Sunday, January 25, 2015

The Dangerous Law of Small Numbers


As numbers absorbers we are all aware of the Law of Large Numbers. That is the law that indicates that it is difficult for a large number to grow at the high rate of smaller numbers. For instance the population of the World in the short run is unlikely to grow at the same rate of increase as a bunch of newlyweds. Much less recognized is a law, (perhaps one that I am inventing), the “Law of Small Numbers.” Both laws are designed to prevent fellow numbers absorbers from getting their expectations wrong. Enough about math and on to investing, both for others through institutions or individuals including us.

Plus or minus 20% for 2015

What is behind such a bold statement? The answer is “the Law of Small Numbers.”  Both the investment media and various year-end treatises are full of small numbers in terms of growth of earnings, sales, margin improvement, inflation and interest rates. Most of these currently have two things in common. They are expressed as mid to low single digits and they are being revised downward. I cannot dispute the math of the calculations, but I do their scenarios.

A single small number, particularly when it includes a decimal point, screams of its painstaking accuracy. Most economists and analysts probably forgot most of their history and only remember key dates, but not the underlying movements. One of those elements, the power of surprise to change the equation of various battles, one learns from military, including naval, history.  While Certified Public Accountants do not allow for contingencies in their audited statements, I have in various businesses, including non-profits, always insisted in the mathematical recognition of uncertainty about the future, and created at least in my mind or in operating statements, reasonable reserves for things that could go wrong. Occasionally, reserves may be needed to pay for an upside breakthrough or other development opportunity that requires immediate funding before revenues are generated. In the US Marine Corps it is standard to hold back part of one’s forces on line, keeping one combat unit in reserve to relieve and support the front line elements. Even after these reserves are committed, a secondary reserve is created out of the headquarters staff, including the band and other support elements. Thus in the Marines, I was always taught to have reserves ready to deal with contingencies or surprises. I believe this kind of thinking is necessary for long-term investment survival. Thus, I look askance at small number future estimates.

Why 2015?

While I acknowledge I do have a well-honed contrarian streak, the current year may well be one of surprises not built into the small number estimates. On the upside various US consumer sentiment surveys are showing that in 2013, 35% of consumers believed that they were better off  than before, and in 2014 the number jumped to 47%. Carrying this sentiment further, 65% responded that they expected their finances would improve. (Interesting that 2013 was a better than average year for equity investing; 2014 was good but less than 2013 and considerably less for most managed money portfolios. The year 2015 so far is nervously flat.) I believe that it is likely that the two US political parties will dwell on the upside, albeit with different views of the future, in the run up to the 2016 election.

I have mixed views as to this rising sentiment. For some time I believed that the US stock market has been building toward a dramatic peak. One of the missing elements that presage a peak that will bring on a major decline is a bout of great enthusiasm which could lead to a parabolic stock price explosion. While I might enjoy the experience, my responsibilities for my related accounts will require extreme timing prudence which is not easy during periods of great excitement.

The 20% downside is less frightening to me as we have experienced these in the past and survived and prospered. Nevertheless, we need to be aware of negative surprises caused by nature, political miscalculations, misplaced military adventures, and market structure issues; e.g., counterparty problems unfortunate court cases, etc. These are not built into the small number estimates which are floating around.

Perhaps naïvely, I currently perceive that there are more risks outside of the US than in it. The US is expanding despite the structural damage of bailouts and quantitative easing instead of fiscal policy. Too many European and some Asian countries will be burdened by top-down economics rather than bottom up efforts of a striving population. (Over the next fifty or more years, it is just possible that some Southern Hemisphere countries will be more productive in terms of investments than the average in the Northern Hemisphere.)

Bottom line

The year 2015 may be more exciting than 2014 and many former years. We should be able to tolerate a cyclical decline from today’s levels but the emotional absorption of a surprise major market gain could create a nasty hangover. For our accounts we will be guarding those with relatively short-term time horizons and likely to be more active in terms of trading. Our longer-term investment accounts focus on selective secular growth should be relatively quiet except to follow Sir John Templeton’s instructions to look for better bargains. (John was a very much valued client both of our data and consuming services and we enjoyed being a shareholder in his funds and company when it was relatively briefly traded publicly.)

Question of the week:
Please share with me your views as to what are the odds of a 20% gain and what are the odds of a 20% fall.
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A. Michael Lipper, C.F.A.,
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