This Mindset Can Destroy Your Portfolio

This Mindset Can Destroy Your Portfolio by Chris Mayer – International Man

Remember when people used to say that when quantitative easing (QE) ended, the stock market would tank? Surely you haven’t forgotten about QE? That’s when the Fed bought bonds to drive interest rates lower.

Well, if you plotted the Fed’s QE program against the S&P 500 (“the stock market”), you saw a nice, clean correlation. Ergo, it appeared that QE propped up the market. That chart got a lot of play.

But QE ended in 2014. And the market kept rolling. And here we are near all-time highs. So much for that!

Still, even today, you’ll find some people citing how the Fed’s actions “explain” 93% or whatever of the stock market’s movements since such and such a date. They’re like Flat Earthers with fancy charts and impressive-sounding lingo. But they’re just as hidebound and wrong.

This is the old “correlation is not causation” that your statistics teacher used to tell you about.

You may remember the old joke about the man on the street corner waving a red flag. Someone goes up to him and asks what he’s doing.

“I’m keeping the elephants away.”

“But there are no elephants here.”

“Then it’s working.”

Right.

And yet we still see nonsense like this example every day. But the nonsense is usually not so obvious. It is subtle. The correlations plotted seem plausible. But as Caltech professor David Leinweber warns us, “Just because something appears plausible, it doesn’t mean that it is.”

As I say, the world is a much more confusing and complex place. Drawing out reliable cause-and-effect relationships that hold firm in financial markets (and life in general) is hard. Maybe impossible.

Humility and Doubt

As ever, humility and doubt are good guides here.

Whenever you see an “If X then Y” statement, you should distrust it.

If interest rates rise (or fall), then stocks will fall (or rise)…

The problems here are many. First off, in markets, you can’t change one variable and leave everything else the same. Rates may rise (or fall), but what happens to sales growth? What about profit margins? What about countless other things that also continue to change?

Besides, which stocks? The earnings of brokers, banks, and insurance companies generally rise when rates float higher. We’ll see more about why generalizing is dangerous in a minute.

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