for pitchers cannot be unreservedly dismissed simply because a non-psychological model does not readily present circumstances for said importance to become apparent.

An inescapable exception to psychological excuses is the strikeout record for batters. In 2002, Milwaukee Brewers third baseman Jose Hernandez, at the end of an allstar season, approached the all-time single-season record for strikeouts. With five games remaining in the season, management benched him to save Hernandez the ignominy of tying or breaking the record. There exists no possible justification for playing an alternative ahead of Hernandez if management’s goals were to win that season or win in coming years. Keith Ginter, a 26-year-old whom one could only charitably describe as a prospect, took the playing time from then on out. This was not an isolated occurrence, as the record had been approached before and after until Ryan Howard finally broke it and put it to rest.

The Brewers focused on a number, and not a particularly meaningful one given that Hernandez was the team’s only allstar, as a reason for benching him. Everyone accepted that it had nothing to do with winning games, but so Hernandez wouldn’t feel stigmatized. The very people -the managers, players, announcers, and the fourth estate- who at that time frequently condemned the use of baseball statistics, acted in the interests of nothing more than, as Joe Sheehan put it, an accountant’s spreadsheet.

Within the markets, the legislature, financial commentators, public officials, and the masses make the identical error. All anyone can think about is pushing the market up. If Bloomberg and MSNBC tell us that the number of abacus beads has gone in our favor, we feel good. People made money. If it goes down, investors curse the heavens and push for the market to be stabilized. Stabilization only becomes important if it keeps you from losing money.

To keep the market climbing, social and political factors inhibit market participants from keeping it in check when irrational exuberance arrives for dinner. The purest example is the disgust felt by many of the notion of selling short. This derivative has a downward effect on prices, meaning the investor shorting the commodity “wins” when everyone else is “losing”. “Why should we allow someone to profit on the failure of our economy?”, proffers those of such persuasion.

The answer is that the stock market is not the economy. Its function, or at least what its function should be, is to provide a medium for interested parties to develop a portfolio of risk that best fits their goals. When someone invests, he does not, or at least should not if the market is working properly, invest to push the price up. The goal is to acquire a return, through dividends, interest, capital gains, or otherwise, above and beyond that which would be acquired through the nearly riskless t-bills or money market accounts. An experienced, skilled investor may even shrewdly choose securities that provide a return over the expected return given the risk profile. Yet, these choices do not necessarily push the market up. They make it more accurate, or efficient.

The “goal” of the market is not as some causal factor that may increase productivity and keep the economy near full employment. If it has any goal at all, it is to keep securities as close to their “true” underlying value, where that value is normally defined as the expected amortized profits over the next twenty years. The next time the stock market inevitably drops in value by a third, it is not a cause for mourning and depression unless you were overexposed in a market to begin with. If the market was either correcting itself or responding to a change in the real economy, this is a good thing. The relative price levels of all securities in the market, weighted by their respective risk profiles, should strive to match reality. The reason why we have these prices at all is to communicate value, not to remain high so investors can feel rich.

I’m not arguing that the government should intervene to curtail such behavior, or that any intervention is even possible without further disruption to the truths communicated by price level. The focus on increasing the level of the stock market, whether caused by public policy or psychology and culture, causes situations wherein the market is irrationally high. Just as traditional baseball people confuse pitcher wins, saves, and batters’ strikeouts for actual wins, commentators conflate the level of the markets with the real economy. The final statistics in a season are incidental to the goal of winning as is the level of the market is to the economy.

Espousers of rational expectations, in accordance with the efficient market hypothesis, or as Soros dismissively puts it, market fundamentalism, say that I don’t have a lot to worry about. By the invisible hand, the market will push prices towards a rational equilibrium. If this is true, great. My concern is completely unwarranted. However, the preponderance of conjectured biases the market may possess go in a single direction- up. Whether it is the cultural factors scorning selling short I alluded to or the Post-Keynesian’s view of the market as a Ponzi Scheme, there aren’t very many systemic factors that can push a security or the market down without a wise investor grabbing it.

“Market Efficiency” is a loaded term. Edgy and all the rage of the early 80s, that very notion, much like the supposed failures of supply-side economics, the Laffer Curve, and monetarism, has become little more than a blunt object used to assault any conservative economics. Hence, I do not carry a flag for “market efficiency”, but the unstated goal of that concept, market accuracy. Whether through the Keynesian means of effective fiscal and monetary policy or through lifting the cultural and institutional biases against it, the key to helping the economy is to make the market accurate.

The truth to our economic condition is not the price level of securities or even our crude notion of gross domestic product. The real indicators to consider are our level of technology, our average, individual ability to command resources, the stability of money, and the minimization of externalities. Do not lose sight of that.