Sunday, August 23, 2015

Awareness Risks and Opportunities:
The Search for Outliers


After stock prices slumped last week, particularly Thursday and Friday, we should be aware that our judgments are far from perfect. To help us in our deliberations, I am calling up our top strategy team, RT&E. Let me introduce the team: they are more formally known as Donald Rumsfeld, Mark Twain, and Albert Einstein. Rumsfeld divided knowledge into “Known Knowns,” “Known Unknowns,” and “Unknown Unknowns.” Mark Twain cautioned us as to what we “know” that is just not true. Einstein, a three-time visiting professor at Caltech, told us “Everyone sits in the prison of his own ideas, he must burst it open.” He suggested that we must think differently to produce different results. We should always be aware of risks and opportunities including those that we create by our own narrow thinking.

Known Knowns

1.      In the modern era, where the leading academic institutions teach the unsuspecting students a top/down view of the world in order to put the academics near the top of the power structure, they teach that markets are primarily driven by monetary policies implemented by the Fed and other central banks.

2.      The best examples are China and Russia, both are command economies and therefore the governments can totally deliver what they want.

3.      Price momentum leads to further price momentum for stock prices.
(see table below).

Known Unknowns

Each of the “knowns” are macro trends, or if you prefer, gross understandings that can be transmitted to the audience in sound bites up to 40 minutes of class time.  These averaging or actuarial approaches to human behavior lead to surprises or counter developments that are derived from the study of micro trends which when netted against the gross trends cause periodic reversals. This may well have been what happened last week with the gross beliefs being carried beyond their “sell date.”

For some time it has been reported that most publicly traded stocks in the US were falling, but the popular market averages were being held up by a couple handfuls of favored shares. Many of these favored stocks prices in one day fell into a correction (10%) or a full bear market (20%).

Filtering the largest dollar volume declines on NASDAQ the following names could lead a major price trend change list:

These stocks have preformed very well in the past, but the unknown element is when would they give some back, and how quickly would it occur.

(I am not commenting on the attractiveness of these names, but the surprising rapidity of their decline in high dollar volume which up to last week was unknown.) 

Unknown Unknowns

The “knowns” are premised on “all other things being equal.” We live in a world of small and occasionally large changes daily. Strange as it may seem, each day we grow older and perhaps wiser, but not definitively different than the day before in terms of our attitudes and mental and physical health. Not only are we changing, but we are experiencing the never-ending changes caused by technology.   Because of cell phones, billions of people are now aware almost instantaneously of any important news item, interesting rumor, or critical price change. Markets move with the speed of electronics; in many respects for major “chunks” of money no market is closed.

Teenagers’ buying habits and other consumer demand swings occur rapidly, responding to perceived models can lead to major changes in distribution chains globally, with much unsold inventory.

The Known is Untrue

While I am a professional analyst and money manager at my core I am also a student. Thus each day I am aware that some of my rock-solid facts are going to be challenged. Many of these “facts” come from respected sources. The best of which are my own experiences and yet some of these are extrapolated too far to be general cases and not just specific relationships. For example, for many years I have been following the weekly Barron’s Confidence Index which measures selected Intermediate-rated bond yields compared to a selection of High Grade yields. When the yields of the High Grades go down relative to the Intermediate Grade, which means that high grade prices are raising at a faster rate than the lesser quality is a measure of risk coming off for bonds, which often is indicative of current attitudes toward stocks. Most weeks the change in relative yields is under 1%. This week the move itself was 3.7 percentage points which is the most dramatic change I can remember and signifies a major risk aversion. Whenever some ratio goes to a historic level most people believe it is a confirmation of a trend. My training from the racetrack is to either doubt the mechanics or believe it is less reliable in terms of the future because it represents an extreme. At the moment I am being cautious and doubting the validity of the ratio, but I can be wrong.

Dr. Einstein’s Prison Breakout

We all like the past because we know what happens. The future is uncertain and we need to learn when to jump off the comfort of extrapolating the past. One of the advantages of my practice is that regularly I can examine extreme performance both good and bad. I would be a poor analyst if I assumed that these extremes would continue. The odds are that there will be some reversals where a poor performing fund will do much better than average in some future period. Often this happens because the portfolio manager or the CEO of a company sees something in a different light than the rest of the pack. My job is to find these rare reversal types and get enough confidence in their approach to follow them. The nice part of our portfolios is that almost always there can be room for an unusual approach as they breakout of the conventional prisons.

Question of the week:
Which managers are doing unconventional things that we should study?
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