Thursday, September 21, 2006

The Wisdom of Needles

About 6 years ago (aka, long before the days of RSS), I set up an email account on my server to gather various news feeds with the aim of correlating news against market data. I also scraped a few pertinent sites and threw together some latent semantic analysis code to correlate against real time stock quotes. While my code stopped running about 6 months ago when I moved from Solaris to Linux and never bothered recompiling, I continue to amass the news feeds. And what have I learnt from this exercise: That markets are a great predictor of news. Not the other way around.

We now find ourselves in the blog-o-sphere[1] and this idea is being revisited:

Edward Hadas over at breakingviews.com (another paywall, but really good analysis site founded by Hugo Dixon) likens it to using the ‘wisdom of crowds’ to trade. I’m sorry Edward but actually I think you’ve got this one wrong. ‘Wisdom of crowd’ - mining would be things like Marketocracy and SocialPicks. Monitor110 in my opinion is all about finding the needle in the haystack; finding the individual voice or nugget that escapes crowd amplification. Finding the kernel before it becomes a snowball. Where I do agree with him however is the paradox of diminishing returns: the more people find the needle the more difficult it will be to monetise. Or paraphrasing Dash - ‘if everybody is special, it really just means that nobody is…’

Do I think there is anything in Marketocracy? Sure! If/when these ideas take off they will evolve to efficient markets that are almost as good as using real markets to predict the future. Which, to paraphrase Barry Ritholtz, is only really good for trend following. And despite our best wishes, looking at historical market data provides us with damn near nothing informative about the future.

One could argue that the problem with my attempt to correlate news with market activity is that I wasn't looking for the needles in the haystack, and in fact my haystack was being generated and distributed by journalists and PR staffers well after the event. I agree that this is a problem, but I do not see mining the blog-o-sphere as a profitable long term strategy. One just has to look at the pump'n'dump schemes that fill my inbox or the lead-gen junk that fills SERPs. When a voice no longer needs to be amplified by agreement, ala in prediction markets, it is very easy for a lone voice to manipulate others.

Prediction markets are so hot right now, but I get the feeling that people are missing out on some basic economics in terms of understand what is a prediction market and what isn't. If you can buy something now, hold it for the future (possibly a some cost) then prediction markets don't really have a reason to exist. Compare the situation with stocks verus weather derivatives. Anyone can buy a stock today and can hold it. Or they can use options to replicate that strategy. At an arguably lower cost they can even use the nascent single stock futures market to do this. This replication strategy is available to anyone. If the market has an informed view about the future evolution of returns then this will be reflected in the spot price because such replication strategies exist and there will be no arbitrage between spot and future prices. This argument holds for all commodities that can be stored.

Hence any prediction market for this class of commodities is irrelevant. Existing market mechanisms provide an environment where future predictions are embedded within the current spot price.

No one can fill their pockets with summer cooling days. I can not keep a cloud in my lounge room and unleash it on Florida during orange picking season. The weather today does not particularly informative of the weather 3 months from now and as such prediction markets are valuable for future events or things that can't be stored as there is no way to replicate strategies on the spot markets to embed information in current prices.

Yesterday my friend Jon dropped by the office and we talked about his research project as he starts his thesis under Robert Engle. One of the ideas we discussed was what I see as the three causes of information asymmetry in markets:

  1. Timing: I know something before you do
  2. Accuracy: I know something about something, but I'm not sure what
  3. Interpretation: I know that X will happen which I think means Y, whereas you think it means Z

Of course, information is latent in financial microstructure. We can't readily see it or measure it, even after the fact. But lets assume that blog-o-mining has solved this. I still see nothing that gives any agent a distinct advantage in the war for information asymmetry.







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[1] For some reason whenever I hear 'blogosphere', I think Biosphere

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