Reponse to The Falcon on the matter of independent betting markets. Also, how Warren Buffet unwittingly changed the world.

You know Falcon, you've brought us full circle and back to the crux of the market conundrum.

I know we've talked of this before, but the mispricing in the horse racing situation does not influence the outcome because it is independent of the bettors expectations. This means that if you know the real factors that influence the outcome of the race you can take advantage of that mispricing, much like the quantitative horse racing model Thor sent a while back that used an algorithm that balanced approximately 120 weighted factors.

(quantitative horse model: http://www.contingenciesonline.com/contingenciesonline/20090506/?sub_id=qxyLfphSqUiJ)

As we know that is not the case with financial markets owing to feedback between expectations and outcomes. Those feedback loops are deep, varied and I'd imagine nearly impossible to quantify in a non-stationary way.

For example, the present sharp rally in equities might reflect the most optimistic recovery themes. Without an objective metric we'll never actually know. But what we can strongly suggest is that the rise has allowed many firms to raise additional capital where they would have otherwise been unable. This has undoubtedly changed the future path of their businesses in an unknowable and unalterable way. In addition there will have resulted certain less tangible elements that stem from prices acting a signal, e.g. of broader sentiment and the perceived wealth effects. In other words, do the higher equity prices encourage consumers to spend, employers to hire, etc?

This isn't just abstract Kantianism. This is a fact.

Warren Buffet once remarked that in the short run markets were a "voting machine" but in the long run a "weighing machine". But I doubt strongly whether the market machine serves two masters. Instead, I suspect that Buffet has been unusually lucky in the sense that the voting machine has always tended to eventually validate his weighing process.

And why wouldn't it? In the same way Smith's work cemented our belief in the "laws" of supply and demand, Graham's Security Analysis has had a profound influence on beliefs about valuation. As just another belief, this is liable to change with time. However, at the present time it appears that while price might deviate substantially from "value" in the Graham/Dodd sense, eventually price and value converge and reward those with the time, liquidity and patience to wait for it to do so.

And this is where Buffet has been genius. He has always ensured that any acquisition has provided him with "float". These invaluable free cash flows have funded his speculation while waiting for the voting machine to catch up. Stripped of all the narrative it is just another convergence bet, not too dissimilar to the ones made by Long Term, with the exception that Buffet due to his fear of leverage and use of "float" has always been in a position to withstand the liquidity risks associated with convergence bets.

I also think it is interesting to ponder how Buffet has played a hand in spreading the Graham and Dodd gospel upon which he relies to make a profit. What would the world now be like without Security Analysis, and without Warren Buffet?

So finance guru's, the question is how then to create a model which can account quantitatively for exogenous and endogenous factors?

Finally, one thing to note with that quantitative horse betting model is that their experience working solely off the 120 factors was relatively mixed. Their performance didn't' really improve until they incorporated market generated prices into the model.