Some Comments on the Quantity Theory of Money

As I mentioned in my previous post - Inflation - Why the official numbers are wrong! - I pointed out that the general theory for which inflation is based upon implies that the "price level" is a vector but measures of inflation represent this as a scalar. Today I want to explore how that complicates the picture for the Quantity Theory of Money.

Financial Mathematics: Statistics - Expected Values

In statistics, a probability distribution is any function, $f(x)$ which is never negative (probability is either 0 or positive) and it sums up to 1 (100%). Mathematically we'd express this as:
\[\begin{align*}
\forall x f(x)\ge 0 \\
\sum_x f(x) = 1
\end{align*}\]
In the case of a continuous random variable, the second formula would be expressed as an integral:
$$\int_x f(x)dx = 1$$
There are some differences between discrete and continuous random variables but the ideas behind them are the same.

To motivate the idea behind an expected value, we'll begin with a more familiar concept: an average.

The Efficient Markets Hypothesis is Meaningless

I'm going to begin a critique of the Efficient Markets Hypothesis (EMH). This is not the first nor will it be the last that have been presented. Most of these critiques accept the basic paradigm an attempt to empirically prove that one can "beat the market".

For the practitioner, this can be quite appealing as it allows one to find some strategy that would allow one to earn "excess returns".

My approach, which I've been toying with in my mind for the last year or so, is going to be a bit different. My contention is that the entire paradigm is questionable and perhaps "meaningless"¹. At the very least, proponents of EMH have a a lot more work to do as there is a lot of ideological baggage and not much in the way of a legitimate scientific hypothesis.

How to Ignore the Noise in Financial News

One of the most difficult things we face in the information age is the problem of too much information. It's everywhere around us. There's absolutely no way for us to get through all of that information much less be able to utilize it.

There's even a good deal of research that indicates that, not only are we unable to handle extra information, that additional information may make us less accurate and more confident in our inaccurate predictions: The illusion of knowledge: When more information reduces accuracy and increases confidence.

Now it seems to me that there are at least three goals we need to focus on in order to handle all of this information:

1. Focus on important information.
2. Ignore the useless noise.
3. Know what we do not know.

While I think this is important in general terms, there is the question of how to deal with financial news. 

Cape Alternative - Update

In a previous post, CAPE - An Alternative Calculation, I discussed some problems with CAPE (cyclically adjusted price to earnings ratio) and offered a solution which addresses one of those problems which is the growth problem. Today I'll briefly illustrate the growth problem and then look at my solution from an historical perspective.

More on the Constant Growth Assumption

So earlier, in Uncertainty of the Constant Growth Assumption, I discussed how even if we know with certainty (hah!) what rate of growth cash flows (in our example, dividends) will grow at, we may still end up getting the value incorrect. This is due to the fact that actual cash flows are lumpy and don't grow at a nice constant rate but vary quite a bit. The result is that the present value of the asset can be a good deal more or less than where we estimated it to be.

Today I want to look at this from a different perspective. I also wanted to change some of the inputs of the model I used (which, you could do on your own if you downloaded or made a copy of the original spreadsheet.) Instead of focusing on how the actual present value of the cash flows differs from what the model predicts, I want to look at it from the perspective of what returns you'll actually get.

O Captain! My Captain!

So August 11 was a sad day apparently; I managed to misplace my keys.

In other news, I found some of the movies you can find on Netflix and Amazon Prime starring a Mr. Robin Williams.

Inflation - Why the official numbers are wrong!

I'm certainly not the first to claim this and I won't be the last. But I think I'll say this differently than most who happen to say it.

For starters, when I refer to inflation, I'm preferring to price inflation.  Some (particularly Austrians), by inflation, mean monetary inflation so I think it's important to be clear on what's being discussed.

Many feel that the current inflation figures (whether we're talking CPI or CPI minus food and energy) understate the actual rate of inflation. Other methods are sometimes used which in many cases are not any better than the official numbers (and in many ways worse.)

Howerever, what I'd like to suggest is that Any method of coming up with an inflation number is flawed. To understand this we'll have to take a brief detour.