"Des waerelds doen en doolen, is maar een mallemoolen,"

"Des waerelds doen en doolen, is maar een mallemoolen," engraving from Het Groote Tafereel der Dwaasheid, 1720.

"The actions and designs of the world go round as if in a mill." South Sea bubble financial crisis.

Saturday, August 20, 2011

Social mood as an underlying

U.S. mood throughout the day inferred from Twitter

Is there a better example of Keynes' "beauty contest" metaphor than Derwent Capital beating the market with a Twitter-based algorithm ? The underlying in Derwent's trading strategy is the feeling of the crowd. Bloomberg's Jack Jordan reports that the trading model is developed by computer scientists Bollen, Mao and Zeng and will gauge the mood of the market, tracking especially instances of word related to a calm mood:
Their results showed that rises and falls in the number of instances of words related to a calm mood could be used to predict the same moves in the Dow’s closing price between two and six days later, with a fall in these “calm” words being followed by a fall in the index. The other moods did not have the same predictive quality.
The algo is based on Bollen, Mao and Zeng's paper published by the Journal of Computational Science in March 2011:
Our results indicate that the accuracy of DJIA (Dow Jones Industrial Average) predictions can be significantly improved by the inclusion of specific public mood dimensions but not others. We find an accuracy of 87.6% in predicting the daily up and down changes in the closing values of the DJIA and a reduction of the Mean Average Percentage Error by more than 6%.
Nofsinger in 2005 published a similar paper in the Journal of Behavioral Finance . He notes that the "stock market is itself a direct measure or gauge of social mood". The causality is reversed in these perspective. Social mood is not just correlated with market, it moves it.  An algo based on Twitter would then allow its user to be ahead of the curve. In a world of constant media coverage, this has huge implications for our understanding of financial systems.

Monday, August 15, 2011

Buy on the rumor - sell on the rumor, also

What happened to Société Générale lately fits right in between the Efficient Market Hypothesis and the madness of crowd, in what is still a no-man's land, in spite of all the welcoming push of behavioral finance to take into account human behavior.

The Daily Mail in the U.K. asserted on Sunday on 7 August 2011 that the bank was in a "perilous state and possibly on the brink of disaster".  Needless to say that in the present frantic environment, it triggered a whirlpool of speculation dragging down SocGen stock price. The Daily Mail admitted later the analysis was unfounded and apologized in a public statement.

Zachary Karabell's point is that rumors have a lot more weight when financial sectors lack credibility and no one trust it anymore: 
We have, in short, arrived in Looking Glass world where no one believes anything that anyone in finance-land says. And for that, we have Dick Fuld, Lehman Brothers, and the entire culture of Wall Street, Washington, and European finance over the past five years to thank. They are the inverse of the boy who cried wolf, and no one now believes that the wolf is not at the door.

Wednesday, August 10, 2011

The return of Political Economy II

The downgrade of US debt by S&P and the commentaries following it took the debate on credit rating agencies (CRAs) added-value to a next level. It is worth reading the S&P's statement and spotting the key paragraph ( if you missed the "political risk" in the title): 
[T]he downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011....
Compared with previous projections, our revised base case scenario now assumes that the 2001 and 2003 tax cuts, due to expire by the end of 2012, remain in place. We have changed our assumption on this because the majority of Republicans in Congress continue to resist any measure that would raise revenues, a position we believe Congress reinforced by passing the act.
It comes as no surprise that nobody is arguing about the U.S. debt ratios. It is understood that S&P downgrade has to be viewed within the current political context of the U.S. Here's Dan Drezner's rounds up of the initial reax to the downgrade and why he thinks S&P took an unjustified step. Micheal Cohen holds a different view from across the pond.

These arguments show that once in the "political economy" field however, one has to ask whether S&P has the knowledge and expertise to issue statements and ratings that are political in nature, hence subjective. CRAs gained their legitimacy partly due to a process "hardening of information" whereby financial information is quantified. The process is efficient if risks can be expressed numerically in the form of a debt ratios, but become problematic when politics has to be embedded in a three letter code. We might have reached the limits of what "hard information" can tell us.