I’ve just updated Keeping Score. The market was deep in the plus column last month, with IT leading the way (for once). Will the market begin to discount 2015 earnings prospects over the summer?
Category Archives: Constructing a Portfolio
catching a falling knife
what they say
American stock market sayings tend to be earthy and fatalistic, like “what goes around…”, or to refer to ursine gustatory “sometimes you eat the bear…” or waste evacuation practices. Colorful, maybe, and consoling, but otherwise not very practical.
British financial clichès, on the other hand, are somewhat more high-tone but equally useless in practice–think: “jam tomorrow,” or “horses for courses.” One exception: trying to catch a falling knife. It’s a gruesome and appropriate image.
catching a falling knife
Catching a falling knife means buying a stock that’s going down in flames, while the downward spiral is still in progress. It’s never a good idea.
On the other hand, however, if the stock in question has any intrinsic merit, there must come a time when it’s right to buy it. And, in my view, that certainly shouldn’t be only after it has recovered, say, half of a 30% decline. So there should be–remember, I’m an aggressive investor–a time when it’s right to behave in a way that looks a lot like grabbing for a blade in freefall.
To my mind, there are two aspects to any substantial stock/sector/market decline. One is valuation, the other emotion.
valuation
This is the realm of fundamental analysis and is the more straightforward of the two. Many times, stock declines begin when valuation is stretched and end when valuations are more reasonable. This is what market corrections are all about–to provide some financial incentive–say, the possibility of a 10% gain over the coming year–for new buyers to act.
But valuation isn’t enough.
At the very beginning of my Wall Street career, I talked with everyone I could find who had experienced the market collapse of 1973-74 first-hand. One of the portfolio managers I worked for in the late 1970s told me of buying stocks in mid-1974 for less than the net cash on the balance sheet, only to see them continue to fall, by another 10%-20%, over the ensuing six months.
Look at price charts of just about any stock today to get a more current example. Look at their prices at the market low in March 2009. Many were changing hands then at under 10% of the current quote. How so? People were scared out of their wits–something that always happens at market lows–and unable to function objectively.
emotion
This is all about technical analysis, gauging the level of investor fear/greed.
For me personally, a stock has to be trading at an attractive price on fundamentals before I’m willing to start the very subjective, voodoo-ish process of trying to figure out whether negative emotion surrounding a stock/sector/the market is mostly exhausted.
I look at:
—time, since fear always takes longer to abate than I’d expect
—trading volume, since sometimes downdrafts end with a final high-volume rush to sell
–the extent of the decline
–hints that the stock is finding a level below which it doesn’t want to go (this is risky, since the stock may only be two or three steps down a flight of stairs).
why write about this now?
I think the selling of “concept” stocks that we’ve seen over the past couple of months is over, and it’s time to sift through these names carefully in a more than nibbling kind of way.
“smart beta” (ll): traditional active management in a “passive” package
how active manager operate
Active managers create portfolios that differ from a benchmark index, such as the S&P 500. The do so in an effort to achieve higher returns than the index. History shows that very few manages with public records succeed. They follow one or both fo two basic strategies:
–they hold stocks that are not in the index, as substitutes for index constituents, and/or
–they hold index constituents in different proportions than the index–having more or less depending on their assessment of valuation and future prospects, as well as the strength of their conviction.
Conceptually, it’s as simple as that.
smart beta
Purveyors of “smart beta” say they’re not active managers. What they do instead of seeking (dumb) alpha is to change the index being used by the client–not through subjective judgment but by using flat-out rules, enforced not by a fallible human but by a computer program!
The simplest smart beta “product” is to use an equal-weighted index rather than a capitalization-weighted index like the S&P 500. The difference? Let’s say we’re using the members of the S&P 500 as our universe of names. Capitalization weighting means percentage changes in the value of stocks with gigantic market values, like AAPL, XON or MSFT, count for more than tiny ones. Equal weighting means each stock counts the same–.2% of the index total.
The result is a substantial shift in emphasis away from large-cap stocks and toward small ones. The decision to do so is clearly a subjective judgment made by a human being. By calling it “beta,” however, it is being packaged as a passive/index judgment that supposedly doesn’t introduce more risk into the portfolio.
More ambitious smart beta products include collecting analyst earnings estimates, calculating forward PE ratios and creating a portfolio that’s tilted more or less strongly toward the lowest PE, highest earnings growth members of the investment universe. Subjective rules about what combination of factors should be favored/disfavored are crystallized into a computer program that performs the requisite rebalancing of the portfolio as new information emerges.
This is straight out of The Wizard of Oz. Don’t look behind the curtain!
There’s nothing passive about this approach except the name. Having worked at Value Line, which used a more sophisticated version of this approach fifty years ago, I recognize what’s going on very clearly. Only Value Line was more upfront about what it was doing.
Smart beta is almost exactly what many traditional active value managers do in practice. They’re extremely rules bound, although, unlike smart beta, they reserve the right to override the rules in unusual circumstances.
why is this approach appealing?
Several reasons:
–pension plan sponsors whose plans are seriously underfunded–and that’s those of most government bodies–are in a very difficult position. They need either to up the returns they are achieving on their assets, or ask their bosses to increase contributions to the plans. The latter is probably the first step on the (short) road to unemployment. So these sponsors are very open to any approach that promises high returns without extra risk. Look at the explosion of investment into hedge funds, despite these vehicles’ sub-par performance records.
–the idea that an “objective” computer is running the show rather than a fallible group of individuals has, for some reason, a lot of appeal
–smart beta products up the risk of an overall portfolio. But it’s not 100% obvious that they’re doing so. So there’s some chance of explaining away underperformance if it occurs
–in addition to being less obvious as active management, they may be cheaper than hiring a new active manager.
To my mind, this will all end in tears, both for the purveyors of these products and the buyers. The Value Line experience is a case in point.
when quantitative investment strategies “add up to fraud”
Yesterday’s online Financial Times contains an article titled “When use of pseudo-maths adds up to fraud.” It references an academic paper (which I haven’t read yet–and may never) which concludes that while quantitative management strategies may look impressive to neophytes, many are mathematically bogus. This could be why they often fail deliver the superior investment performance they appear to promise. Anyone with mathematical training needed to construct such a statistical stock-picking system should know this.
Quelle surprise!, as they say.
There’s a powerful cognitive urge to simplify and systematize data. But that’ not why investment management companies typically create the mathematical apparatus they tout to clients.
The reality is that investment management has a large right-brain component to it. It depends on individual judgment and intuition honed by experience. This fact makes clients uncomfortable.
Typically the company treasurer, or other person in the finance department who is in charge of supervising the company pension plan, has little or no investment training or experience. He may know corporate finance, but that’s a lot different from portfolio investing. Suppose the manager I just hired begins to lose something off his fastball, he thinks. He tells me he reads 10-Ks, but suppose he just goes into his office, takes an hallucinogen and picks stocks based on the visions he experiences. How can I explain this to my boss if the pension plan returns go south?
That’s why his first step is to hire a third-party pension consultant. It’s not necessarily that the consultant knows any more than the treasurer–in my experience, the consultant probably doesn’t. Hiring an “expert” is a form of insurance.
Selecting a manager with a quantitative stock-picking system is another. The supposed objectivity of the system itself–safe from emotions or other human foibles–is a second form of defense.
Up until now, the apparent safety net created by hiring the consultant and selecting a recommended manager who relies on “science” instead of intuition has been enough to clinch the deal for many quantitative managers. Of course, while this decision may make the treasurer feel better–and may be an effective defense as/when the quantitative system in question blows up–it doesn’t eliminate the risk in manager selection. It simply shifts the risk fulcrum away from the human portfolio manager to the statistician who has constructed the stock selection model. The paper the FT references, “Pseudo-Mathematics and Financial Charlatanism,” argues that, empirically, this is a terrible idea.
I wonder if anything will come of it.
Current Market Tactics, April 16, 2014
I’ve just updated Current Market Tactics. Time to nibble at former high-fliers? I think we’re getting cloae.