Posts filed under ‘Profiles’
If something sounds like BS, looks like BS, and smells like BS, there’s a good chance you’re probably eyeball-deep in BS. In the investment world, I encounter a lot of very intelligent analysis, but at the same time I also continually step into piles of investment BS. One of those piles of BS I repeatedly step into is the CAPE ratio (Cyclically Adjusted Price-to-Earnings) created by Robert Shiller. For those who are not familiar with Shiller, he is a Nobel Prize winner in economics who won the award in 2013 for his work on the “empirical analysis of asset prices.” Shiller vaulted into fame in large part due to the timing of his book, Irrational Exuberance, which was published during the 2000 technology market peak. He gained additional street-credibility in the mid-2000s when he spoke about the bubble developing in the real estate markets.
What is the CAPE?
Besides being a scapegoat for every bear that has missed the tripling of stock prices in the last five years, the CAPE effectively is a simple 10-year average of the P/E ratio for the S&P 500 index. The logic is simple, like many theories in finance and economics, there often are inherent mean-reverting principles that are accepted as rules-of-thumb. It follows that if the current 10-year CAPE is above the 134-year CAPE average, then stocks are expensive and you should avoid them. On the other hand, if the current CAPE were below the long-term CAPE average, then stocks are cheap and you should buy. Here is a chart of the Shiller CAPE:
As you can see from the chart above, the current CAPE ratio of 26x is well above the 134-year average of 16x, which according to CAPE disciples makes the stock market very expensive. Or as a recent Business Insider article stated, the Shiller CAPE is “higher than at any point in the 20th century with the exception of the peaks of 1929 and 2000 – you know what happened after those.”
Problems Behind the Broken CAPE Tool
There are many problems with Shiller’s CAPE analysis, but let’s start with the basics by first asking, how useful has this tool actually been over the last, 10, 20, or 30 years? The short answer…not very. For example, if investors followed the implicit recommendation of the CAPE for the periods when Shiller’s model showed stocks as expensive (see above chart 1990 – 2014), they would have missed a more than quintupling (+469% ex-dividends) in the S&P 500 index. Over a shorter timeframe (2009 – 2014) the S&P 500 is up +114% ex-dividends (+190% since March 2009).
Even if you purchased at the worst time at the peak of the stock market in 2000 when the CAPE was 44 (S&P 500 – 1553), an investor would still have earned a total return of about +45% from 2000 – 2014, despite the CAPE still being 63% higher (more expensive) than the 134-year CAPE average of 16.
Peaches for $.25 Post-Bubble?
To illustrate a point, let’s assume you are a peach lover and due to a bubble in peach demand, prices spiked to an elevated level of $2.60 per pound for 9 years, but in year 10 the price plummeted to $.25 per pound today (see chart below). Assuming the 134-year average for peach prices was $1.60 per pound, would you still want to purchase your beloved peaches for the fire sale price of $.25 per pound? Common sense tells you $.25/lb. is a bargain, but if you asked the same question to Robert Shiller, he would say absolutely “NO”! The 10-year Peach CAPE ratio would be $2.37 ([9 yrs X $2.60] + [1 yr X $.25]) #1, but since the 10-year CAPE is greater than the LT-Average peach price of $1.60 per pound #2, Shiller would say peaches are too expensive, even though you could go to Kroger (KR) and buy a pound of peaches today for $0.25 #3.
This complete neglect of current market prices in the calculation of CAPE makes absolutely no sense, but this same dynamic of ignoring current pricing reality is happening today in the stock market. Effectively what’s occurring is the higher P/E ratios experienced over the last 10 years are distorting the Shiller CAPE ratio, thereby masking the true current value of stocks. In other words the current CAPE of 26x vastly exaggerates the pricey-ness of the actual S&P 500 P/E ratio of 16x for 2014 and 14x for 2015.
There are plenty of other holes to poke into CAPE, but the last major component of Shiller’s ratio I want to address is interest rates. Even if you disregard my previous negative arguments against Shiller’s CAPE, should anyone be surprised that the ratio troughed in the early 1980s of 7x when long-term interest rates peaked. If I could earn 18% on a CD with little risk in 1981, not many people should be dumbfounded that demand for risky stocks was paltry. Today, the reverse environment is in place – interest rates are near record lows. It should therefore come as no surprise, that all else equal, a higher P/E (and CAPE) is deserved when interest rates are this low. Nevertheless, this discussion of P/E and CAPE rarely integrates the critical factor of interest rates.
While I have spent a decent amount of time trashing the CAPE-BS ratio, I want to give my pal Bob Shiller a fair shake. I can do this by looking into a mirror and admitting there are periods when the CAPE ratio can actually work. Although the CAPE is effectively useless during long, multi-year upward and downward trending markets (think bubbles & depressions), the CAPE makes perfect sense in sideway, trendless markets (see chart below).
The investing public is always looking for a Holy Grail financial indicator that will magically guide them to riches in both up and down markets. Despite the popularity of Shiller’s CAPE ratio, regrettably no one perfect indicator exists. So before you jump on the bandwagon and chase the hot indicator du jour, make sure to look down and make sure you haven’t stepped in any Shiller CAPE-BS.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds, but at the time of publishing SCM had no direct position in KR, 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.
I know what you’re saying, “Please, not another article on Michael Lewis’s Flash Boys book and high frequency trading (HFT),” but I can’t resist putting in my two cents after the well-known author emphatically proclaimed the stock market as “rigged.” Lewis is not alone with his outrageous claims… Clark Stanley (“The Rattlesnake King”) made equally outlandish claims in the early 1900s when he sold lucrative Snake Oil Liniment to heal the ailments of the masses. Ultimately Stanley’s assets were seized by the government and the healing assertions of his snake oil were proven fraudulent. Like Stanley, Lewis’s over-the-top comments about HFT traders are now being scrutinized under a microscope by more thoughtful critics than Steve Kroft from 60 Minutes (see television profile). For a more detailed counterpoint, see the Reuters interview with Manoj Narang (Tradeworx) and Haim Bodek (Decimus Capital Markets).
While Lewis may not be selling snake oil, the cash register is still ringing with book sales until the real truth is disseminated. In the meantime, Lewis continues to laugh to the bank as he makes misleading and deceptive claims, just like his snake oil selling predecessors.
The Inside Perspective
Regardless of what side of the fence you fall on, the debate created by Lewis’s book has created deafening controversy. Joining the jihad against HFT is industry veteran Charles Schwab, who distributed a press release calling HFT a “growing cancer” and stating the following:
“High-frequency trading has run amok and is corrupting our capital market system by creating an unleveled playing field for individual investors and driving the wrong incentives for our commodity and equities exchanges.”
What Charles Schwab doesn’t admit is that their firm is receiving about $100 million in annual revenues to direct Schwab client orders to the same HFT traders at exchanges in so called “payment-for-order-flow” contracts. Another term to describe this practice would be “kick-backs”.
While Michael Lewis screams bloody murder over investors getting fraudulently skimmed, some other industry legends, including the godfather of index funds, Vanguard founder Jack Bogle, argue that Lewis’s views are too extreme. Bogle reasons, “Main Street is the great beneficiary…We are better off with high-frequency trading than we are without it.”
Like Jack Bogle, other investors who should be pointing the finger at HFT traders are instead patting them on the back. Cliff Asness, managing and founding principal of AQR Capital Management, an institutional investment firm managing about $100 billion in assets, had this to say about HFT in his Wall Street Journal Op-Ed:
“How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars… on the whole high-frequency traders have lowered costs.”
Is HFT Good for Main Street?
Many investors today have already forgotten, or were too young to remember, that stocks used to be priced in fractions before technology narrowed spreads to decimal points in the 1990s. Who has benefited from all this technology? You guessed it…everyone.
Lewis makes the case that the case that all investors are negatively impacted by HFT, including Main Street (individual) investors. Asness maintains costs have been significantly lowered for individual investors:
“For the first time in history, Main Street might have it rigged against Wall Street.”
In Flash Boys, Lewis claims HFT traders unscrupulously scalp pennies per share from retail investor pockets by using privileged information to jump in front of ordinary investors (“front-run”). The reality, even if you believe Lewis’s contentions are true, is that technology has turned any perceived detrimental penny-sized skimming scheme into beneficial bucks for ordinary investors. For example, trades that used to cost $40, $50, $100, or more per transaction at the large wirehouse brokerage firms can today be purchased at discount brokerage firms for $7 or less. What’s more, the spread (i.e., the profits available for middlemen) used to be measured in increments of 1/8, 1/4, and 1/2 , when today the spreads are measured in pennies or fractions of pennies. Without any rational explanation, Lewis also dismisses the fact that HFT traders add valuable liquidity to the market. His argument of adding “volume and not liquidity” would make sense if HFT traders only transacted solely with other HFT traders, but that is obviously not the case.
Regardless, as you can see from the chart below, the trend in spreads over the last decade or so has been on a steady, downward, investor-friendly slope.
How Did We Get Here? And What’s Wrong with HFT?
Similarly to our country’s 73,954 page I.R.S. tax code, the complexity of our financial market trading structure rivals that of our government’s money collection system. The painting of all HFT traders as villains by Lewis is no truer than painting all taxpayers as crooks. Just as there are plenty of crooked and deceitful individuals that push the boundaries of our income tax system, so too are there traders that try to take advantage of an inefficient, Byzantine exchange system. The mere presence of some tax dodgers doesn’t mean that all taxpayers should go to jail, nor should all HFT traders be crucified by the SEC (Securities and Exchange Commission) police.
The heightened convoluted nature to our country’s exchange-based financial system can be traced back to the establishment of Regulation NMS, which was passed by the SEC in 2005 and implemented in 2007. The aim of this regulatory structure was designed to level the playing field through fairer trade execution and the creation of equal access to transparent price quotations. However, rather than leveling the playing field, the government destroyed the playing field and fragmented it into many convoluted pieces (i.e., exchanges) – see Wall Street Journal article and chart below.
The new Reg NMS competition came in the form of exchanges like BATS and Direct Edge (now merging), but the new multi-faceted structures introduced fresh loopholes for HFT traders to exploit – for both themselves and investors. More specifically, HFT traders used expensive, lightning-fast fiber optic cables; privileged access to data centers physically located adjacent to trading exchanges; and then they integrated algorithmic software code to efficiently route orders for best execution.
Are many of these HFT traders and software programs attempting to anticipate market direction? Certainly. As the WSJ excerpt below explains, these traders are shrewdly putting their capitalist genes to the profit-making test:
Computerized firms called high-frequency traders try to pick up clues about what the big players are doing through techniques such as repeatedly placing and instantly canceling thousands of stock orders to detect demand. If such a firm’s algorithm detects that a mutual fund is loading up on a certain stock, the firm’s computers may decide the stock is worth more and can rush to buy it first. That process can make the purchase costlier for the mutual fund.
Like any highly profitable business, success eventually attracts competition, and that is exactly what has happened with high frequency trading. To appreciate this fact, all one need to do is look at Goldman Sachs’s actions, which is to leave the NYSE (New York Stock Exchange), shutter its HFT dark pool trading platform (Sigma X), and join IEX, the dark pool created by Brad Katsuyama, the hero placed on a pedestal by Lewis in Flash Boys. Goldman is putting on their “we’re doing what’s best for investors” face on, but more experienced veterans understand that Goldman and all the other HFT traders are mostly just greedy S.O.B.s looking out for their best interests. The calculus is straightforward: As costs of implementing HFT have plummeted, the profit potential has dried up, and the remaining competitors have been left to fend for their Darwinian survival. The TABB Group, a financial markets’ research and consulting firm, estimates that US equity HFT revenues have declined from approximately $7.2 billion in 2009 to about $1.3 billion in 2014. As costs for co-locating HFT hardware next to an exchange have plummeted from millions of dollars to as low as $1,000 per month, the HFT market has opened their doors to anyone with a checkbook, programmer, and a pulse. That wasn’t the case a handful of years ago.
Admittedly, not everything is hearts and flowers in HFT land. The Flash Crash of 2010 highlighted how fragmented, convoluted, and opaque our market system has become since Reg NMS was implemented. And although “circuit breaker” remedies have helped prevent a replicated occurrence, there is still room for improvement.
What are some of the solutions? Here are a few ideas:
- Reform complicated Reg NMS rules – competition is good, complexity is not.
- Overhaul disclosure around “payment-for-order-flow” contracts (rebates), so potential conflicts of interest can be exposed.
- Stop inefficient wasteful “quote stuffing” practices by HFT traders.
- Speed up and improve the quality of the SIP (Security Information Processor), so the gaps between SIP and the direct feed data from exchanges are minimized.
- Improve tracking and transparency, which can weed out shady players and lower probabilities of another Flash Crash-like event.
These shortcomings of HFT trading do not mean the market is “rigged”, but like our overwhelmingly complex tax system, there is plenty of room for improvement. Another pet peeve of mine is Lewis’s infatuation with stocks. If he really thinks the stock market is rigged, then he should write his next book on the less efficient markets of bonds, futures, and other over-the-counter derivatives. This is much more fertile ground for corruption.
As a former manager of a $20 billion fund, I understand the complications firsthand faced by large institutional investors. In an ever-changing game of cat and mouse, investors of all sizes will continue looking to execute trades at the best prices (lowest possible purchase and highest possible sales price), while middlemen traders will persist with their ambition to exploit the spread (generate profits between the bid and ask prices). Improvements in technology will always afford a temporary advantage for a few, but in the long-run the benefits for all investors have been undeniable. The same undeniable benefits can’t be said for reading Michael Lewis’s Flash Boys. Like Clark Stanley and other snake oil salesmen before him, it will only take time for the real truth to come out about Lewis’s “rigged” stock market claims.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in GS, SCHW, ICE, 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.
Billionaire hedge fund manager of Tudor Investment Corporation, Paul Tudor Jones, recently suffered from a case of foot-in-mouth disease when he addressed a sensitive subject – the lack of female traders and investors on Wall Street. Rather than provide a diplomatic response to the mixed audience at a recent University of Virginia symposium, Tudor Jones went on an unambiguous rant. Here’s an excerpt:
“You will never see as many great women investors or traders as men. Period, end of story….As soon as that baby’s lips touch that girl’s bosom, forget it. Every single investment idea, every desire to understand what’s going to make this go up or gonna go down is going to be overwhelmed by the most beautiful experience, which a man will never share of that emotive connection between that mother and baby.”
A more complete review of his unfiltered response can be found in this video:
Clearly there is a massive minority of females on Wall Street, but why such an under-representation in this field relative to other female-heavy professional industries such as advertising, nursing, and teaching? I addressed this controversial subject in an earlier article (see Females in Finance)
If there are 155.8 million females in the United States and 151.8 million males (Census Bureau: October 2009), then how come only 6% of hedge fund managers (BusinessWeek), 8% of venture capitalists, and 15% of investment bankers are female (Harvard Magazine)? Is the finance field just an ol’ boys network of chauvinist pig-headed males who only hire their own? Maybe cultural factors such as upbringing and education are other factors that make math-related jobs more appealing to men? Or do the severe time-demands of the field force females to opt-out of the industry due to family priorities?
Although I’m sure family choices and quality of life are factors that play into the decision of entering the demanding finance industry, from my experience I would argue women are notoriously underrepresented even at younger ages. For example, anecdotal evidence coming from my investment management firm (Sidoxia Capital Management – www.Sidoxia.com) clearly shows a preponderance of internship applications coming from males, even though it is premature for these students to fully contemplate family considerations at this young age.
If under-representation in the finance field is not caused by female choice, then perhaps the male dominated industry is merely a function of more men opting into the field (i.e., men are better suited for the industry)? More specifically, perhaps male brains are just wired differently? Some make the argument that all the testosterone permeating through male bodies leads them to positions involving more risk. If you look at other risk related fields like gambling, women too are dramatic minorities, making up about 1/3 of total compulsive gamblers.
Women Better than Men?
The funny part about the under-representation of females in finance is that one study actually shows female hedge fund managers outperforming their male counterparts. Here’s what a BusinessWeek article had to say about female hedge fund managers:
A new study by Hedge Fund Research found that, from January 2000 through May 31, 2009, hedge funds run by women delivered nearly double the investment performance of those managed by men. Female managers produced average annual returns of 9%, versus 5.82% for men and, in 2008, when financial markets were cratering, funds run by women were down 9.6%, compared with a 19% decline for men.
The article goes onto to theorize that women may not be afraid of risk, but actually are better able to manage risk. A UC Davis study found that male managers traded 45% more than female managers, thereby reducing returns by -2.65% (about 1% more than females).
Regardless of the theories or studies used to explain gender risk appetite, the relative under-representation of females in finance is a fact. Many theories exist but further thought and research need to be conducted on the subject.
However, before Paul Tudor Jones is completely demonized or sent to the guillotine, let’s not forget Tudor Jones is obviously not your ordinary, heartless, cold-blooded Wall Street type, as evidenced by his recent philanthropic profile on 60 Minutes. Thanks to his generous efforts, Tudor Jones and his Robin Hood Foundation charity have raised more than $400 million for worthy causes since 1988.
While Paul Tudor Jones may not have harbored any malicious intent with regards to his comments, it may make sense for Tudor Jones to take a course on gender sensitivity. Bosoms and women may be an interesting subject for many, however he might consider filtering his commentary the next time he speaks to a large symposium recorded on the internet.
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 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.
It’s been a painful four years for the bears, including Peter Schiff, Nouriel Roubini, John Mauldin, Jimmy Rogers, and let’s not forget David Rosenberg, among others. Rosenberg was recently on CNBC attempting to clarify his evolving bearish view by explaining how central banks around the globe have eaten his forecasting homework. In other words, Ben Bernanke is getting blamed for launching the stock market into the stratosphere thanks to his quantitative easing magic. According to Rosenberg, and the other world-enders, death and destruction would have prevailed without all the money printing.
In reality, the S&P 500 has climbed over +140% and is setting all-time record highs since the market bottomed in early 2009. Despite the large volume of erroneous predictions by Rosenberg and his bear buddies, that development has not slowed the pace of false forecasts. When you’re wrong, one could simply admit defeat, or one could get creative like Rosenberg and bend the truth. As you can tell from my David Rosenberg article from 2010 (Rams Butting Heads), he has been bearish for years calling for outcomes like a double-dip recession; a return to 11% unemployment; and a collapse in the market. So far, none of those predictions have come to fruition (in fact the S&P is up about +40% from that period, if you include dividends). After being incorrect for so long, Rosenberg has switched his mantra to be bullish on pullbacks on selective dividend-paying stocks. When pushed whether he has turned bullish, here’s what Rosenberg had to say,
“So it’s not about is somebody bearish or is somebody bullish or whether you’re agnostic, it’s really about understanding what the principle driver of this market is…it’s the mother of all liquidity-driven rallies that I’ve seen in my lifetime, and it’s continuing.”
Rosenberg isn’t the only bear blaming central banks for the unexpected rise in equity markets. As mentioned previously, fear and panic have virtually disappeared, but these emotions have matured into skepticism. Record profits, cash balances, and attractive valuations are dismissed as artificial byproducts of a Fed’s monetary Ponzi Scheme. The fact that Japan and other central banks are following Ben Bernanke’s money printing lead only serves to add more fuel to the bears’ proverbial fire.
Speculative bubbles are not easy to identify before-the-fact, however they typically involve a combination of excessive valuations and/or massive amounts of leverage. In hindsight we experienced these dynamics in the technology collapse of the late-1990s (tech companies traded at over 100x’s earnings) and the leverage-induced housing crisis of the mid-2000s ($100s of billions used to speculate on subprime mortgages and real estate).
I’m OK with the argument that there are trillions of dollars being used for speculative buying, but if I understand correctly, the trillions of dollars in global liquidity being injected by central banks across the world is not being used to buy securities in the stock market? Rather, all the artificial, pending-bubble discussions should migrate to the bond market…not the stock market. All credit markets, to some degree, are tied to the trillions of Treasuries and mortgage-backed securities purchased by central banks, yet many pundits (i.e., see El-Erian & Bill Gross) choose to focus on claims of speculative buying in stocks, and not bonds.
While bears point to the Shiller 10 Price-Earnings ratio as evidence of a richly priced stock market, more objective measurements through FactSet (below 10-year average) and Wall Street Journal indicate a forward P/E of around 14. A reasonable figure if you consider the multiples were twice as high in 2000, and interest rates are at a generational low (see also Shiller P/E critique).
The news hasn’t been great, volatility measurements (i.e., VIX) have been signaling complacency, and every man, woman, and child has been waiting for a “pullback” – myself included. The pace of the upward advance we have experienced over the last six months is not sustainable, but when we finally get a price retreat, do not listen to the bears like Rosenberg. Their credibility has been shot, ever since the central bank dog ate their homework.
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 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.
With the Easter bunny relaxing after a busy holiday, kids from all over are given the task of organizing the candy and money collected during their hunts. Investors are also constantly reminded that their portfolio eggs should not be solely placed in one basket either. Instead, investors are told to diversify their investments across a whole host of asset classes, geographies, styles, and sizes. In other words, this means investors should be spreading their money across commodity, real estate, international, emerging market, value, growth, small-cap, and large-cap investments. As Jason Zweig, journalist from a the Wall Street Journal points out, much of the diversification benefits can be achieved with relatively small change in the position count of a portfolio:
“As many studies have shown, at least 40% of the variability in returns can be reduced by moving from a single company to 20. Once a portfolio contains 20 or 30 stocks, adding more does little to damp the fluctuations in wealth over time.”
But wait. Going from one banking stock to 20 banking stocks is not going to provide you with the proper diversification you want or need. Rather, what is as important as investing across asset class, geography, style, and size, is to follow the individual stock strategies of guru Peter Lynch. In order to put his performance into perspective, Lynch’s Fidelity Magellan fund averaged +29% per year from 1977 – 1990 – almost doubling the return of the S&P 500 index for that period.
More specifically, to achieve these heroic returns, Lynch divided the stocks in his fund into the following categories:
Slow Growers: This group of stocks wasn’t Lynch’s favorite because these companies typically operate in mature industries with limited expansion opportunities. For these single-digit EPS growers, Lynch focused more on identifying high dividend-paying stocks that were trading at attractive valuations. In particular, he paid attention to a dividend-adjusted PEG ratio (Price-to-Earnings Growth). A utility company would be an example of a “Slow Grower.”
Stalwarts: These are large established companies that still have the ability to achieve +10% to +12% annual earnings growth regardless of the economic cycle. Lynch liked these stocks especially during recessions and downturns. Valuations are still very important for Stalwarts, and many of them pay dividends. An investor may not realize a “home run” with respect to returns, but a +30% to 50% return over a few years is not out of the question, if selected correctly. Former examples of “Stalwarts” include Coca Cola (KO) and Procter & Gamble (PG).
Fast Growers: This categorization applies to small aggressive firms averaging about +20% to +25% annual earnings growth. While “Fast Growers” offer the most price appreciation potential, these stocks also offer the most risk, especially once growth/momentum slows. If timed correctly, as Lynch adeptly achieved, these stocks can increase multi-fold in value. The great thing about these “Fast Growers” is they don’t have to reside in fast growth industries. Lynch actually preferred market share gainers in legacy industries.
Cyclicals: These companies tend to see their sales and profits rise and fall with the overall economic cycle. The hyper-sensitivity to economic fluctuations makes the timing on these stocks extremely tricky, leading to losses and tears – especially if you get in too late or get out too late. To emphasize his point, Lynch states, “Cyclicals are like blackjack: stay in the game too long and it’s bound to take all your profit.” The other mistake inexperienced investors make is mistaking a “Cyclical” company as a “Stalwart” at the peak of a cycle. Examples of cyclical industries include airline, auto, steel, travel, and chemical industries.
Turnarounds: Lynch calls these stocks, “No Growers,” and they primarily of consist of situations like bail-outs, spin-offs, and restructurings. Unlike cyclical stocks, “Turnarounds” are usually least sensitive to the overall market. Even though these stocks are beaten down or depressed, they are enormously risky. Chyrysler, during the 1980s, was an example of a favorable Lynch turnaround.
Asset Plays: Overlooked or underappreciated assets such as real estate, oil reserves, patented drugs, and/or cash on the balance sheet are all examples of “Asset Plays” that Lynch would consider. Patience is paramount with these types of investments because it may take considerable time for the market to recognize such concealed assets.
Worth noting is that not all stocks remain in the same Lynch category. Apple Inc. (AAPL) is an example of a “Fast Grower” that has migrated to “Stalwart” or “Slow Grower” status, therefore items such as valuation and capital deployment (dividends and share buyback) become more important.
Peter Lynch’s heroic track record speaks for itself. Traditional diversification methods of spreading your eggs across various asset class baskets is useful, but this approach can be enhanced by identifying worthy candidates across Lynch’s six specific stock categories. Hunting for these winners is something Lynch and the Easter bunny could both agree upon.
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) and AAPL, but at the time of publishing SCM had no direct position in KO, PG, Chrysler, Fidelity Magellan, 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.
As my grandmother always told me, “Be careful where you get your advice!” Or as renowned Wall Street trader Gerald Loeb once said, “The Buick salesman is not going to tell you a Chevrolet will fit your needs.” In other words, when it comes to investment advice, it is important to realize that opinions and recommendations are often biased and steeped with inherent conflicts of interest. Having worked in the financial industry over several decades, I have effectively seen it all.
However, one unique aspect I have grown accustomed to is the nauseating and fatiguing over-exposure of PIMCO’s dynamic bond duo, CEO Mohamed El-Erian and founder Bill Gross. Over the last four years and 13 consecutive quarters of GDP growth (likely 14 after Q4 revisions), I and fellow CNBC viewers have been forced to endure the incessant talk of the “New Normal” of weak economic growth to infinity. Actual results have turned out quite differently than the duet’s cryptic and verbose predictions, which have piled up over their seemingly non-stop media interview schedule. Despite the doomsday rhetoric from the bond brothers, El-Erian and Gross have witnessed a more than doubling in equity prices, which has soundly trounced the performance of bonds over the last four years.
After being mistaken for such a long period, certainly the PIMCO marketing machine would revise their pessimistic outlook, right? Wrong. In true biased fashion, El-Erian cannot admit defeat. Just this week, El-Erian argues stocks are artificially high due to excessive liquidity pumped into the financial system by central banks (see video below). I’m the first one to admit Federal Reserve Chairman Ben Bernanke is explicitly doing his best to force investors into risky assets, but doesn’t generational low interest rates help bond prices too? Apparently that mathematical fact has escaped El-Erian’s bond script.
El-Erian’s buddy, Bill Gross, can’t help himself from jumping on the stock rain parade either. Just six weeks ago Gross followed the bond-pumping playbook by making another dour prediction that the market would rise less than 5% in 2013. Unfortunately for Gross, his crystal ball has also been a little cloudy of late, with the S&P 500 index already up more than +6.5% this year. Since doomsday outlooks are what keeps the $2 trillion PIMCO machined primed, it’s no surprise we hear about the never-ending gloom. For those keeping score at home, let’s please not forget Bill Gross’s infamously wrong Dow 5,000 prediction (see article).
PIMCO Smoke & Mirrors: Stock Funds with NO Stocks
Just when I thought I had seen it all, I came across PIMCO’s Equity-Related funds. Never in my career have I seen “equity” mutual funds that invest solely in “bonds.” Well, apparently PIMCO has somehow creatively figured out how to create stock funds without investing in stocks. I guess that is one strategy for a bond-centric company of getting into the equity fund market? This is either ingenious or bordering on the line of criminal. I fall into the latter camp. How the SEC allows the world’s largest bond company to deceivingly market billions in bond-filled stock funds to individual investors is beyond me. After innocent people got fleeced by unscrupulous mortgage brokers and greedy lenders, in this Dodd-Frank day and age, I can’t help but wonder how PIMCO is able to solicit a StockPlus Fund that has 0% invested in common stocks. You can judge for yourself by reviewing their equity-related funds on their website (see also chart below):
PIMCO Active Equity Funds Struggle
With more than 99% of PIMCO’s $2 trillion in assets under management locked into bonds, company executives have made a half-hearted effort of getting into the equity markets, even though they’ve enjoyed high-fiving each other during the three-decade-long bond bull market (see Downhill Marathon Machine). In hopes of diversifying their bond-heavy revenue stream, in 2009 they hired the head of the high-profile $700 billion, government TARP program (Neil Kashkari). Subsequently, PIMCO opened its first set of actively managed funds in 2010. Regrettably for PIMCO, the sledding has been quite tough. In 2012, all six actively managed equity funds lagged their benchmarks. Moreover, just a few weeks ago, Kashkari their rock star hire decided to quit and pursue a return to politics.
Mohamed El-Erian and Bill Gross have never been camera shy or bashful about bashing stocks. PIMCO has virtually all their bond eggs in one basket and their leaderless equity division is struggling. What’s more, like some car salesmen, they have had a creative way of describing the facts. If it’s a Chevy or unbiased advice you’re looking for, I recommend you steer clear from Buick salesmen and PIMCO headquarters.
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 PIMCO funds, 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.
I have seen a lot of things in my two decades in the investment industry, but seeing a verbal cage fight between a senile 76 year-old corporate raider and a white-haired, 46 year-old Harvard grad makes for surprisingly entertaining viewing. The investment heavyweights I am referring to are the elder Carl Icahn, Chairman of Icahn Enterprises, and junior Bill Ackman, CEO of Pershing Square Capital Management. If getting a few billionaires yelling at each other on live TV is not enough to interest you, then how about adding some tongue-laced f-bombs coupled with blow-by-blow screaming from background traders?
What’s the source of the venomous, spitting hatred between these stock market tycoons? In short, it can be boiled down to a decade old lawsuit (profitable for both I might add), and a disagreement over the short position of a controversial stock, Herbalife (HLF). Regarding the legal spat, in 2003 the SEC was investigating Ackman while his Gotham Partners hedge fund was collapsing, so Ackman asked Icahn to buy shares of Hallwood Realty in hopes of salvaging his fund. Eventually, Icahn bought shares, but a difference in opinion over the transaction led to a lawsuit that Icahn lost, thereby forcing him to pay Ackman $9 million.
Icahn also had a beef with Ackman’s handling of Herbalife: Parading in front of hundreds of investors to self-indulgently create a bear raid on an unsuspecting company is poor form in Icahn’s view, and Carl wanted to make sure Ackman was aware of this investing faux pas.
Normally, investing reporting over cable television is rather mundane, unless you consider entertainers like Jim Cramer yelling “booyah” amusing (see also my article on Mr. Booyah)? On the other hand, if you enjoy billionaires embracing the spirit of the Jerry Springer Show by screaming purple-faced profanities, then you should check out the CNBC cage fight here in its entirety:
If you lack time in your busy schedule to soak in the full bloody battle, then here is a synopsis of my favorite highlights:
Icahn on Ackman the “Crybaby”: “I really sort of have had it with this guy Ackman….I get a call from this Ackman guy. I’m telling you, he’s like the crybaby in the schoolyard. I went to a tough school in Queens. They used to beat up the little Jewish boys. He was like a little Jewish boy crying that the world was taking advantage of him.”
Ackman Referring to Icahn as a “Bully” and Himself as “Roadkill on the Hedge Fund Highway”: “Why did he [Icahn] threaten to sue me? He was a bully. Okay? I was not in a good place in my business career. I was under investigation by Spitzer, winding down my fund. There was negative press about Gotham Partners. I was short MBIA (MBI). They were aggressively attacking me and Carl Icahn thought this guy [Ackman] is roadkill on the hedge fund highway… This is not an honest guy [Icahn] who keeps his word. This is a guy who takes advantage of little people.”
Agitated Icahn Tearing a New One for Scott Wapner (CNBC Commentator): “I didn’t get on to be bullied by you [Wapner]… I’m going to talk about what I want to talk about. Okay? If you want to take that position, I will never go on CNBC. You can say what the hell you want. I’m going to talk about what Ackman just said about me, not about Herbalife. I’ll talk about Herbalife when I want to, not when you ask me. I’m never going on a show with you again, that’s for damn sure. Let’s start with what I want to say. Ackman is a liar.”
Icahn on Another Ackman Rampage: “I will tell you something. As far as I’m concerned, he wanted to have dinner with me and I laughed. I couldn’t figure out if he was the most sanctimonious guy or the most arrogant… the guy takes inordinate risk…I don’t have an investment with Ackman. I wouldn’t have one if you paid me, if Ackman paid me to do it… I made a huge mistake getting involved with him…After he won [the lawsuit], he planted some article in the New York Times pounding his chest telling the world how great he was. You know, as far as I’m concerned the guy is a major loser.”
New CNBC Revenue Stream?
There hasn’t been this much fireworks since Professor Jeremy Siegel took Bill Gross to task on the Pimco Boss’s assessment that the “cult of equity is dying” last July. In retrospect, that minor tiff was child’s play relative to the Icahn vs. Ackman battle. With CNBC viewership down from pre-crisis levels, the network may strongly consider instituting a new pay-per-view revenue stream dedicated to battles between opposing investment enemies. I will even offer up my services to verbally smack down some of the enemies I’ve written about previously. If my phones don’t ring, then I can always offer up my American Investment Idol concept in which I can play Simon Cowell.
This may or may not be the last round of the Carl Icahn and Bill Ackman fight, but the ultimate bragging rights may depend on the ultimate outcome of Ackman’s Herbalife short. If Icahn makes a tender offer for Herbalife, I will anxiously wait for CNBC’s Scott Wapner to invite Carl back on the show. I can hardly wait…
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 HLF, MBI, NYT, Hallwood Realty, 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.
Faster than a speedy credit default swap, more powerful than a federal funds interest rate cut, and able to leap a tall Mario Draghi in a single bound, look…it’s Helicopter Ben! How did Federal Reserve Chairman Ben Bernanke become a monetary superhero with such a cool nickname as Helicopter Ben (a.k.a. “HB”)? Bernanke, a former Princeton University professor, has widely been known to be a diligent student of the Great Depression, and his aviation nickname stems from a 2002 speech in which he referenced dropping money from a helicopter to combat deflation. While investors may worry about HB’s ability to fight the inflation thugs, there should be no questions about his willingness to implement accommodative, deflation-fighting monetary policies.
Chairman Bernanke may not epitomize your ideal superhero, however this slightly past middle-aged bearded and balding man has helped mastermind some of the most creative and aggressive monetary rescue efforts our country and globe has seen in the history of man (and woman). This week’s money-printing QE3 announcement solidified Bernanke’s historic capital saturating ranking.
Since Helicopter Ben’s heroic appointment as Federal Reserve Chairman in 2006 by George W. Bush, Bernanke has instituted numerous monetary gadgets in hopes of meeting the Federal Reserve’s dual mandate, which is i) to achieve low inflation and ii) to strive for maximum employment. Arguably, given the anemic growth here in the U.S.; the recession in Europe; and slowing growth in the emerging markets (i.e., China, Brazil, India, etc.), slack in the economy and static labor wages have largely kept inflation in check. With the first part of the dual mandate met, Bernanke has had no problem putting his monetary superpowers to work.
As referenced earlier, Bernanke’s bazooka launch of QE3, an open ended MBS (Mortgage Back Securities) bond binging program, will add $40 billion of newly purchased assets to the Fed’s balance sheet on a monthly basis until the labor market improves “substantially” (whatever that means). What’s more, in addition to the indefinite QE3, Bernanke has promised to keep the federal funds rate near zero “at least through mid-2015,” even for a “considerable time after the economic recovery strengthens.”
HB’s Track Record
Throughout superhero history, Superman, Spider-man, and Batman have used a wide-array of superhuman powers, extraordinary gadgets, and superior intellect to conquer evil-doers and injustices across the globe. Bernanke has also forcefully put his unrivaled money-printing talents to work in an attempt to cure the financial ills of the world. Here’s a quick multi-year overview of how Bernanke has put his unique talents to print trillions of dollars and keep interest rates suppressed:
Rate Cuts (September 2007 – December 2008): Before “quantitative easing” was a part of our common vernacular, the Fed relied on more traditional monetary policies, such as federal funds rate targeting, conducted through purchases and sales of open market securities. Few investors recall, but before HB’s fed funds rate cut rampage of 10 consecutive reductions in 2007 and 2008 (the fed funds rate went from 5.25% to effectively 0%), Bernanke actually increased rates three times in 2006.
Crisis Actions (2007 – 2009): Love him or hate him, Bernanke has been a brave and busy soul in dealing with the massive proportions of the global financial crisis. If you don’t believe me, just check out the Financial Crisis Timeline listed at the St. Louis Federal Reserve. Many investors don’t remember, but Bernanke helped orchestrate some of the largest and most unprecedented corporate actions in our history, including the $30 billion loan to JPMorgan Chase (JPM) in the Bear Stearns takeover; the $182 billion bailout of AIG; the conversion of Morgan Stanley (MS) and Goldman Sachs Group Inc. (GS) into bank holding companies; and the loan/asset-purchase support to Fannie Mae (FNMA) and Freddie Mac (FMCC). These actions represented just the tip of the iceberg, if you also consider the deluge of liquidity actions taken by the Fed Chairman.
HB Creates Acronym Soup
In order to provide a flavor of the vastness in emergency programs launched since the crisis, here is an alphabet soup of program acronyms into which the Fed poured hundreds of billions of dollars:
- Term Asset-Backed Securities Loan Facility (TALF)
- Term Auction Facility (TAF)
- Money Market Investor Funding Facility (MMIFF)
- Commercial Paper Funding Facility (CPFF)
- Primary Dealer Credit Facility (PDCF)
- Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF)
- Temporary Reciprocal Currency Arrangements (Swap lines)
- Term Securities Lending Facility (TSLF)
Plenty of acronyms to go around, but these juicy programs have garnered most of investors’ attention:
QE1 (November 2008 – March 2010): In hopes of lowering interest rates for borrowers and stimulating the economy, HB spearheaded the Fed’s multi-step, $1 trillion+ buying program of MBS (mortgage backed securities) and Treasuries.
QE2 (November 2010 – June 2011): Since the Fed felt QE1 didn’t pack enough monetary punch to keep the economy growing at a fast enough clip, the FOMC (Federal Open Market committee) announced its decision to expand its holdings of securities in November 2010. The Committee maintained its existing policy of reinvesting principal payments from its securities holdings and to also purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011 (an equivalent pace of about $75 billion per month).
Operation Twist (September 2011 – December 2012): What started out as a $400 billion short-term debt for longer-term debt swap program in September 2011, expanded to a $667 billion program in June 2012. With short-term rates excessively low, Bernanke came up with this Operation Twist scheme previously used in the early 1960s. Designed to flatten the yield curve (bring down long-term interest rates) to stimulate economic activity, Bernanke thought this program was worth another go-around. Unlike quantitative easing, Operation Twist does not expand the Fed’s balance sheet – the program merely swaps short-term securities for long-term securities. Currently, the program is forecasted to conclude at the end of this year.
The Verdict on HB
So what’s my verdict on the continuous number of unprecedented actions that Helicopter Ben and the Fed have taken? Well for starters, I have to give Mr. Bernanke an “A-” on his overall handling of the financial crisis. Had his extreme actions not been taken, the pain and agony experienced by all would likely be significantly worse, and the financial hole a lot deeper.
With that said, am I happy about the announcement of QE3 and the explosion in the Fed’s money printing activities? The short answer is “NO”. It’s difficult to support a program with questionable short-run interest rate benefits, when the menacing inflationary pressures are likely to outweigh the advantages. The larger problem in my mind is the massive fiscal problem we are experiencing (over $16 trillion in debt and endless trillion dollar deficits). More importantly, this bloated fiscal position is creating an overarching, nagging crisis of confidence. A resolution to the so-called “fiscal cliff,” or the automated $600 billion in tax increases and spending cuts, is likely to have a more positive impact on confidence than a 0.05% – 0.25% reduction in mortgage rates from QE3. Once adequate and sustained growth returns, and inflation rears its ugly head, how quickly Helicopter Ben tightens policy will be his key test.
Until then, Bernanke will probably continue flying around while gloating in his QE3 cape, hoping his quantitative easing program will raise general confidence. Unfortunately, his more recent monetary policies appear to be creating diminishing returns. Even before QE3’s implementation, Helicopter Ben has witnessed his policies expand the Fed’s balance sheet from less than $900 billion at the beginning of the recession to almost $3 trillion today. Despite these gargantuan efforts, growth and confidence have been crawling forward at only a modest pace.
No matter the outcome of QE3, as long as Ben Bernanke remains Federal Reserve Chairman, and growth remains sluggish, you can stay confident this financial man of steel will continue dumping money into the system from his helicopter. If Bernanke wants to create a true legendary superhero ending to this story, the kryptonite-like effects of inflation need to be avoided. This means, less money-printing and more convincing of Congress to take action on our out-of-control debt and deficits. Now, that’s a comic book I’d pay to read.
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 positions in JPM, AIG, MS, GS, FNMA, FMCC, 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.
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 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;
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.