Behavior Patterns Help and Hurt

Introduction

Investment professionals and seasoned investors prize numbers including repetitive patterns. With these abstractions of reality we can build nice neat statistical formulas that give us a good chance to be correct most of the time. The problem with that belief is the recognition that we won’t be right all of the time and some of the time when we are wrong the results are costly. Probably the best known user of numbers was the physicist Albert Einstein, who was lured away from Caltech to Princeton by more money (again numbers).  According to John Mauldin’s latest letter the Professor had on his desk a sign which read “not everything can be measured and not everything which counts can be measured.” Clearly he was recognizing that the “unknown unknowns,” as Donald Rumsfeld has said, make us understand that we can not have complete confidence about both the understanding of the current situation and our ability to predict the future.

Behavior

Many learned institutions around the world, including Caltech have been studying how various elements in the brain’s circuitry light up repetitively as reactions to (or possibly causes of) specific behavior patterns. Of the work that I have seen, the connections between the specific brain waves and human acts are pretty simple and rely on learned memories of past pleasures or pains; e.g., digesting food when hungry. So far I have not seen how our minds react to indirect stimuli. This is important in that we live in a dynamic world where threats of bubbles and forgone opportunities are present at a much accelerating rate.

Opportunities

My study of history indicates that every single day some people are not only making money, but each day someone begins the climb to real wealth. Often those periods when great fortunes were ignited were described by the headlines of the day as troubled. Many investors, some seasoned and some not, are perturbed by the level of real unemployment or underemployment throughout the age range, but particularly for the youth with or without college education. They are concerned by the political uncertainties in most democracies. The low level of interest rates manipulated by the major central banks is leading many into uncomfortable, and in some cases, unusual investments. In other words, many investors lack confidence and are unhappy. On the other hand, currently most economic and financial conditions as reported are not getting worse. The relatively low level of financial and investment activity is reassuring to some that are current market participants, as there are less chances that global transaction prices go crazy, with the exception of extreme high-end real estate.

Perhaps in the real world that is beyond the financial and political communities, people are coping. They are getting on with their lives and new hard-worked fortunes are beginning. What our academic friends have not yet captured is the ability of humans to cope with conditions that they have no historical preparations. Think in terms of the recoveries of people in London, during and after their bombings, New York City after 9/11, Japan after the Fukushima disaster, and in Boston after the explosions at their Marathon. Humans can eventually figure out how to survive and then prosper by using their developed problem-solving abilities that have no direct historical parallel. I believe we are in such a period now. Coping is working slowly and we are making some progress. We have a framed motto in our home from the US Marine Corps which intones “Adapt, Improvise, and Overcome.” People all over the world are doing just that.  This is not to say that everything is wonderful for all or that in the future we won’t suffer from human-induced bubbles.

Bubbles

Many keen observers of market prices have written about bubbles for hundreds of years. The most famous in the English language was Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds.” Other insightful authors were Charles Kindleberger and Hyman Minsky. Not at the same level but an effective scribe is John Mauldin who is promoting his latest book through his weekly letter, quoting others that have written well on bubbles.

Most of the time financial prices act in a rational fashion often extrapolating near-term trends into the nearby future. Major price swings are largely absent and can be easily explained. In other words most investments are dull, which is the best possible operating conditions for disciplined traders. However, what the media and the amateur investors focus on are bubbles which distort for a period of time the normal price trajectories. I have not seen a good definition of a bubble so let me suggest one:

 

     An exponential price move (multiple doubles) in a relatively compressed period of time, normally 250 or less trading days on the way up and a similar (or more frequently, a smaller number of trading days in decline). 

     Unless one is in control of one’s investment emotions these not infrequent disruptions can destroy a sound careful investment strategy.

What is particularly disturbing about bubbles is that they start out as recognition of some important price trend outside the normal trading markets for most investors. While the mathematical description of bubbles is remarkably consistent, the external factors are different. There is the so-called Kindleberger-Minsky Perspective of five stages. The first is heralded change to the perceived order of things the widespread advent of electricity, radio, nuclear power, Internet and new debt instruments. In the second phase early adapters enjoy a boom. By the time of the third stage almost everyone has joined in the Euphoria. 

I remember the bubble in transistors the forerunner of semiconductors. We were told to think about how big the market would be for transistor radios when they penetrated each village in India and how much better the world would be. This in turn led to the fourth stage or crisis. (Something happened between the bullish case of the 1960s and now when cell phones are helping lower-earning farmers to negotiate better prices for their crops knowing what the markets are paying.) What happened was over-capacity and under-financed marginal companies bombed the prices for transistors. The final stage of the cycle is one of revulsion. I remember one large mutual fund in the 1960s that was heralded for having little to no investments in electronics. It was the equivalent of having a closet full of Nehru jackets or for women having skirts of the wrong length.

I do not know when and from what sector a bubble will appear. Others have identified bubbles in 1929, 1962, 1987, 1998, 2000 and 2008. I might add some others that I have lived through. The main point is that we could be due for one which will be called an upside breakout to recognize how productive the world will be in the future. What has me particularly concerned is that various studies at Caltech and elsewhere have found that many participants in a simulated bubble knew it was risky, but were playing the so-called “bigger fool theory” that were paying too much but believed that they could sell at a bigger price. When the eventual decline is underway the most likely panickers will be the bigger-fools turning on themselves.

Statistical hurdles

In trying to convince investors of the soundness of any manager or investment thesis, back-tested results are brought out. Notice none are shown that put the proposed concept at a disadvantage. While I am skeptical about all back-testing I am particularly cynical of ideas that do not show the purported annual performance since 1990. Better yet would be quarterly performance since 1985. The comparisons should be against live, expense-paying competitors not a publisher’s collection with its own biases.

Investment applications

Far too many investors and some managers are using Index funds, ETFs and closet indexers to meet the investment needs of their institutional and individual clients. These are closed minded systems that only change their holdings when required to by outside forces that have nothing to do with sound investment judgment. One of my real concerns is  that in the rapid acceleration phase of a bubble; e.g., the run-up of Apple’s price to $705 in NASDAQ and other portfolios created all kinds of risks. This was just the parabolic performance impact of one stock; imagine the long term impact of a bubble on the whole index. This may well explain why the NASDAQ Index is still well below its peak during the Internet bubble of the 1990s even though many of the companies within the index have prospered.

Professor Einstein had it right when he focused on what we can measure and what we can’t.

What are you not measuring that you should?           

_______________________

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Long Term Investors Are Too Short Term: The Key Question is ‘How Long is the Race?’

Introduction

As the readers of my posts already know, I learned critical elements of security analysis and portfolio management by handicapping thoroughbred horses at the New York racetracks. In deciding on which races to wager on as distinct from just observing, the key decision was to guess how fast the race was going to be run. Further, some guesses were helpful in terms of the segments of the race. Through this analysis one could determine the probability of which horses were likely to be in the lead at important times and whether horses that normally run from behind the crowd had enough time to catch up and be a leader at the end.

Do you notice that almost all discussions of supposedly long-term investors are focused on the present or the very immediate future? Can you remember an instance when we have seen the best performing stock in early January be the best for the year, or much more importantly the best stock for ten or more years?

Investing for grandchildren can help the picks of the grandparents

At a recent investment group of semi-retired and fully retired portfolio managers, chief investment officers and senior fundamental and technical analysts almost all of the talk was how these remarkably experienced and smart investors focused on their own accounts as they dwelt on how they saw the current investment picture. The general conclusion was sobering which led  many of the individuals to only a few possible purchase decisions, without much in the way of changes made to their existing personal portfolios.

In an attempt to bring greater value to the discussion, I asked that we focus on investing for our grandchildren. In that line of thinking, I asked the group to show by a raised hand how many thought that in some period at least ten or twenty years in the future would we see US Treasury interest rates above ten percent, the vast majority of hands went up. I suggest that this view is more important in setting policy than whether the esteemed Dan Fuss of Loomis Sayles is right in his intermediate projection for ten year US Treasuries at 4.25%. The key point is that this “horse race,” which is indefinite in length, is likely to be run differently than our memories of past performance.

Change of data has unrecognized impacts

Those who follow the races should take into consideration a change of equipment on the horse. The following changes are probably under appreciated:

• US Treasuries are already trading on the basis that they are "AA" relative to German Bunds 

• Observable prices are going up; real estate at the high end, many food items, costs of services. (We don't fully appreciate the impact of the decline in energy prices.)
  
  

• The measures quoted by the various government agencies on inflation do not capture the hollowing out of middle class employment conditions. While there are a large number of highly skilled job openings, the costs of general employment are structurally rising and those positions that can not be replaced by machines are being supplanted by lower cost domestic and foreign contractors.

Society and investment policies do not reflect the changes and the long-term outlook.

Please share with me how your long term outlook is involving.

_______________________

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Betting For or Against Nobel Prize Winners

Introduction

This past week we learned that Gene Fama, Lars Peter Hansen and Bob Shiller  received Nobel Prizes for Economic Sciences. These are relatively new awards starting in 1969 in honor of the founder of the Nobel awards, Alfred Nobel.

Nobel Prizes, except the questionable Peace Prize given by a different committee in Norway, are based on the discoveries and insights developed many years before the award. A relatively small number of the awards given for economics have had their focus on securities selection. There is no substantive record of whether they work in producing winning portfolio performance. A number of past winners became highly paid consultants to investment groups after the award. These have produced nice lunches and wonderful dinners, but little in the way of commercially exploitable performance.

What are the implications of these three awards?

Each recipient was trying to find a systematic way to invest profitably. They should have gone to the racetrack and listened to those in the Grandstand or perhaps better, in the higher priced Clubhouse. After each race people talk about why in the next race their particular choice will win. If someone has a number of winners in succession or at least a preponderance of winners, he or she has a “system.” Having been exposed to these various systems whether they have been mathematically based or dependent upon anecdotal information about the horse, its breeding, its trainer, its jockey, the jockey’s agent, the condition of the track or the colors of either the horse or what the jockey is wearing, I can attest to the fact that none of them work a majority of the time. The key to making intelligent bets at the track and in the market is to be sensitive to changes from the past. Otherwise one can be like some generals/admirals in the Pentagon fighting the last war brilliantly; for after the war they have determined what may have caused the victory or defeat.

Is there is a message in the Nobel Prizes?

By awarding three learned economists this year’s prize where each had a different point of view, methodology, or to use the racetrack term a system, the committee may be saying that there is no uniform selection process that works all the time. This is not to say that their work is worthless. Gene Fama was one of the founders of Dimensional Fund Advisors (DFA) which manages a number of mutual funds, some of which we use for clients. The practitioners have focused their money using other selection and perhaps more importantly, trading techniques. The result is a relatively low cost (not as low as pure index funds) portfolio of a large number of securities which allows them to nibble at bargains when offered. Sometimes they will have above average results and some times not.  As the inventor of segmented performance by quintiles, I can’t remember seeing their performance in the top or bottom one fifth of an array.

The Shiller approach, looking at the last ten years earnings relative to current prices, is a useful beginning to analysis. The analyst in me rejects sole reliance on reported results. I believe that one must first adjust the results for changes in tax rates, mix of business and tactical opportunities, accounting changes, changes in shares outstanding and significant changes of management. While I urge client expectations to focus on performance of at least the last ten years, I do adjust my thinking to recognize cyclical developments.

All of these approaches are useful until they become too popular.  They are not the complete answers to successful investing. In part because the favored investment styles of the economists  (small, value, momentum, and quality) will be redefined by market forces and in all likelihood smart-eyed observers may find other winning groups based on management techniques, technological supply chains, beneficiaries of social media, etc.

Changing conditions

One of the problems when intensely looking at present conditions is that something that appears to portend broader changes may not be very important in the future, and other incidental observations could be the recognition of bigger things to come. Two items caught my eye this weekend. I offer them up for our subscribers to consider or reject in terms of implications and importance.

The first item is that hedge funds reportedly have their biggest short position in gold since January. This may be a sideshow and only important to “gold bugs” or it could be a clue of how some hedge funds are looking to play catch-up from being behind the larger market advances. Undoubtedly at some point various markets will decline, perhaps meaningfully. The risk that all short sellers take is if the items that they are short move up dramatically, they may be forced to buy back the shorted securities at a rapidly advancing price. In other words they could be caught in a short squeeze, particularly those who shorted gold. With announced trading volume quite light, a squeeze could be applied.

The second item is that yields on German Bunds are closing in on the yields on US Treasury Bonds. For some time, global investors have felt more secure with the credit value of the German government paper than that of the US. Thus they were more expensive in price with lower yields. The closing of the yield spread could indicate that global investors are less worried about the credit value of US government paper which could be good for the US stock market from a foreigner’s point of view. At the very same time foreign currencies are appreciating against the dollar. Part of this may well be caused by an increase of US investments into Europe and possibly Japan.

Would you please let me know what you think?

_____________________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.