The Dual Role of Price in Financial Markets

March 26, 2012

Price has a dual role in financial markets.

  • Price represents the intersection of supply and demand.  It is the point at which buyers and sellers can agree on a value at which to exchange.  Everyone in the financial markets knows this.  Even economists get it.
  • Price also stimulates demand.  This price function is largely overlooked in the financial markets, but is the very reason why investors pile into strong stocks or strong assets.  Relative strength can obviously be a great help in identifying what those strong assets are.  Economists don’t understand how higher prices can drive demand, and just think investors are irrational.

If you are not convinced, here’s an excerpt from a Bloomberg article today:

Hedge funds trailing the Standard & Poor’s 500 (SPX) Index for the last five months are giving up on bearish bets and buying stocks at the fastest rate in two years.

The reason is obvious, and also mentioned in the article:

The benchmark gauge for U.S. equities is on track for the best first-quarter gain since 1998, according to data compiled by Bloomberg.

Yep.  A strong market stimulates demand for equities.  This tends to be true of all financial markets.

This runs counter to the traditional economic theory of supply and demand, where lower prices are expected to stimulate demand.  Traditional economic theory is correct in a special case—only if there is a concrete end use for the product.  For example, if gasoline prices went to $1.25 per gallon, users might be tempted to put tanks in their driveway and fill them up to take advantage of the low price, knowing they will use the gasoline later.  The same thing will be true of canned goods, toothpaste, and toilet paper.  People will buy as much as they can use before it spoils to take advantage of low prices.

Stocks are different.  Financial assets are intangible.  You can’t eat stock certificates or fuel your car with them.  Their end use is performance.  Performance is intangible, but performance depends on rising prices (assuming you are long, anyway).  When prices are rising strongly, it is a market signal that this asset may be useful for performance—and that is what stimulates additional demand.  Relative strength is like a neon sign in this respect.

Hedge funds and institutional investors are particularly subject to performance pressures, so they are very sensitive to market signals.  When markets are trending, they tend to go after the strongest assets first.  This is entirely rational economic behavior when continued poor performance can put you out of business.  Money flows follow performance.

Source: GlassGiant.com

[Endnote:  It is entirely possible, of course, to buy stocks when they are out of favor and make money too.  This is exactly what contrarian, value investors do.  One of the appeals of value investing is that buyers have very little competition when buying out-of-favor assets.  Yet even a value investor needs demand fueled by rising prices to ultimately profit.  It may be true that for every asset there is some “fair” or “intrinsic” value, but it’s probably also true that the asset is correctly priced only twice each cycle—once on the way up, and once on the way down.]

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From the Archives: Ken French Should Check His Website

March 26, 2012

A new paper from Eugene Fama and Ken French is circulating, suggesting that active mutual fund managers don’t add value.  Articles, like the one here at MarketWatch, have been appearing and the typical editorial slant is that you should just buy an index fund.

I have a bone to pick with this article and its conclusions, but certain things are not in dispute.  Fama and French, in their article Luck versus Skill in the Cross Section of Mutual Fund Returns, look at the performance of domestic equity funds from 1984 to 2006.  (You can find a summary of the paper here.)  They discover that the funds, in aggregate, are worse than the market by 80 basis points per year–basically the amount of the fees and expenses.  (After backing out fees and expenses, the funds are 10 basis points per year above the market.)  After that, Fama and French run 10,000 simulations with alpha set to zero to see if the distribution of returns from actual fund managers is any different from the distribution of returns from the random simulations.  They conclude it is not very different and suggest that any fund manager that outperforms is simply lucky.

Let me start my critique by pointing out that, based on their sample and their goofy experimental design, their conclusions are probably correct.  Existing mutual funds in aggregate pretty much own the market portfolio and underperform by the amount of fees and expenses.  There clearly are some above-average mutual fund managers, but as Fama and French point out, it’s difficult to tell statistically from just performance data if they are good or simply lucky.  Within a big sample of funds like they had, after all, a few are bound to have good performance just because the sample is so large.

This is quite a quandary for the individual investor, so let’s think about the realistic scenarios and their outcomes–in other words, let’s take actual investor behavior into account.

Scenario 1.  Buy a mutual fund after its good performance is advertised somewhere and bail out when it has a bad year.  Continue this behavior throughout your investment lifetime.  According to Dalbar’s QAIB and other data, this is what actually happens most of the time.  Not a good outcome–underperformance by a large margin, often 500 basis points or more annually.

Scenario 2.  Buy a decent mutual fund and make the radical decision to leave it alone, come hell or high water.  Do not be tempted by the blandishments of currently hot funds or panicked by underperformance in your fund when it inevitably happens.  Close eyes and hold on for dear life.  Continue your ostrich-with-its-head-in-the-sand routine throughout your investment lifetime.  Your outcome, as Fama and French point out, will probably be market returns less the 80 basis point per year in fees.  Your returns will probably be 400 basis points annually or more better than Scenario 1.

Scenario 3. Throw active management overboard entirely.  Buy an S&P 500 index fund or a total market index fund and proceed as in Scenario 2.  Your outcome might be 60-70 basis points per year better from reduced costs than the investor in Scenario 2.  (Your cost is that you don’t get to brag at cocktail parties on the occasions when your actively managed fund has a good year.)  On the other hand, you are no less likely to succumb to Scenario 1 than an actively managed mutual fund investor.  Unfortunately, index mutual funds tend to show the same pattern of lagging returns due to investor behavior as actively managed funds.

Scenario 4. Visit Ken French’s own website.  Look for factors that are tested and that have outperformed consistently over time.  Hint: relative strength.  (Academics tend to call it ”momentum,” I suspect because it would be very deflating to have to admit that anything related to technical analysis actually works.)  Find a manager that exposes a portfolio to the relative strength factor in a disciplined fashion over time.  Buy it and pretend you are Rip Van Winkle.  Continue this dolt-like behavior for your entire investment lifetime.  Your outcome, according to Ken French’s own website, is likely to be market outperformance on the magnitude of 500 basis points per year or more.  (You can link to an article showing a performance chart back to 1927 here, and the article also includes the link to Ken French’s database at Dartmouth University.)

I prefer Scenario 4, but maybe that’s just me.  Since it is well-known even to Eugene Fama and Ken French that momentum has outperformed over time, what is their study really saying?  It’s saying that essentially no one in the mutual fund industry is employing this approach.  That’s more a problem with the mutual fund industry than it is with anything else.  (Mutual fund firms are businesses and they have their reasons for running the business the way they do.)  One option, I guess, is to throw up your hands and buy an index fund, but maybe it would make more sense to seek out the rare firms that are employing a disciplined relative strength approach and shoot for Scenario 4.

Their flawed experimental design makes no sense to me.  Although I am still 6’5″, I can no longer dunk a basketball like I could in college.  I imagine that if I ran a sample of 10,000 random Americans and measured how close they could get to the rim, very few of them could dunk a basketball either.  If I created a distribution of jumping ability, would I conclude that, because I had a large sample size, the 300 people would could dunk were just lucky?  Since I know that dunking a basketball consistently is possible–just as Fama and French know that consistent outperformance is possible–does that really make any sense?  If I want to increase my odds of finding a portfolio of people who could dunk, wouldn’t it make more sense to expose my portfolio to dunking-related factors–like, say, only recruiting people who were 18 to 25 years old and 6’8″ or taller?  In the same fashion, if I am looking for portfolio outperformance, doesn’t it make a lot more sense to expose my portfolio to factors related to outperformance, like relative strength or deep value, rather than to conclude that managers who add value are just lucky?  No investigation of possible sub-groups that were consistently following relative strength or deep value strategies was done, so it is impossible to tell.  Fama and French are right, I think, in their assertion that plenty of luck is involved in year-to-year performance, but their overall conclusion is questionable.

In short, I think a questionable experimental design and possible sub-groups buried in the aggregate data (see this post for more information on tricks with aggregate data) make their conclusions rather suspect.

—-this article originally appeared 12/3/2009.  It turned out to be one of the blog readers’ favorite rants, so I am reprising it here.  I still think active management can add value over time through disciplined exposure to a reliable return factor.

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Why You Are A Trend Follower, Part…

March 26, 2012

Morgan Housel sheds some light on valuations:

This all raises the question of where valuations are today. When looking at a broad index like the S&P 500, the unfortunate (but honest) answer is no one really knows. Using a straight P/E ratio, the market looks a little cheap historically. Using a metric like the cyclically adjusted P/E ratio that averages 10 years’ of earnings together, it looks a little pricey. Profit margins are near all-time highs and could contract. But interest rates are low, so stocks look attractive when compared with bonds. Equally smart people disagree on what these all actually mean.

Clear as mud?  This is just your daily reminder of why you are a trend follower!

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Weekly RS Recap

March 26, 2012

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return.  Those at the top of the ranks are those stocks which have the best intermediate-term relative strength.  Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (3/19/12 – 3/23/12) is as follows:

High RS stocks outperformed the universe last week.

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