How To Win Keynes’ Beauty Contest

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Tuesday’s election result was about as expected as you can get in markets. The accepted wisdom going into the election was that Democrats would take control of the House of Representatives and Republicans would retain control of the Senate. Sure, there were scattered articles by Democratic partisans predicting – hoping – for a wave that would gain them the Senate too. And there were scattered articles by Republican partisans predicting – hoping – they would keep the House. But the polls all pointed to the expected outcome and Nate Silver, the most celebrated crystal ball gazer of our day, posted odds overwhelmingly favoring that outcome (see here and here).

And turns out, Silver and the conventional wisdom were correct. The Democrats took the House and the Republicans held the Senate. There are still some undecided races so we don’t know the exact makeup of Congress yet, but the issue of control has been decided. The Democrats will gain somewhere between 29 and 42 seats in the House when all is said and done and Republicans will probably pick up a couple of seats in the Senate.

So then why exactly were stocks up over 2% the day after the election? One would think that the expected outcome – especially one where the odds were overwhelming – would be largely priced into the market. Sure, you might get some movement from the expected because those betting on the unexpected would need to unwind those bets. But in general, a big move on an expected outcome is not, well, expected. Indeed, most of the old timers I know – that would include me – would probably bet on a market move that is opposite the expectation. That’s the old Wall Street wisdom that says, “buy the rumor, sell the news”. The market anticipates so whoever buys (or sells) in anticipation of an expected outcome will take their profits when it happens.

In attempting to explain stock price movements, John Maynard Keynes described a fictional newspaper beauty contest. Entrants were asked to choose the six most attractive faces from 100 photographs. The winners were those who picked the most popular faces. The most obvious strategy is to just choose the six you think are most attractive. A more nuanced player might choose the six she thinks fit the majority perception of attractive. And the strategy can be extended as Keynes pointed out:

It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees

An expert at this game would not be able to consistently choose the 6% of photos that eventually are determined to be the most popular. Maybe someone really good at this might be able to get 3 or 4 or maybe even 5 sometimes, but the odds of choosing all 6 are astronomical.

And so back to the market reaction to the election and why we got such an outsized move from what seemed an expected result. Trying to predict the post-election market movement using Keynes’ Beauty contest gets complicated quickly; there were some investors betting on unexpected outcomes, some on the expected and some sitting it the whole thing out.

Those who thought Republicans would keep control of Congress were probably betting on more tax cuts and a higher stock market. Those who thought Democrats would take complete control were probably betting on….what? Other than an impeachment hearing? Or a Pence Presidency? The knee jerk reaction to a complete Republican collapse would have probably been stock market negative but who knows? Maybe enough investors would see Pence as a more conventional Republican who would roll back Trump’s anti-trade agenda and that outcome might be a positive for stocks.

And what were those betting on the expected outcome really betting on? An infrastructure bill that Obama couldn’t pass in two terms even with complete control of Congress for his first two years? Really? Healthcare reform again? I suppose it isn’t unreasonable to expect insurance and health care companies to benefit – again – from any political changes to the healthcare system, but finding something a Democratic House and a Republican Senate can agree on is a Sisyphean task; or in military lingo, healthcare is FUBAR. Gridlock? There were surely plenty of articles about that before the election but what is the economic impact of that? I suppose Congress doing nothing means they aren’t doing anything bad but that doesn’t seem like much to trade on.

We would also need to consider those who decided the election outcome was too unpredictable to make a bet at all and sat in cash until there was a known outcome. Do those people fall in the category of expecting the unexpected outcome of a Democratic sweep? Does that mean they bought after the result was known? How many of the people who expected the Democrats to take the Senate actually sold the market short?

There are a myriad of possibilities, numerous positions that could have been taken, all affected by the incalculable biases of the traders involved. But if the wisdom of crowds has any validity, if markets are efficient, an outcome that is expected should have been reflected in current prices the day before the election. And yet, that doesn’t seem to have been true. Why?

Trading isn’t what most people think it is. To use a baseball analogy, trading is not about batting average; it is much more about slugging percentage. Batting average is how many hits you get as a percentage of your at bats. Slugging percentage is the fraction of those hits that are for extra bases – doubles, triples and homers. To shift back to trading lingo, it isn’t how often you are right or wrong that determines whether you are a successful trader. It is how much you make when you are right and how much you lose when you are wrong.

If your wins are large and your losses small, the batting average doesn’t have to be all that great to make a good return. I know lots of successful traders who are not even right half the time. Want to know why most people can’t trade? Think about the psychological toll of being wrong so often; most people just can’t do it. When I hear someone say they bought a position as a trade I always wonder if they considered it a trade when they bought it. Most of the time it means “I bought this investment and it isn’t going my way but I’m going to hold it until I get even so I’m calling it a trade until I give up on it completely”. That is a recipe for a short career as a trader.

So what caused that 2% pop in the market post-election? I have no idea. And it doesn’t matter anyway; the market has already given back over half the move between yesterday and today. Trading is a profession that requires very specific skills that most investors do not possess. For most people the best option is block out the short term market noise. To paraphrase an old movie, the only way to win Keynes’ beauty contest, is to not play.

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