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When Growth Stalls

I am in no way a fundamental analyst – in fact as a skill set for investing I regard it as irrelevant and an example of being seduced by your own narrative fallacy.  However, I am in business and I am intrigued as to why some businesses stall, whither and die. I came across the graphic below from a Harvard Business Review article that looks at why businesses stall after periods of growth.

stall

The graphic shows that once growth stalls it is impossible to recover and this seems logical because from a physical standpoint  once the energy has gone out of a system the system collapses. So if your own business stalls and ceases to be vibrant then it seems to be part of a death spiral that is hard to escape. Think of this in terms of activities outside of business such as getting fit or losing weight. Everyone starts with a bang or period of growth and then progress slows or plateaus and moving away from this plateau is extremely hard and requires a redoubling of effort. It would seem from a business perspective that this redoubling of effort is extremely hard.

The article then goes on to try and identify causes for this loss of momentum. However, this proved to be more problematic as show by the graphic below.

cause

More here – Harvard Business Review.

Confusion

I grabbed the piece below from a social drivel site because it neatly explores something I spoke about in Sydney last week.

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This offers a paradox in that it attempts to explain something that needs no explanation and the explanation it offers is wrong. I say that the movement in the market requires no explanation because in reality successful trading does not depend upon generate what are effectively post hoc rationalisations for something that has happened. I am certain that the worlds best surfers could not explain wave action in terms of hydrodynamics – they dont have to they merely need to know how to surf .

When markets move no one truly knows the reason why unless it is a massive driver such as the recent move in the CHF. Any rationale is simply someones narrative it is there way of attempting to explain something they cannot understand. It is no different from our ancestors believing that night was merely a veil draped across the sky by one of their deities.  The reason the explanation is wrong is really quite simple and is to be found in the expected range that the market would move over a given time period.

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The chart above is of the Dow with ATR plotted along with a 250ma to give a a sense of what the long term trend in ATR is. ATR is a measure of volatility so it gives us a sense of what to expect in terms of movement. We can see that ATR over recent days has spiked with a peak of over 250 points and the long term and the long term ATR drifted up to 159 points. So if we assume a day on which no news hit the market we would expect it to move within these ranges because that is simply the nature of volatility. Markets are natural systems and as such they are subject to all the natural laws that are present in the rest of our world.

The desire to offer an explanation for everything that happens in markets is to me a slippery slope that leads to confusion, disappointment and inaction. The question that is always foremost in my mind when I hear explanations (and I consider things such as value investing an explanation) is how are you going to convince the market that your explanation is correct. What actions can you take to prove to the market that you are right? I would suggest that there are none. I would also suggest that because traders become emotionally invested in their narratives that they will act to protect their narrative and hence their ego once it goes wrong. The only way we can act to preserve our ego is to slightly alter the narrative and offer up statements such as the market is wrong. Markets can never be wrong – price at any given point in time is always correct. It is just that the market might have a completely different narrative to the one you are clinging to.

 

I Love (Insert Stock Name Here)

One of the things I find most intriguing about going to conferences is watching other speakers simply because their approach to the universe is so different to my own. Most go with the aim of confusing the attendees sufficiently that they believe the notion that said guru is indispensable and they must buy whatever they are offering them in order to navigate the investing world. Generally ( read almost always) there is no evidence to support any of the contentions that are being raised, just a load of homilies and half truths. The thing I found most interesting is the love affair that some presenters have with stocks. There is a staggering amount of anthropomorphising about stocks – such and such is a good stock because or I love this stock because. It reminds me of people who claim that their dog is a comedian because it rubs its arse on the carpet and then licks its balls in front of strangers. Your dog is just being a dog. The same is true of stocks and in fact I am surprised that some of the fundamentally oriented presenters didn’t start dry humping the lectern whenever they mentioned their favourite stock.

Part of the issue I have with this is the notion of the narrative fallacy – people are trapped by their own story.  In my mind this raises a  question I have never been able to get an answer to. How do you convince the market of your narrative? If we assume that the market is a voting machine what happens if the market does not agree with your belief structure about a given stock. Your affection for it will not in any way alter the trajectory of price. This in turn raises the awkward question of what is your plan B? As an example, consider this piece by Morningstar that dropped into my junk mail folder. It is a rather lengthy piece on ANZ’s  growth strategy – whatever that might mean. The piece itself is a carefully contracted narrative but it doesn’t tell me what to do and when to do it. It gives me a story that I can feel confident repeating to myself or to others as a justification for whatever price action follows my decision. This is the crux of this sort of piece – it is simply a justification mechanism that appeals to my emotions as opposed to making a mechanical case for trading. A compelling justification can insulate me from both the need to take action and the emotional consequences of my action. I can simply either cling to the story or blame the story. Either way responsibility for my actions is abrogated to the narrative.

After seeing this piece I decided to have a look at ANZ to see what if anything I could glean just by looking at the actual data of price – what was the market telling me about its perception of the company. The first thing to do was to look at it in light of the other four banks and as can be seen from the chart below ANZ has not really been the stand out performer over the past 90 months. That honour goes to CBA with NAB bringing up the rear.

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This tells me that the market doesn’t necessarily agree with the narrative being put forward by Morningstar. The interesting thing to note is that fundamental analysts all draw their information from the same sources,  either Thompson/Reuters or Bloomberg. Therefore they all know the same things and the market knows the things they know and then it decides on the veracity of their belief. Which again raises the uncomfortable question of how to you convince the market that your story is the right story. To adopt such a position is in some ways the height of arrogance since you believe that your view is the correct one in the face of what the market says. As an example at the 2012 version of the same conference someone asked one of the presenters what they thought of WES. He proudly stated that he wouldn’t buy the stock because his valuation method valued the stock at $4.00 – at the time it was trading at around $30. A year later it was $43. The narrative is a powerful and compelling piece of our psychology – it is also a completely useless piece of the trading puzzle.

The Story Telling Ape

Every so I often I get an email from someone asking whether they should buy or sell a given stock. My answer is always the same I cannot offer you advice and do your own thinking. However, recently I got such a request regarding Echo Entertainment that interested me.

As you can see from the chart below the performance of Echo(EGP) has not been stellar with the share value dropping from a high of $4.41 to the current price of $2.42

 

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The request was accompanied by a link to an article in the SMH, which proclaimed that EGP was the cheapest casino in the developed world according to a report generated by VGI Partners. VGI Partners coincidentally have just taken a 3% stake in EGP so it is hardly surprising that they would generate a report that was positive to their investment. It is unlikely that having taken a large stake in the company that they would come out and say that the company was worth about as much as the chip shop around the corner. So you can regard it as little more than a marketing statement. In the old days we used to call this talking your book. Brokers would take positions in companies and then proceed to trumpet to the world how marvellous the company was in an attempt to lift the share price.

The reason why I was interested in this email was that it and the accompanying news items are what I would call N=1 problems. That is they are anecdotes or opinions. In my opinion and in line with my background they fail the test of the law of large numbers. That is they are not representative of a consensus view or a view that is either easily testable or repeatable. And herein lies the crux of the problem with analysts work – they are anecdotes. They may have the appearance of carefully crafted research in fact investment houses call their storytellers analysts and refer to their departments as research departments when in fact they should be referred to as story telling departments. There is an old rule in actual research that if someone else cannot repeat your research then it is merely an opinion.

I have long been interested in the power of the narrative and the effect it has on individuals. We have a natural bias towards story telling and from an evolutionary standpoint this is understandable. Before the invention of writing information was passed on via stories. We learnt about what foods to eat, what foods to avoid and what might want us as food from stories. Within this context it is easy to understand the power of the narrative.

However, the power of the narrative makes us blind to data and is in part why I think magical thinking still exists today. Magical thinking aside from being a cognitive deficit is also closely linked to our desire for a narrative that excludes data or rational thinking. We are apes that tell stories.

If we return to the EGP story we can actually generate data that takes its cue from the collective so it conforms to the law of large numbers and is reproducible. From what I can tell part of the argument for EGP that VGI make is that based upon their models it is cheap, particularly when compared with Crown (CWN). A comparison with the performance of CWN is enlightening.

 

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The issue of comparing the performance of one entity with another with an idiosyncratic model generates a problem. Someone else may have a different model and this is the situation that has arisen with the marketing piece generated by VGI.

According to the source article –

The most expensive casino, according to the VGI presentation, is Wynn Macau, which is priced at 16.2-times.

But Goldman Sachs analyst Adam Alexander said Echo’s forward earnings multiple is a function of the unique way that it normalises its volatile VIP earnings. This, therefore, makes comparisons across the industry difficult, he said.

“If you valued Crown and Echo on equivalent win rates then Crown is cheaper than Echo,” Mr Alexander said.

So according to someone else and their narrative CWN is actually cheaper than EGP. This is the central problem with narratives; at their heart they reflect the collective biases of the individual generating them. Someone says EGP is cheap and someone else counters that it is actually expensive.

As the article in the SMH says it is confusing and at times I think it is designed to appear that way since if it is confusing then you couldn’t possibly be able to think for yourself. So in part we have a narrative designed to generate credibility but also to confuse which lands financial analysts squarely in the camp of weasel speak.

This raises the question of how do we make a decision regarding an entity such as EGP where there is argument about is valuation and by extension its suitability as an investment. I am unable to give you that advice but I can offer you some raw data. Below is the value of $1 invested in EGP over time and its drawdown curve.

 

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You can see that any investment in EGP has languished over the past two years. This naturally does not tell you what the future will be – it is little more than a crystal clear look at the past. But this introduces another philosophical divide that is similar to problems with the narrative fallacy. Any form of future prediction is merely a guess – so when an analyst tells you that a share will be worth X in the future they are merely voicing an opinion. But this is precisely why stories are so attractive; they attempt to give us a sense of the future when we have actually have no knowledge of the future at all.

In deciding whether to buy or sell any entity you have to form your own opinion and in part this opinion is a narrative but with a distinct difference from the narrative of someone like VGI. Think of it in scientific terms. Assume that you decide with EGP that you will buy if it makes a new 52 week high – this is your hypothesis and you are going to test this hypothesis by buying it is it does this. Note this is not in the strictest sense a narrative because if you are being vaguely professional you are not emotionally wedded to your story since you accept that your story is merely a hypothesis backed by the collective wisdom of price. If your hypothesis is incorrect you move on and generate a new one.

Is The Market Overvalued?

This is a question that tends to get posed at boardrooms and dinner parties any time the market has had an extended run. Whenever, someone poses this question to me, my immediate and somewhat flippant answer is don’t know and don’t care. My response is based upon the notion that I feel it is the wrong question because it is based upon the false assumption that markets can in some way be fairly valued. I feel a more telling and pertinent question to ask is the market exhibiting signs of mania?

By mania I mean is the world consumed by what is happening in the market? Does everyone you met from all walks of life talk incessantly about the market? If the market is a topic of conversation everywhere you go then it is a good bet that the market is in the grip of mania. The problem with this is that it is simply an anecdotal observation that may be skewed by any number of factors.

Defining mania in a quantitative sense is very hard since it is a sociological phenomenon and the social sciences are notoriously fuzzy. The notion of measuring mania is a problem I have returned to over and again. And as the years pass I don’t think I am actually any closer to answering my own question. Traditionally when looking at the notion of valuation and the broader market fundamentalists (as least those with a global view) have turned to looking at relative PE ratios. The thinking behind this as a measure is that as markets accelerate and valuations become more out of alignment with whatever the perceived reality is then this will show up in the markets overall PE ratio.

The chart below is of the Schiller PE ratio compared to the S&P500.

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The issue with the sort of data is that it is not a timing tool and therefore it is problematic for those of us who time the market. It also suffers from the problem that the GFC occurred at a time when valuations did not seem to be that divorced from reality. There is a problem for this mechanism and it highlights a problem in general with outlier moves. They may effectively blindside investors because there is no reasonable forewarning and this is one of the problems that seems to have bedeviled markets over the past few decades.

The other tool that I have investigated is margin debt on the NYSE since people when full of misguided conviction will ignore the risks of being over leveraged.

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The use of margin debt as a proxy for mania is an interesting concept and is one that I do think has some merit but only as a background measure. I say it is a tool of qualified use because over the years there has been a structural change in the market that I think skews the picture a little. The emergence of hedge funds that use massive amounts of leverage means that when looking at margin debt we are not actually looking solely at retail margin but also institutional margin. So in effect we are seeing institutional mania.

However, some would argue that we are actually seeing intuitional confidence and I would in part agree with these in the earlier stages of the take up of leverage. But, it assumes that hedge funds are smarter than the average punter and less prone to emotional swings. In my opinion this is not true. All investors are flawed emotionally and prone to the same reckless errors. It is just that hedge funds and the like make their mistakes on a massive scale, which is why they are so dangerous.

One of the errors that creeps into thinking about tools that could be used to identify mania is the belief that they are predictive when in fact they are post- dictive.  They tell us what the peak of mania might have been once we are past it. They are a good rear view mirror tool as are all technical tools. They have a slightly different orientation but they are neither better nor worse than any other tool.

I often state that the single most important rule for trading is knowing when to be in the market. Equally important is when to stay with the market and be a pig. These tools don’t actually do this because they act as in many ways as little more than confirmation bias. If you feel the market is overvalued or in the grip of mania you will look at one of these tools to confirm you view. If you think the market is undervalued you will do the same thing. Confirmation bias is the enemy of traders and sentiment or market valuation tools tend to have a stronger pull than strict trading tools. I have often wondered whether this is because they form part of narrative that traders construct and therefor they strongly support the underlying narrative.

This inevitably raises the question of what do I do. What I do is based upon a few ground rules.

  1. I have no idea where the market is going – never have had, never will have. I was obviously born without the special crystal rubbing, psychic, tarot reading, seeing dead people gene that so many peanuts on Facebook seem to have. Strange how they are all poor.
  2. I am not wedded to any particular mindset – the notion of bull or bear is largely irrelevant in a trading context. I might be a bull this week, a bear next and back to being a bull.
  3. Go as hard as you go for as a long as you can. When you cannot go any longer then the good times are probably over.
  4. Don’t trust yourself – each of us is fallible in ways we never imagine and never take into consideration.
  5. Don’t get killed.

In terms of how I take the temperature of the market I tend to be very simple and use the following two charts. When they are long I am long, when they are short I am out or short.

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The Death Of Value Investing

I got bounced this for comment and my immediate thought was why if value investing is doing so well why is one of the rotating images in the the page header what looks to be a shitty little Toyota 86. But that’s just me being bitchy… a more reasoned response follows.

Value investing will never die for a simple reason – monkeys love stories. Humans fall prey to what is know as the narrative fallacy, as such we value stories over data. This is perfectly understandable from an evolutionary perspective. Our ancestors were not capable of whipping up a neat little Powerpoint display with embedded excel charts to show that the big cat with the pointy teeth was bad, so they told stories about it. Those with both a capacity to tell stories and absorb the lessons from them were selected for.

Humans are particularly bad at absorbing data in its raw form – this data needs to be woven together into a narrative to make sense to us. Initially, this seems sensible since the narrative explains the data. All academic papers have a discussion section where the results are put into context and ideas and possible explanations are raised. However, most of the material we are presented in life is not subject to the rigor of an academic paper and this is especially true of the finance industry. In the finance industry the desire os not for truth but rather the selling of truth since a particularly appealing truth may come with a commission or it may be used to defend a particular cognitive bias.

The most compelling example of this is the notion of the Apple fanboy – the Apple cult extends well beyond their products into the investing arena. I have written about this before here and here . This is a perfect example of the narrative fallacy and by extension is an example of why value investing will never die. The majority of investors would prefer to hear a story regarding their stock than be shown a simple chart telling them it was stuffed.

Building A Beginner Portfolio

Neatly encapsulated in this video are all the things NOT to do. Top of the list should be DONT LISTEN TO ANYTHING YOU SEE ON TV

General Advice Warning

The Trading Game Pty Ltd (ACN: 099 576 253) is an AFSL holder (Licence no: 468163). This information is correct at the time of publishing and may not be reproduced without formal permission. It is of a general nature and does not take into account your objectives, financial situation or needs. Before acting on any of the information you should consider its appropriateness, having regard to your own objectives, financial situation and needs.