Monday, September 14, 2009

On Market Perceptions - Alpha

Vega brings up a good point to distinguish the momentum followers from the intelligent investors and sharp speculators.

Momentum followers look at a rising price trend and create a rationale for why it will continue. Much of the market consensus that Vega mention is simply this. Trend/momentum following, aka herding.

An intelligent investor looks at a stable cash flow series coming from an asset. She then tries to calculate conservatively how the cash flows will grow, and what the risks are that they diminish. An investor needs a fair amount of certainty, but can take risk in making a decision. That is, she needs probabilities and magnitudes of different states of the world that could produce different cash flow outcomes. But after everything is factored, she can build a spreadsheet to assess "intrinsic value" and make a rational decision. Negative price trends, that is, falling prices, are what interest investors, because at some point the price of an asset is so far below a conservative estimate of the asset's intrinsic value that an investor will want to buy it.

A sharp speculator is one who is willing to "bet" with less information than an investor, where the probability or magnitude of different states are unknown. The best speculators have a deep domain knowledge about one area (software stocks, orange juice futures, IG bonds, etc.) and stick to that area.

Yet the line between investing and speculation is a grey zone, since most people aren't omniscient and don't ever truly know whether they have all the information or if their subjective judgments on probability and magnitude are well-founded. Hence as an example, even as an outside observer it's tough to know what to call Buffett's different trades over the last decade - some were speculative like his silver position or his Dow Jones merger arb position or Goldman Sachs slug, whereas others were more like true investments such as his Iscar purchase.

The key to successful investment and speculation is to have a "variant perception." That is, know what the market consensus is and have a strong, well-backed view about why the facts on the ground are different, and how the difference can lead to a profitable trade. Profitable variant perceptions are uncommon.

Always Chasing the Market - Vega

At the end of 2008, the government of Mexico hedged its crude oil exports. They hedged not at the market top of $145 but well into the collapse at $70. They then hedged their 2010 exports at $55, near the bottom of the market.

In 2007, money managers were chasing higher returns with leverage and high beta stocks. Then after a 50% collapse in equity prices they reduced their equity exposure and bought puts to hedge.

Barrick Gold Corp recently announced that they would be issuing new equity to buy back their gold hedges because they believe gold prices will continue rising. This comes after one of the most bullish decades for gold in history (gold was $270 at the start of 2001).

What do these examples have in common? Money managers, corporate titans, and industry experts are always chasing the market. They become more bullish after long rallies and hedge after significant sell offs. This is a tautology if you appreciate that the cause of a long rally is a growing and gradual appreciation of bullish fundamentals. By the time the major players are all confident that prices will continue rising, everyone who can buy has already bought so there are no new buyers to send prices higher. The peak of a rally is then by definition a peak in the confidence that prices will go higher.

Unlike in any other field, a consensus of experts can therefore be an inherent contrarian indicator. In medicine, every additional doctor I find who agrees with the diagnosis lends me additional confidence. In investing, every new analyst who believes prices must go higher instead weakens the case, because that is one more person who is already long.

Is this true of all investment consensus? A consensus that prices will remain stable is itself stable. Such a belief requires no new converts to be proven true. But a consensus that prices will rise must eventually be disappointed because rising prices require new money for buying; eventually we run out of new buyers or new money for buying.

A potential exception is equities where a population may continously devote a portion of newly created wealth to purchases. For example, if we all take 10% of our paychecks to buy equities every month, there is a continual influx of new money. As long as the general wealth of the society is growing, new money will outpace the withdrawals of retirees. The problem we faced in 2007 is that the commitment to devote savings to equity purchases was based on the belief that equities would rise. As equities fell and wealth was destroyed, workers reduced their exposure. In commodities, the situation is even starker. A consensus that prices will rise increases production putting further pressure on prices. Then when the bubble bursts, not only is demand reduced, but production has been enlarged so prices fall below the initial equilibrium.

Monday, September 7, 2009

The Failure of Macroeconomics - Alpha

I've always said that macroeconomics was a voodoo discipline.

Now, one of the field's best admits it. Really, all the important macro research was done by Keynes, a handful of behavioral economists, and some academic interlopers who didn't drink the math-heavy kool-aid. Economics, to be a science and not voodoo, needs to return to empiricism - which means the bubble of 2008 and other real world phenomena need to be taken into account and not ignored as aberations.

A bracing read:

Here's another critique from one of the field's best: