The Rules, Part XVIII

When rules become known and acted upon, the system changes to incorporate them, making them temporarily useless, until they are forgotten again.

When a single strategy becomes dominant, it can become temporarily self-reinforcing.  Eventually, it will become self-reinforcing on the negative side.

A healthy market ecology has multiple strategies that are working in separate areas at the same time.

I have been invited to speak twice in the next two months on the efficient markets hypothesis [EMH].  Once in Denver, once in NYC.  Fortunately for me, the folks in Denver are paying my way, and I will take a regional train to NYC and back.

I grew up on the idea that the EMH in its weak form was true, no doubt.  No one can make money looking at past price movements.  As for the semi-strong form of the EMH, which says that you can’t make money off of any past or present public data, I believed it with some reservations.  My mother was a self-taught investor who regularly beat the markets.  She used a discipline of half utilities (“they are my bonds”) and half “growth at a reasonable price” [GARP] stocks.  She is why I went to Johns Hopkins, rather than the University of Wisconsin.

The EMH in its strong form, that no one can make money off of insider information, was doubted by almost all.  Even today, we track insiders, and there is money to be made by following them.  Even following 13F filings of successful investors is profitable to many.

Yet, the EMH is compromised even in its weak form.  When one reads academic research on the markets, what is the most durable and powerful of all of the anomalies? Price momentum, which violates the weak EMH.  That said, a lot of economic actors know that price momentum works well, and so it gets used.  And overused.

Any strategy can be overused.  Before a strategy peaks, the overuse of a strategy makes the strategy work overly well, as prices for stocks are pushed above equilibrium levels through strategy momentum.

In the long run the stock market is a weighing machine, so the short-term overshoot will correct itself eventually.  But when too many follow momentum, the market goes wild.  Volatility rises; daily moves tend to be up or down a percent or more.  During such a period, price momentum stops working for a time, until enough abandon the strategy.

The same applies to longer term strategies, like value investing, or overweighting small companies, or overweighting companies with sound financials, or low price volatility, etc.  Any one of these can be pursued too much.  When any of them is pursued too much the stocks involved will overshoot and plunge.

There is no magic strategy that works all of the time.  Smart investors have to be aware of almost all of the strategies that exist in the market, and understand when they are underplayed (buy) and overplayed (sell).

Healthy markets have multiple strategies that work.  When the strategy becomes monoculture, e.g. tech stocks, then beware.  When there is only one road to wealth, the market is in a bad place, and smart investors will hold cash, or invest conservatively away from the one thing that is working now.  Broad leadership is needed in a true bull market.  When leadership thins to one idea, it is time to take profits.

Don’t confuse brilliance with a bull market.  Try to understand where you are in the cycle of your stock picking strategy.  It does not work all the time, so when things are at the best that you have seen, wait a bit, and then take two steps back.  When things are horrible, wait a while and redouble your efforts.

Factors in investment returns move in cycles. Be aware of where you are in the cycles, and maybe you can profit from them.