Category Archives: Investor Psychology

Multiple Delusions: Paper Wealth, A Booming Economy, and Bitcoin

Let us not, in the pride of our superior knowledge, turn with contempt from the follies of our predecessors. The study of the errors into which great minds have fallen in the pursuit of truth can never be uninstructive.”
– Charles Mackay

Extraordinary Popular Delusions and the Madness of Crowds

A good read on investor psychology by John Hussman: https://www.hussmanfunds.com/comment/mmc171218/

Be careful not to blindly label every steep chart a bubble; it leads to sloppy thinking.

Just remember what the current stock market feels like with its low volatility and steady rises because this is what a bear market FEELS like (Video link):

https://youtu.be/X-bogN0V8RM?t=1m56s

Why Ackman struggles:https://www.institutionalinvestor.com/article/b15ywsstynx8fm/whats-eating-bill-ackman     Hint: he overpays.

Intrinsic Value–Objective or Subjectively Determined? Bitcoin

A Discussion about Whether Austrian Economists and Value Investors Agree on How Intrinsic Value is Determined.

CSInvesting: Understand that Intrinsic Value is SUBJECTIVELY determined while prices are set by the marginal buyer and seller.  All an investor does is compare price to value.

Essentially, value investing focuses on the comparison of a good’s intrinsic value and its market price and recommends investing in it as long as the asset’s value exceeds its price given a margin of safety.

The first article says in summary: value investing and Austrian economics are nevertheless incompatible, particularly given that value investing’s definition of value contradicts the Austrian value concept.

End-the-Myth-On-Value-Investing’s-Incompatibility-with-Austrian-Economics-by-Olbrich-et-al   I would skim this article.

An Austrian economist who is also a value investor, Chris Leithner rebuts the above statement: “Value investors’ conception and assessment of value are congruent with the Austrian School’s.”

“A value investor” measures value by one of two methods:

  1. First, he/she values a company according to the external prices of its assets. He/she observes, for example, that X Ltd owns quantity Y of land, and that such land has a market price of $Z per hectacre.
  2. Second, the value investor makes plausible (based, perhaps, upon past experience and/or domain specific expertise) assumptions about a company’s future cash flows and, using some rate, discounts them to the present.  He might do these calculations in his head or on a spreadsheet.

The Hinge between the theory of Value and the Practice of Value Investing.

John Burr Williams in his The Theory of Investment Value, 1938 wrote, “With bonds, as with stocks, prices are determined by marginal opinion…..Concerning the right and proper interest rate (discount rate), however, opinions can easily differ, and differ widely….Hence those who believe in a low rate will consent to pay high prices for bonds…while those who believe in a high rate will insist on low prices…Thus investors will be bullish or bearish on bonds according to whether they believe low or high interest rates to be suitable under prevailing economic conditions.   As a result, the actual price of bonds….will thus be only an expression of opinion, not a statement of fact.  Today’s opinion will make today’s rate; tomorrow’ opinion, tomorrow’s rate; tomorrow’s opinion, tomorrow’s rate; and seldom if ever will any rate be exactly right as proved by the event.

How then does Warren Buffett define and measure value? In his 1994 Letter to Shareholders he writes:

We (Charlie Munger and I) define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life.  Anyone’s calculation intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move.  Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.

Graham, by the way, would agree with the definition of intrinsic value but he would doubt whether investors could usefully apply it. (Ben Graham, 1939)  “The rub,” writes James Grant in the 6th Edition of Security Analysis (2009), page 18, “was that, in order to apply Williams’s method, one needed to make some very large assumptions about the future course of interest rates, the growth of profit, and the terminal value of the shares when growth stops.”

The entire article by Chris Leithner is an important read: Value Investing and Austrian Economics Leithner

BITCOIN

Certainty is not certaintude–Oliver Wendell Holmes

  1. Bitcoin Certitude is not certainty
  2. Bitcoin Adoption and Usage
  3. The Promise and Peril of Bitcoin

The video below–though choppy in the first few minutes–is worth hearing about the psychology of market bubbles.   The interviewer of Bob Moriarty is ignorant of basic economics (Can prices EVER go below the cost pf producing a useful/needed product? Yes or No), but you can follow the discussion.  Note the pushback of the interviewer who is also an owner of bitcoins to Moriarty’s questions.  The psychology is fascinating–the will to believe and suspend judgment.

Other Comments

Bitcoin is up more than 2,000 percent in the last year and now trades above $17,000. Bitcoin futures trading launched this week on the Cboe exchange, gaining more than 19 percent Monday in the first full day of trading.
There are now 1,358 cryptocurrencies in existence, according to CoinMarketCap. Other digital currencies such as ethereum are better designed for programmable “smart contracts” and have quicker transaction times versus bitcoin.

Bitcoin’s scalability is another issue. There is technical limitation on how many transactions that can be processed at the same time. Partly as a result, widespread use of the cryptotcurrency for payments has not occurred yet.
So cryptocurrency investors must honestly ask themselves, is bitcoin really changing the word through blockchain technology innovation or is it mainly speculative asset? It’s the latter.

Kynikos Associates short-seller Jim Chanos, lauded for his prescient negative calls on Enron and Tyco, compared bitcoin to previous fads.

Bitcoin “is a speculative mania. It’s Beanie Babies,” he said at a Schechter event in Detroit, Michigan Wednesday, referring to the toy fad craze during the 1990s.
DoubleLine Capital CEO Jeffrey Gundlach criticized the lack of analytical rigor in the recent “nice round number” $1,000,000 price targets for the bitcoin, which is reminiscent of previous speculative blow-offs.

“I have no interest in this type of maniacal type of trading market,” he said on CNBC Wednesday.

Hedge fund manager Seth Klarman, the value investing giant who often draws comparisons to Warren Buffett, wrote in his classic “Margin of Safety” book an illuminating parable warning against speculation:

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, ‘You don’t understand. These are not eating sardines, they are trading sardines.’

Like sardine traders, many financial-market participants are attracted to speculation, never bothering to taste the sardines they are trading. … trading in and of itself can be exciting and, as long as the market is rising, lucrative. But essentially it is speculating, not investing. You may find a buyer at a higher price—a greater fool—or you may not, in which case you yourself are the greater fool.”

 

The ART of Contrary Thinking

When everyone thinks alike, everyone is likely to be wrong.

If you wish to keep from guessing wrong, learn to think contrarily.  –Humphrey Neill

CSInvesting: Humphrey Neill wasn’t advising to blindly go against the “crowd” but to think things through rationally.   For example, investors might be excited by the new invention of the air conditioner, but the second-order effects were more powerful like increase in demand for real estate in Southern cities in the USA.

The BOOK: NEILL(H_B_)-The_Art_of_Contrary_Thinking_(1985)

Critique of the book 2016-07-29_BR_ML

Contrary thinking in action….

Has Apple Stock Peaked?
December 3, 2012|by Timothy Lutts

Has Apple (AAPL) Stock Peaked?
In the Footsteps of Coca-Cola
The Next Apple?

Everybody knows Apple.
With more than 85 million iPhones sold, $156 billion in annual revenues and a market capitalization that recently hit $660 billion, Apple is the second most respected brand on the planet. Number one is Coca-Cola.

But what does that mean for investors?

It means there’s a chance that investor perception of the company is so high that all the big investors already own as much Apple as they can carry. It means there’s more potential selling pressure on Apple’s stock than buying pressure. And that means there’s a good chance the stock has topped!

Now, some investors, looking at numbers alone, will disagree.

They’ll point out that the company is still growing fast, that the third quarter saw revenues grow 27%, and earnings grow 23%, and that analysts are expecting 12% growth in 2013 and 18% in 2014. Then they’ll point to the stock’s forward PE ratio of 12 and say, “Apple is cheap!”

But using numbers alone is a mistake in evaluating growth stocks, particularly exceptional growth stocks like Apple.

For example, we at Cabot did very well recommending Amazon.com way back when the company (selling only books) was still unprofitable, and most bean-counters wouldn’t touch it with a 10-foot pole. We jumped on little Crocs (plastic shoes!) and rode it to the moon. And we did very well with ridiculously “expensive” First Solar, in part because we sold early, while its business was still booming, but its stock was on the skids. We could have justified owning none of those stocks if all we looked at were numbers.

Bottom line: to make money in exceptional growth stocks, you can’t just look at numbers; you’ve also got to look at momentum and sentiment.

But before I get deeper into Apple’s case, I want you to study this long-term chart of Coca-Cola (KO–see above) (the number one brand in the world today), spanning the years from 1965 to the end of 1985.  See at the top of this article.Note the earnings line, with each dot marking a quarterly earnings figure. It’s a steady uptrend, with the exception of a sharp dip in late 1974 and a stumble in 1981-1982. Then look at the dividend line; Coke’s dividends were increased every year, like clockwork. Finally, observe the price line, noting that Coke’s price peaked in late 1972 and didn’t exceed that level until late 1985, 13 years later.

The explanation for those “lost 13 years” lies not in the numbers; it lies in crowd psychology, and specifically, in the investing environment of the times. Coca-Cola was one of the Nifty Fifty, popularly regarded as one-decision stocks that you would simply buy and hold forever. (Others in this august group included Digital Equipment, Eastman Kodak, J.C. Penney and Simplicity Pattern).
Well, for investors who truly had the patience and guts to hold Coke through those lost 13 years, it worked out okay. But most investors don’t work with that kind of time horizon. Most investors can’t hold five years without seeing a profit—and they shouldn’t have to!

The truth is, the extreme popularity of those stocks (call it reverence, even), was a sign of their potential to top. But it was very hard for investors to see it then!
So, getting back to Apple, I’ve already mentioned the stock’s high regard among the general public; it’s the number two brand in the world. Among institutional investors, it’s regarded as royalty, providing both a dividend and spectacular growth. In fact, if you manage institutional money, owning AAPL has become almost a requirement in recent years, and the result of all that buying power is that even after the recent correction, AAPL is still up 45% for the year!
But when everyone who might buy a stock has bought it, what happens?
The same thing that happened to Coca-Cola in 1972.

It stops going up, and to some extent—every stock is different—it goes down.
Now, I have no doubt that Apple (the company) will continue to grow revenues and earnings for years to come. I’ve been an Apple user since 1987, when I bought a Macintosh SE for Cabot (to join our IBM Displaywriter—Google that!). Today I use a MacBook Pro, an iPad and an iPhone on a daily basis, and I expect to be an Apple user to the day I die, benefiting from the company’s legendary ability to make complicated technological interactions simple.

Nevertheless, I’m bearish on Apple (AAPL) stock today and here’s why.
There’s a dirty word to describe what happens when a company’s growth slows, and when the perception of the company’s future becomes just slightly tarnished. As that word spreads, and as those perceptions spread, the stock slowly collapses, as the supply of stock (potential sellers) overwhelms demand (potential buyers).


The Dirty Word
The word is deceleration, which is a fancy phrase for slowing down. And Apple is decelerating! That third quarter earnings growth of 23% followed second quarter earnings growth of 20%. Those were the slowest quarters since mid-2009! And looking forward, the projected 12% growth in 2013 is even slower, though 18% for 2014 provides hope.

Now, 12% growth is nothing to sneeze at; many companies would kill for 12% growth. And 18% is excellent! But it’s quite a comedown from the nine consecutive quarters from 2010 into 2012 where Apple’s earnings grew more than 50%! It’s deceleration.

And that brings us to the stock’s performance, which is where the rubber meets the road. Because more important than numbers, more important than sentiment, is the stock’s actual performance. So here’s Apple’s chart, since the 2009 bottom.

As on Coke’s chart, you see the earnings line, trending higher, but rounding somewhat recently; that’s the deceleration of earnings. There’s no dividend line on this chart; Apple’s dividend history is short but healthy. But there is another line on this chart and that’s the RP line. RP stands for Relative Performance; it depicts the performance of the stock relative to the broad market.

Note that over the past four years, whenever AAPL corrected, its RP line basically flattened out (ignoring the tiny weekly movements). But in this year’s correction, AAPL’s RP line turned down, and for eight weeks, AAPL performed worse than the overall market.

Now, this underperformance alone is not the kiss of death. Many stocks can pull out of similar corrections and move out to new highs.

But look back at Coke’s chart. If you look at the RP line, you’ll see the same pattern! From 1964 through 1973, KO was pretty healthy, beating the broad market overall, and holding its own in corrections. But after 1973, as sentiment turned, and the selling pressures slowly overwhelmed buying pressures, KO’s RP turned clearly negative, beginning a pattern that lasted many years longer than most investors could stomach.

And that’s very likely where AAPL is today.
So when you put it all together…
• The extremely high market cap
• The extremely positive public opinion
•The extremely high level of institutional ownership
• The deceleration of earnings growth
• The weakening relative performance line
…it looks ominous.

Now, big, well-respected stocks don’t collapse overnight. To the contrary; when a high-quality stock like Apple pulls back, you’ll hear a new chorus of “It’s a great value down here” and “Buy the dips.” But as time goes by, and the stock fails to return to its old highs, those choruses fade, and the stock falls slowly out of the limelight—just like Coca-Cola did in the 1970s.

Stepping back to look at the big picture, it’s worth remembering that investing is not a science. Uncertainty is a given.

But to be a successful investor, you need to put the odds in your favor, and today, the odds are not good for investors in Apple.  See more  http://www.timothylutts.com/

ALAS, NEVER CEASE TO DO YOUR OWN THINKING.

You might have sold out of a uniquely profitable company as AAPL went on to triple over the next five years!~

 

Whining about Chipotle

This makes an interesting psychological study.  Who holds the stock and how they react.   ($CMG last at $278, down 14.5%)  Many conversations below show no interest in discussing the valuation of CMG, but just the price (and if the price is declining, the pitiful management).

Also, note the focus on P/E ratio for valuation.   What about the flaws in using P/Es as a valuation metric?   No discussion about the business, cash flows or discount rate.

CMG will probably trade north of 6 million shares today or about 20% of the 28.5 million outstanding shares.  Where are the long-term shareholders?  One in five investors will sell based on one quarterly report.

If you have done your homework on valuation, then unreflective sellers who are throwing in the towel may mean an attractive price over the next few weeks.

I don’t know much about Chipotle, but management should be able to right the ship OVER TIME–the next 24 months–not next quarter. I don’t own any CMG currently.

Time to pile on (rats falling from the ceiling!):   https://www.bloomberg.com/news/articles/2017-10-25/ackman-s-lost-a-lot-of-queso-on-his-stake-in-chipotle

An interesting article on the struggle within the turnaround efforts.

“Every chain restaurant, he says, goes through this rite of passage. For every success like Starbucks, there are former high-flyers like Baja Fresh and Boston Market that no longer have cultural currency and are slowly fading.
Moran (Chipotle founder) remains confident that Chipotle will not end up an afterthought dotting the strip malls of America, but he preaches patience. “Will we climb out of it and get back to our former greatness? I absolutely believe we will,” he told me in June. “But will that take a year or two or three or four? I don’t know. The full recovery from this is going to take a long time.” https://www.fastcompany.com/3064068/chipotle-eats-itself

  • AlabamaHobo

    Why does a burrito company trades for 70 PE.

    Lots of room all the way down to 15 PE. 

    DowPete

    DowPete    yesterday
    Ackman has been unusually quiet about his position in Shipotle. For someone who is forever whining, the silence is golden. Glad he’s underwater in $CMG.

    Mad

    Mad

    13 hours ago

    200$ may not be that impossible tomorrow or later.

    CowboyFan

    CowboyFan

    13 hours ago

    Overvalued stock , for a burrito company.
  • CowboyFan

    CowboyFan

    14 hours ago

    What a POS! Seriously , this is a $40 stock
  • BB
    BB

    16 hours ago

    Why does almost every retail restaurant or fast food chain trade at 15-25xs earnings and Chipotle get to trade at >60xs? Its still way overpriced, should be $100/share or less. Concept is easily duplicatable and has been many times now. Theres plenty of fast food burrito places out there now..

    Tenley

    Tenley

    10 hours ago

    I want a refund on my burrito. It taste weird…
  •  DaveR
    DaveR

    20 hours ago

    Even a lemonade stand could beat the latest benchmark for CMG earnings. If they miss this bunny forget about it.
  • Jh

    Jh

    14 hours ago

    Fair market value $50
  • joe

    joe

    16 hours ago

    Hundreds of high school students chow down at these restaurants every day. Me too
  • liberal

    liberal

    1 hour ago

    I’m loving this fall, hope it goes on through the day and we see 270s today. Make some mulla on those put options from yesterday
  • CT

    CT

    4 hours ago

    The battle line is drawn at $295 ps. Buyers must buy at this previously held level – otherwise, it is abandoned and a new lower strength level is found. But holding this level will be difficult as it represents a triple bottom.

    My bet is that the shares go lower. Once the dam at $295 is broken, the selling will accelerate and we may end up the day at -20%.

  • Jerome R

    Jerome R

    23 hours ago

    20% short interest on a 25 mill float, see you at $400 after ER
  • Jerome R
    Jerome R

    23 hours ago

    20% short interest on a 25 mill float, see you at $400 after ER
  • S.P.
    S.P.

    17 hours ago

    Owning this stock is like having CMG’s molten cheese poured on
  • george

    george

    20 hours ago

    Bloodbath coming after hours. The bombs start decimating your portfolio at 4:30 PM. Get your shovel out to dig your own grave. Just jump in, we’ll kick some dirt on top of you.
  • Mocula

    Mocula

    13 hours ago

    What was the total compensation for the CEO this year? The small amount of money I lost on this stock, means nothing to the officers. As long as they car drive a fancy car or pay a lot for a douchebag haircut, they will just continue to make excuses and take as much as they can.
  • Robert
    Robert

    15 hours ago

    Jerome, Hope you didn’t get killed too bad. This stock is a pig. Over priced. Should see $250 in a week. Cannot beat same stores off a week quarter to comp. McDonald’s had stores close in Houston and Florida. Face it. Bad food, overpriced, competition. The shorts won’t cover until $275.00.
  • WIZARD1973

    WIZARD1973

    16 hours ago

    I can’t believe they think remodeling the restaurants and raising prices are going to bring people back. I hope they have a better plan than that!’
    • Bay Area

      8 hours ago

      This burrito seller is still trading at insanely high PE. Fools find 300 cheap because they are comparing with the peak of 2015. That was a pure scam by Kramer type people. Giving the mess and slumped earnings, risky low margin business, very specific narrow menu, this stock should be trading at no more than PE =10
    • Ahh Haa

      Ahh Haa

      19 hours ago

      About to be Bill Ackholed.
    • Andre

      Andre

      12 hours ago

      I’m hoping this dips sub $290ish for a quick trade. The most brutal selloff periods are in the first hour of trading. Don’t fall in love with a position whether long or short. Volatility in any stock makes it great to spot a trend and make a great trade.
    • kevin

      kevin

      39 minutes ago

      Spoiled foods. Empty stores. Flopping queso. Run and sell!!!

Bulls Rampage

Increasing debt for equity swap

Sentiment bullish and prices high relative to the past.

A Review: The Bre-X Scandal

The Peak
It was touted by media and banks as the “richest gold deposit ever”
In December 1996, Lehman Brothers Inc. strongly recommended a buy on “the gold discovery of the century.”

Bre-X’s salted samples were never checked by a third party, people wanted to believe so they never questioned the rising price of the stock. Do not ignore the warning signs.

Patience is paying off in http://csinvesting.org/2017/05/12/a-tontine/

Weekend Reading; A Practicing Stoic

WEEKEND READING

Winner take all economy: Winner Take All 13D Article

A STOIC in Action or Practicing Stoicism

Hedge Fund Analyst Quiz–NG $3 The New Normal

Your boss runs into your office and slaps this report onto your desk: Don‘t Bet Against Innovation_Sub-$3 Is the New Normal

After reading the report and using your knowledge of how capital cycles work, what would you say to your boss about using the information in that report for investing?  IF you wanted to make an outstanding investment, then how might the report help you?   The video below might give you a hint.  Remember that the JP Morgan report goes to thousands of portfolio managers and analysts, so how can YOU use the information to have an edge? Or can you? Comments needed in order to keep your hedge fnd job.

Good luck!

 

Work on the YOU: Free Course on Stoic Training

Article announcing Stoic Mindfulness and Resilience Training (SMRT) 2017 with details of live webinar sessions, etc.

 

Enrolment is now open for the Stoic Mindfulness and Resilience Training (SMRT) 2017 online course.  This is a free eLearning course, which Donald Robertson has been running once or twice each year for Modern Stoicism since 2014.  You can access the preliminary area now and the four weeks of the course will officially begin on Sunday 16th July, when enrolment will close.  This year over 500 people enrolled within the first 48 hours after it was announced on social media.  Around 650 people are now enrolled and we anticipate that will have increased to nearly 1,000 by the course start date.

Sign up here: http://learn.donaldrobertson.name/p/stoic-mindfulness-resilience-training-smrt/

In the first year, over 500 people took part in SMRT and data was collected from participants, using the Stoic Attitudes and Behaviours Scale (SABS) and a battery of validated outcome measures of the kind used in research on CBT and positive psychology.  You can download a PDF of our report here showing the findings in detail: SMRT_Report_2014

The writings of Seneca! http://tim.blog/2017/07/06/tao-of-seneca/

CSInvesting: Though this philosophy takes active practice, you might find developing the ability to control your thoughts and reactions to what you encounter in daily life helpful–especially in dealing with Mr. Market. Below is a schema of Stoicism (Click on diagram, then enlarge through your browser to read text).


Learning from Grants:http://grantpub.libsyn.com/episode-1-grants-interest-rate-observer

Why “smart” people do dumb things.   Rational thought. https://www.scientificamerican.com/article/rational-and-irrational-thought-the-thinking-that-iq-tests-miss/

No Price Discovery Then No Markets; A Reader’s Question

Has the meteoric rise of passive investing generated the “greatest bubble ever”?
The better we understand the baked-in biases of algorithmic investing, the closer we can come to answers.

 

The following article was originally published in “What I Learned This Week” on June 15, 2017. To learn more about 13D’s investment research, visit website.     https://latest.13d.com/tagged/wiltw

In an article for Bloomberg View last week titled “Why It’s Smart to Worry About ETFs”, Noah Smith wrote the following prescient truth: “No one knows the basic laws that govern asset markets, so there’s a tendency to use new technologies until they fail, then start over.” As we explored in WILTW June 1, 2017, algorithmic accountability has become a rising concern among technologists as we stand at the precipice of the machine-learning age. For more than a decade, blind faith in the impartiality of math has suppressed proper accounting for the inevitable biases and vulnerabilities baked into the algorithms that dominate the Digital Age. In no sector could this faith prove more costly than finance.

The rise of passive investing has been well-reported, yet the statistics remain staggering. According to Bloomberg, Vanguard saw net inflows of $2 billion per day during the first quarter of this year. According to The Wall Street Journal, quantitative hedge funds are now responsible for 27% of all U.S. stock trades by investors, up from 14% in 2013. Based on a recent Bernstein Research prediction, 50% of all assets under management in the U.S. will be passively managed by early 2018.

In these pages, we have time and again expressed concern about the potential distortions passive investing is creating. Today, evidence is everywhere in the U.S. economy — record low volatility despite a news cycle defined by turbulence; a stock market controlled by extreme top-heaviness; and many no-growth companies seeing ever-increasing valuation divergences. As always, the key questions are when will passive strategies backfire, what will prove the trigger, and how can we mitigate the damage to our portfolios? The better we understand the baked-in biases of algorithmic investing, the closer we can come to answers.

Over the last year, few have sounded the passive alarm as loudly as Steven Bregman, co-founder of investment advisor Horizon Kinetics. He believes record ETF inflows have generated “the greatest bubble ever” — “a massive systemic risk to which everyone who believes they are well-diversified in the conventional sense are now exposed.”

Bregman explained his rationale in a speech at a Grant’s conference in October:
“In the past two years, the most outstanding mutual fund and holding- company managers of the past couple of decades, each with different styles, with limited overlap in their portfolios, collectively and simultaneously underperformed the S&P 500…There is no precedent for this. It’s never happened before. It is important to understand why. Is it really because they invested poorly? In other words, were they the anomaly for underperforming — and is it reasonable to believe that they all lost their touch at the same time, they all got stupid together? Or was it the S&P 500 that was the anomaly for outperforming? One part of the answer we know… If active managers behave in a dysfunctional manner, it will eventually be reflected in underperformance relative to their benchmark, and they can be dismissed. If the passive investors behave dysfunctionally, by definition this cannot be reflected in underperformance, since the indices are the benchmark.”

At the heart of passive “dysfunction” are two key algorithmic biases: the marginalization of price discovery and the herd effect. Because shares are not bought individually, ETFs neglect company-by-company due diligence. This is not a problem when active managers can serve as a counterbalance. However, the more capital that floods into ETFs, the less power active managers possess to force algorithmic realignments. In fact, active managers are incentivized to join the herd—they underperform if they challenge ETF movements based on price discovery. This allows the herd to crowd assets and escalate their power without accountability to fundamentals.

With Exxon as his example, Bregman puts the crisis of price discovery in a real- world context:

“Aside from being 25% of the iShares U.S. Energy ETF, 22% of the Vanguard Energy ETF, and so forth, Exxon is simultaneously a Dividend Growth stock and a Deep Value stock. It is in the USA Quality Factor ETF and in the Weak Dollar U.S. Equity ETF. Get this: It’s both a Momentum Tilt stock and a Low Volatility stock. It sounds like a vaudeville act…Say in 2013, on a bench in a train station, you came upon a page torn from an ExxonMobil financial statement that a time traveler from 2016 had inadvertently left behind. There it is before you: detailed, factual knowledge of Exxon’s results three years into the future. You’d know everything except, like a morality fable, the stock price: oil prices down 50%, revenue down 46%, earnings down 75%, the dividend-payout ratio almost 3x earnings. If you shorted, you would have lost money…There is no factor in the algorithm for valuation. No analyst at the ETF organizer—or at the Pension Fund that might be investing—is concerned about it; it’s not in the job description. There is, really, no price discovery. And if there’s no price discovery, is there really a market?”

 

We see a similar dynamic at play with quants. Competitive advantage comes from finding data points and correlations that give an edge. However, incomplete or esoteric data can mislead algorithms. So the pool of valuable insights is self-limiting. Meaning, the more money quants manage, the more the same inputs and formulas are utilized, crowding certain assets. This dynamic is what caused the “quant meltdown” of 2007. Since, quants have become more sophisticated as they integrate machine learning, yet the risk of overusing algorithmic strategies remains.

Writing about the bubble-threat quants pose, Wolf Street’s Wolf Richter pinpoints the herd problem:

“It seems algos are programmed with a bias to buy. Individual stocks have risen to ludicrous levels that leave rational humans scratching their heads. But since everything always goes up, and even small dips are big buying opportunities for these algos, machine learning teaches algos precisely that, and it becomes a self-propagating machine, until something trips a limit somewhere.”

As Richter suggests, there’s a flip side to the self-propagating coin. If algorithms have a bias to buy, they can also have a bias to sell. As we explored in WILTW February 11, 2016, we are concerned about how passive strategies will react to a severe market shock. If a key sector failure, a geopolitical crisis, or even an unknown, “black box” bias pulls an algorithmic risk trigger, will the herd run all at once? With such a concentrated market, an increasing amount of assets in weak hands have the power to create a devastating “sell” cascade—a risk tech giant stocks demonstrated over the past week.

With leverage on the rise, the potential for a “sell” cascade appears particularly threatening. Quant algorithms are designed to read market tranquility as a buy-sign for risky assets—another bias of concern. Currently, this is pushing leverage higher. As reported by The Financial Times, Morgan Stanley calculates that equity exposure of risk parity funds is now at its highest level since its records began in 1999.

This risk is compounded by the ETF transparency-problem. Because assets are bundled, it may take dangerously long to identify a toxic asset. And once toxicity is identified, the average investor may not be able to differentiate between healthy and infected ETFs. (A similar problem exacerbated market volatility during the subprime mortgage crisis a decade ago.) As Noah Smith writes, this could create a liquidity crisis: “Liquidity in the ETF market might suddenly dry up, as everyone tries to figure out which ETFs have lots of junk and which ones don’t.”

J.P. Morgan estimated this week that passive and quantitative investors now account for 60% of equity assets, which compares to less than 30% a decade ago. Moreover, they estimate that only 10% of trading volumes now originate from fundamental discretionary traders. This unprecedented rate of change no doubt opens the door to unaccountability, miscalculation and in turn, unforeseen consequence. We will continue to track developments closely as we try and pinpoint tipping points and safe havens. As we’ve discussed time and again with algorithms, advancement and transparency are most-often opposing forces. If we don’t pry open the passive black box, we will miss the biases hidden within. And given the power passive strategies have rapidly accrued, perpetuating blind faith could prove devastating.

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A Reader’s question that I post below so the many intelligent folks that read this can chip in their thoughts….

The part that confuses me the most is this:

From what I gather, Greenblatt typically calculates his measurement of normal EBITDA – MCX. He then puts a conservative multiple on this, typically 8 or 10 times EBITDA-MCX. He says higher quality companies may deserve 12x or more. He often says something like “this is a 10% cash return that is growing at 6% a year. A growing income is worth much more than a flat income”. He seems to do this on page 309-310 of the notes you sent me  complete-notes-on-special-sit-class-joel-greenblatt_2.

My question is: Greenblatt’s calculation of earnings (EBITDA – MCX) only includes the maintenance portion of capital expenditure. The actual cash flow may be lower because of growth capex. Yet he is assuming a 6% growing income. It seems strange to me that he calculates the steady-state income (no growth capex. Only Maintenance capex), but he assumes that the income will grow. It seems like he is assuming the income will grow 6% but doesn’t incude the growth capex in his earnings calculation. Is it logical to assume that the steady-state earnings will grow, but not deducting the cost of the growth capex from the earnings? 

Answer/reply?………….