Posts filed under ‘Behavioral Finance’
Fence-Sitting: The Elusive Art of More Data and Pullbacks
The world of financial markets is full of fence-sitters, especially in the professional realm. Why? Well, for starters, fence-sitting provides the luxury of never being wrong. If fence-squatting observers do nothing and provide no opinions, then they cannot by definition be wrong or mistaken. Why should a professional put their neck out for an economic, sector, or investment specific forecast, if there is a potential of looking stupid or losing a job?
For many, the consequences of possibly being wrong feel so horrendous that participants choose instead to sit on the non-committal fence. In most cases, the fence posts on any financial issue or investment align along the comfort of consensus thinking. Unfortunately, consensus thinking has a limited shelf life, because the views held by the majority are constantly changing. Repeatedly modifying personal opinions to match consensus views may prevent the bruising of egos, however, this naïve strategy can be destructive to long-term returns. Here are a few examples:
2000
Consensus View: New Normal tech stocks will continue explosive growth; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2006
Consensus View: Home prices will rise forever and leverage is beautiful; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2010
Consensus View: Greece and European collapse to cause a double-dip global recession; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2011
Consensus View: U.S. credit downgrade will be bad for Treasuries and rates; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2012
Consensus View: Uncertainty surrounding election bad for equities; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2012
Consensus View: China’s slowing growth and real estate bubble expected to cause a global double-dip recession; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2012
Consensus View: Impending fiscal cliff bad for equities; Consensus Outcome: Wrong; Investor Net Result: Losses and/or Lost Profits.
2013
Consensus View: Debt ceiling debate bad for equities; Consensus Outcome: ???; Investor Net Result: ???.
2013
Consensus View: Looming sequestration bad for equities; Consensus Outcome: ???; Investor Net Result: ???.
In recent years the market has continued to climb a wall of worry, but will this year be different? We shall soon see.
Placing the concern du jour aside, if consensus fears coalesce around a specific upcoming event, chances are that particular issue is already factored into existing expectations and price structures. Therefore, rather than wasting personal “worry” bandwidth on those fears, investor anxiety should be dedicated to less prevalent but potentially more impactful unknown concerns. Or if you need clarification about the unknowns to worry about, perhaps Donald Rumsfeld can clarify the situation by highlighting the risk of “unknown unknowns”:
I Love Data and Pullbacks!
When faced with apprehension or uncertainty, many fence-sitting investors revert to wanting more data or waiting for a better price. For example, I often hear, “I love stock XYZ, but I want to wait for the earnings to come out,” or analyst day, or share buyback announcement, or merger closing, or restructuring, etc., etc., etc. For strategists and economists, they are famished for the next critically irrelevant weekly jobless claims number, Federal Reserve policy minutes, ISM monthly manufacturing data, or latest consumer confidence figure.
More data for fence sitters is not sufficient. I often listen to stock-pickers say, “I love XYZ stock, but not at the current $52.50 price, but I’ll back up the truck at $51.50!” Okay, so you’re telling me that you think the stock is worth +40% more, but you want to litigate the purchase price over $1?!
Sadly, there is a cost for all this fence-sitting: a) if good news comes out, investment prices catapult higher and the investor is stuck with a pricier investment; b) if bad news comes out, that long-awaited price pullback is usually not acted upon because fundamentals have now deteriorated; or c) in many cases the price grinds higher before the long-awaited jewel of information is disseminated. The net result is further fence-sitting paralysis, which paradoxically is not helped by more information or a price pullback.
The other reason fence-sitters say or do nothing is because articulating a gloomy thesis simply sounds smarter. For instance, saying “The reason I’m on the sidelines is because we are in a secular bear market due to the debasement of our currency as a result of inflationary Fed monetary policies,” sounds smarter and more compelling than “Stocks are cheap and are already factoring in a lot of negativity.”
Investing is an unbelievably challenging endeavor, but for those fence-sitters with an insatiable appetite for more data and elusive pullbacks, I humbly point out, there is an infinite amount of information that regenerates itself daily. In addition, there is nothing wrong with having a disciplined valuation process in place, but if your best investment ideas are predicated on a minor pullback, then enjoy watching your returns wither away…as you sit on your cozy fence.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Uncertainty: Love It or Hate It?
Source: Photobucket
Uncertainty is like a fin you see cutting through the water – many people are uncertain whether the fin sticking out of the water is a great white shark or a dolphin? Uncertainty generates fear, and fear often produces paralysis. This financially unproductive phenomenon has also reared its ugly fin in the investment world, which has led to low-yield apathy, and desensitization to both interest rate and inflation risks.
The mass exodus out of stocks into bonds worked well for the very few that timed an early 2008 exit out of equities, but since early 2009, the performance of stocks has handily trounced bonds (the S&P has outperformed the bond market (BND) by almost 100% since the beginning of March 2009, if you exclude dividends and interest). While the cozy comfort of bonds has suited investors over the last five years, a rude awakening awaits the bond-heavy masses when the uncertain economic clouds surrounding us eventually lift.
The Certainty of Uncertainty
What do we know about uncertainty? Well for starters, we know that uncertainty cannot be avoided. Or as former Secretary of the Treasury Robert Rubin stated so aptly, “Nothing is certain – except uncertainty.”
Why in the world would one of the world’s richest and most successful investors like Warren Buffett embrace uncertainty by imploring investors to “buy fear, and sell greed?” How can Buffett’s statement be valid when the mantra we continually hear spewed over the airwaves is that “investors hate uncertainty and love clarity?” The short answer is that clarity is costly (i.e., investors are forced to pay a cherry price for certainty). Dean Witter, the founder of his namesake brokerage firm in 1924, addressed the issue of certainty in these shrewd comments he made some 78 years ago, right before the end of worst bear market in history:
“Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished.”
Undoubtedly, some investors hate uncertainty, but I think there needs to be a distinction between good investors and bad investors. Don Hays, the strategist at Hays Advisory, straightforwardly notes, “Good investors love uncertainty.”
When everything is clear to everyone, including the novice investing cab driver and hairdresser, like in the late 1990s technology bubble, the actual risk is in fact far greater than the perceived risk. Or as Morgan Housel from Motley Fool sarcastically points out, “Someone remind me when economic uncertainty didn’t exist. 2000? 2007?”
What’s There to Worry About?
I’ve heard financial bears argue a lot of things, but I haven’t heard any make the case there is little uncertainty currently. I’ll let you be the judge by listing these following issues I read and listen to on a daily basis:
- Fiscal cliff induced recession risks
- Syria’s potential use of chemical weapons
- Iran’s destabilizing nuclear program
- North Korean missile tests by questionable new regime
- Potential Greek debt default and exit from the eurozone
- QE3 (Quantitative Easing) and looming inflation and asset bubble(s)
- Higher taxes
- Lower entitlements
- Fear of the collapse in the U.S. dollar’s value
- Rigged Wall Street game
- Excessive Dodd-Frank financial regulation
- Obamacare
- High Frequency Trading / Flash Crash
- Unsustainably growing healthcare costs
- Exploding college tuition rates
- Global warming and superstorms
- Etc.
- Etc.
- Etc.
I could go on for another page or two, but I think you get the gist. While I freely admit there is much less uncertainty than we experienced in the 2008-2009 timeframe, investors’ still remain very cautious. The trillions of dollars hemorrhaging out of stocks into bonds helps make my case fairly clear.
As investors plan for a future entitlement-light world, nobody can confidently count on Social Security and Medicare to help fund our umbrella-drink-filled vacations and senior tour golf outings. Today, the risk of parking your life savings in low-rate wealth destroying investment vehicles should be a major concern for all long-term investors. As I continually remind Investing Caffeine readers, bonds have a place in all portfolios, especially for income dependent retirees. However, any truly diversified portfolio will have exposure to equities, as long as the allocation in the investment plan meshes with the individual’s risk tolerance and liquidity needs.
Given all the uncertain floating fins lurking in the economic background, what would I tell investors to do with their hard-earned money? I simply defer to my pal (figuratively speaking), Warren Buffett, who recently said in a Charlie Rose interview, “Overwhelmingly, for people that can invest over time, equities are the best place to put their money.” For the vast majority of investors who should have an investment time horizon of more than 10 years, that is a question I can answer with certainty.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) including BND, but at the time of publishing SCM had no direct positions in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Decision Making on Freeways and in Parking Lots
Many drivers here in California adhere to the common freeway speed limit of 65 miles per hour, while some do not (I’ll take the 5th). In the vast majority of cases, racing to your destination at these faster speeds makes perfect sense. However, driving 65 mph through the shopping mall parking lot could get you killed, so slower driving is preferred in this instance. Ultimately, the specific environment and situation will dictate the rational and prudent driving speed. Decision making works in much the same way, and Nobel Daniel Kahneman, a Nobel Prize winner, has encapsulated his decades of research in psychology and economics in his most recent book, Thinking, Fast and Slow.
Much of Kahneman’s big ideas are analyzed through the lenses of “System 1” and “System 2” – the fast and slow decision-making processes persistently used by our brains. System 1 thinking is our intuition in the fast lane, continually making judgments in real-time. Our System 1 hunches are often correct, but because of speedy, inherent biases and periodic errors this process can cause us to miss an off-ramp or even cause a conclusion collision. System 2, on the other hand, is the slower, methodical decision-making process in our brains that keeps our hasty System 1 process in check. Although little mental energy is exerted by using System 1, a great deal of cerebral horsepower is required to use System 2.
Summarizing 512 pages of Kahneman’s book in a single article may be challenging, nevertheless I will do my best to summarize some of the interesting highlights and anecdotes. A multitude of Kahneman’s research is reviewed, but a key goal of the book is designed to help individuals identify errors in judgment and biases, in order to lower the prevalence of mental mistakes in the future.
Over Kahneman’s 50+ year academic career, he has uncovered an endless string of flaws in the human thought process. To bring those mistakes to life, he uses several mind experiments to illustrate them. Here are a few:
Buying Baseball: We’ll start off with a simple Kahneman problem. If a baseball bat and a ball cost a total of $1.10, and the bat costs $1 more than the ball, then how much does the ball cost? The answer is $0.10, right? WRONG! Intuition and the rash System 1 forces most people to answer $0.10 cents for the ball, but after going through the math it becomes clear that this gut answer is wrong. If the ball is $0.10 and the bat is $1 more, then that would mean the bat costs $1.10, making the total $1.20…WRONG! This is clearly a System 2 problem, which requires the brain to see a $0.05 ball plus $1.05 bat equals $1.10…CORRECT!
The Invisible Gorilla: As Kahneman points out, humans can be blind to the obvious and blind to our blindness. To make this point he references an experiment and book titled Invisible Gorilla, created by Chritopher Chabris and Daniel Simons. In the experiment, three players wearing white outfits pass a basketball around at the same time that a group of players wearing black outfits pass around a separate basketball. The anomaly in the experiment occurs when someone in a full-sized gorilla outfit goes prancing through the scene for nine full seconds. To the surprise of many, about half of the experiment observers do not see the gorilla. In addition, the gorilla-blind observers deny the existence of the large, furry animal when confronted with recorded evidence (see video below).
Green & Red Dice: In this thought experiment, Kahneman describes a group presented with a regular six-sided die with four green sides (G) and two red sides (R), meaning the probability of the die landing on green (G) is is much higher than the probability of landing on red (R). To make the experiment more interesting, the group is provided a cash prize for picking the highest probability scenario out of the following three sequences: 1) R-G-R-R-R; 2) G-R-G-R-R-R; and 3) G-R-R-R-R-R. Although most participants pick sequence #2 because it has the most greens (G) in it, if one looks more closely, sequence #2 is the same as #1 except for sequence #2 has an additional green (G). Therefore, the highest probability winning answer should be sequence #1 because sequence #2 adds an uncertain roll that may or may not land on green (G).
While the previous experiments described some notable human decision-making flaws, here are some more human flaws:
Anchoring Effect: Was Gandhi 114 when he died, or was Gandhi 35 when he died? Depending how the question is asked, asking the initial question first will skew the respondents answer to a higher age, because the respondents answer will be somewhat anchored to the number “114”. Similarly, the price a homebuyer would pay for a house will be influenced or anchored to the asking price. Another word used by some for anchoring is “suggestion”. If a subliminal suggestion is planted, people’s responses can become anchored to that idea.
Overconfidence: We encounter overconfidence in several forms, especially from what Kahneman calls the “Illusion of Pundits,” which is the confidence that comes with 20-20 hindsight experienced in our 24/7 media world. Or as Kahneman states in a different way, “The illusion that we understand the past fosters overconfidence in our ability to predict the future.” Driving is another example of overconfidence – very few people believe they are poor drivers. In fact, a well-known study shows that “90% of drivers believe they are better than average,” despite defying the laws of mathematics.
Risk Aversion: In Kahneman’s book, he also references risk aversion studies by Mathew Rabin and Richard Thaler. What the researchers discovered is that people appear to be irrational in the way they respond to certain risk scenarios. For example, people will turn down the following gambles:
A 50% chance to lose $100 and a 50% chance to win $200;
OR
A 50% chance to lose $200 and a 50% chance to win $20,000 .
Although rational math would indicate these are smart bets to take, however most people decline the game because humans on average weigh losses twice as much as gains (see also the Pleasure/Pain Principle). To get a better understanding of predictive human behavior, the real emotional costs of disappointment and regret need to be accounted for.
Truth Illusions: A reliable way to make people believe in falsehoods is through repetition. More exposure will breed more liking. In addition to normal conversations, these repetitive truth illusions can be witnessed in propaganda or advertising. Minimizing cognitive strain also reinforces points. Using bold, colored, and contrasted language is more convincing. Simpler language rather than more complex language is also more credible.
Narrative Fallacies: We humans have an innate desire to continually explain the causation of an event due to skill or stupidity – even if randomness is the best explanation.People try to make sense of the world, even though many outcomes have no straightforward explanation. Often times, a statistical phenomenon like “regression to the mean” can explain the results (i.e., outliers revert directionally toward averages). The “Sports Illustrated Jinx,” or the claim that a heralded cover story athlete will be subsequently cursed with bad performance, is used as a case in point. Actually, there is no jinx or curse, but often fickle luck disappears and athletic performance reverts to norms.
Kahneman on Stocks
Many of the principles in Kahneman’s book can be applied to the world of stocks and investing too. According to Kahneman, the investing industry has been built on an “illusion of skill,” or the belief that one person has better information than the other person. To make his point, Kahneman references research by Terry Odean, a finance professor at UC Berkely, who studied the records of 10,000 brokerage accounts of individual investors spanning a seven-year period and covering almost 163,000 trades. The net result showed dramatic underperformance by the individual traders and confirmed that stocks sold by the traders consistently did better than the stocks purchased.“Taking a shower and doing nothing” would have been better than the value destroying trading activity. In fact, the most active traders did much worse than those who traded the least. For professional managers the conclusions are not a whole lot different. “For a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of every three mutual funds underperform the overall market in any given year,” says Kahneman. I don’t disagree, but I do believe, like .300 hitters in baseball, there are a few managers that can consistently outperform.
There are a lot of lessons to be learned from Daniel Kahneman’s book Thinking, Fast and Slow and I apply many of his conclusions to my investment practice at Sidoxia. We all race through decisions every day, but as he repeatedly points out, familiarizing ourselves with these common mental pitfalls, and also utilizing our more methodical and accurate System 2 thought process regularly, can create better decisions. Better decisions not only for our regular lives, but also for our investing lives. It’s perfectly OK to race down the mental freeway at 65 mph (or faster), but don’t forget to slow down occasionally, in order to avoid mental collisions.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Experts vs. Dart-Throwing Chimps
Daniel Kahneman, a professor of psychology at Princeton University, knows a few things about human behavior and decision making, and he has a Nobel Prize in Economics to prove it. We live in a complex world and our brains will often try to compensate by using shortcuts (or what Kahneman calls “heuristics” and “biases”), in hopes of simplifying complicated situations and problems.
When our brains become lazy, or we are not informed in a certain area, people tend to also listen to so-called experts or pundits to clarify uncertainties. In the process of their work, Kahneman and other researchers have discovered something – experts should be listened to as much as monkeys. Frequent readers of Investing Caffeine understand my shared skepticism of the talking heads parading around on TV (read first entry of 10 Ways to Destroy Your Portfolio)
Here is how Kahneman describes the reliability of professional forecasts and predictions in his recently published bestseller, Thinking, Fast and Slow:
“People who spend their time, and earn their living, studying a particular topic produce poorer predictions than dart-throwing monkeys who would have distributed their choices evenly over the options.”
Most people fall prey to this illusion of predictability created by experts, or this idea that more knowledge equates to better predictions and forecasts. One of the factors perpetuating this myth is the rearview mirror. In other words, human’s ability to concoct a credible story of past events creates a false confidence in peoples’ ability to accurately predict the future.
Here’s how Kahneman describes the phenomenon:
“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained…Our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability. Everything makes sense in hindsight, a fact financial pundits exploit every evening as they offer convincing accounts of the day’s events. And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday. The illusion that we understand the past fosters overconfidence in our ability to predict the future.”
Even when experts are wrong about their predictions, they tend to not accept accountability. Rather than take responsibility for a bad prediction, Philip Tetlock says the errors are often attributed to “bad timing” or an “unforeseeable event.” Philip Tetlock, a psychologist at the University of Pennsylvania did a landmark twenty-year study, which was published in his book Expert Political Judgment: How Good Is It? How Can We Know? (read excellent review in The New Yorker). In the study Tetlock interviewed 284 economic and political professionals and collected more than 80,000 predictions from them. The results? The experts did worse than blind guessing.
Based on the extensive training and knowledge of these experts, many of them develop a false sense of confidence in their predictions. Or as Tetlock explains it, “They [experts] are just human in the end. They are dazzled by their own brilliance and hate to be wrong. Experts are led astray not by what they believe, but by how they think.”
Brain Blunders and Stock Picking
The buyer of a stock thinks the price will go up and the seller of a stock thinks the price will go down. Both participants engage in the transaction because they believe the current stock price is wrong. The financial services industry is built largely on this phenomenon that Kahneman calls an “illusion of skill,” or ability to exploit inefficient market pricing. Relentless advertisements and marketing pitches continually make the case that professionals can outperform the markets, but this is what Kahneman found:
“Although professionals are able to extract a considerable amount of wealth from amateurs, few stock pickers, if any, have the skill needed to beat the market consistently, year after year. Professional investors, including fund managers, fail a basic test of skill: persistent achievement…Skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated in the price of its stock. Traders apparently lack the skill to answer this crucial question, but they appear ignorant of their ignorance.”
For the few managers that actually do outperform, Kahneman assigns luck to the outcome, not skill:
“For a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of three mutual funds underperform the overall market in any given year…The successful funds in any given year are mostly lucky; they have a good roll of the dice.”
The picture for individual investors isn’t any prettier. Evidence from Terry Odeam, a finance professor at UC Berkeley, who studied 100,000 individual brokerage account statements and about 163,000 trades over a seven-year period, was not encouraging. He discovered that stocks sold actually did +3.2% better than the replacement stocks purchased. And this detrimental impact on performance excludes the significant expenses related to trading.
In response to Odean’s work, Kahneman states:
“It is clear that for the large majority of individual investors, taking a shower and doing nothing would have been a better policy than implementing the ideas that came to their minds….Many individual investors lose consistently by trading, an achievement that a dart-throwing chimp could not match.”
In a future Odean paper titled, “Trading is Hazardous to your Wealth,” Odean and his colleague Brad Barber also proved that “less is more.” The results showed the most active traders had the weakest performance, and those traders who traded the least had the best returns. Interestingly, women were shown to have better investment results than men.
Regardless of whether someone is listening to an expert, fund manager, or individual investor, what Daniel Kahneman has discovered in his long, illustrious career is that humans consistently make errors. If you are wise, you will heed Kahneman’s advice by stealing the expert’s darts and handing them over to the chimp.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
The Pleasure/Pain Principle
The financial crisis of 2008-2009 was painful, not to mention the Flash Crash of 2010; the Debt Ceiling / Credit Downgrade of 2011; and the never-ending European saga. Needless to say, these and other events have caused pain akin to burning one’s hand on the stove. This unpleasant effect has rubbed off on investors.
Admitting one has a problem is half the battle of conquering a challenge. A key challenge for many investors is understanding the crippling effects fear can have on personal investment decisions. While there are certainly investors who constantly see financial markets through rose-colored glasses (my glasses I argue are only slightly tinted), Nobel Prize winner Daniel Kahneman and his partner Amos Tversky understand the pain of losses can be twice as painful as the pleasure experienced through gains (see diagram below).
Source: Investopedia
Said a little differently, faced with sure gain, most investors are risk-averse, but faced with sure loss, investors prefer risk-taking. Don’t believe me? Well, let’s take a look at some of Kahneman and Tversky’s behavioral finance work on what they called “Prospect Theory” (1979) – the analysis of decisions made under various risk scenarios.
In one specific experiment, Kahneman and Tversky presented groups of subjects with a number of problems. One group of subjects was presented with this problem:
Problem #1: In addition to whatever you own, you have been given $1,000. You are now asked to choose between:
A. A sure gain of $500
B. A 50% change to gain $1,000 and a 50% chance to gain nothing.
Another group of subjects was presented with this problem:
Problem #2: In addition to whatever you own, you have been given $2,000. You are now asked to choose between:
A. A sure loss of $500
B. A 50% chance to lose $1,000 and a 50% chance to lose nothing.
In the first group, 84% of the respondents chose A and in the second group, 69% of the respondents chose B. Both problems are identical in terms of the net cash outcomes ($1,500 for Answer A, and 50% chance of $1,000 or $2,000 for Answer B). Nonetheless, due the different “loss phrasing” in each question, Answer A sounds more appealing in Question #1, and Answer B sounds more appealing in Question #2. The results are irrational, but investors have been known to be illogical too.
In practical trading terms, the application of “Prospect Theory” often manifests itself via the pain principle. Due to loss aversion, investors tend to cash in gains too early and fail to allow their winning stocks to run higher for a long enough period.
The framing of the Kahneman and Tversky’s questions is no different than the framing of political and economic issues by the various media outlets (see Pessimism Porn). Fear can generate advertising revenue and fear can also push investors into paralysis (see the equity fund flow data in Fund Flows Paradox).
Greed can sell in the financial markets too. The main sources of financial market greed have been primarily limited to bonds, cash, and gold. If you caught those trends early enough, you are happy as a clam, but like most things in life, nothing lasts forever. The same principle applies to financial markets, and over time, capital in today’s winners will slowly transition into today’s losers (i.e., tomorrow’s winners).
A healthy amount of fear is healthy, but correctly understanding the dynamics of the “Pleasure/Pain Principle” can turn those fearful tears into profitable pleasure.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including fixed income ETFs), but at the time of publishing SCM had no direct position in GLD, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Time Arbitrage: Investing vs. Speculation
The clock is ticking, and for many investors that makes the allure of short-term speculation more appealing than long-term investing. Of course the definition of “long-term” is open for interpretation. For some traders, long-term can mean a week, a day, or an hour. Fortunately, for those that understand the benefits of time arbitrage, the existence of short-term speculators creates volatility, and with volatility comes opportunity for long-term investors.
What is time arbitrage? The concept is not new and has been addressed by the likes of Louis Lowenstein, Ralph Wanger, Bill Miller, and Christopher Mayer. Essentially, time arbitrage is exploiting the benefits of moving against the herd and buying assets that are temporarily out of favor because of short-term fears, despite healthy long-term fundamentals. The reverse holds true as well. Short-term euphoria never lasts forever, and experienced investors understand that continually following the herd will eventually lead you to the slaughterhouse. Thinking independently, and going against the grain is ultimately what leads to long-term profits.
Successfully executing time arbitrage is easier said than done, but if you have a systematic, disciplined process in place that assists you in identifying panic and euphoria points, then you are well on your way to a lucrative investment career.
Winning via Long-Term Investing
Legg Mason has a great graphical representation of time arbitrage:
Source: Legg Mason Funds Management
The first key point to realize from the chart is that in the short-run it is very difficult to distinguish between gambling/speculating and true investing. In the short-run, speculators can make money just as well as anybody, and in some cases, even make more profits than long-term investors. As famed long-term investor Benjamin Graham so astutely states, “In the short run the market is a voting machine. In the long run it’s a weighing machine.” Or in other words, speculative strategies can periodically outperform in the short run (above the horizontal mean return line), while thoughtful long-term investing can underperform.
Financial Institutions are notorious for throwing up strategies on the wall like strands of spaghetti. If some short-term outperforming products spontaneously stick, then the financial institutions often market the bejesus out of them to unsuspecting investors, until the strategies eventually fall off the wall.
Beware o’ Short-Termism
I believe Jack Gray of Grantham, Mayo, Van Otterloo got it right when he said, “Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” What’s led to the excessive short-termism in the financial markets (see Short-Termism article)? For starters, technology and information are spreading faster than ever with the proliferation of the internet, creating a sense of urgency (often a false sense) to react or trade on that information. With more than 2 billion people online and 5 billion people operating mobile phones, no wonder investors are getting overwhelmed with a massive amount of short-term data. Next, trading costs have declined dramatically in recent decades, to the point that brokerage firms are offering free trades on various products. Lower trading costs mean less friction, which often leads to excessive and pointless, profit-reducing trading in reaction to meaningless news (i.e., “noise”). Lastly, the genesis of ETFs (exchange traded funds) has induced a speculative fervor, among those investors dreaming to participate in the latest hot trend. Usually, by the time an ETF has been created, the cat is already out of the bag, and the low hanging profit fruits have already been picked, making long-term excess returns tougher to achieve.
There is never a shortage of short-term fears, and today the 2008-09 financial crisis; “Flash Crash”; debt downgrade; European calamity; upcoming presidential elections; expiring tax cuts; and structural debts/deficits are but a few of the fear issues du jour in investors’ minds. Markets may be overbought in the short-run, and a current or unforeseen issue may derail the massive bounce from early 2009. For investors who can put on their long-term thinking caps and understand the concept of time arbitrage, buying oversold ideas and selling over-hyped ones will lead to profitable usage of investment time.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Happy Birthday Bull Market!
Birthdays are always fun, but they are always more fun when more people come to the party. The birthday of the current bull market started on March 9, 2009, and as many bears point out, volume has been low, with a relatively small number of investors joining the party with hats and horns. This skepticism is not unusual in typical bull markets because the psychological scars from the previous bear market are still fresh in investors’ minds. How can investors get excited about investing when we are surrounded by record deficits, political gridlock, a crumbling European Union, slowing China, and peak corporate margins?
Bears Receive Party Invite but Stay Home
Perma-bears like Peter Schiff, Nouriel Roubini, John Mauldin, Mohamed El-Erian, and David Rosenberg have been consistently wrong over the last three years with their advice, but in some instances can sound smart shoveling it out to unassuming investors.
While nervous investors and bears have missed the 125%+ rally (see table below) over the last three years (mitigated by upward but underperforming gold prices), what many observers have not realized is that the so-called “Lost Decade” (see also Can the Lost Decade Strike Twice?) has actually been pretty spectacular for shrewd investors. Even if you purchased small and mid cap stocks at the peak of the market in March 2000, that large swath of stocks is up over +100%…yes, that’s right, more than doubled over the last 12 years. If you consider dividends, the numbers look significantly better.
Doubters of the equity market rally also ignore the three-year +135% advance in the NASDAQ (see also Ugly Stepchild) in part because the 11-year highs being registered still lag the peak levels reached in March 2000. Even though the NASDAQ increased 9-fold in the 1990s, if you bought the NASDAQ index in the first half of 1999, you would have still outperformed the S&P 500 index through the 2012 year-to-date period. Irrespective of how anyone looks at the performance of the NASDAQ index, it still has outperformed the S&P 500 index by more than +200% over the last 25 years, even if you include the bursting of the 2000 technology bubble.
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The point of all these statistics is to show that if you didn’t buy technology stocks at the climax of late 1999 or early 2000 prices, then the amount and type of available opportunities have been plentiful. The table above does not include emerging markets like Brazil, Mexico, and India (to name a few) that have also about doubled in price from the 2000 timeframe to 2012.
Heartburn can Accompany Sweet Treats
Being Pollyannaish after a doubling in market prices is never a wise decision. After three years of massive appreciation, those participating in the bull market run have eaten a lot of tasty cake. Now the question becomes, will investors also get some ice cream and a gift bag to go before the party ends? With the sweetness of the cake still being digested, there are still plenty of scenarios that can create investor heartburn. Obviously, the sovereign debt pig still needs to work its way through the European snake, and that could still take some time. In addition, although macroeconomic data (including employment data) generally have been improving, the trajectory of corporate profits has been decelerating – due in part to near record profit margins getting pressured by rising input costs. Domestically, structural debt and deficit issues have not gone away, and perpetual neglect will only exacerbate the current problems. On the psychology front, even though investors remain skittish, those still in the game are getting more complacent as evidenced by the VIX index now falling to the teens (a negative contrarian indicator).
Despite some of these cautionary signals, the good news is that many of these issues have been known for some time and have been reflected in valuations of the overall large cap indexes. Moreover, trillions of dollars remain idle in low yielding strategies as investors wait on the sidelines. Once prices move higher and there is more comfort surrounding the sustainability of an economic recovery, then capital will come pouring back into equity markets. In other words, investors will have to pay a premium cherry price if they wait for a comforting consensus to coalesce.
Limited Options
The other advantage working in investors’ favor is the lack of other attractive investment alternatives. Where are you going to invest these days when 10-year Treasuries and short-term CDs are yielding next to nothing? How about investing in risky, leveraged, illiquid real estate, just as banks unload massive numbers of foreclosures and process millions of short sales? If those investments don’t tickle your fancy, then how about pricey insurance and annuity products that nobody can understand? Cash was comforting in 2008-2009 and during volatility in recent summers, but with spiking food, energy, leisure, and medical costs, when does that cash comfort turn to cash pain?
Easy money and low interest rate policies being advocated by Federal Reserve Chairman Ben Bernanke and other global central bankers have sucked up available investment opportunities and compelled investors to look more closely at riskier assets like equities. With the large run in equities, I have been trimming back my winners and redeploying proceeds into higher dividend paying stocks and underperforming sectors of the market. Skepticism still abounds, and we may be ripe for a short-term pullback in the equity markets. For those rare birthday party attendees who are called long-term investors, opportunities still remain despite the large run in equities. The cake has been sweet so far, but if you are patient, some ice cream and a gift bag may be coming your way as well.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including emerging market, international, and bond/treasury ETFs), but at the time of publishing SCM had no direct position in VXX, MXY, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Buying Bathing Suits in Winter
Buying fire insurance when your neighbor’s house is on fire or flood insurance as your car floats down your driveway can be a very expensive proposition. Stuffing money under the mattress in money market accounts, savings accounts, CDs, and low-yielding bonds can be a very expensive proposition too, as inflation eats away at the value and the auspice of higher interest rates looms. However, buying things when they are out of favor, like bathing suits in the winter, is an opportunistic way of cashing in on bargains when others are uninterested.
Speaking of uninterested, CNBC recently conducted a survey regarding the attractiveness of stock investing, and according to the participants, there has never been a worst time to invest (as long as the survey has been conducted). Despite consumers planning to spend +22% more on gifts this year, the national mood has not been worse since the financial crisis began in earnest during 2008. Specifically, as it pertains to stocks, 53% of Americans believe it is a bad time to invest in the stock market (SEE VIDEO BELOW).
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Not a very happy picture. The study filtered through 4,600,000,000 expressions posted by 63 million unique Twitter social media users and graphically displayed people’s happiness (or lack thereof).
Endless Number of Concerns
There is no shortage of concerns, whether one worries about the collapse of Europe, declining home values, or an uncertain employment picture. But is now the time to give up and follow the scared herd? The best time to follow the herd is never. As the old saying goes, “the herd is led to the slaughterhouse.” Investing is game like chess where one has to anticipate and be forward looking multiple moves in advance – not reacting to every shift and move of your competitor.
Certainly, investing in stocks may not be appropriate for those investors needing access to liquid funds over the next year or two. Also, retirees needing steady income may not be in a position to handle the volatility of equities. However, for many millions of investors who are planning for the next 5, 10, or 20+ years, what happens over the next few months or next few years in Italy, Greece, or Spain is likely to be meaningless. As far as our economy goes, the U.S. averages about two recessions a decade, and has done quite well over the long-run despite that fact – thank you very much. Investors need to understand that investing is a marathon, and not a sprint.
December may not be the best time to head the beach in your swim trunks, bikini, or thong, but winter is now upon us and incredible deals abound (see deals for women & men). It may also be windy outside with frigid conditions in the water for stock investors too, but with winter beginning this week, the amount of bargains for long-term investors continue to heat up no matter how chilly the sentiment remains.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in Twitter, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Boo! Will History Offer a Bearish Trick or BullishTreat?
October is not only a scary month for trick-or-treaters during Halloween, but October is also a scary month for investors.
Boo! Scared yet? Well if not, need I remind you of the market crashes of 1929 and 1987 also occurred during this ghoulish month? With a wall of worry and concerns galore overwhelming myopic traders, it’s no surprise nervous memories become shortened in anxious times like these.
The financial crisis of 2008-2009 is seared into the minds of investors and every Greek debt negotiation creates fresh new Armageddon fears. But perhaps history will repeat itself in a shorter-term more positive way? Just last year, I wrote about the excessive pessimism (It’s All Greek to Me) in July 2010, when “de-risking” was the buzz word of the day and hedge funds were bailing in droves – right before the +30%+ QE2 (quantitative easing) melt-up. Despite a massive expansion in earnings growth over the last few years, the S&P 500 just touched 1074 a few weeks ago – putting the index at similar trading levels as in Fall 2009 (see chart below).
Source: Yahoo! Finance
Will Europe crater the U.S. into an abyss, or will Bernanke need to pull a QE3 rabbit out of his hat? I’m not sure what’s going to happen, but I do know it’s better to follow the wisdom of Warren Buffett who says to “buy fear and sell greed.” If a 2% 10-Year Treasury, elevated VIX, and trillions in swollen cash reserves do not represent fear, then I may just need to pack my backs and head out to the Greek island of Santorini – that way I can at least enjoy my fear on a sunny beach.
Regardless of the Q4 outcome, I thought my friend Mark Twain could provide some insight about history’s role in financial markets. Here is an Investing Caffeine flashback from the fall of 2009 (History Never Repeats Itself, but it Often Rhymes) which also questioned the extremely negative sentiment at the time (S&P 500: 1069):
As Mark Twain said, “History never repeats itself, but it often rhymes.” There are many bear markets with which to compare the current financial crisis we are working through. By studying the past we can understand the repeated mistakes of others (caused by fear and greed), and avoid making similar emotional errors.
Do you want an example? Here you go:
Today there are thoughtful, experienced, respected economists, bankers, investors and businessmen who can give you well-reasoned, logical, documented arguments why this bear market is different; why this time the economic problems are different; why this time things are going to get worse — and hence, why this is not a good time to invest in common stocks, even though they may appear low.”
Although the quote above seems appropriate for 2009, it actually is reflective of the bearish mood felt in most bear markets. We have been through wars, assassinations, banking crises, currency crises, terrorist attacks, mad-cow disease, swine flu, and yes, even recessions. And through it all, most have managed to survive in decent shape. Let’s take a deeper look.
1973-1974 Case Study:
For those of you familiar with this period, recall the prevailing circumstances:
- Exiting Vietnam War
- Undergoing a recession
- 9% unemployment
- Arab Oil Embargo
- Watergate: Presidential resignation
- Collapse of the Nifty Fifty stocks
- Rising inflation
Not too rosy a scenario, yet here’s what happened:
S&P 500 Price (12/1974): 69
S&P 500 Price (8/2009): 1,021
That is a whopping +1,380% increase, excluding dividends.
What Investors Should Do:
- Avoid Knee-Jerk Reactions to Media Reports: Whether it’s radio, television, newspapers, or now blogs, the headlines should not emotionally control your investment decisions. Historically, media venues are lousy at identifying changes in price direction. Reporters are excellent at telling you what is happening or what just happened – not what is going to happen.
- Save and Invest: Regardless of the market direction, entitlements like Medicare and social security are under stress, and life expectancies are increasing (despite the sad state of our healthcare system), therefore investing is even more important today than ever.
- Create a Systematic, Disciplined Investment Plan: I recommend a plan that takes advantage of passive, low-cost, tax-efficient investment strategies (e.g. exchange-traded and index funds) across a diversified portfolio. Rather than capitulating in response to market volatility, have a systematic process that can rebalance periodically to take advantage of these circumstances.
For DIY-ers (Do-It-Yourselfers), I suggest opening a low-cost discount brokerage account and research firms like Vanguard Group, iShares, or Select Sector SPDRs. If you choose to outsource to a professional advisor, I recommend interviewing several fee-only* advisers – focusing on experience, investment philosophy, and potential compensation conflicts of interest.
If you believe, like some economists, CEOs, and investors, we have suffered through the worst of the current “Great Recession” and you are sitting on the sidelines, then it might make sense to heed the following advice: “Some people say they want to wait for a clearer view of the future. But when the future is again clear, the present bargains will have vanished.” Dean Witter made those comments 77 years ago – a few weeks before the end of worst bear market in history. The market has bounced quite a bit since March of this year, but if history is on our side, there might be more room to go.
Portions of this article were originally published on September 16, 2009.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
*For disclosure purposes: Wade W. Slome, CFA, CFP is President & Founder of Sidoxia Capital Management, LLC, a fee-only investment adviser based in Newport Beach, California.
Stirring the Sentiment Tea Leaves Redux
The equity markets have been on a volatility rollercoaster while participants continue to search for the Holy Grail of indicators - in hopes of determining whether the next large move in the markets is upwards or downwards. Although markets may be efficient in the long-run (see Crisis Black Eye), in the short-run, financial markets are hostage to fear and greed, and these emotions have been on full display. In the last two weeks alone, we have witnessed the Dow Jones Industrial Average catapult skyward over +1,200 points, while just a few weeks earlier the Dow cratered about -800 points in a five day period. With fresh fears of a European banking collapse, a global recession, and an uncertain election in the U.S. approaching, investors are grasping for clues as they read the indicator tea leaves to better position their portfolios. Some of these contrarian sentiment indicators can be helpful to your portfolio, if used properly, however interpreting many of the sentiment indicators is as useful as reading tea leaves is for picking winning lotto numbers.
The Art of Tea Leave Reading
The premise behind contrarian investing is fairly simple – if you follow the herd, you will be led to the slaughterhouse. There is a tendency for investors to succumb to short-termism and act on their emotions rather than reason. The pendulum of investment emotions continually swings back and forth between fear and greed, and many of these indicators are designed with the goal of capturing emotion extremes.
The concept of mass hysteria is nothing new. Back in 1841, Charles Mackay published a book entitled, Extraordinary Popular Delusions and the Madness of Crowds, in which Mackay explores the psychology of crowds and mass mania through centuries of history, including the infamous Dutch Tulip Mania of the early 1600s (see Soros Super Bubble).
Out of sympathy for your eyeballs, I will not conduct an in-depth review of all the contrarian indicators, but here is brief sampling:
Sentiment Surveys: The American Association of Individual Investors (AAII) releases weekly survey results from its membership. With the recent stock market bounce, bullish sentiment has escalated up near historic averages (39.8% bullish), yet the bears still remain skeptical – more than 6% higher than normal (36.4% bearish). A different survey, conducted by Investors Intelligence, called the Advisors Sentiment Index, surveys authors of various stock advice newsletters. The index showed bearish sentiment reaching 46.3%, the highest negative reading since the 2008-2009 bear market low. These data can provide some insights, but as you can probably gather, these surveys are also very subjective and often conflicting.
Put-Call Ratio: This is a widely used ratio that measures the trading volume of bearish put options to bullish call options and is used to gauge the overall mood of the market. When investors are fearful and believe prices will go lower, the ratio of puts to calls escalates. At historically high levels (see chart below), this ratio usually indicates a bottoming process in the market.
Volatility Index (VIX): The VIX indicator or “Fear Gauge” calculates inputs from various call and put options to create an approximation of the S&P 500 index implied volatility for the next 30 days. Put simply, when fear is high, the price of insurance catapults upwards and the VIX moves higher. Over the last 25 years a VIX reading of 44 or higher has only been reached nine times (source: Don Hays), so as you can see from the chart below, the recent market rally has coincided with the short-term peak in the VIX.
Source: Market-Harmonics.com
Strategist Sentiment: If you’re looking for a contrarian call to payoff, I wouldn’t hold your breath by waiting for bearish strategist sentiment to kick-in. Barry Ritholtz at the Big Picture got it right when he summarized Barron’s bullish strategist outlook by saying, “File this one under Duh!” Like most Wall Street and asset management firms, strategists have an inherent conflict of interest to provide a rosy outlook. For what it’s worth, the market is up slightly since the Barron’s strategist outlook was published last month.
Short Interest: The higher the amount of shares shorted, the larger the pent-up demand to buy shares becomes in the future. Extremely high levels of short interest tend to coincide with price bottoms because as prices begin to move higher, holders of short positions often feel “squeezed” to buy shares and push prices higher. According to SmartMoney.com, hedge fund managers own the lowest percentage of stocks (45%) since March 2009 market price bottom. Research from Data Explorer also suggests that sentiment is severely negative – the highest short interest level experienced since mid-2009.
Fund Flow Data: The direction of investment dollars flowing in and out of mutual funds can provide some perspective on the psychology of the masses. Recent data coming from the Investment Company Institute (ICI) shows that -$63.6 billion has flowed out of all equity funds in 2011, while +$81.7 billion has flowed into bond funds. Suffice it to say, investor nervousness has made stocks as about as popular as the approval ratings of Congress.
When it comes to sentiment indicators, I believe actions speak much louder than words. To the extent I actually do track some of these indicators, I pay much less attention to those indicators based on opinions, surveys, and technical analysis data (see Astrology or Lob Wedge). Most of my concentration is centered on those indicators explaining actual measurable investor behavior (i.e., Put-Call, VIX, Short Interest, Fund Flow, and other action-oriented trading metrics).
As we know from filtering through the avalanche of daily news data, the world can obviously become a much worse place (i.e., Greece, eurozone collapse, double-dip, inflation, banking collapse, muni defaults, widening CDS spreads, etc,). If you believe the world is on the cusp of ending and/or you do not believe investors are sufficiently bearish, I encourage you to build your bunker stuffed with gold, and/or join the nearest local Occupy Wall Street chapter. If, however, you are looking to sharpen the returns on your portfolio and are thirsty for some emotional answers, pour yourself a cup of tea and pore over some sentiment indicators.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in JPM, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
