Posts tagged ‘Benjamin Graham’

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

Time Arbitrage: Investing vs. Speculation

The clock is ticking, and for many investors that makes the allure of short-term speculation more appealing than long-term investing. Of course the definition of “long-term” is open for interpretation. For some traders, long-term can mean a week, a day, or an hour.  Fortunately, for those that understand the benefits of time arbitrage, the existence of short-term speculators creates volatility, and with volatility comes opportunity for long-term investors.

What is time arbitrage? The concept is not new and has been addressed by the likes of Louis Lowenstein, Ralph Wanger, Bill Miller, and Christopher Mayer. Essentially, time arbitrage is exploiting the benefits of moving against the herd and buying assets that are temporarily out of favor because of short-term fears, despite healthy long-term fundamentals. The reverse holds true as well. Short-term euphoria never lasts forever, and experienced investors understand that continually following the herd will eventually lead you to the slaughterhouse. Thinking independently, and going against the grain is ultimately what leads to long-term profits.

Successfully executing time arbitrage is easier said than done, but if you have a systematic, disciplined process in place that assists you in identifying panic and euphoria points, then you are well on your way to a lucrative investment career.

Winning via Long-Term Investing

Legg Mason has a relevant graphical representation of time arbitrage:

Source: Legg Mason Funds Management

The first key point to realize from the chart is that in the short-run, it is very difficult to distinguish between gambling/speculating and true investing. In the short-run (left side of graph), speculators can make nearly as much profits as long-term investors. As famed long-term investor Benjamin Graham astutely states:

“In the short-run, the market is a voting machine. In the long-run, it’s a weighing machine.”

 

Or in other words, speculative strategies can periodically outperform in the short run (above the horizontal mean return line), while thoughtful long-term investing can underperform. Like a gambler/speculator dumping money into a slot machine in Las Vegas, the gambler may win in the short-run, but over the long-run, the “house” always wins.

Financial Institutions are notorious for throwing up strategies on the wall like strands of spaghetti. If some short-term outperforming products randomly stick, then financial institutions often market the bejesus out of the funds to unsuspecting investors, until the strategies eventually fall off the wall.

Beware o’ Short-Termism

I believe Jack Gray of Grantham, Mayo, Van Otterloo got it right when he said, “Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” What’s led to the excessive short-termism in the financial markets (see Short-Termism article)? For starters, technology and information are spreading faster than ever with the proliferation of the internet, creating a sense of urgency (often a false sense) to react or trade on that information. With 3 billion people online and 5 billion people operating mobile phones globally, no wonder investors are getting overwhelmed with a massive amount of short-term data.

Next, trading costs have also declined dramatically in recent decades to the point where brokerage firms are offering free trades on various products. Lower trading costs mean less friction, which often leads to excessive and pointless, profit-reducing trading in reaction to meaningless news (i.e., “noise”).  Lastly, the genesis of ETFs (exchange traded funds) has induced a speculative fervor, among those investors dreaming to participate in the latest hot trend. Usually, by the time an ETF has been created, any exploitable trend has already been exploited. In other words, the low-hanging profit fruits have already been picked, making long-term excess returns tougher to achieve.

There is rarely a scarcity of short-term fears. Currently, concerns vary between Federal Reserve monetary policy, political legislation,  Middle East terrorism, foreign exchange rates, inflation, and other fear-induced issues du jour. Markets may be overbought in the short-run, and/or an unforeseen issue may derail the current bull market advance. However, for investors who can put on their long-term thinking caps and understand the concept of time arbitrage, opportunistically buying oversold ideas and selling over-hyped ones should lead to significant profits.

investment-questions-border

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.

December 17, 2016 at 10:14 am Leave a comment

Invest with a Telescope…Not a Microscope

Telescope-Microscope

It was another bloody week in the stock market (S&P 500 index dropped -3.1%), and any half-glass full data was interpreted as half-empty. The week was epitomized by a Citigroup report entitled “World Economy Trapped in a Death Spiral.” A sluggish monthly jobs report on Friday, which registered a less than anticipated addition of 151,000 jobs, painted a weakening employment picture. Professional social media site LinkedIn Corp. (LNKD) added fuel to the fire with a soft profit forecast, which resulted in the stock getting almost chopped in half (-44%)…in a single day (ouch).

It’s funny how quickly the headlines can change – just one week ago, the Dow Jones Industrial index catapulted higher by almost +400 points in a single day and we were reading about soaring stocks.

Coherently digesting the avalanche of diverging and schizophrenic headlines is like attempting to analyze a windstorm through a microscope. A microscope is perfect for looking at a single static item up close, but a telescope is much better suited for analyzing a broader set of data. With a telescope, you are better equipped to look farther out on the horizon, to anticipate what trends are coming next. The same principle applies to investing. Short-term traders and speculators are great at using a short-term microscope to evaluate one shiny, attention-grabbing sample every day. The investment conclusion, however, changes the following day, when a different attention-grabbing headline is analyzed to a different conclusion. As Mark Twain noted, “If you don’t read the newspaper, you are uninformed.  If you do read the newspaper, you are misinformed.”

Short-termism is an insidious disease that will slowly erode short-run performance and if not controlled will destroy long-run results as well. This is not a heretic concept. Some very successful investors have preached this idea in many ways. Here are a few of them:

‘‘We will continue to ignore political and economic forecasts which are an expensive distraction for many investors and businessmen.” –Warren Buffett (Annual Newsletter 1994)

‘‘If you spend more than 14 minutes a year worrying about the market, you’ve wasted 12 minutes’’ –Peter Lynch

Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth” -Jack Gray Grantham

 

On the flip side, those resilient investors who have succeeded through investment cycles understand the importance of taking a long-term view.

Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed.” –Peter Lynch

The farther you can lengthen your time horizon in the investment process, the better off you will be.” – David Nelson (Legg Mason)

Long term owners are more relaxed, more informed, more patient, less emotional.” –John Templeton

If you are really a long-term investor, you will view a bear market as an opportunity to make money.” –John Templeton

Long term is not a popular time-horizon for today’s hedge fund short-term mentality. Every wiggle is interpreted as a new secular trend.” –Don Hays

In the long run, one of the greatest risk to your net worth is not owning stocks. Bonds do not grow. They can only return their face value at maturity…Inflation is a silent, insidious tax that erodes your net worth…Fortunately, there is an easy way to keep pace with and even beat inflation, and this is stocks.” – John Spears

In the short-term, the stock market is a voting machine; in the long-term a weighing machine.” -Benjamin Graham

 

There has been a lot of pain experienced so far in 2016, and there may be more to come. However, trying to time the market and call a bottom is a fruitless effort. Great companies and investments do not disappear in a bear market. At times like these, it is important to stick to a systematic, disciplined approach that integrates valuation and risk controls based on where we are in an economic cycle. Despite all the recent volatility, as I’ve repeated many times, the key factors driving the direction of the stock market are the following: 1) Corporate profits; 2) Interest rates; 3) Valuations; and 4) Sentiment (see also Don’t Be a Fool, Follow the Stool). Doom and gloom “Death Spiral” headlines may currently rule the day, but the four key stock-driving factors on balance remain skewed towards the positive…if you have the ability to put away your microscope and take out your telescope.

investment-questions-border

www.Sidoxia.com

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 had no direct position in LNKD 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.

February 6, 2016 at 11:05 pm 1 comment

Investing with Crayons

Child's Drawing of Family

At one level, investing can be extremely challenging if you consider the plethora of diverse and unpredictable factors such as monetary policy, fiscal policy, wars, banking crises, natural disasters, currency crises, geopolitical turmoil, Ebola, Scottish referendums, etc. On the other hand, investing (not trading or speculating) should be quite simple…like drawing stick figures with a crayon. However, simplicity does not mean laziness. Successful stock research requires rigorous due diligence without cutting corners. Once the heavy research lifting is completed, concise communication is always preferred.

In order to be succinct, investors need to understand the key drivers of stock performance. In the short run, investors may not be able to draw the directional path of stock prices, but over the long run, Peter Lynch described stock predictions best (see Inside the Investing Genius) when he stated:

“People may bet on hourly wiggles of the market but it’s the earnings that waggle the wiggle long term.”

 

In other words, if revenues, earnings, and most importantly cash flows go up over the long-term, then it is highly likely that stock prices will follow. Besides profits, interest rates and sentiment are other key contributing factors affecting the trajectory of future stock prices.

In high school and college, students often cram as much information into a paper with the goal of layering pages as high as possible. Typically, the heaviest papers got A’s and the lightest papers got C’s or D’s. However, as it relates to stock analysis, the opposite holds true – brevity reigns supreme.

American psychologist and philosopher William James noted, “The art of being wise is the art of knowing what to overlook.”

In our digital world of informational overload, knowing what to overlook is quite a challenge. I experienced this dynamic firsthand early on in my professional career when I was an investment analyst. When asked to research a new stock by my portfolio manager, often my inclination was to throw in the data kitchen sink into my report. Rather than boil down the report to three or four critical stock-driving factors, I defaulted to a plan of including every possible risk factor, competitor, and valuation metric. This strategy was designed primarily as a defense mechanism to hedge against a wide range of possible outcomes, whether those outcomes were probable or very unlikely. Often, stuffing irrelevant information into reports resulted in ineffectual, non-committal opinions, which could provide cosmetic wiggle room for me to rationalize any future upward or downward movement in the stock price.

Lynch understood as well as anyone that stock investing does not have to be complex rocket science:

“Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it.”

 

In fact, when Lynch worked with investment analysts, he ran a three-minute timer and forced the analysts to pitch stock ideas in basic terms before the timer expired.

If you went back further in time, legendary Value guru Benjamin Graham also understood brain surgery is not required to conduct successful equity analysis:

“People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.”

 

Similarly, Warren Buffett hammers home the idea that a gargantuan report or extravagant explanation isn’t required in equity research:

“You should be able to explain why you bought a stock in a paragraph.”

 

Hedge fund veteran manager Michael Steinhardt held the belief that a stock recommendation should be elegant in its simplicity as well. In his book No Bull – My Life In and Out of Markets he states that an analyst “should be able to tell me in two minutes, four things: 1) the idea; 2) the consensus view; 3) his variant perception; and 4) a trigger event.

All these previously mentioned exceptional investors highlight the basic truth of equity investing. A long, type-written report inundated with confusing charts and irrelevant data is counterproductive to the investment and portfolio management process. Outlining a stock investment thesis is much more powerful when succinctly written with a crayon.

Investment Questions Border

 

www.Sidoxia.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions in certain exchange traded fund positions, 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.

September 20, 2014 at 3:15 pm 2 comments

Broken Record Repeats Itself

Article is an excerpt from previously released Sidoxia Capital Management’s complementary June 2012 newsletter. Subscribe on right side of page.

Traditional music records have been replaced with CDs (compact discs) and digital downloads. Although the problem of a broken record repeating itself is no longer an issue, our financial markets have not conquered the problem of repetition. More specifically, the timing of the -6.3% stock market decline during May (as measured by the S&P 500 index), coincides with the same broken sell-offs we have temporarily experienced over the last two summers. First, we had the “Flash Crash” in the summer of 2010, and then the debt ceiling debate and credit downgrade of 2011.

So far, the “Sell in May and go away” mantra has followed the textbook lessons over the last few years, but as you can see from the chart below, the short-lived seasonal sell-offs have been followed by significant advances (up +33% from 2010 lows and up +29% from the 2011 lows). Given the global challenges, a two-steps forward, one-step back pattern in equity markets should not be seen as overly surprising by investors.

Source: Yahoo Finance

Although the late-spring and summer doldrums have not been a joy-ride in recent years, these overly simplistic seasonal trading rules of thumb have not been exceedingly reliable either. For example, even though the months of May in 2010-2012 produced negative returns, the previous 25 Mays going back to 1985 produced positive returns more than 2/3 of the time. Rather than fiddle with these unreliable, unscientific trading rules, individuals would be better served by listening to famous Jedi Master Yoda from Star Wars, who so astutely noted, “Uncertain, the future is.”

Voting Machines and Scales

Given the spread of globalization and technology, the speed of news dissemination has never been faster. With the 2008-2009 financial crisis still burned into investors’ minds, the default response to any scary news item is to shoot first and ask questions later. Renowned long-term investing legend Ben Graham famously highlighted, “In the short run the market is a voting machine. In the long run it’s a weighing machine.”

As it relates to short-run current events, here are some of the items that investors were voting on (no pun intended) this month:

Europe, Europe, Europe: This problem has been with us for some time now, and there are no signs it will disappear anytime soon. In a game of chicken between the EU (European Union) and Greek legislators, fresh elections are taking place on June 17th, which will ultimately determine if Greece will exit the Euro monetary union or stick to the bitter medicine of austerity prescribed by the key European decision-makers in Germany. As Greece attempts to clean up its own mess, European politicians and G-20 leaders around the globe are scrambling to create plans that ring-fence countries like Spain and Italy from succumbing to a Greek-born contagion.

Presidential Politics: If you haven’t been living in a cave for the last six months, you probably know that 2012 is a presidential election year. Regardless of your politics, there are big questions surrounding the economy, jobs, deficits, debt, taxes, entitlements, defense, gay marriage, and other important issues. Answers to many of these questions will remain unclear until we get closer to the elections. The financial markets do not like uncertainty, so probabilities would indicate volatility will remain par for the course for the foreseeable future.

Facebook Folly: Despite my warnings, Facebook’s initial public offering (IPO) failed to live up to the social media giant’s hype – the share price has fallen -22% since the shares originally priced. Great companies do not always make great stocks, especially when a relatively new kid on the block has his company’s stock initially valued at a hefty price-tag of more than a $100 billion. Finger pointing is being spread liberally on the botched Facebook deal (e.g., Morgan Stanley, NASDAQ, Facebook), but no need to shed a tear for 28-year-old founder Mark Zuckerberg since his ownership stake in the company is still valued at around $15 billion – enough to cover a European trip to McDonald’s with his newlywed wife.

Dimon in a Rough Spot: Jamie Dimon, the poster child of the banking industry (and CEO of JP Morgan Chase – JPM), dropped a bomb on the investment community earlier in the month by explaining how a rogue “whale” trader racked up $2 billion in initial losses (and growing) by taking excessive risk and throwing controls into the wind.

Chinese Dragon Losing Steam: The #2 global economy has been losing some steam as witnessed by slowing industrial production and GDP growth (Gross Domestic Product). In turn, the self correcting economic forces of supply and demand have provided relief to consumers and corporations in the form of lower fuel, energy, and commodity prices. Chinese leaders are not sitting still – there are plans of accelerating infrastructure spending and assisting banks in the form of capital injections and lower reserve requirements.

As I discussed in a previous Investing Caffeine article (see The European Dog Ate My Homework), although the current headlines remain gloomy, that will always be the case. Just a few years ago, Bear Stearns, Lehman Brothers, AIG, CDS (credit default swaps), and subprime mortgages were the boogeymen. In the 1980s, we had the Savings & Loan financial crisis and the infamous 1987 Crash. During the 1970s, the Vietnam War, Nixon’s impeachment proceedings, and rising inflation were the dominating issues. Since then, the equity markets are up over 20x-fold – time will always reward those patient long-term investors. Despite all the doom and gloom, stock markets have roughly doubled over the last three years and all the major indexes remain solidly in the black for the year. Choppy waters are likely to remain as we approach this year’s elections, but for those who understand broken records often repeat themselves, there’s a good chance the music will eventually sound much better.

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 (including commodities, inflation protection, floating rate bonds, real estate, dividend, and alternative investment ETFs), but at the time of publishing SCM had no direct position in FB, MCD, JPM, MS, NDAQ, AIG, Lehman Brothers, Bear Stearns, 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.

June 2, 2012 at 6:51 pm 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. Regrettably, nobody has found the 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 JPMorgan Chase (JPM) and its CEO Jamie Dimon are already on their way to suffering more than $2 billion in losses in the quest for infinite income, due in large part to their over-reliance on pseudo-science trading models.

James Montier of Grantham Mayo van Otterloo’s asset allocation team was recently a keynote speaker at the CFA Institute Annual Conference in Chicago. His prescient talk, which preceded JP Morgan’s recent speculative trading loss announcement, explained why bad models were the root cause of the financial crisis. Essentially these computer algorithms under-appreciate the number and severity of Black Swans (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.”

 

Just a month ago, when Dimon was made aware of the rogue trading activities, the CEO strenuously denied the problem before reversing course and admitting the dilemma last week. 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). 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 certain exchange traded funds, but at the time of publishing SCM had no direct position in JPM, 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.

May 20, 2012 at 6:02 pm Leave a comment

Time Arbitrage: Investing vs. Speculation

The clock is ticking, and for many investors that makes the allure of short-term speculation more appealing than long-term investing. Of course the definition of “long-term” is open for interpretation. For some traders, long-term can mean a week, a day, or an hour.  Fortunately, for those that understand the benefits of time arbitrage, the existence of short-term speculators creates volatility, and with volatility comes opportunity for long-term investors.

What is time arbitrage? The concept is not new and has been addressed by the likes of Louis Lowenstein, Ralph Wanger, Bill Miller, and Christopher Mayer. Essentially, time arbitrage is exploiting the benefits of moving against the herd and buying assets that are temporarily out of favor because of short-term fears, despite healthy long-term fundamentals. The reverse holds true as well. Short-term euphoria never lasts forever, and experienced investors understand that continually following the herd will eventually lead you to the slaughterhouse. Thinking independently, and going against the grain is ultimately what leads to long-term profits.

Successfully executing time arbitrage is easier said than done, but if you have a systematic, disciplined process in place that assists you in identifying panic and euphoria points, then you are well on your way to a lucrative investment career.

Winning via Long-Term Investing

Legg Mason has a great graphical representation of time arbitrage:

Source: Legg Mason Funds Management

The first key point to realize from the chart is that in the short-run it is very difficult to distinguish between gambling/speculating and true investing. In the short-run, speculators can make money just as well as anybody, and in some cases, even make more profits than long-term investors. As famed long-term investor Benjamin Graham so astutely states, “In the short run the market is a voting machine. In the long run it’s a weighing machine.” Or in other words, speculative strategies can periodically outperform in the short run (above the horizontal mean return line), while thoughtful long-term investing can underperform. 

Financial Institutions are notorious for throwing up strategies on the wall like strands of spaghetti. If some short-term outperforming products spontaneously stick, then the financial institutions often market the bejesus out of them to unsuspecting investors, until the strategies eventually fall off the wall.

Beware o’ Short-Termism

I believe Jack Gray of Grantham, Mayo, Van Otterloo got it right when he said, “Excessive short-termism results in permanent destruction of wealth, or at least permanent transfer of wealth.” What’s led to the excessive short-termism in the financial markets (see Short-Termism article)? For starters, technology and information are spreading faster than ever with the proliferation of the internet, creating a sense of urgency (often a false sense) to react or trade on that information. With more than 2 billion people online and 5 billion people operating mobile phones, no wonder investors are getting overwhelmed with a massive amount of short-term data. Next, trading costs have declined dramatically in recent decades, to the point that brokerage firms are offering free trades on various products. Lower trading costs mean less friction, which often leads to excessive and pointless, profit-reducing trading in reaction to meaningless news (i.e., “noise”).  Lastly, the genesis of ETFs (exchange traded funds) has induced a speculative fervor, among those investors dreaming to participate in the latest hot trend. Usually, by the time an ETF has been created, the cat is already out of the bag, and the low hanging profit fruits have already been picked, making long-term excess returns tougher to achieve.

There is never a shortage of short-term fears, and today the 2008-09 financial crisis; “Flash Crash”; debt downgrade; European calamity; upcoming presidential elections; expiring tax cuts; and structural debts/deficits are but a few of the fear issues du jour in investors’ minds. Markets may be overbought in the short-run, and a current or unforeseen issue may derail the massive bounce from early 2009. For investors who can put on their long-term thinking caps and understand the concept of time arbitrage, buying oversold ideas and selling over-hyped ones will lead to profitable usage of investment time.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

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 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 25, 2012 at 6:09 pm Leave a comment

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