<h1>Deploying Expert Traders</h1> <h2>by Dr. Mark White<br> Partner, White & Associates</h2> <h4>13 June 1996</h4><p> <p> Observers have called the Efficient Markets Hypothesis (which denies even the possibility of price bubbles and crashes) the state religion of economics departments and business schools. Since bubble and crash studies conflict with this state religion, referees at most scholarly journals reject them out of hand with comments like: “If you’re so smart, why aren’t you rich?” Setting aside for a moment the fact that scientists thirst for knowledge, not riches, a heretic scientist who dares violate the state religion by using his knowledge of bubbles and crashes to gain riches could expect an orthodox referee to invoke a streak of good luck as the appropriate pretext for rejecting any bubble and crash study that reports extraordinary gains in a real trading account.

Nonetheless, the research project outlined by this series should persuade even the strongest defenders of the faith if it succeeds. The project’s goal is a consistent increase in a trading account amounting to two percent per trading day. Two percent per trading day, compounded, amounts to about fifty times per year. In about two years, an account growing two percent daily would increase by 2,500 times. An account starting with 1,000,000 dollars (one million) would grow to 2,500,000,000 dollars (two-and-a-half billion). Of course, a single account could not grow indefinitely, or it wouldn’t just trade the markets, it would be the markets!

This goal seems outrageous until one takes a close look at the world’s three million securities. In any given day, there are securities that rise 50%, 75%, 100%, even 150% without any reported news. Other securities fall 40%, 50%, even 60% without any reported news. Every day hundreds of securities rise or fall by more than this project’s two percent goal, and they do so on predictable internal dynamics generated by traders, rather than upredictable external dynamics generated by news. An infallible trader could easily generate daily returns in excess of ten percent by buying the bubbles and selling the crashes among the world’s three million securities, but there are no infallible traders.

There are, however, expert traders, and this project aims to acheive its two-percent goal by assigning expert traders to manage a diversified portfolio of bubbles and crashes from around the world. With their superior pattern recognition abilities, expert traders have a bias towards correct positions, even though they do make mistakes. By diversifying broadly among bubbles and crashes, a portfolio strategy should turn the expert traders’ bias into consistently superior returns (experts in derivatives markets can achieve these levels of returns, but underdiversification makes them inconsistent). Given the size of the daily returns on the world’s bubbles and crashes, these consistently superior returns could reasonably meet the project’s goal and quiet any orthodox murmurings about lucky streaks.

Beyond contributing to academic finance’s ongoing transformation from religion into science, this project’s success would present market regulators with a rather stark choice. Nobel-laureate Merton Miller, one of the high priests of the efficient markets religion and chief defenders of existing market designs, notes that markets have owners who try to maximize profits. Market owners maximize their profits by maximizing trading volume, and try to capture regulators to keep them from threatening those profits just for the sake of better guiding society’s savings to its investment opportunities. Captive regulators would prefer to let market operators maintain the existing rules that encourage bubbles and crashes and just watch volatility, volume, and profits soar as more and more people implement systems like the one this project is pioneering. If this project succeeds, though, market regulators won’t have much academic cover left for ducking the fight by simply turning a blind eye to the bubbles and crashes multiplying around the world. The public would probably force them into a very tough fight to change the rules to minimize bubbles and crashes.

This series of four columns has been what scientists call a reputational bet. By publicly announcing the goal of two percent daily returns from buying bubbles and selling crashes, I am bidding for recognition as one of the world’s leading scientists on bubbles and crashes. Even if the state religion doesn’t reward those whose studies violate its strictures, financial markets themselves have ways to reward those who discover truths about their behavior. I am willing to let financial markets judge this research, knowing that science will ultimately recognize results rather than pretexts. Next week this column will turn to other important topics, occasionally returning to this one. Readers wishing to follow the project more closely can contact me now about receiving updates.

Readers with questions or comments for Dr. White can call 011(525)595-6045, fax 011(525)683-5874, or email white@profmexis.sar.net

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