Posts filed under ‘Themes – Trends’

Predictions – A Fool’s Errand

Making bold predictions is a fool’s errand. I think Yogi Berra summed it up best when he spoke about the challenges of making predictions:

“It’s tough to make predictions, especially about the future.”

 

While making predictions might seem like a pleasurable endeavor, the reality is nobody has been able to consistently predict the future (remember the 2012 Mayan Doomsday?), besides perhaps palm readers and Nostradamus. The typical observed pattern consists of a group of well-known forecasters bunched in a herd coupled with a few extreme outliers who try to make a big splash and draw attention to themselves. Due to the law of large numbers, a few of these extreme outlier forecasters eventually strike gold and become Wall Street darlings…until their next forecasts fail miserably.

Like a broken clock, these radical forecasters can be right twice per day but are wrong most of the time. Here are a few examples:

Peter Schiff: The former stockbroker and President of Euro Pacific Capital has been peddling doom for decades (see Emperor Schiff Has No Clothes). You can get a sense of his impartial perspective via Schiff’s reading list (The Real Crash: America’s Coming Bankruptcy, Financial Armageddon, Conquer the Crash, Crash Proof – America’s Great Depression, The Biggest Con: How the Government is Fleecing You, Manias Panics and Crashes, Meltdown, Greenspan’s Bubbles, The Dollar Crisis, America’s Bubble Economy, and other doom-instilled titles.

Meredith Whitney: She made an incredible bearish call on Citigroup Inc. (C) during the fall of 2007, alongside her accurate call of Citi’s dividend suspension. Unfortunately, her subsequent bearish calls on the municipal market and the stock market were completely wrong (see also Meredith Whitney’s Cloudy Crystal Ball).

John Mauldin: This former print shop professional turned perma-bear investment strategist has built a living incorrectly calling for a stock market crash. Like perma-bears before him, he will eventually be right when the next recession hits, but unfortunately, the massive appreciation will have been missed. Any eventual temporary setback will likely pale in comparison to the lost gains from being out of the market. I profiled the false forecaster in my article, The Man Who Cries Bear.

Nouriel Roubini: This renowned New York University economist and professor is better known as “Dr. Doom” and as one of the people who predicted the housing bubble and 2008-2009 financial crisis. Like most of the perma-bears who preceded him, Dr. Doom remained too doom-ful as the stock market more than tripled from the 2009 lows (see also Pinning Down Roubini).

Alan Greenspan: The graveyard of erroneous forecasters is so large that a proper summary would require multiple books. However, a few more of my favorites include Federal Reserve Chairman Alan Greenspan’s infamous “Irrational Exuberance” speech in 1996 when he warned of a technology bubble. Although directionally correct, the NASDAQ index proceeded to more than triple in value (from about 1,300 to over 5,000) over the next three years. – today the NASDAQ is hovering around 6,100.

Robert Merton & Myron Scholes: As I chronicled in Investing Caffeine (see When Genius Failed), another doozy is the story of the Long Term Capital Management hedge fund, which was run in tandem with Nobel Prize winning economists, Robert Merton and Myron Scholes. What started as $1.3 billion fund in early 1994 managed to peak at around $140 billion before eventually crumbling to a capital level of less than $1 billion. Regrettably, becoming a Nobel Prize winner doesn’t make you a great predictor.

Words From the Wise

Rather than paying attention to crazy predictions by academics, economists, and strategists who in many cases have never invested a penny of outside investor money, ordinary investors would be better served by listening to steely investment veterans or proven prediction practitioners like Billy Beane (minority owner of the Oakland Athletics and subject of Michael Lewis’s book, Moneyball), who stated the following:

“The crime is not being unable to predict something. The crime is thinking that you are able to predict something.”

 

Other great quotes regarding the art of predictions, include these ones:

“I can’t recall ever once having seen the name of a market timer on Forbes‘ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.”

-Peter Lynch

“Many more investors claim the ability to foresee the market’s direction than actually possess the ability. (I myself have not met a single one.) Those of us who know that we cannot accurately forecast security prices are well advised to consider value investing, a safe and successful strategy in all investment environments.”

–Seth Klarman

 “No matter how much research you do, you can neither predict nor control the future.”

John Templeton

 “Stop trying to predict the direction of the stock market, the economy or the elections.”

–Warren Buffett

“In the business world, the rearview mirror is always clearer than the windshield.”

–Warren Buffett

In the global financial markets, Wall Street is littered with strategists and economists who have flamed out after brief bouts of fame. Celebrated author Mark Twain captured the essence of speculation when he properly identified, “There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.” Instead of attempting to predict the future, investors will avoid a fool’s errand by simply seizing opportunities as they present themselves in an ever-changing world.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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.

May 20, 2017 at 10:46 pm 1 comment

Ignoring Economics and Vital Signs

As stock prices sit near all-time record highs, and as we enter year nine of the current bull market, I remain amazed and amused at the brazen disregard for important basic economic concepts like supply & demand, interest rates, and rising profits.

If the stock market was a doctor’s patient, over the last decade, bloggers, pundits, talking heads, and pontificators have been ignoring the improving, healthy patient’s vital signs, while endlessly predicting the death of the resilient stock market.

However, let’s be clear – it has not been all hearts and flowers for stocks – there have been numerous -10%, -15%, and -20% corrections since the Financial Crisis nine years ago. Those corrections included the Flash Crash, debt downgrade, Arab Spring, sequestration, Taper Tantrum, Iranian Nuclear Threat, Ukrainian-Crimea annexation, Ebola, Paris/San Bernardino Terrorist Attacks, multiple European & Chinese slowdowns and more.

Despite the avalanche of headlines and volatility, we all know the net result of these events – a more than tripling of stock prices (+259%) from March 2009 to new all-time record highs. With the incessant stream of negative news, how could prices appreciate so dramatically?

Over the years, the explanations by outside observers have changed. First, the recovery was explained as a “dead cat bounce” or a short-term cyclical bull market within a long-term secular bear market. Then, when stock prices broke to new records, the focus shifted to Quantitative Easing (QE1, QE2, QE3, and Operation Twist). The QE narrative implied the bull advance was temporary due to the non-stop, artificial printing presses of the Fed. Now that the Fed has not only ended QE but reversed it (the Fed is actually contracting its balance sheet) and hiked interest rates (no longer cutting), outsiders are once again at a loss. Now, the bears are left clinging to the flawed CAPE metric I wrote about three years ago (see CAPE Smells Like BS), and using political headlines as a theory for record prices (i.e., record stock prices stem from inflated tax cut and infrastructure spending expectations).

It’s unfortunate for the bears that all the conspiracy theory headlines and F.U.D. (fear, uncertainty, and doubt) over the last 10 years have failed miserably as predictors for stock prices. The truth is that stock prices don’t care about headlines – stock prices care about economics. More specifically, stock prices care about profits, interest rates, and supply & demand.

Profits

It’s quite simple. Stock prices have more than tripled since early 2009 because profits have more than tripled since 2009. As you can see from the Macrotrends chart below, 2009 – 2016 profits for the S&P 500 index rose from $6.86 to $94.54, or +1,287%. It’s no surprise either that stock prices stalled for 18 months from 2015 to mid-2016 when profits slowed. After profits returned to growth, stock price appreciation also resumed.

Source: Macrotrends

Interest Rates

When you could earn a +16% on a guaranteed CD bank rate in the early 1980s, do you think stocks were a more or less attractive asset class? If you can sense the rhetorical nature of my question, then you can probably understand why stocks were about as attractive as rotten milk or moldy bread. Back then, stocks traded for about 8x’s earnings vs. the 18x-20x multiples today. The difference is, today interest rates are near generational lows (see chart below), and CDs pay near +0%, thereby making stocks much more attractive. If you think this type of talk is heresy, ignore me and listen to the greatest investor of all-time, Warren Buffett who recently stated:

“Measured against interest rates, stocks are actually on the cheap side.”

 

Source: Trading Economics

Supply & Demand

Another massively ignored area, as it relates to the health of stock prices, is the relationship of new stock supply entering the market (e.g., new dilutive shares via IPOs and follow-on offerings), versus stock exiting the market through corporate actions. While there has been some coverage placed on the corporate action of share buybacks – about a half trillion dollars of stock being sucked up like a vacuum cleaner by cash heavy companies like Apple Inc. (AAPL) – little attention has been paid to the trillions of dollars of stock vanishing from mergers and acquisition activities. Yes, Snap Inc. (SNAP) has garnered a disproportionate amount of attention for its $3 billion IPO (Initial Public Offering), this is a drop in the bucket compared to the exodus of stock from M&A activity. Consider the trivial amount of SNAP supply entering the market ($3 billion) vs. $100s of billions in major deals announced in 2016 – 2017:

  • Time Warner Inc. merger offer by AT&T Inc. (T) for $85 billion
  • Monsanto Co. merger offer by Bayer AG (BAYRY) for $66 billion
  • Reynolds American Inc. merger offer by British American Tobacco (BTI) for $47 billion
  • NXP Semiconductors merger offer by Qualcomm Inc. (QCOM) for $39 billion
  • LinkedIn merger offer by Microsoft Corp. (MSFT) for $28 billion
  • Jude Medical, Inc. merger offer by Abbott Laboratories (ABT) for $25 billion
  • Mead Johnson Nutrition merger offer by Reckitt Benckiser Group for $18 billion
  • Mobileye merger offer by Intel Corp. (INTC) for $15 billion
  • Netsuite merger offer by Oracle Corp. (ORCL) for $9 billion
  • Kate Spade & Co. merger offer by Coach Inc. (COH) for $2 billion

While these few handfuls of deals represent over $300 billion in disappearing stock, as long as corporate profits remain strong, interest rates low, and valuations reasonable, there will likely continue to be trillions of dollars in stocks being purchased by corporations. This continued vigorous M&A activity should provide further healthy support to stock prices.

Admittedly, there will come a time when profits will collapse, interest rates will spike, valuations will get stretched, sentiment will become euphoric, and/or supply of stock will flood the market (see Don’t be a Fool, Follow the Stool). When the balance of these factors turn negative, the risk profile for stock prices will obviously become less desirable. Until then, I will let the skeptics and bears ignore the healthy economic vital signs and call for the death of a healthy patient (stock market). In the meantime, I will continue focus on the basics of math and offer my economics textbook to the doubters.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own AAPL, ABT, INTC, MSFT, T, and certain exchange traded funds, but at the time of publishing SCM had no direct position in SNAP, TWX, MON, KATE, N, MBLY, MJN, STJ, LNKD, NXPI, BAYRY, BTI, QCOM, ORCL, COH, RAI, Reckitt Benckiser Group,  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.

May 14, 2017 at 12:27 am Leave a comment

The Fallacy Behind Populism and Automation Fears

The rise of global populism and anti-immigration sentiments, coupled with the perpetual rising trend of automation and robotics has stoked the fear fires of job security. Many stories perpetuate erroneous stereotypes and falsehoods. The news reports and blog articles come in various flavors, but in a nutshell the stories state the U.S. is hemorrhaging jobs due to the thieves of illegal immigration and heartless robotics. The job displacement theory is built upon the idea that these two sources of labor (immigrants & robots) are cheaper and more productive than traditional blue collar and white collar American workers.

Although these logical beliefs make for great soundbites, and may sell subscriptions and advertising, unfortunately the substance behind the assertions holds little water. Let’s take a look at the facts. In the most recent April jobs report, nonfarm payrolls employment increased by 211,000 jobs, according to the U.S. Bureau of Labor Statistics. Since early 2009 the unemployment rate has plummeted from 10.0% down to a historically low level of 4.4%. Over the similar timeframe, the economy has added over 15,000,000 new jobs. Does this sound like an environment in which immigrants and robots are killing all American jobs?

Sounds like a bunch of phoney-baloney, if you ask me. Just look at the employed person chart below, which shows a rising employment trend over the last seven decades, with the exception of some brief recessionary periods.

As I point out in a previous article (see Rise of the Robots), from the beginning of the United States, the share of the largest segment of the economy (agriculture) dropped by more than 98%, yet the standard of living and output in the agriculture sector have still exploded. There may not have been robots two and a half centuries ago, but technology and automation were alive and well, just as they are today. Although there were no self-driving cars, no internet, no biotech drugs, and no mobile phones, there were technological advances like the cotton gin, plow, scythe, chemical fertilizers, tractors, combine harvesters, and genetically engineered seeds over time.

Source: Carpe Diem

And while there most certainly were farmers who regrettably were displaced by these technologies, there were massive new industries fostered by the industrial revolution, which redeployed labor to new burgeoning industries like manufacturing, aerospace, transportation, semiconductors, medicine, and many more.

While it may be difficult to fathom what industries will replace the workers displaced by self-service kiosks at restaurants, airports, and retail stores, famed economist Milton Friedman summed it up best when he stated:

“Human wants & needs are infinite, and so there will always be new industries, there will always be new professions.”

As globalization and technology continue permeating through society, it is true, the importance of education becomes more critical. Billions of people around the globe in developing markets, along with automation technology, will be stealing lower-paying American jobs that require repetitive processes. Educating our workforce up the value-add food chain is imperative.

The bottom-line is that integration of technology and automation will improve the standard of living for the masses. Sure, immigration will displace some workers, but if legislative policy can be designed to cherry-pick (attract) the cream of the skilled foreign crop (and retrain displaced workers), skilled immigrants will keep on innovating and creating higher valued jobs. Just consider a recent study that shows 51% of U.S. billion-dollar startups were founded by immigrants.

The populist drum may continue to pound against immigration, and horror stories of job-stealing robots may abound, however the truth cannot be erased. Over the long-run, the fallacies behind populism and automation will be uncovered. The benefits and truths surrounding highly skilled immigrants and robots will be realized, as these dynamics dramatically improve the standard of living and productivity of our great economy.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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.

May 6, 2017 at 11:11 pm Leave a comment

Glass Half Full or Half Empty?

This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (May 1, 2017). Subscribe on the right side of the page for the complete text.

We live in a time of confusing dichotomies, which makes deciphering the flood of daily data quite challenging. In that context, determining whether the current economic fundamentals should be viewed from a glass half empty of glass half full perspective can be daunting.

More specifically, stock markets have again recently hit new all-time record highs, yet if you read the newspaper headlines, you might think we’re in the midst of Armageddon. Last month, the Dow Jones Industrial Average stock index eclipsed 21,000 and the technology-heavy NASDAQ index surpassed the psychologically important 6,000 threshold. In spite of the records, here’s a sampling of the steady stream of gloomy feature stories jamming the airwaves:

  • French Elections – Danger of European Union Breakup
  • Heightened Saber Rattling by U.S. Towards North Korea
  • Threat of U.S. Government Shutdown
  • First 100 Days – Obamacare repeal failure, tax reform delays, no significant legislation
  • NAFTA Trade Disputes
  • Russian Faceoff Over Syrian Civil War & Terrorism
  • Federal Reserve Interest Rate Hikes Could Derail Stock Market
  • Slowing GDP / Economic Data

Given all this doom, how is it then that stock markets continue to defy gravity and continually set new record highs? Followers of my writings understand the crucial, driving dynamics of financial markets are not newspaper, television, magazine, and internet headlines. The most important factors are corporate profits, interest rates, valuations, and investor sentiment. All four of these elements will bounce around, month-to-month, and quarter-to-quarter, but for the time being, these elements remain constructive on balance, despite the barrage of negative, gut-wrenching headlines.

Countering the perpetual flow of gloomy, cringe-worthy headlines, we have seen a number of positive developments:

  • Record Breaking Corporate Profits:  Profits are the chief propellant for higher stock prices, and so far, for the 1st quarter, S&P 500 company profits are estimated to have risen +12.4%  –  the highest rate since 2011, according to Thomson Reuters I/B/E/S. As I like to remind my readers, stock prices follow profits over the long-run, which is evidenced by the chart below.

Source: Trading Economics

  • Interest Rates Low: With interest rate levels still near generational lows (10-Year Treasury @ 2.28%), and inflation relatively stable around 2%, this augurs well for most asset prices. For U.S. consumers there are many stimulative effects to lower interest rates, whether you are buying a house, purchasing a car, paying off a school loan, and/or reducing credit card debt. Lower rates equal lower payments.
  • Potential Tax Reform: There are numerous stimulative components to the largest planned tax-cut in history. First of all, cutting the tax rate from 35% to 15% for corporations and small businesses (i.e. pass-through entities like LLCs and S-Corps) would place a lot of dollars back in the pockets of taxpayers and should stimulate economic growth. Other components of the White House proposal include the termination of the estate tax, the elimination of the AMT (Alternative Minimum Tax) targeted at wealthier households, and the doubling of the standard deduction to help middle-income families. All of this sounds great on paper, but not a lot of details have been provided yet on how these benefits will be paid for – removing state tax deductions alone is unlikely to fully offset revenue declines. The chart below highlights how high U.S. corporate income tax rates are relative to other foreign counterparts.

Source: The Wall Street Journal

  • Business Spending & Confidence on the Rise: Ever since the 2008-09 Great Recession, the U.S. has been a better house in a bad neighborhood relative to other global developed economies. However, the recovery has been gradual and muted due to tight-fisted companies being slow to hire and invest. Although recent Q1 GDP economic data came in at a sluggish +0.7% growth rate, the bright spot embedded in the data was a +12% annualized increase in private fixed investment. This is consistent with the spike we’ve seen in recent business and consumer confidence surveys (see chart below). Although this confidence has yet to translate into an acceleration in broader economic data, the ramp in capital spending and positive business sentiment could be a leading indicator for faster economic growth to come. Stimulative legislation enacted by Congress (i.e., tax reform, infrastructure spending, foreign repatriation, etc.) could add further fuel to the economic growth engine.

Source: Trading Economics

  • Economy Keeps Chugging Along: As the wealthiest country on the planet, we Americans can become a little spoiled with success, which helps explain the media’s insatiable appetite for growth. Nevertheless, the broader economic data show a continuing trend of improvement. Simply consider the trend occurring in these major areas of the economy:
    • Unemployment – The jobless rate has been chopped by more than half from a 10.0% cycle peak to 4.5% today.
    • Housing  –  The number of annual existing home sales has increased by more than +60% from the cycle low to 5.7 million units, which still leaves plenty of headroom for growth before 2006 peak sales levels are reached.
    • Consumer Spending – This segment accounts for roughly 70% of our country’s economic activity. Although we experienced a soft patch in Q1 of 2017, as you can see from the chart below, we Americans have had no problem spending more to keep our economy functioning.

Source: Trading Economics

While key economic statistics remain broadly constructive, there will come a time when prudence will dictate the pursuit of a more defensive investment strategy. When will that be? In short, the time to become more cautious will be when we see a combination of the following occur:

  • Sharp increase in interest rates
  • Signs of a significant decline in corporate profits
  • Indications of an economic recession (e.g., an inverted yield curve)
  • Spike in stock prices to a point where valuation (prices) are at extreme levels and skeptical investor sentiment becomes euphoric

To date, there is no objective evidence indicating these dynamics are in place, so until then, I will remain thirsty and grab my half glass full of water.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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.

May 1, 2017 at 2:37 pm Leave a comment

Managing the Chaos – Investing vs. Gambling

How does one invest amid the slew of palm sweating, teeth grinding headlines of Syria, North Korea, Brexit, expanding populism, Trumpcare, French candidate Marine Le Pen, and a potential government shutdown? Facing a persistent mountain of worries can seem daunting to many. With so many seemingly uncontrollable factors impacting short-term interest rates, foreign exchange rates, and equity markets, it begs the question of whether investing is a game of luck (gambling) or a game of skill?

The short answer is…it depends. Professional gambler Alvin “Titanic” Thompson captured the essence when someone asked him whether poker was a game of chance. Thompson responded by stating, “Not the way I play it.”

If you go to Las Vegas and gamble, most games are generally a zero sum-game, meaning there are an equal number of winners and losers with the house (casino) locking in a guaranteed spread (profit). For example, consider a game like roulette – there are 18 red slots, 18 black slots, and 2 green slots (0 & 00), so if you are betting on red vs. black, then the casino has a 5.26% advantage. If you bet long enough, the casino will get all your money – there’s a reason Lost Wages Las Vegas can build those extravagantly large casinos.

The same principles of money-losing bets apply to speculative short-term trading. Sure, there are examples of speculators hitting it big in the short-run, but most day traders lose money (see Day Trading Your House) because the odds are stacked against them. In order to make an accretive, profitable trade, not only does the trader have to be right on the security they’re selling (i.e. that security must underperform in the future), but they also have to be right on the security they are buying (i.e. that security must outperform in the future). But the odds for the speculator get worse once you also account for the trading fees, taxes, bid-ask spreads, impact costs (i.e., liquidity), and informational costs (i.e., front running, high frequency traders, algorithms, etc.).

The key to winning at investing is to have an edge, and the easiest way to have an investing edge is to invest for the long-run – renowned Professor Jeremy Siegel agrees (see Stocks for the Long Run). It’s common knowledge the stock market is up about two-thirds of the time, meaning the odds and wind are behind the backs of long-term investors. Short-term trading is the equivalent of going fishing, and then continually pulling your fishing line out of the water (you’re never going to catch anything). The fisherman is better off by researching a good location and then maintaining the lure in the water for a longer period until success is achieved.

Although most casino games are based on pure luck, there are some games of skill, like poker, that can produce consistent long-term positive results, if you are a patient professional with an advantage or edge (see Dan Harrington article ).  Having an edge in investing is crucial, but an edge is not the only aspect of successful investing. How you structure a portfolio to control risk (i.e., money management), and reducing your personal behavioral biases are additional components to a winning investment strategy. Professional poker player Walter Clyde “Puggy” Pearson summed it up best when he described the three critical components to winning:

“Knowing the 60-40 end of a proposition, money management, and knowing yourself.”

 

At Sidoxia Capital Management, we have also achieved long-term success by following a systematic, disciplined process. A large portion of our investment strategy is focused on identifying market leading franchises with a long runway of growth, and combining those dynamics with positions trading at attractive or fair values. As part of this process, we rank our stocks based on multiple factors, primarily using data from our proprietary SHGR ranking (see Investing Holy Grail) and free cash flow yield analysis, among other important considerations. Based on the risk-reward profiles of our existing holdings and the pool of targeted investments, we can appropriately size our positions accordingly (i.e., money management). As valuations rise, or risk profiles deteriorate, we can make the corresponding portfolio positions cuts, especially if we find more attractive alternative investments. Having a proven, systematic, unbiased process has helped us tremendously in minimizing behavioral pitfalls (i.e., knowing yourself) when we construct client portfolios.

The world is under assault…but that has always been the case. Throughout investment history, there have been wars, assassinations, unexpected election outcomes, banking crises, currency crises, natural disasters, health epidemics, and more. Unfortunately, millions have gambled and bet their money away based on these frivolous, ever-changing, short-term headlines. On the other hand, those investors who understand the 60-40 end of a proposition, coupled with the importance of money management and controlling personal biases, will be the skillful winners to prosper over the long-run.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

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.

April 23, 2017 at 10:53 am Leave a comment

Investing in a World of Black Swans

In the world of modern finance, there has always been the search for the Holy Grail. Ever since the advent of computers, practitioners have looked to harness the power of computing and direct it towards the goal of producing endless profits. Today the buzz words being used  across industries include, “AI – Artificial Intelligence,” “Machine Learning,” “Neural Networks,” and “Deep Learning.” Regrettably, nobody has found a silver bullet, but that hasn’t slowed down people from trying. Wall Street has an innate desire to try to turn the ultra-complex field of finance into a science, just as they do in the field of physics. Even banking stalwart JPMorgan Chase (JPM) and its renowned CEO/Chairman Jamie Dimon suffered billions in losses in the quest for infinite income, due in large part to their over-reliance on pseudo-science trading models.

Preceding JPM’s losses, James Montier of Grantham Mayo van Otterloo’s asset allocation team gave a keynote speech at a CFA Institute Annual Conference in Chicago, where he gave a prescient talk explaining why bad models were the root cause of the financial crisis. Montier noted these computer algorithms essentially underappreciate the number and severity of Black Swan events (low probability negative outcomes) and the models’ inability to accurately identify predictable surprises.

What are predictable surprises? Here’s what Montier had to say on the topic:

“Predictable surprises are really about situations where some people are aware of the problem. The problem gets worse over time and eventually explodes into crisis.”

 

When Dimon was made aware of the 2012 rogue trading activities, he strenuously denied the problem before reversing course and admitting to the dilemma. Unfortunately, many of these Wall Street firms and financial institutions use value-at-risk (VaR) models that are falsely based on the belief that past results will repeat themselves, and financial market returns are normally distributed. Those suppositions are not always true.

Another perfect example of a Black Swan created by a bad financial model is Long Term Capital Management (LTCM) – see also When Genius Failed. Robert Merton and Myron Scholes were world renowned Nobel Prize winners who single-handedly brought the global financial market to its knees in 1998 when LTCM lost $500 million in one day and required a $3.6 billion bailout from a consortium of banks. Their mathematical models worked for a while but did not fully account for trading environments with low liquidity (i.e., traders fleeing in panic) and outcomes that defied the historical correlations embedded in their computer algorithms. The “Flash Crash” of 2010, in which liquidity evaporated due to high-frequency traders temporarily jumping ship, is another illustration of computers wreaking havoc on the financial markets.

The problem with many of these models, even for the ones that work in the short-run, is that behavior and correlations are constantly changing. Therefore any strategy successfully reaping outsized profits in the near-term will eventually be discovered by other financial vultures and exploited away.

Another pundit with a firm hold on Wall Street financial models is David Leinweber, author of Nerds on Wall Street.  As Leinweber points out, financial models become meaningless if the data is sliced and diced to form manipulated and nonsensical relationships. The data coming out can only be as good as the data going in – “garbage in, garbage out.”

In searching for the most absurd data possible to explain the returns of the S&P 500 index, Leinweiber discovered that butter production in Bangladesh was an excellent predictor of stock market returns, explaining 75% of the variation of historical returns. By tossing in U.S. cheese production and the total population of sheep in Bangladesh, Leinweber was able to mathematically “predict” past U.S. stock returns with 99% accuracy. To read more about other financial modeling absurdities, check out a previous Investing Caffeine article, Butter in Bangladesh.

Generally, investors want precision through math, but as famed investor Benjamin Graham noted more than 50 years ago, “Mathematics is ordinarily considered as producing precise, dependable results. But in the stock market, the more elaborate and obtuse the mathematics, the more uncertain and speculative the conclusions we draw therefrom. Whenever calculus is brought in, or higher algebra, you can take it as a warning signal that the operator is trying to substitute theory for experience.”

If these models are so bad, then why do so many people use them? Montier points to “intentional blindness,” the tendency to see what one expects to see, and “distorted incentives” (i.e., compensation structures rewarding improper or risky behavior).

Montier’s solution to dealing with these models is not to completely eradicate them, but rather recognize the numerous shortcomings of them and instead focus on the robustness of these models. Or in other words, be skeptical, know the limits of the models, and build portfolios to survive multiple different environments.

Investors seem to be discovering more financial Black Swans over the last few years in the form of events like the Lehman Brothers bankruptcy, Flash Crash, and Greek sovereign debt default. Rather than putting too much faith or dependence on bad financial models to identify or exploit Black Swan events, the over-reliance on these models may turn this rare breed of swans into a large bevy.

See Full Article on Montier: Failures of Modern Finance

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own JPM and certain exchange traded funds, but at the time of publishing SCM had no direct position in Lehman Brothers, 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.

April 15, 2017 at 10:25 am Leave a comment

Double Dip Expansion?

Ever since the 2008-2009 financial crisis, every time the stock market has experienced a -5%, -10%, or -15% correction, industry pundits and media talking heads have repeatedly sounded the “Double Dip Recession” alarm bells. As you know, we have yet to experience a technical recession (two reported quarters of negative GDP growth), and stock prices have almost quadrupled from a 2009 low on the S&P 500 of 666 to 2,378 today (up approximately +257%).

Over the last nine years, so-called experts have been warning of an imminent stock market collapse from the likes of PIIGS (Portugal/Italy/Ireland/Greece/Spain), Cyprus, China, Fed interest rate hikes, Brexit, ISIS, U.S. elections, North Korea, French elections, and other fears. While there have been plenty of “Double Dip Recession” references, what you have not heard are calls for a “Double Dip Expansion.”

Is it possible that after the initial 2010-2014 economic expansionary rebound, and subsequent 2015-2016 earnings recession caused by sluggish global growth and a spike in the value of the U.S. dollar, we could possibly be in the midst of a “Double Dip Expansion?” (see earnings chart below)

Source: FactSet

Whether you agree or disagree with the new political administration’s politics, the economy was already on the comeback trail before the November 2016 elections, and the momentum appears to be continuing. Not only has the pace of job growth been fairly consistent (+235,000 new jobs in February, 4.7% unemployment rate), but industrial production has been picking up globally, along with a key global trade index that accelerated to 4-5% growth in the back half of 2016 (see chart below).

Source: Calafia Beach Pundit

This continued, or improved, economic growth has arisen despite the lack of legislation from the new U.S. administration. Optimists hope for an improved healthcare system, income tax reform, foreign profit repatriation, and infrastructure spending as some of the initiatives to drive financial markets higher.

Pessimists, on the other hand, believe all these proposed initiatives will fail, and cause financial markets to fall into a tailspin. Regardless, at least for the period following the elections, investors and companies have perceived the pro-business rhetoric, executive orders, and regulatory relief proposals as positive developments. It’s widely understood that small businesses supply the largest portion of our nation’s jobs, and the upward spike in Small Business Optimism early in 2017 is a welcome sign (see chart below).

Source: Calafia Beach Pundit

Yes, it is true our new president could send out a rogue tweet; start a trade war due to a tariff slapped on a critical trading partner; or make a hawkish military remark that isolates our country from an ally. These events, along with other potential failed campaign promises, are all possibilities that could pause the trajectory of the current bull market. However, more importantly, as long as corporate profits, the mother’s milk of stock price appreciation, continue to march higher, then the stock market fun can continue. If that’s the case, there will likely be less talk of “Double Dip Recessions,” and more discussions of a “Double Dip Expansion.”

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing 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.

March 19, 2017 at 12:34 pm Leave a comment

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