January Effect?

Urban legends are rampant in the investing world, one of them is the January Effect.  The idea that stocks often rally in January following tax loss selling in December, as well as the idea that a good January will signal a good year.  There is little data to back these myths up but they persist – one of the tenants of behavioral investing is that people like to see patterns where none exist.

Looking at the markets today, there is little economic data to make one believe we should see a sustainable market rally.  As mentioned in a recent post, steel production could be used as a good barometer of economic activity right now and the news there is bleak.  The steel industry, like so many others, sees government stimulus as their only short-term hope.

Steel production is merely part of the larger story, as global manufacturing has now experienced is largest slowdown in decades, as covered in NYT, WSJ, and FT.  The story is much the same around the world.

Nevertheless, the markets could see a rally in the short term.  Institutional investors are hopeful that global governmental stimulus packages will have an impact and may attempt to time the bottom in anticipation of those packages being implemented.  These investors have a large amount of cash on hand from their massive selling in the second half of 2008 and may be tempted to put some of it to work in anticipation of a market rebound.

I believe, however, that any rally will be short-lived as the economic news remains discouraging and the huge amount of deleveraging that still needs to be done works its way through the system.  Many institutional investors will see any rally as an opportunity to sell as they continue to raise the cash they need to repair balance sheets and satisfy forced redemptions.

Further, there is a lot of jockeying remaining to be done on the stimulus package here in the US.  The news today is that the republicans are threatening to delay any package, and the democrats are hardly united in what they want.

Remember that only a few days ago the IMF called for global government stimulus or face the prospect of global depression.

Remember also that during the past 20 years Japan’s stock market has had rallies of 20% or more at some point nearly every year, only to subsequently fall to new lows.

The Doomsayers Who Got It Right

There’s an article today in the WSJ profiling three money managers who at least partially called the current bust correctly.  Jeremy Grantham has been on my radar for some time, the other two I had not heard of before.  They are not optimistic about prospects for 2009.

What is of note to me, however, is the behavioral aspect of the story.  The story discusses how these investors were largely “mocked for predictions that seemed outlandish at the time”.  Indeed, while I read Grantham, Schiller, Roubini, Krugman, Calculated Risk, etc., and believed that we were in for a difficult 2008, their predictions were so far outside the mainstream that it was difficult to communicate the risks with clients.

A very similar account is also in today’s WSJ Real Time Economics blog, “Ignoring the Oracles…“  This posts recounts a 2005 presentation by Raghuram Rajan to the Kansas City Fed’s Jackson Hole Symposium where he laid out many of the dangers that have come to pass and the way “he was attacked and then discounted”.

Economic forecasting and investing are all too frequently herd activities.

Consumer Confidence at Record Low

It was widely reported today that consumer confidence has fallen to an all-time low.  Here’s the story in the Washington Post. I’ve mentioned the Odd-Lot Theory in prior posts.  It and other contrarian theories of investing would take this as good news.  The general idea is that when things look worst they are about to turn around.  Warren Buffet has been widely quoted as saying, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

There is much merit to contrarian investing, but like all investing theories it has limitations and false signals.  A number of indicators have signaled multiple “bottoms” over the past year only to be followed by new lows.  Consumer confidence, for example, hit a previous new low in October.

It could be that consumer confidence is at a record low because the economy is truly in very bad shape and it may not be a contrarian indicator at all.  In fact, record low consumer confidence could reinforce a deteriorating economy as consumers pull back on purchases.

As stated by George Loewenstein, a professor of economics and psychology at Carnegie Mellon University,

Because I study the role of emotions in economics, a lot of people have been asking me questions about whether the current downturn is driven by irrational negative emotions, such as fear and anxiety, with the implicit assumption that if we could only calm these emotions, things might return to normal.

It’s possible that those emotions do play some role, especially in the collapse of credit markets, but it isn’t obvious to me that the anxiety and pessimism are unfounded. People have good reason to be fearful.

Every investor who doesn’t have his or her head in the sand is struggling with the question of whether the economy and stock markets have bottomed out or have a lot further to fall. Unfortunately, no one knows the answer, which creates a lot of uncertainty and a lot understandable misery as a result of not knowing how one should behave.

Messy World of Investing

The Israeli air strikes into Gaza should serve to remind us, once again, just how “messy” investing can be.  Fears of this latest armed conflict broadening and disrupting oil shipments have sent oil prices up and stock markets down.  Nothing unusual there.  Unforeseen and momentous events occur with surprising regularity, along with “Black Swan” events, that disrupt the best laid plans.

It does reinforce, in my mind at least, how much of an “art” investing is no matter how much people would like it to be a science.  If it were a science then it would not be nearly as messy and gut-wrenching.

Just last week I was on the phone with a colleague who was incredulous that I did not see the same value in his CIMA certification that he did (a financial management and accounting designation mostly designed for professionals working in large businesses).  He was angry that with my statement that good investment management and financial planning for individuals was not predicated on earning a professional designation.  In fact it could come from someone who had decades of business experience and an inquisitive mind.

As one with a master’s degree and a passion for constant learning, I think education is an essential process for learning how to learn.  But, the best investors in the world do not rely on simple financial and accounting formulas.

The world is much too messy a place to believe that a CIMA, CFA, CFP, or any other designation is a marker of good investment advice.  (I certainly did not see any professional society warning about the housing or credit crisis before they were obvious to all.) The best investors in the world have taken a different route: a synthesis of economics, investing principles, human psychology, and a passion for research and learning.  Combined these are an art form, not a science, which is why so few do it well.

Asset Bubbles are Forever

The holidays are giving me a chance to catch up on some reading, I’m making it through the December edition of The Atlantic, and they have a second article on investment bubbles worth noting.  I previously posted on the article describing academic research showing humans always create investment bubbles, even when it appears completely irrational to do so.  In “Why Wall Street Always Blows It” Henry Blodget provides a similar discussion but from a real-world observational perspective.

A quick sidebar: Blodget is one of the bad guys from the Tech Bubble.  He gives a superficial review of his roll as a star stock analyst who helped pump tech stocks of questionable value, but ultimately claims he was just a cog in a much larger wheel. As someone who was more than a casual observer of the workings of Wall Street during that time, I can say that Blodget was a very large cog, if not a wheel himself.  There is a reason he was subsequently barred from the securities industry.  That being said, he has reinvented himself as an insightful commentator on Wall Street and his article is a worthwhile read in its entirety.  Below are just a few snippets and comments.

I wholeheartedly agree with Blodget’s claim that our current economic crisis is much more than a housing bubble bursting.  As I have also been telling clients,

Boom-and-bust cycles like the one we just went through take a long time to complete. The really big busts, in fact, the ones that affect the whole market and economy, are usually separated by more than 30 years—think 1929, 1966, and 2000. (Why did the housing bubble follow the tech bubble so closely? Because both were really just parts of a larger credit bubble, which had been building since the late 1980s. That bubble didn’t deflate after the 2000 crash, in part thanks to Greenspan’s attempts to save the economy.)

Blodget spends a lot of time talking about the psychology of investors, investment professionals, and quotes one of the best commentators on the subject that I have read, Jeremy Grantham. (Grantham’s quarterly letters are not to be missed; they were the earliest words of caution that I read on the impending housing bubble and the massive havoc it would cause.)  As Blodget quotes from one of Grantham’s recent letters:

“We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term.”

Most interesting to me is the discussion of “this time it’s different”.  Often used as an excuse to invest into a obvious bubble, it is also used later to explain the foolishness of investing in that bubble (you didn’t actually believe that it would be different this time, did you?).  If, in fact, it is not different this time, then what should we expect going forward?  One answer is that we recover quickly, the ever-resilient economy gets back on its feet in a relatively short period of time, and the stock market resumes its inexorable march up and to the right.  Another answer is implied, although not explicitly stated, by Blodget.

If we are in the midst of one of the “really big busts” that have happened only a few times, “think 1929, 1966, and 2000″, what does that imply?  We know what happened in the Great Depression.  What about 1966?  In January 1966 the S&P 500 hit a high of 92.88. Over 12 years later, in March of 1978 the S&P 500 was trading lower, at 89.21.  In fact, if you invested in the S&P in January of 1966 and held on until July 1982 – that’s 16.5 years – you would have seen your investment rise from 92.88 to 107.09 a paltry 14.21 or 15.3%.  We’re more in the mindset of expecting 15.3% annual returns, not that much in 16.5 years!  A simple savings account would have done better.

If it is not different this time, then we will have a hang-over from this bubble bursting for a while longer than many hope.

Pop Psychology

“Pop” as in the popping of bubbles.  This month’s Atlantic claims that “asset bubbles are a part of the human condition that regulation can’t cure”.

This is a thought-provoking discussion of experiments run by economists to watch human trading behavior.  Even when the assets being traded had a known, set value that would not change, bubbles were formed as individuals attempted to out-smart and take advantage of each other.

Here, finally, is a security with security-no doubt about its true value, no hidden risks, no crazy ups and downs, no bubbles and panics. The trading price should stick close to the expected value.

At least that’s what economists would have thought before Vernon Smith, who won a 2002 Nobel Prize for developing experimental economics, first ran the test in the mid-1980s. But that’s not what happens. Again and again, in experiment after experiment, the trading price runs up way above fundamental value. Then, as the 15th round nears, it crashes…You get bubbles and crashes. Ninety percent of the time.

Why is it that in a controlled experiment where everyone knows the value of an asset do people trade these assets at elevated prices?

In an experimental market, where the value of the security is clearly specified, “worth” shouldn’t vary with taste, cash needs, or risk calculations. Based on future dividends, you know for sure that the security’s current value is, say, $3.12. But-here’s the wrinkle-you don’t know that I’m as savvy as you are. Maybe I’m confused. Even if I’m not, you don’t know whether I know that you know it’s worth $3.12. Besides, as long as a clueless greater fool who might pay $3.50 is out there, we smart people may decide to pay $3.25 in the hope of making a profit. It doesn’t matter that we know the security is worth $3.12. For the price to track the fundamental value, says Noussair, “everybody has to know that everybody knows that everybody is rational.” That’s rarely the case. Rather, “if you put people in asset markets, the first thing they do is not try to figure out the fundamental value. They try to buy low and sell high.” That speculation creates a bubble.

In other words, the belief in our own superiority over other investors (one of the tenants of behavioral investing) drives irrational outcomes. The article is short and worth the read, but if you just want to jump to the bottom line:

For those of us who invest our money outside the lab, this research carries two implications.

First, beware of markets with too much cash chasing too few good deals. When the Federal Reserve cuts interest rates, it effectively frees up more cash to buy financial instruments. When lenders lower down-payment requirements, they do the same for the housing market. All that cash encourages investment mistakes.

Second, big changes can turn even experienced traders into ignorant novices. Those changes could be the rise of new industries like the dot-coms of the 1990s or new derivative securities created by slicing up and repackaging mortgages. I asked the Caltech economist Charles Plott, one of the pioneers of experimental economics, whether the recent financial crisis might have come from this kind of inexperience. “I think that’s a good thesis,” he said. With so many new instruments, “it could be that the inexperienced heads are not people but the organizations themselves. The organizations haven’t learned how to deal with the risk or identify the risk or understand the risk.”

Behavioral Biases of Aggressive Investors

Morningstar, the mutual fund rating company, publishes MorningstarAdvisor, a magazine for financial advisors that covers a range of topics.  One topic is understanding the psychology of different investor types, how to recognize them, and how to work with those clients.  The current issue has an article on aggressive investors.  This one really struck a cord with me as I have clients that fit this model perfectly, to their detriment of late.

Aggressive investor biases are mainly emotional which is very important to recognize when working with these investor-types. In the current market environment, many aggressive investors, with equity allocations of up to 60% or even more, have suffered serious losses with equity markets down almost 40% year-to-date through mid-December 2008. The velocity with which these losses have occurred has shocked and dismayed aggressive investors. What many advisors are learning is that aggressive investors like to take risk when the markets rise, but clearly don’t like it when markets swoon.

I have this client.  They don’t remember the warnings I made and now feel I should have timed the market for them with precision.

As a reminder, aggressive clients are typically active investors, meaning that they have been actively involved in wealth creation, risking their own capital to achieve their wealth objectives. This makes them naturally prone to taking risk in their investment portfolios. Active investors have a higher tolerance for risk than they have need for security. As such, aggressive clients naturally fall in the high end of the risk tolerance scale and primarily have emotional biases driving their investing decisions. By way of review, emotions are physical expressions, often involuntary, related to feelings, perceptions or beliefs about elements, objects or relations between them, in reality or in the imagination. Often, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to correct. This is especially true with aggressive investors.

The issue I see most often with aggressive investors is too much self confidence.

Overconfidence is best described as unwarranted faith in one’s own thoughts and abilities – which contains both cognitive and emotional elements. Overconfidence manifests itself in investors’ overestimation of the quality of their judgment. Many aggressive investors claim an above-average aptitude for selecting stocks; however numerous studies have shown this to be a fallacy. For example, a study done by researchers Odean and Barber showed that after trading costs (but before taxes), the average investor underperformed the market by approximately 2% per year because of unwarranted belief in their ability to assess the correct value of investment securities.

Experts?

As posted today in Stumbling and Mumbling,

It’s a bad day for experts. The Times complains that economic forecasters are as blind as ancient soothsayers, whilst proof that Colin Stagg was innocent discredits Paul Britton’s expertise as a forensic pyschologist. To point out that experts are wrong, however, is to misunderstand the purpose of them. Their function is not to provide knowledge, and still less clear thinking. Instead, it is to provide certainty. People hate dissonance, doubt and uncertainty. Experts help dispel these. So, Paul Britton’s function was to tell the police that they had the right man, whilst economic forecasters’ job is to provide an impression that the future is knowable; no-one wants to hear about standard errors, parameter uncertainty or the Lucas critique.

Or to repeat the old joke, “God created weathermen to make economists look good.”

The truth is that the future is unknowable and that we must deal with the probabilities and the ranges of potential outcomes. I’ve had clients fire me because they wanted certainty, something they could find on CNBC but not in my office. These are educated people, who have run companies, who have studied economics. Another excellent example of behavioral investing.

Oxymoron: Sophisticated Investor

WSJ: How Bernie Madoff Made Smart Folks Look Dumb:

What do George Carlin and Bernard Madoff have in common?

The late comedian immortalized oxymorons, those absurd word pairs like “jumbo shrimp” and “military intelligence.” Mr. Madoff just put the silliest of all financial oxymorons into the spotlight: “sophisticated investor.”

Seriously, this is an excellent case study in Behavioral Investing, a topic I hope to spend much more time discussing here soon. The WSJ story is worth reading.

Mr. Madoff emphasized secrecy, lending his investment accounts a mysterious allure and sense of exclusivity. The initial marketing often was in the hands of what one source described as “a macher” (the Yiddish term for a big shot). At the country club or another exclusive rendezvous, the macher would brag, “I’ve got my money invested with Madoff and he’s doing really well.” When his listener expressed interest, the macher would reply, “You can’t get in unless you’re invited…but I can probably get you in.”

Robert Cialdini, a psychology professor at Arizona State University and author of “Influence: Science and Practice,” calls this strategy “a triple-threat combination.” The “murkiness” of a hedge fund, he says, makes investors feel that it is “the inherent domain of people who know more than we do.” This uncertainty leads us to look for social proof: evidence that other people we trust have already decided to invest. And by playing up how exclusive his funds were, Mr. Madoff shifted investors’ fears from the risk that they might lose money to the risk they might lose out on making money.

If you did get invited in, then you were anointed a member of this particular club of “sophisticated investors.” Once someone you respect went out of his way to grant you access, says Prof. Cialdini, it would seem almost an “insult” to do any further investigation. Mr. Madoff also was known to throw investors out of his funds for asking too many questions, so no one wanted to rock the boat.

Another perspective on how Madoff made-off with so much can be found in The Big Picture. Barry Ritholtz claims that part of the problem is that firms like mine simply don’t bother to do any due-diligence on hedge funds. He observes that there are now more hedge funds that there are stocks (!) and while we dedicate hundreds of analysts to covering stocks we assign only a small handful to covering hedge funds.