A Dash of Insight

The Academic Stereotype

The study of behavioral finance has exposed many of the heuristics and biases of investors.  While financial pundits are aware of this literature, they are just as susceptible as the average investor.

At "A Dash" we believe that opportunity knocks when too many rush to over-simplify.

Pundits and the  Academic Stereotype

Here is a test that readers can try at home.  When some financial writer or trader dismisses someone as an academic, take an extra look at the argument offered.  Our experience is that those using such stereotypes do so to mask hasty arguments.

These writers reveal their own naivete' , since any sophisticated person knows better than to reason from stereotypes.

Inhabitants of the Ivory Tower

Academics come in all shapes and sizes.  These include many who fit the stereotype of the ivory tower dreamer just perfectly.  Our colleagues have included one who could name the leader of virtually any foreign nation.  "Let's see," he said, presenting a little test for his colleagues at lunch one day in the 80's, "are we allies with the South Yemeni's or the North Yemeni's?"  He was great on facts, but not as good on political and economic processes.  Another was an expert in sociology and political theory, but he did not know what a linebacker was, and certainly could not name eone.  Another joined us for a Packer playoff game at Lambeau Field.  After the first score he  inquired how many points were awarded for the kick after a touchdown.  At least he knew when to cheer!

By contrast, there are professors who are quite interested in both theory and application.  In science and engineering, their work is the basis for much of our progress - things like new drug discoveries, new software, advances in computing, and better manufacturing processes.  In the humanities one would be surprised by the many practical questions from speech, language, and literature.  Any reader who does not understand this missed some great classes.

In public policy analysis there are academics whose work is directly relevant to the study of existing policies and possible improvements.

Dismissing someone as an "academic" is a disparaging stereotype that is no more accurate than any of other, including the insults rejected by any thinking observer -- those based upon race, ethnicity, or gender.

The Natural Human Tendency

We conducted many classes that had team teaching with professors from different fields.  The biggest single problem was to get each of these experts to appreciate the contributions of the others.  In a seminar on environmental policy, for example, the scientists had an attitude of "zero tolerance."  The economists favored incentives that encouraged pollution reduction.  Political scientists looked for solutions that could garner the coalition of political support necessary for adoption.

What traders and market pundits do is much the same thing.  They dismiss the relevance of knowledge they personally lack.

Why Should We Care?

In general, investors can profit from mistaken viewpoints that are widely shared in the financial community.  (Yes, we know.  It does not happen overnight.  This is a recurring theme at "A Dash.")

In this case we believe that the financial punditry has done a poor job of anticipating and explaining Fed actions.  This is partly because they dismiss the Fed members as "academics" while they are "realists."

Getting this right can be profitable.

Discovering Relevant Academics

Here is a simple lesson that any financial pundit should be able to grasp.  When looking for relevant academic expertise --

....let the market do it for you.

There is a very simple rule that we learned long ago in our own (extensive) consulting work.  Those who are doing something relevant are in demand -- working as consultants and sometimes moving into government.  Those whose work is strictly theoretical stay in the university.

Applying this Principle to the Fed

Last week we highlighted the excellent discussion of David Merkel, who described various attributes of Fed members.  He went so far as to highlight the relevance of academic research from some, getting most of the way to a conclusion.

We wrote as follows:

Some months ago when the FOMC membership was criticized as a bunch of academics we did our own check of the backgrounds.  We were looking for a very specific credential which gets no respect in the financial community.  Even in the astute Merkel analysis, this credential is not mentioned;  in fact, it is given short shrift.

Any guesses as to what this might be?

Let us turn to the Merkel summary and find a few highlights.  It is pretty easy because virtually every FOMC member has something relevant.

The key ideas are under "political" dealings.  (Kudos to reader Chris who spotted the point from our earlier article).   Public policy analysts distinguish between "political" and "policy formation."  David would not know this, but it is not nit-picking.  It is just as significant as any technical term from his own insurance experience.

The FOMC members have a range of relevant experience including the following:

• Membership and chairing the Council of Economic Advisors -- perhaps the most important role in economic policy formation;
• Under-Secretary positions at Treasury.  Once again, these are the positions sought by academics who seek to have some impact on the world;
• World Bank, IMF, and other consulting;
• Experience at money management firms including Morgan Stanley;
• Associations with an wide array of policy-oriented think-tanks.  These are places where research is expected to be policy-relevant.

Briefly put, nearly every member of the FOMC has extensive experience in policy formation and implementation, far from the theoretical world of the ivory tower.  This experience is much more relevant that that of someone who has worked on a trading desk or (for example) run a trucking company.  It is more relevant in breadth and in method.

Conclusion

Most Fed observers in the financial press have been slow to grasp and appreciate Fed policy.  As a result, their predictions and explanations have been poor.  They have been more interested in criticizing the Fed and offering their own opinions of what should be done, rather than helping investors understand what is actually happening.  They have looked only at the level of the Fed funds rate and the money supply.  Meanwhile, the Bernanke Fed has looked more carefully and deeply into the problem.  The result is a set of policies that has (at least partially) made up for the broken "mark-to-market" accounting methods by addressing the most acute liquidity needs.

ETF Trading is a Key to Sector Rotation

The rise of ETF's has caused a major change in trading, particularly in sector rotation strategies.  There are several good current articles on this subject.

The Float, which does a nice job of covering developments in ETF's, cites an article by Michael Sesit on how ETF's threaten actively managed funds.  This is a very significant development.  The regular mutual funds can outperform only by making big sector bets, but turning the positions is a slow process.  For the big funds, changing sector weightings is like turning an oil tanker.  ETF trading is much more subject to "hot money."  Market participants, including individual investors, financial consultants, and hedge fund managers, switch ETF's in a heartbeat.  Transaction costs are low.  There is often no detailed analysis of fundamentals.  If someone has the idea, for example, that energy is "toppy"', it is easy to sell anything related to energy.  Individual stocks, whatever the merits, go along for the ride.  Long-term investors must understand and ignore this, while traders need a faster trigger finger.

Abnormal Returns also frequently covers the ETF universe.  In an important article, the author provides a valuable insight on the birth and death of ETF's, and why investors should be paying attention to fund assets and potential liquidations.

Bill Luby at VIX and More shows what has been working, and what has not.  We always compare Bill's listings to our own model results, posted weekly with a one-day delay.

Conclusion

Investors trying to achieve superior performance through sector rotation must use the following criteria:

1. Does the ETF have real liquidity?
2. Does it overweight a few names, providing little overall exposure?
3. Does your strategy provide an element of anticipation?
4. Does your approach exit in a timely fashion?

Meeting all of these tests is essential for successful ETF trading and investing.

Interpreting Market Action

A principal mission at "A Dash" is developing a guide for the intelligent individual investor.  (We are eager for more comments and emails from any readers who qualify, since you are the target).  Sometimes our interest intersects with that of more active traders, and this may be one of those times.

Our Current Posture

As we have indicated, our investment posture varies with the time frame.  Since we have different products for different investors, our positions may seem to be at odds.  It is actually quite consistent for those with different time frames to have different perspectives.

The main point is that we have no market bias.  We have different methods for different investors, as we should.  We follow our methods with rigor, always watching changes in our indicators.  We are willing to vary our position according to circumstances,  just as we did in the 2000-01 era for long-term investors.

Drivers of Current Market Action

Looking at the behavior of stocks and sectors over the last two weeks shows a very unusual pattern.  There is certainly a problem, centered in securities related to subprime mortgages, and then  apparently spreading to other mortgage-backed assets.  Many observers (too numerous to cite, but all astute)  have pointed out that the problems are affecting stocks that have absolutely no relationship to the mortgage markets.  Ben Stein's article in today's New York Times points this out, and attempts to provide some overall quantification.

Investors should attempt to profit from deviations from the efficient market hypothesis.  If Ben Stein has an accurate read on the overall problem, why is the general market experiencing such selling?  There are two divergent theories:  Economic collapse and hedge fund activity.

Economic Collapse

Regular readers of "A Dash" know that we do not endorse the theory that this is the first of many dominoes leading to a recession.  There is plenty of economic data suggesting that this is not the case.  It is a subject to which we shall return -- but not today.

Hedge Fund Activity

There are many quantitative "black box" hedge funds, developed by people with PhD's, that seek to exploit small differences between two securities.  Some of these strategies involved monthly yields of 30 bps or so -- not enough to generate an attractive annual yield.  By convincing banks of the wisdom of these approaches, the funds applied leverage.  This turned the annual yield into rates of 15% to 30%.  For a time, these yields were uncorrelated with the overall equity market.  This was extremely attractive to  investors who bought into the backtesting methods, the debt ratings of mortgage securities from major firms, and the general concept that something with a yield was safe.  We cited James Altucher concerning some of these strategies, showing how the leverage proved fatal to the hedge funds involved.

Ripple Effects

Let us now turn to a different hedge fund strategy.  Suppose the fund buys senior debt and sells junior debt, a process nicely described by John Mauldlin.  (We recommend reading the entire article carefully -- twice if necessary.  While Mauldin has been incorrectly bearish for some time, he often shows a strong understanding of relationships in his comments.  We do not agree with his assessment of the time frame for sorting this out, but no one really knows).

Next suppose that the junior debt halts trading, so it cannot be evaluated.  Some hedge funds are selling senior debt, since they face redemptions and margin calls.  The result is that a fund with a sound strategy faces apparent losses based upon current marks.  This is caused not by the fundamental relationship between the securities, but by a loss of liquidity for one of them, a topic covered nicely by Bill Rempel.

Exacerbating the problem is that many funds have a combination of "sound" and unsound strategies.  Facing redemptions and margin calls, the funds are forced to sell what they can.  This includes unwinding many  theoretically good pair trades  of one  stock or sector versus another.

Our observation of stock and sector trading is that many attractive holdings have been caught in this process.  We advised our investors that this was an opportunity, with timing still a bit uncertain.

The End of Hedge Fund Forced Selling?

It may be difficult to spot the exact end of this process.  Goldman Sachs today held a conference call where they stated that the deleveraging was, in their opinion, more than 75% complete and perhaps approaching 100%.  They invested in one of their (losing) funds and brought in new investors to the tune of $3 Bilion.  This was a statement that they preferred to hold on to strong strategies until the relevant markets achieved normalcy.  The market was skeptical, so the end has not yet been reached.

David Merkel has a typically excellent article with many links discussing how far the process has gone, and what future prospects might be.  The conclusions vary, but provide plenty of food for thought.

It is not the end of model-based trading, and there is nothing wrong with having a PhD.  (Some of our best friends have the degree!)  It has more to do with balancing strict mathematics with sound research methods and simulation -- something that many of the big-money funds did not do.

Where to Learn?

There is so much conflicting interpretation and advice that it is confusing for the average investor, no matter how smart she is.  There is so much bombastic comment, loaded with symbolic language, that the average intelligent investor may not know where to turn.

The problem of finding good sources of information -- analysis as well as anecdotes -- is the major challenge for an investor making his own decisions.  An incorrect choice of sources means that a little knowledge can actually be dangerous.

One of our ongoing missions is how to find dependable sources, especially in a multi-year climate where perma-bear blogs regularly hit the top of the ratings charts, even when their forecasts have been quite wrong.

The Three Stooges and the Seven Dwarfs

A recent poll by Zogby International showed that 75% of the people can name the Three Stooges, but only 42% can name the three branches of government.  80% could accurately name two of the seven dwarfs but only 30% could name two Supreme Court justices -- and Clarence Thomas was the most frequently named.  There is more fun:  Harry Potter or Tony Blair, Krypton or Mercury.  The inescapable result is that the people polled lacked relevant knowledge of a pretty basic sort, while possessing knowledge from television and other entertainment.

This is nothing new, of course.  I used to give a basic knowledge quiz to Poli Sci 101 students.  About half of them (based upon a multiple choice question) thought that the Electoral College was "a small liberal arts school in Minnesota."  Many polls have shown that about half of U.S. citizens cannot name their own Congressperson.

The Zogby survey reflects all of U.S. society.  The people questioned are not stupid and many of them have college degrees.

In upcoming posts we will pursue this theme a bit, since it provides a tremendous opportunity for investors. It is one that has been explored at some length in non-economic social science studies and more recently in the study of behavioral finance.  Two major themes of our work here at "A Dash" are as follows:

1. Investors, like voters, are poorly informed and subject to various psychological influences.
2. Investment managers and pundits are subject to the same influences.  Reading a book about behavioral finance does not innoculate one from the effects.

In the political world, there are mechanisms that allow us to have a great democracy despite widespread voter ignorance and apathy.  In the investment world, the mechanisms that might accomplish this are seriously flawed.

In democracy, you and I cannot take advantage of a poorly informed electorate.  In a poker game, poorly informed opponents make it much more attractive to play.

Trading or investing provides a similar opportunity.  While investing is not gambling, the poker game is a good analogy when it comes to knowledge.  You cannot profit from people not knowing who is on the Supreme Court, but you can profit when the the market does not accurately reflect information about investments.

Hedge Funds and ETF Trading

Jeff Macke is a very intelligent man, a sharp trader, and someone with a lot of good ideas.  So is Doug Kass.  That makes them two excellent examples of a strange phenomenon in hedge fund management.  It has important implications for those trading the individual stocks within ETF's.

Macke was on CNBC tonight and described his trading in ETF's.  He said that he often had opinions about the price of oil or precious metals and did not want to deal with the eccentricities of individual stocks.  He just bought or sold the ETF based upon his opinion of oil futures or gold futures.  Doug Kass recently described a similar trade where he took a synthetic position in SPY with options.

This raises a question:  Why don't these big-time, highly visible traders have futures accounts?  The futures are deep and liquid markets with favorable margin treatment, low commissions, and little slippage.  For those steeped in the tradition of the Chicago options and futures markets, this is second nature.  When trying to implement it in my fund, I learned that prime brokers did not even have the accounting set up right.  It took a little work to get it going.

Why is this important?  Well suppose that you trade in the upstream end of the energy market.  Exploration and production stocks and oil services names should be mostly geared to expectations some years out.  The biggest factors are long-term energy demand, future bookings, and capex spending by the integrated oil firms.

But that is not how they trade.  If the big shots do not trade the futures, imagine what is happening with investment managers and individual investors.  The latest example is the TV commercial of the construction guy in the Jaguar who "has a feel" for sectors, trading them on a laptop from the job site, even though he does not follow individual stocks.  Sheesh!

For anyone who does want to do some homework on specific names, this ETF proxy trading generates opportunities for both buying and selling when the upstream stocks get out of line.

There are probably other similar chances, but energy seems to be the most obvious.

Steven Levitt and Two Poles of Research

Steven Levitt and his team of researchers made an appearance at the recent North American Bridge Championships in Chicago.  He was conducting research that was vaguely described to some of my participating friends as the transferrability of knowledge from one card game to another.  The experiment was quite interesting, and I look forward to his analysis.  His next stop was to test players at the World Series of Poker.

His appearance reminded me that while I have highlighted his excellent book, Freakonomics, I have yet to comment on it.  It is a very important work for those of my generation who learned and taught research methods.  My guess is that only one in four of those trained in public policy research stayed in the academic world.  Here is why.

The academic world prizes careful scholarship, building brick-by-brick on past work, extensive peer review, and use of the most sophisticated methods.  The result is that it was difficult for the Vietnam-era scholars to achieve their "change the world" goals.  Most policy makers did not share our interest in cost-benefit analysis and most academics did not prize practical policy work.

Wall Street research is a polar opposite.  Those with the most visible jobs crank out some sort of analysis almost weekly.  There is no peer review.  There is an unwritten code about criticizing anyone else's work and no time to get the opinion of peers before floating the latest research product.  (Readers of 'A Dash' know that we are free from this constraint.)

The result is that Street research is of comparatively poor quality.  Even the most expensive services make many mistakes.  Sometimes the researcher looks at a small number of cases without any historic context.  Other times the researcher uses the power of the modern computer and the presence of large databases to look at every case -- regardless of the relevance, the existence of any hypotheses, or a prior idea about a causal model.

Analysts on specific stocks have a different task.  They used to serve investment banking goals and hype the companies that did business with their firm.  Now they are required to find a balance of "sell" and "hold" recommendations, even while the number of firms covered has shrunk dramatically.  This is why we find analysts making macro calls and offering opinions on the economy instead of covering their stocks.

Steven Levitt's work strikes an inspiring balance between these poles.  Many of us are delighted in the academic and popular acclaim he has received.  In our own work we aspire to provide the same practical insights -- using the right data, in the right time periods, in the right way.  We want to be like Steve.  I suspect that many of us would have stayed in the academic world if we could have found both his approach and the acceptance twenty-five or thirty years ago.

While we were not all as good as Steve is, some were.  The world did not seem ready.  For now, my generation of researchers is still trying to improve the quality of understanding in many fields.  Many are working in health policy.

At "A Dash" this work means trying to point out who is doing good research.  Our mission is to spot the data miners, back-fitters,  and the anecdotal story-spinners.

It is difficult to do, since consumers of investment research do not know what to look for.  Most are narrowly focused on what worked in the last year or so.  I have watched those doing great work lose their jobs when their models "did not work" for a a year or two.  Many "global strategists" are constantly scrambling to do "walk-forward testing"  thinking that this will keep them current.  The time horizon is dictated by the individual investor and hot money funds, despite our knowledge that this is a losing method.

Think about it.  The period from late 1998 to early 2000 was an extremely strange time, influenced by Y2K fears and an unprecedented surge in employment and the economy, well documented by David Malpass.  From 2000 to 2002 there was an equally strange plunge from these conditions with a rather shallow recession.  In 2003 there was a delayed economic reaction by businesses (more on this in a future post) because of the expectation of war.

If you were building a model, would you use that time period for your data?  It makes no sense, but that is what most big firm strategists did.  Those who chose more wisely are now with different firms, often with their own name as the corporate identity.  The economics of the Street has  punished good research and elevated back-fitting.

That (and maybe some election-year spinning in 2004) has brought us to a 30-month period where we have had repeated calls for economic collapse in the face of unprecedented economic and corporate success.

Future posts will continue to catalog the many prevalent research techniques that lack predictive power.  Steve Levitt got a prize from statisticians for the correct use of data.  I wonder what they would make of the body of Wall Street research.

You, too, can be a Contrarian

How many strategists and managers can be contrarian?  Why does everyone want to be one?

As with many principles, the basic idea is easiest to understand by looking at extremes.  At market bottoms (or bottoms in specific stocks, commodities, etc.) no one wants to buy.  This is a terrific opportunity because the selling is over.  Ownership has moved into strong hands.  There is no one left to sell, so the stock is ready to rise.

At tops it is the opposite.  Think of the famous story about Joe Kennedy and the shoeshine boy who offered him some stock advice.  Kennedy famously sold his holdings, avoiding the '29 crash, since he realized that there was no one left to buy.  [I had a close eye on a hotel parking attendant in Denver a couple of weeks ago.  He headed for the business center, so I watched to see if he was planning a little online trading.  PHEW!  He was just checking his email.  Don't laugh.  In 1999 I saw CNBC on in parking garages and assorted retail establishments with everyone checking quotes.]

So every hedge fund manager or strategist wants to be a contrarian, since that shows there is a big opportunity.  You just have to find something where you can contend that everyone else is wrong and you have a lot of edge.

There is a lot of interest in this topic right now, so I plan a series of posts looking at a framework for analysis, some examples of those who are taking contrary positions, a look at some of the indicators and why they are broken right now, and finally, my suggestion for the best contrarian trade.

Hedge Fund Managers and Data

In market-based activities, the errors of others present opportunities.  It is profitable to look for any aspect of analysis where many are getting it wrong.  Since hedge funds are such an important part of the current market, understanding their managers is also essential.

Understanding and interpreting government data is fertile ground.  It is especially good for me, because of my background as a former poli sci prof, government consultant, specialist in research methods, and long-time consumer of government information.

Contrast this with the average hedge fund manager.  Now don't get me wrong.  These managers are among my best friends!  They are really smart and very talented, or they would never get a chance to run money.  Every last one of them talks a good game and has had meaningful success somewhere.

The problem is that it is a young man's game.  (I could try to be politically correct, but it is a world of mostly men, and that is part of the point).  There is rapid burnout.  From the perspective of regular business people, the managers are limited in experience.  There is a danger in knowledge that is a mile wide and an inch deep, where you must have an opinion on everything.

We know a lot about what hedge fund managers think because they network, some of them blog, and others write columns online.  They generally want to be contrarian, fast thinking and acting, and willing to make bold moves.  A lot of confidence and machismo is de rigeur.

The idea of being contrarian is quite sound.  It is at the heart of exploiting market inefficiencies.  The irony is how to be a contrarian when all of the other managers are doing the same thing.

Disparaging government data becomes a way of showing off.  Acting like there is a conspiracy to manipulate results may seem like sophistication.  It is usually easy to find some argument and take it to the lowest common denominator.  It is very convenient to dismiss data, since it then becomes possible to argue anecdotally.  If you do not understand something, just dismiss it as irrelevant!

A hedge fund manager who really wanted to be contrarian would want to learn more about government data releases and how to interpret them.  This is the place.

The CPI as a measurement of inflation is such an easy target for pundits.  Let's start there, but we'll eventually look at nearly all of the government releases.

No Inflation???

Pundits on TV and websites express amazement that today's CPI data show no change overall and only a .1% increase in the core rate.  Writers on Cramer's site, experts on CNBC, and even Bill Gross all claim that government measures of inflation are silly and inaccurate.  To them, it is obvious that prices are much higher than reported.  Just look at medical care, gas prices, hamburger, or home prices.

That argument sure sounds good.  It is easy to understand, and most people do not think it through any more.  That means that for those willing to get a deeper understanding, there is real opportunity.

Let's look at some evidence and then try to approach the problem with an open mind.

There are several government indicators of inflation, including the CPI, the PPI, the PCE (focused on wage related costs) and the GDP price deflator.  Greenspan favors the PCE, but the others all get some attention and each is a slightly different measure.  They all show inflation as running about 2 - 2.5%  This is not a bad reading.  It is consistent with a healthy economy.

Another way of looking at this is by turning to the market.  The Treasury now issues inflation-protected bonds.  You can look at the difference between the rate for TIPS and the rate for other government bonds and find the expected inflation.

The result is similar to the inflation readings for the next ten years.  This shows the verdict of one of the largest and most liquid markets -- hardly the picture of stagflation that some expect.

So what is wrong with the anecdotal story?  Part II of this series will be the explanation.