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Monday, January 25, 2010

“Reverse Attribution” – What the News Doesn’t Know

On Jan 21st 2010, President Barack Obama announced that he would limit the amount of “gambling” (i.e. high-risk leveraged trading) that banks would be allowed to do using client money. Traders worried that as a result of this announcement, future bank earnings may not be as high as they’d anticipated, and so stocks dropped. Pretty straightforward, isn’t it? Not really. Investors should be aware that the market is understood via “reverse attribution” (also known as “post hoc ergo propter hoc”). That is, after a market event has occurred, analysts try to determine why it happened and report it as news. In reality, there are limitless reasons for market moves: some simple, some complex, and others masterfully planned.

In 1929, millionaire trader Jesse Livermore sensed a change in the public. After weeks and months of positive news, he sensed that people were getting bored with the “prosperity” story. Livermore knew that a well-known economist, Roger Babson, was going to give a speech the following day, saying that markets were overpriced and due for a crash. Livermore knew that this would be the speech because it was the same speech that Babson had given the previous two years! Recognizing the opportunity, Livermore sold short vast quantities of stock (meaning that he would make a profit if the market declined), and then had his staff of secretaries call every major new agency in the U.S. and alert them to an “important speech” that was about to take place. When the press conference took place, it took place to a packed crowd of eager reporters. The following day, Babson’s dire predictions made front-page headlines, and the market took a frightening dive. This was the beginning of the end for investor confidence in 1929. The infamous” great crash” occurred less than two months later, with many blaming Livermore’s orchestrated press conference as the catalyst that started it.

The market decline that began on Jan 21st 2010 may have been caused by Barack Obama’s pronouncement, as explained in the opening paragraph. Or, it may have been caused by opportunistic traders. For weeks prior, traders had been saying that the market had gone too high and was due for a correction. These traders, upon hearing Obama’s speech -- and seizing the opportunity -- started short-selling bank stocks like mad. The short-selling led to anxiety on the trading floor, causing stocks to drop further. George Soros calls this “reflexivity”: that cause and effect make things that were not previously a reality, a reality. Or, I could be completely wrong, and it could be that a wealthy Arab, for no particular reason whatsoever, decided to sell his bank stocks that day.

A few years ago, a mutual fund manager told me the story of when his mutual fund decided to sell a certain company’s stock. The day they started selling just happened to coincide with an announcement by the same company, saying that they were changing some of their board members. The next days’ headline: “X company stock drops after appointment of new board members: investors not pleased with changes.”

In the book Wall Street Meat, Andy Kessler tells the story of a German banker who decided to have some fun at the bank’s annual Christmas party. The inebriated banker called in a buy order for a massive number of shares in pharmaceutical company Eli Lilly. As the whole party watched the computer monitor in anticipation, the share price ticked higher and higher and higher due to the onslaught from the huge order. When the Dow Jones newswire reported “heavy buying” by a foreign investor, the partygoers screamed with delight. Finally, the New York Stock Exchange halted the buying on rumors that this was a takeover attempt. Disappointed that the fun was over, the partygoers went back to their steins and punchbowls to continue their Christmas celebration. The following morning the large purchase was quietly sold off.

When news agencies simply have no idea why markets are moving, they employ common expressions, most notably “profit taking” (to describe a drop) and “bargain hunting” (to describe a gain). For instance, “the markets went up today on bargain hunting,” is a convenient way to describe an increase in the market on a day with no substantial news. “Profit taking” and “bargain hunting” are your clues that in fact no one has a clue.

On any given day, no one knows exactly why stocks move. Sometimes guesses are (probably) accurate. Sometimes they are dead wrong. Sometimes they cite a single reason when in fact there are several. It’s up to you to dig further than people watching from their sofas. It’s up to you to know that sometimes people manipulate the market for fun or for personal gain, even if it kills grandmother’s retirement plans.


“Heavy selling out of the Middle East was an old standby. Since no one ever had any clue what the Arabs were doing with their money or why, no story involving Arabs could ever be disputed.” Michael Lewis, Liar’s Poker.