By Justice Litle
“Essentially, all models are wrong – but some are useful.” That noted quote comes from Dr. George E.P. Box, a grand old man of science and statistics.
It can be disconcerting to embrace the idea that “all models are wrong.” Especially when the insight comes from a legendary statistician!

It makes sense, though, because useful models are simple by definition. Think of a map. What you really need from a good city map is the layout of intersections and streets. A certain level of detail is okay, and even useful. But the more detail that gets added, the more cluttered the map becomes. A map that tried to do too much would cease to become useful at all.

In this sense, the map is “wrong” because it doesn’t give a 100% accurate picture. But, oddly, it is wrong on purpose. It has a very specific purpose and intent, and intentionally leaves things out.Market models – that is to say, different analogies, metaphors, and ways of observing or thinking about the market – are similar. Like a good city map, the right market model can be extremely useful in terms of aiding trading and investing decisions.

In the spirit of continuous improvement, your editor is always seeking to refine, improve and upgrade his market models. Sometimes this means a small change. Sometimes it means a big change. Sometimes it means discarding a model entirely, or coming up with something entirely new.

In that context, here is one of your editor’s most important lessons learned in 2009...

“Real” and “Paper” Are Different Worlds
Let’s break down the insight in market model terms. To begin, when it comes to trading and investing, there is the “real” economy and the “paper” economy. The real economy represents what is really and truly happening – the cut and thrust of Main Street, of jobs and wages, of boots on the ground and day-to-day life. The paper economy, in contrast, tracks what’s happening on Wall Street (as reflected in equities, bonds, commodities and currencies).

One can break out the two as follows:
Looking at the factors listed in the table above, it is easy to say, “Duh.” None of these factors are especially new. In fact we’ve talked about them all at one time or another. But sometimes major realizations are subtle. The market model shift is not always dramatic. Sometimes a small adjustment leads to a game-changing insight.

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It is a further irony that big breakthroughs often have a whiff of “duh” to them. This is because a truly useful insight is, more often than not, simple. And sometimes the gain is in reweighting priorities – changing the recipe without changing the ingredients, so to speak.

In this case, the gist could be summed up like this: The real economy and the paper economy are not just “different,” they are different worlds... and thus should be thought about separately and distinctly.

Back to the mental model thing again...
Think of two planets, one slightly larger than the other. These two planets have a relationship. Each holds the other within a mutual gravitational pull. But, because the relationship is not stable, the distance between the planets changes over time. When there is convergence, the planets move closer to each other. When there is divergence, they move apart.

One of these is “Planet Real.” The other is “Planet Paper.” And thus, if it sometimes seems that the “Real” folks are living on a different planet than the “Paper” folks... that’s because it is more or less true.

A Sharp Disagreement
This market model – seeing “real” and “paper” as distinct worlds to be analyzed separately – is controversial for a number of reasons. Those who embrace standard economic theory, for one, would reject such a model entirely.
Standard theory says that the real economy and the paper economy are very closely linked... that the stock market is both a barometer of health for the real economy and a leading indicator for the real economy’s future direction... and that the main purpose of the market is to allocate capital, i.e. to funnel cash to worthy enterprises and thus aid the real economy.

Your editor has always been skeptical of academic types. As a result of all that’s happened in 2009, his skepticism has morphed into full-on rejection of these common assertions put forth in grad school finance classes. In other words:

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