March 15, 2011

March Madness starts today as the first of 68 teams begin play for the NCAA men’s basketball title. While most of us will not be able to watch all the games, we will follow the results closely because we have one or more brackets completed for tournament pools.

There are almost as many methods for selecting teams as there are for selecting stocks. All of the methods used to select either teams or stocks have one thing in common: they do not give the correct pick every time. No matter what you do, some of your picks will not pan out.

However, we do know that some methods are statistically more successful overall and that is the topic of a recent article by Matthew Huston in the Psychology Today blog.  The article recommends that players should not try to predict upsets in tournament pools.  While there will certainly be upsets, trying to pick them is very likely to reduce your overall win percentage. Mr. Huston discusses the statistical fallacy at work here:

…McCrea and Hirt found that people did not predict upsets as a result of thinking the worse-seeded team was actually the better team. So what’s going on? The researchers concluded that fans adhere to a strategy called probability matching.

Let’s say you’re drawing balls from a large box that contains 25 red balls and 75 blue balls. Many people tasked with predicting draws will predict red 25 percent of the time and blue 75 percent of the time. They match their guesses to the probabilities of the outcomes, in this case yielding a 62.5 percent success rate. But if they just guessed blue on each draw, they’d be right, on average, 75 percent of the time.

Similarly, people know there will be a certain number of upsets in each NCAA tournament, and therefore betting on a Cinderella-free tourney seems silly. The only logical thing to do, they conclude, is to figure out when those upsets will take place. The drawback, of course, is that by shooting for perfection, they end up handicapping themselves. In McCrea and Hirt’s research using real NCAA data, for example, people would have been much better off just sticking to the seedings.

This strategy of probability matching is similar to trying to bottom fish stocks.  It can be incredibly gratifying—not to mention ego-boosting—to correctly pick the Cinderella team or stock, but the probabilities are not in your favor.  Instead of picking weak teams or weak stocks to win, you would most likely do better by going with strength even though not all your picks will be correct.

Source: www.faqs.org

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## The Clown Says It’s Undervalued

March 26, 2010

The Economist has once again published its “Big Mac Index“.   As some long-time readers may recall, this index is based on the theory of purchasing-power parity, in which exchange rates should equalize the price of a basket of goods across countries.

The index shows that the Big Mac that costs \$3.58 in the U. S. would cost \$6.16 in Switzerland and \$6.87 in Norway.  This suggests that their currencies are overvalued relative to the U. S. dollar.  On the other end of the valuation spectrum, a Big Mac in China costs \$1.83, suggesting that the yuan is 49% below its fair-value benchmark with the dollar.

source: The Economist. Click to enlarge.

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## Are We There Yet?

March 22, 2010

No journey ever seems to get taken without that question getting asked.  Most parents have experienced it coming from the back seat of the family car.  Most investment advisers have heard it from clients wanting to know if the bull market has run its course.

The Chart of the Day offers some good historical perspective on how our current bull market journey compares to previous ones.  Are we there yet?

The Chart of the Day indicates our journey could last a while longer in both distance traveled and time.

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## Is the Rent Due?

March 18, 2010

A recent article in The Economist discusses the outlook for inflation and interest rates in the United States.  It points out that the core rate of inflation in February (1.3%) was at its lowest point in six years.  This has allowed the Fed to state in their March 16 meeting that they would probably keep rates low (0-0.25%) for an extended period of time.  Inflation and interest rates have a major influence on the capital markets and the U.S. dollar, so it behooves one to pay attention to their movements and what may cause them.

The single largest component of the core rate of inflation is housing costs.  This big boy weighs in at over 40% of the core CPI.  The proxy used for housing cost is the what someone would have to pay in order to rent the house he owns.  Rents have declined a great deal during the economic downturn; so much so, that if they were excluded, the core CPI would have gone up rather than down over the period.  Of course there are many other factors that influence core inflation, but the future of the dollar and the capital markets may well be largely in the hands of your landlord.

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## How To Cope With Inflation…Or Not

February 26, 2010

Many investors are worrying about inflation these days. There is certainly a good case that can be made for inflation as an eventual consequence to the vast amounts of debt being issued by many governments.   Matthew Bandyk, writing for U.S. News and World Report, looked at some investment possibilities for hedging against inflation.  His article points out that about half of the economists surveyed believe the Fed will keep inflation under control, while 41% believe that there will be significant inflation.  In other words, inflation does not seem to be a foregone conclusion.

Just in case, Mr. Bandyk looks at three major areas as possible inflation hedges.  These would be investments whose value can resist a weakening dollar or rising consumer-good prices.  He examines TIPS (Treasury inflation-protected securities), gold, and real estate and concludes that no single hedge works for all inflation situations.  We agree and further suggest that rather than focusing on forecasts for a single asset class, investors utilize a strategy that has the ability to shift among a variety of asset classes as dictated by which ones are actually working.

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## A not so Happy Valentine’s Day

February 17, 2010

What could be more appropriate on Valentine’s Day than an article about being in the red?  Tom Raum of Associated Press published an alarming article Sunday on why US debt will keep growing even with recovery.  It looks like there are some very difficult choices ahead for voters and their representatives.  Current projections have our national debt exceeding our GDP within the next few years.  In addition, the interest on that debt will be 80% of the federal budget within a decade.

Needless to say, if the government does not act on this problem, the financial markets certainly will at some point.  For example, Reuters recently reported that some of China’s generals have called for using our debt as a weapon against us by having their government sell off U.S. Treasury bonds if we sell arms to Taiwan.

We do not profess to know all that is needed to solve this problem, although obviously we need to throttle back the government gravy train.  As responsible voters, we need to contact our representatives to get them to take the budget problem seriously.  But as investors, we need to have enough flexiblity in our investment policy to position our assets to protect them if our representatives don’t act.

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## Markets Act Like Real People

January 5, 2010

Critics of the Efficient Market Hypothesis continue to get more press.  Newsweek’s Barrett Sheridan recently wrote an article that discusses the Efficient Market Hypothesis (EMH) versus the adaptive-markets hypothesis (AMH).  He mentions one of the key flaws in EMH: that market participants are rational.

He goes on to focus on MIT professor Andrew Lo and his AMH work.  Lo does not share the EMH tenet that the financial markets consist of cool, calm, and rational investors. He suggests that investors will behave differently depending on their psychology at any given moment.  (Some of the old brokers I knew called it the fear-greed pendulum.) It follows that any investment rule based on a fixed measurement of value for the market such as yield, P/E ratio, etc. will work only sporadically over time if the AMH is valid.  Nothing is set in stone because investors continually change and adapt to the market ecosystem.

Our Systematic RS portfolios use relative measurements.  We believe in an adaptive approach to investing that recognizes that since markets are controlled by real people, they act like real people.

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## Investors’ 2010 Forecast

December 10, 2009

CNN Money is currently running an informal poll on their website. They are asking investors “Which type of investments will you focus on in 2010?”

The results so far are:

U. S. Stocks 35%
Emerging Markets 15%
Bonds 10%
Commodities 6%
Bank accounts 33%

The portfolio, you may note, is cash-heavy and U.S.-centric.  Instead of getting bogged down in a possibly outmoded policy portfolio, why not select “all of the above?”  With the exception of bank accounts, all of these asset classes are also choices available in our Systematic Global Macro portfolio.  (The Global Macro strategy is available both as a separate accounts and a mutual fund.)  Instead of bank accounts, Global Macro substitutes short-term U.S. government bonds—but it also covers a much broader range of asset classes, including domestic and international equities, fixed income, inverse funds, commodities, currencies, and real estate.  Rather than guessing what may work in 2010, it might be more prudent to use a disciplined and rigorously tested method to select  investments.

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## The SRI Concern

October 22, 2009

There is an unspoken concern that many investors have about Socially Responsible Investing (SRI).  In short, the concern is that if you invest in socially responsible companies, your investments will not do very well, or at least not as well as they would have otherwise.  I was reminded of this recently while reading an article by Stephen Mauzy, CFA of The Motley Fool.  While I recognize that the article was meant to be humorous, (not that I find the idea of mixing firearms and alcohol to be funny) it still perpetuates the concern that there will be a performance penalty with SRI.

When we put together an SRI account, we took a different approach.  We knew that our core systematic relative strength strategy had historically outperformed.  The challege was to adapt that same process in an SRI account.

We engaged KLD Research & Analytics to screen our universe of domestic mid- and large-cap stocks for environmental, social, and corporate governance factors.  KLD goes about their screening in an interesting way.  Rather than taking the typical approach of throwing out certain companies on an absolute basis because of their involvement with some perceived negative, KLD groups companies by industry and then boots the companies that score the worst on their environmental, social, and corporate governance scales.  It allows the investment universe to have broad industry representation, which is not necessarily typical of other SRI screening processes.  The advantage for the manager is that we can get exposure to every industry, so that we can potentially benefit when that industry is in favor.

Our next step was to apply the exact same core systematic relative strength process to the screened SRI universe as we do to our standard mid- and large-cap universe.  Lo and behold, the long-term performance is virtually identical between the two universes!  Same process, same results, even though one universe has low-scoring SRI companies removed.  It turns out that there is no functional difference between our regular core account and our SRI core account.  As a result, clients need not have any trepidation about a performance penalty in SRI.  You can do well even when doing good.

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## Two Up = One Down

October 9, 2009

We have been noticing an interesting anomaly over the last couple of months.  Gold and U. S. bonds have both been rallying.  Mark Hulbert, founder of Hulbert Financial Digest has noticed it too.   He commented on this phenomenon in an article “Who Will Blink First?” on October 7.

In theory, this should not be happening, since what is good for gold (purportedly an inflation hedge) should be bad news for bonds.  If nothing else, this points out that trend following may be more useful than only following the fundamentals.  In the article, Mr. Hulbert suggests a couple of explanations for both markets being up at the same time.  In the long run, however, it seems likely that one of the markets will crumble.  Based on contrarian sentiment analysis, Mr. Hulbert favors gold to be the ultimate winner.  (We’ve also talked about the possible bubble in the bond market many times on this blog.)  This may well be correct, but I am just going to let relative strength sort it out for me.

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## Gopher Mounds

August 28, 2009

Technicians have known it forever.  Most investors have learned it the hard way.  The “Level Playing Field” is full of gopher mounds.  There is always someone who has an advantage in the market.  It might be that they have more knowledge of an industry or a particular company.  It might be that they are more disciplined.  Or, as this article and video point out, it might be that they are large clients of a large firm.   As Mr. Blodget points out, the playing field will never be level

Neither the market nor life is fair.  Once you accept that, you can focus on finding tools to overcome that problem.  Technicians use price as a tool because it reflects the constant battle between supply and demand, regardless of whether it is a result of “huddles” or published material.  We have chosen to use relative price (strength) because we have found it to be the best way for us to eavesdrop on the other teams’ huddles.

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## Oh, What an Untangled Web We Weave

July 29, 2009

My wife and I were enjoying an outdoor summer supper over the weekend when I noticed a spider weaving a web.   It was an orb spider and it was weaving a web similar to the one in this photo.

As I watched, it occurred to me that the spider was in fact an investor and the web was his investment.  His capital was the protein from his body that is used to make the web.  Another thing that I noted is that the spider is a systematic investor.  His web is always woven in the same pattern.  In this case, the web was constructed near a light which would attract insects.  There was no guarantee that this web would result in a return to the spider; however, his prospects of success seemed good.  Why?  Well, he was investing using a proven, systematic method that had stood the test of time and he would not abandon it if it did not produce immediate results.  Perhaps we can all learn something from the spider.

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## The Times They are A Changin’ (some more)

July 23, 2009

One of the few constants in my investment career has been that New York City was the hub of the financial world.  That may be in the process of changing.   Luigi Zingales, a professor at the University of Chicago’s Booth School of Business, recently wrote a commentary that suggests a major change is underway.  Like the Italian city-states, Amsterdam, or London of the past, New York may be in the process of forfeiting the world’s financial crown.  Dr. Zingales points out a wide variety of factors that may contribute to this change.  They include tax policy, brain drain, and poor regulation.

I have witnessed NYC being wheeled into the morgue in the past, but it has always managed to walk out.  Will it be different this time?  I don’t know, but I will be watching the relative strength of foreign markets for a clue.

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