Ten Important, but not Urgent Articles to Ponder
I am an investor who does not consider background academic and semi-academic research to be worthless, even though I am skeptical of much of quantitative finance. Here are a few articles to consider that I think have some importance.
- Implied volatility is up. Credit spreads are up, and the equity market has not corrected. Time to worry, right? Wrong. When implied volatilities (and credit spreads) are higher, fear is a bigger factor; valuations have already been suppressed. Markets that rally against rising implied volatility typically have further rises in store.
- Many thanks to those that liked my piece on the adaptive markets hypothesis. Here is a piece about Andrew Lo, one of the biggest proponents of the AMH, which fleshes out the AMH more fully. I would only note that the concept of evolution is not necessary to the AMH, only the concepts inherent in ecological studies. Also, all of the fuss over neuropsychology is cute, but not necessary to the AMH. It is all a question of search costs versus rewards.
- John Henry alert! Will human equity analysts be replaced by quantitative models? Does their work have no value? My answer to both of those questions is a qualified “no.” Good quant models will eat into the turf of qualitative analysts, and kick out some of the marginal analysts. As pointed out by the second article analysts would do well to avoid focusing on earnings estimates, and look at other information that would provide greater value to investors from the balance sheet and cash flow statement. (I am looking at Piotroski’s paper, and I think it is promising. He has made explicit many things that I do intuitively.
- I work for a hedge fund, but I am dubious of the concept of double alpha. It sounds nice in theory: make money off of your shorts and longs without taking overall market risk. As I am fond of saying, shorting is not the opposite of being long, it is the opposite of being leveraged long, because in both cases, you no longer have discretionary control over your trade. Typically, hedge fund investors are only good at generating alpha on the long side. The short side, particularly with the crowding that is going on there is much tougher to make money at. If I had my own hedge fund, I would short baskets against my long position, and occasionally companies that I knew had accounting problems that weren’t crowded shorts already (increasingly rare).
- Maybe this one should have run in my Saturday piece, but some suggest that we are running out of certain rare metals. I remember similar worries in the early 70s, and we found a lot more of those metals than we thought possible then. There is probably a Hubbert’s peak for metals as well, but conservation will increase the supply, and prices will rise, quenching demand.
- For those that remember my piece, “Kiss the Equity Premium Goodbye,” you will be heartened to know that my intellectual companion in this argument, Morningstar, has not given up. Retail investors buy and sell at the wrong times because of fear an greed, so total returns are generally higher than the realized returns that the investors recieve.
- When there are too many choices, investors tend to get it wrong. When there is too much information, investors tend to get it wrong. Let’s face it, we can make choices between two items pretty well, but with many items we are sunk; same for choosing between two interpretations of a situation versus many interpretations. My own investing methods force me to follow rules, which limits my discretion. It also forces me to narrow the field rapidly to a smaller number of choices, and make decisions from that smaller pool. When I make decisions for the hedge funds that I work for, I might take the dozen names that I am long or short, and compare each pair of names to decide which I like most and least. Once I have done that, numeric rankings are easy; but this can only work with small numbers, because the number of comparisons goes up with the square of the number of names.
- Jeff Miller aptly reminds us to focus on marginal effects. When news hits, the simple linear response is usually wrong because economic actors adapt to minimize the troubles from bad news, and maximize the benefits from good news. People don’t act as if they are locked in, but adjust to changing conditions in an effort to better their positions. The same is true in investing. Good news is rarely as good as it seems, and bad news rarely as bad.
- This article describes sector rotation in an idealized way versus the business cycle, and finds that one can make money using it. Cramer calls methods like this “The Playbook.” (Haven’t heard that in a while from Cramer. I wonder why? Maybe because the cycle has been extended.) I tend not to use analyses like this for two reasons. First, I think it pays more to look at what sectors are in or out of favor at a given moment, and ask why, because no two cycles are truly alike. They are commonalities, but it pays to ask why a given sector is out of line with history. Second, most of these analyses were generated at a time when the US domestic demand was the almost total driver of economic activity. We are now in a global economic demand context today, and those that ignore that fact are underperforming at present.
- Finally, it is rare when The Economist gets one wrong. But their recent blurb on bond indexing misses a key truth. So bigger issuers get a greater weight in bond indexes. Index weightings are still proportional to the range of choices that a bond manager faces. Care to underweight a big issuer because they have too much debt outstanding? Go ahead; there are times when that trade is a winner, and times when it is a loser. Care to buy securities away from the index? Go ahead, but that also can win or lose. If bond indexes fairly represent the average dollar in the market, they have done a good job as a benchmark; that doesn’t mean they are the wisest investment, but indexes by their very nature are never the wisest investment, except for the uninformed.
Well, that’s it for this evening. Let’s see how the market continues to move against the shorts; there are way too many shorts, and too many people wondering why the market is so high. Modifying the concept of the pain trade, maybe the confusion trade is an analogue, the market moves in a way that will confuse the most people.
